French v. Occidental Permian Ltd. (440 S.W.3d 1, 2014)

Chief Justice HECHT

delivered the opinion of the Court.

One method of enhanced oil recovery is to inject carbon dioxide (C02) into a reservoir to sweep the oil to the production wells. The C02 returns to the surface entrained in casinghead gas produced with the oil. In this case, royalty owners contend that the royalty due on the casing-head gas under the parties’ agreements must be determined as if the injected C02 were not present, and that they are not required to share with the working interest the expense of removing the C02 from the gas. We disagree and therefore affirm the judgment of the court of appeals.

I

A

Petitioners, collectively “French”, own the royalty interests under two oil and gas leases in the Cogdell Field, one from the owners of the Fuller Rough Creek Ranch in Scurry and Kent Counties in 1948, and the other from the owners of the Cogdell Ranch in Kent County in 1949. Respondent Occidental Permian Ltd. (“Oxy”) owns the working interest.

The Fuller Lease calls for a royalty “on gas, including casinghead gas or other gaseous substance produced from said land and sold or used off the premises or in the manufacture of gasoline or other product therefrom” equal to “the market value at the well of one-eighth (l/8th) of the gas so sold or used”. The Cogdell Lease calls for a royalty of “1/4 of the net proceeds from the sale” of “gasoline or other products manufactured and sold” from casinghead gas “after deducting [the] cost of manufacturing the same.” Both provisions were standard forms in common use at the time.

Generally speaking, a royalty is “free of the expenses of production [but] subject to postproduction costs, including ... treatment costs to render [production] marketable”, but “the parties may modify this general rule by agreement.” Under the Fuller Lease, the royalty oh casinghead gas is based on its market value at-the well — “what a willing buyer under no compulsion to buy will pay to a willing seller under no compulsion to sell.” Since gas is a commodify, its market value at the well does not depend on the individual producer’s costs of bringing the gas to the surface. As a result, the royalty owner does not share in the costs of production. But postproduction processing that makes the gas marketable enhances its value after it leaves the well. The market price of the processed gas reflects the value of the unprocessed gas at the well only if reasonable postproduction processing costs are deducted. In effect, for gas sold only after processing, the royalty owner shares in those costs, which may vary depending on the quality of the gas coming from the ground. Under the Cogdell Lease, the royalty on casinghead gas products is based on the proceeds from their sale, which, again, are unaffected by production expenses, and expressly net of manufacturing — ie., postproduction — costs. Thus, under both leases, the casinghead gas royalty is net of postproduction expenses but not production expenses. Postproduction, as the word itself implies, ordinarily means after production in time, but in this case, the royalty owners contend that the production process does not end at the wellhead. The dispute is over whether certain expenses are properly considered to be production costs or postproduction costs.

In 1954, not long after primary production had begun from the Canyon Reef formation, the leases were pooled to form the Cogdell Canyon Reef Unit (“CCRU”). The purpose, as stated in the Unitization Agreement among the working interest owners and royalty owners, was “to effect secondary recovery operations or pressure maintenance for oil and gas from the Canyon Reef ... to increase the ultimate recovery of oil therefrom”. In the Agreement, the royalty owners consented to the injection of extraneous substances into the oil reservoir and gave the working interest complete discretion in determining whether and how to conduct the operations:

Royalties owners hereby grant unto the working interest owners, at the working interest owners’ sole discretion, ... the right to inject gas, extraneous gas, water, air or other substances, or any combination of two or more of them, in whatever amounts the working interest owners may deem expedient, into the unit area....

* * *

The working interest owners shall have full discretion in determining if gas, extraneous gas, air, water or other substances, or any combination of two or more of them, should be injected into the unit area in connection with secondary recovery and pressure maintenance operations. In any event the working interest owners shall be the sole judges of the kind of secondary recovery and pressure maintenance operations which shall be conducted in the unit area....

The Agreement defined “gas” as “natural gas (including casinghead gas) and all of its constituent elements produced from wells on lands and leases in the Cogdell Field producing from the Canyon Reef underlying the unit area.” Thus, the working interest owners were given discretion to reinject casinghead gas into the field as part of the operations. The parties agreed that no royalty would be paid on such gas:

All unitized substances ... used in connection with the operation or development of the unit area [or] in injection operations in the unit area ... shall be deducted before the royalties, overriding royalties and other payments out of production payable to royalty owners hereunder are determined, calculated or paid; and no royalty, overriding royalty or other payment out of production shall be due or payable to any royalty owner hereunder on any unitized substances so ... used.... “Unitized substances” were defined to include “all oil, gas, ... or any other substance produced and saved from the Canyon Reef underlying the unit area.”

Finally, the Agreement assigned the cost of the operation to the working interest except to the extent it was already to be borne by the royalty interests:

No part of the costs and expenses incurred in the development and operation of the unit area, including secondary recovery and pressure maintenance costs, shall be charged to any royalty owner unless such royalty owner is already obligated to pay such costs or expenses by the terms of other agreements. Such costs and expenses shall be borne by the working interest owners ....

The parties’ only other agreements were the leases. Thus, the costs of secondary recovery were not to be charged to the royalty owners except as permitted by the leases — that is, in determining the market value of the gas at the well under the Fuller Lease and the cost of manufacturing casinghead gas products under the Gogdell Lease.

B

The secondary recovery operation in the CCRU involved injecting water into the reservoir to increase and maintain pressure lost through primary production and to sweep oil toward producing wells. The operation has proved very successful. The CCRU has produced more than 270 million barrels of oil and billions of cubic feet of casinghead gas, together valued at more than $1.15 billion, with about half the oil remaining in the reservoir. Waterflooding continues, but by the late 1990s, it had become less effective. Oil production had declined from some 30,000 barrels ,per day at the peak to about 1,500 barrels per day.

Since the CCRU was formed, several methods of enhanced oil recovery have been developed, sometimes referred to as tertiary because they typically follow secondary recovery. One is by injecting C02 into the reservoir. This increases pressure in the reservoir, just as water injection does. But more importantly, C02 is miscible with water and, under high pressure and temperature, with oil. In solution with oil and water, C02 can act to reduce oil's viscosity and reduce surface tension, thus easing separation of oil from water in the formation, and improving movement of oil through the formation to the production wellbores. C02 flooding requires enormous volumes of C02, and supplies are limited and expensive. Special well equipment must also be used to withstand the corrosive properties of C02. And the effectiveness of C02 flooding is not assured; it depends on the nature of the oil in the ground and the formations in the reservoir. C02 flooding is more expensive and riskier than waterflooding.

Oxy began a C02 flood in the CCRU in 2001, and it, too, has proved very successful. The roughly 106 active wells in the unit produce about 5,800 barrels of oil daily. Without the C02 flood, oil production would have declined to 200 barrels per day and would no longer have been economically viable, and more than half the oil in the reservoir would have been lost forever.

The wells also produce daily about 140,-000 barrels of water, and casinghead gas containing about 110 million cubic feet of C02. Separating the oil from the water is relatively simple. The mixture is placed in large storage tanks, where the oil floats on the heavier water and is simply skimmed off. Emulsifiers are added to assist the process. The water is then reinjected into the field. The royalty owners have never been charged any part of the expense of this process. The working interest owners have treated the separation of water from oil for reinjection into the field as part of production.

The C02 produced with the casinghead gas is also reinjected into the field, along with additional purchased C02. More than 10 million cubic feet of casinghead gas per day is simply transported in pipelines from the production wells back to the injection wells and pumped back into the reservoir. As noted above, the Unitization Agreement provides that no royalty is due on such gas, and none is paid. All the casinghead gas could be reinjected the same way, and Oxy considered this possibility in designing the C02 flood operation, but the cas-inghead gas is only about 85% C02, and ideally, the injection stream should be more highly concentrated. Also, the hydrocarbon content of the casinghead gas stream not only includes methane (CH4) but is rich in natural gas liquids (NGLs)— ethane (C2H6), propane (C3H8), butane (C4 H10), pentane(C5H12), and natural gasoline (heavier molecules) — which can be extracted and sold. To increase the concentration of C02 in the reinjected stream, and to realize the value of the NGLs entrained in the casinghead gas, Oxy elected to process the gas to remove the C02 and extract the NGLs.

Before the C02 flood, the casinghead gas produced from the field was less than 2% C02 and was processed at the Fuller Gasoline Plant to remove other contaminants like hydrogen sulfide (H2S) and nitrogen (N2), and to extract NGLs, which were then sold along with the residual gas. The processing was undisputedly a postproduction expense shared by the royalty owners and the working interest. French received royalties based on the value of the NGLs and residual gas net of the processing costs.

But the Fuller plant, like most ordinary gasoline plants, could not process gas that is 85% C02. Oxy considered constructing a field refrigeration unit to extract some of the NGLs but ultimately decided to opt for full processing of the casinghead gas. Oxy contracted with Kinder Morgan to build a plant that could process C02-laden gas, an investment of millions of dollars. Using Cynara membrane technology, the Kinder Morgan plant removes at least 90% of the C02 and most of the H2S for reinjection, and also extracts some of the NGLs, about two-thirds of the total produced from the gas stream. Kinder IVfbrgan contracts in turn with Torch Energy Marketing to further process the gas at its Snyder Gasoline Plant. There, the rest of the C02 and H2S are removed for reinjection, and the rest of the NGLs are extracted. For its services, Kinder Morgan deceives from Oxy a monthly fee of 33