In a typical oil and gas lease, lessees are granted the right to extract and sell oil and gas derived from state lands; in return, lessees pay the state a royalty.
Oil and gas leases may specify payment of royalty upon a number of different measures, including net proceeds, gross proceeds and market value.
In New Mexico, the language of the state oil and gas leases are prescribed by statute.
Over the years, the Legislature has enacted several versions of the statutory oil and gas lease, and the plaintiff companies have entered into hundreds of oil and gas leases with the State.
Specifically, the New Mexico Legislature enacted statutory oil and gas leases in 1919, 1925, 1927, 1929, 1931, 1945, 1947 and 1984.
The case at issue concerns the royalty clauses contained in the 1931 and the 1947 statutory lease forms.
Both the 1931 and 1947 leases specify that the payment of royalty is to be calculated as a percentage of the "net proceeds" resulting from the sale of gas. By definition, "net proceeds" constitutes "the sum remaining from gross proceeds of sale minus payment of expenses."
In 2005 and 2006, the state's Commissioner of Public Lands -- who is authorized to execute and issue leases in the name of the State -- audited plaintiffs ConocoPhillips Company and Burlington Resources Oil and Gas Company's royalty payments.
Following the audit, the commissioner notified the lessees that they had been underpaying their royalty obligations and issued them assessments for the underpayment.
In particular, the commissioner claimed that pursuant to the terms of the statutory lease forms the oil companies could not deduct the post-production costs necessary to prepare the gas for the commercial market when calculating their royalty payments. He claimed the improper deductions resulted in ConocoPhillips underpaying royalties by about $18.9 million and Burlington underpaying by about $5.6 million.
In response, the companies filed a complaint in a district court seeking a declaration that the commissioner's assessment of additional royalty constituted a deprivation of due process, an unconstitutional impairment of contract, and breach of contract.
In addition, they claimed that the commissioner had exceeded his constitutional and statutory powers by issuing the assessments and had effectively usurped legislative power by seeking royalty payments under calculation methods not approved by the Legislature.
In response, the commissioner alleged a host of counterclaims for breach of contract, breach of the implied covenant of good faith and fair dealing, and breach of the implied covenant to market.
He sought a declaratory judgment, an accounting, an injunction, and the cancellation of leases.
The lessees sought, and the district court granted, summary judgment.
The commissioner appealed to the state Court of Appeals, which certified the appeal to the state's high court.
Chief Justice Petra Jimenez Maes, who authored the Court's 21-page ruling, said the lower court's reliance on "extrinsic evidence" was proper and it was correct in determining that the net proceeds language of the two lease forms was unambiguous as a matter of law.
The Court also affirmed the district court's findings holding that field and plant fuel are post-production costs that the companies remit to post-production service providers for the development and production of the leased premises.
"They are neither sold nor saved by lessees and therefore are not subject to royalty payments," Maes wrote.
The Court also upheld the lower court's finding that the companies are only obligated to pay royalties on the use of drip condensate -- the portion of a gas stream that becomes liquid during the transmission of the gas from the leased premises to a processing plant -- to the extent that they receive proceeds from such use.
"Lessees' use of drip condensate amounts to a post-production cost that is remitted to post-production service providers," Maes explained.
"Construing the leases so as to give effect to every provision, we conclude that the royalty obligations contained in the 1931 and 1947 lease forms are limited by their respective free use clauses and do not require royalties to be paid on lessees' use of drip condensate to the extent that lessees do not derive proceeds from such use."
The Court also sided with the district court in finding that deductions used in calculating the companies' royalty obligations must be reasonable.
It noted that there is nothing in the 1931 or 1947 statutory lease forms to indicate that the Legislature intended to treat affiliated and non-affiliated transactions differently when deducting post-production costs.
"The district court found that based on the statutory and regulatory history, the New Mexico Legislature and the Commissioner of Public Lands intended both affiliated and nonaffiliated transactions to be treated the same. Therefore, lessees were permitted to deduct reasonable costs incurred for post-production services," Maes wrote.
"We agree with the district court's finding that there was no support for defendant's contention that deductions for affiliated transactions must be limited to actual costs."
In addition, the Court affirmed the district court's dismissal of the commissioner's counterclaim for the breach of the implied covenant to market, saying it does not need to reach the issue in this case.
"When the Legislature adopted the statutory oil and gas leases that we have referenced in this opinion, the Legislature expressed the policy decision that lessees under such leases are entitled to recover some post-production costs associated with making the gas marketable. How much and what kinds of post-production costs remain at issue in this case," Maes wrote.
"However, because of this legislative policy decision we do not need to decide whether the marketable condition rule is inherent in the implied covenant to market. As we indicated in Davis, whether the marketable condition rule applies in New Mexico is not yet ripe for review."
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