The Missing Link in Royalty Analysis: An Essay on Resolving Value-Based Royalty Disputes
8 Pages Posted: 3 Sep 2007
When a landowner or mineral owner enters into an oil and gas lease, their main form of compensation, in the event oil or gas is discovered, will be based on a percentage of the oil and gas produced from their leased land: a "royalty." Once oil and gas are produced, the commodity tends to increase in value as it moves away from the point of production, the "wellhead," towards its ultimate place of consumption, which may be hundreds of miles removed "downstream" from the wellhead. Costs will be incurred to move the oil and gas from the wellhead toward the point of consumption. Lessors will naturally seek a royalty based upon the increased values downstream of the wellhead. This raises two issues: (1) is the lessor entitled to any of the increased downstream value; and (2) if so, can the expenses associated with obtaining the increased downstream value be considered - deducted - to calculate the royalty due the lessor?
This article examines these issues by defining the point at which the oil and gas lease relationship ends regarding oil and gas that have been extracted from the leased land. This missing link analysis focuses on a fundamental issue courts must address to properly resolve lessor/lessee royalty value disputes: When does the lease relationship come to an end? Courts have not articulated an analysis for determining when in the life of the lease, the lease relationship, ends. At what point in the oil and gas development and production process are the lessor and lessee no longer contractually obligated to one another? When has the relationship run its course? Answers to these questions are offered in this essay.
Keywords: affiliate, calculation of royalty, cost netting, deduction of costs, gas, implied covenant to market, lessee, lessor, natural gas regulation, net-back, oil, oil and gas lease, overriding royalty, royalty, royalty calculation, royalty disputes, work-back
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