Disputes over the proper payment of royalty, including whether post-production costs are properly deductible from those payments, is hardly a new issue for many oil companies. Those operating in the State of New Mexico, however, are faced with a potentially new challenge. Despite the usual practice of deducting expenses for transporting, compressing, dehydrating, treating and processing the produced oil and gas, the State Land Office of New Mexico is determined to redefine this practice and require Operators to bear these costs alone.

As operators know, a royalty interest is defined as a “share of production free of the costs of production.” Deceptively simple sounding, this contractual arrangement found in Oil and Gas Leases between Lessors and Lessees returns a portion of the produced oil and gas to the Lessor in exchange for Lessee receiving a right to ingress, egress, exploration and development. Most Lessors do not choose to take their share ‘in kind’, preferring, instead, a share of the proceeds received from the sale of oil or gas. However, costs are incurred between the point of production and the point of sale, including transportation, processing, dehydration, storage and marketing. Who is responsible for paying these ‘post-production costs’ continues to be litigated in many states. A majority of states follow the rule that, unless specified differently in the Lease, all post-production costs are to be shared proportionately by the working interest owners and the royalty owners. New Mexico, recently, appears to have deviated from this trend.

In 2007, ConocoPhillips and Burlington Resources sued the New Mexico State Land Office, rejecting an assessment of sixteen million dollars ($16,000,000.00) of royalties submitted to them. The New Mexico State Land Office alleged the royalties were owed to them because ConocoPhillips and Burlington Resources calculated royalty payments incorrectly. ConocoPhillips and Burlington were successful in their suit, but the Land Commissioner appealed the decision, and the issue is now before the New Mexico Supreme Court.

While the ConocoPhillips and Burlington Resources case is still pending before the New Mexico Supreme Court, the New Mexico State Land Office has not been content to wait on the ruling. It filed suit on March 22, 2011, against Exxon Mobil, Corp., Heyco Energy Group, Inc., Devon Energy Corp,. Marathon Oil Corp., Occidental Petroleum Corp., The Williams Cos., Yates Petroleum Corp. and Chevron Corp., asserting breach of contract.

At issue is the language in the 1947 statutory lease form, which provides that royalty is to be paid on “net proceeds” from the sale of oil and gas produced “in the field”. The Land Office claims that “in the field” means at the point where oil and gas is “marketed or utilized”, and must be within the boundaries of the land leased. In essence, any post-production costs that are outside of the boundaries of the leased lands would—from New Mexico’s perspective—be the responsibility of the operator. What’s more, the Land Office is asking for not only compensatory damages, but punitive damages as well. If the Courts accept the Land Office’s calculation, and agrees that the Operators calculated royalty fraudulently, an enormous judgment equaling tens of millions of dollars could be handed down.

A favorable judgment for the Land Office will also open up future suits against even the independent operators. If this becomes the practice for operations on state lands, independent oil companies will find their costs jump exponentially. In a down market such as ours, this could be a dangerous maneuver, possibly costing jobs and further reducing oil and gas production. As if New Mexico was not already a complicated place to produce oil and gas, the rulings could determine whether operators will have any interest in pursuing New Mexico production in the coming years.