North Dakota Issues Important Royalty Decision

Representing a significant victory for oil and gas producers, on July 9 the North Dakota Supreme Court issued a unanimous decision in Bice v. Petro-Hunt, LLC¹, upholding the deduction of post-production costs based on "at the well" royalty clause language in the oil and gas leases at issue. In reaching this holding, the Court acknowledged it was adopting the “majority rule” followed by Texas, Louisiana, Mississippi, New Mexico, Montana, California and Kentucky, while expressly rejecting the first marketable product doctrine followed by Colorado, Kansas, Oklahoma, Arkansas and West Virginia.

In Bice, over 300 royalty owners in the Little Knife Field brought a class action suit against Petro-Hunt, LLC alleging that because the casinghead gas at issue was not marketable at the well, Petro-Hunt was not entitled to deduct post-production costs incurred to render the casinghead gas marketable.  The oil wells of the Little Knife Field, located in the southern portion of the Williston Basin, produce a significant quantity of casinghead gas – an emulsified mixture of gas, liquid hydrocarbons, water and other contaminants.  Upon production, Petro-Hunt gathers the casinghead gas to the Little Knife Gas Plant, where the water, hydrogen sulfide and other contaminants are extracted.  The residue gas and liquid hydrocarbons are then separated and sold at the plant tailgate.

The leases at issue in Bice each contain a royalty clause which requires the payment of royalties based upon the “market value at the well.”  To establish the market value at the well of the casinghead gas, Petro-Hunt used a "work-back" method and deducted all of the costs incurred at the Little Knife Gas Plant from the sales proceeds received at the tailgate of the plant, and then calculated royalties on this value. 

Relying principally on Rogers v. Westerman Farm Co.², and similar case law from Kansas and Oklahoma, as well as federal regulations governing the calculation of royalties on federal and Indian gas, the royalty owners asked the Court to adopt the so-called “first marketable product doctrine,” which would impose upon the lessee all post-production costs necessary to put the casinghead gas into a marketable condition and transport it to the point of sale.  Instead, the Court interpreted the plain meaning of the language “market value at the well” to mean that royalty is calculated based on the value of the gas at the wellhead.  Accordingly, the Court expressly rejected the first marketable product doctrine and upheld the deduction of post-production costs stating “any costs incurred by the lessee after the [gas] reaches the wellhead, whether to improve the quality of the [gas] or to transport it to a market where it may be sold may be deducted before the royalty is calculated.” 

In rejecting the first marketable product doctrine, the Court criticized this doctrine as unworkable on the basis that the minority jurisdictions which have adopted it have failed to articulate a clear standard for determining at what point a marketable product has been created.

The Bice decision represents a significant victory for oil and gas producers and serves as a direct challenge to the analysis of Rogers v. Westerman Farm Co.  In Rogers, the Colorado Supreme Court held that “at the well” lease language is silent as to the allocation of costs between the lessor and lessee.  Based upon the implied covenant to market and the first marketable product doctrine, as interpreted by the court in Rogers, the lessee must bear all post-production costs necessary to make the gas marketable.  By contrast, in Bice the North Dakota Supreme Court held that “at the well” lease language is not ambiguous or silent, but by its plain meaning, establishes the wellhead as the point of valuation and thereby entitles the lessee to deduct all post-production costs prior to calculating royalty. 

1. 2009 WL 1974745 (N.D. 2009); subject to a petition for rehearing
2. 29 P.3d 887 (Colo. 2001)