Exploring the Origins of Royalty Disputes

Abstract:     
Today the most common area of dispute among oil and gas developers and their landowner or mineral owner lessors is the calculation of royalty. This article examines the various instruments encountered in the oil and gas industry that create a royalty obligation: the oil and gas lease that creates the landowner or mineral owner's "royalty," conveyances out of the mineral interest of a "nonparticipating royalty," and assignments out of the oil and gas lease of an "overriding royalty." The jurisprudential foundations for royalty disputes are examined by studying the "royalty value theorem" and the phenomenon of "linear enhancement of production value." The impact of regulatory change is examined in an effort to explain the recent flurry of gas royalty litigation. An appendix to the article provides "A Concise History of Federal Natural Gas Regulation."

A systematic approach to royalty calculation is provided by first identifying the substance at issue (e.g., oil, gas, condensate, distillate, natural gasoline, casinghead gas). Next, the lease or other relevant document is examined to determine the basic royalty measure being employed (e.g., share of the production, market value, market price, proceeds, amount realized, etc.). The next critical step is identifying the specific location where the royalty must be determined. This provides, in many states, the line of demarcation between production costs and post-extraction costs and investments that must be accounted for to determine the royalty value at a designated location.

Other contracts potentially impacting the calculation of royalty are also surveyed, to include: pooling agreements, unit agreements, operating agreements, gas balancing agreements, sales agreements, gathering and transportation agreements, treatment agreements, processing agreements, marketing agreements, and division orders.

The jurisprudence of royalty calculation is examined by studying judicial applications of the implied covenant to market that result in a modification of the express terms of the oil and gas lease to achieve a royalty calculation more favorable to the lessor. This is contrasted with courts that leave the parties to the terms of their contract by refusing to allow implied terms to negate the express terms of the oil and gas lease.

Number of Pages in PDF File: 40

Keywords: calculation of royalty, contract, cost netting, deduction of costs, gas, implied covenant, implied covenant to market, lessee, lessor, natural gas regulation, net-back, oil, oil and gas lease, overriding royalty, royalty, royalty calculation, royalty deed, work-back

Accepted Paper Series