Energy Company Barred from Deducting Certain Costs when Calculating Royalties

August 23, 2007 | Roger McEowen

A federal court has ruled that Devon Energy Corporation, a natural gas producer, cannot deduct certain costs when it calculates the amount of royalties it owes to the government under its leases to extract coalbed methane gas (gas that is trapped in underground coal seams and held in place by hydraulic pressure) on federal land.  The gas is extracted by lifting the pressure on the coal bed which causes the methane gas to escape.  The gas is captured and gathered to a central delivery point (CDP), removed of any excess carbon dioxide, and dehydrated and pressurized to render it suitable for transport.  Once that process is complete, coalbed methane becomes marketable for use. 

At issue were coalbed methane leases on federal land in the Powder River Basin of Wyoming, an area rich in natural gas.  The government leases its rights to extract the gas in exchange for a statutorily fixed percentage of the proceeds.  The Mineral Leasing Act (30 U.S.C. §226(b)(1)(a)) requires the producer to pay the government a royalty at a rate that is not less than 12.5% in amount or value of the production removed or sold from the lease.  Under the statutory provision, “value of production” is defined as no less than gross proceeds accruing to the lessee for lease production, minus certain allowable deductions.  In 1988, the Department of the Interior (DOI) issued a regulation specifying that the “value of production” had to be no less than “the gross proceeds accruing to the lessee for lease production,” minus certain allowable deductions (such as dehydration and compression costs).  However, the courts have historically interpreted the statutory provision as obligating lessees to put the gas they extract into marketable condition at no cost to the federal government, thereby precluding deduction of any costs. 

In the mid-1990s, the U.S. Department of Interior considered how the so-called “marketable condition rule” should be interpreted with regard to compression and dehydration costs, but the parties disagreed as to the meaning of the DOI’s Royalty Policy Board published guidance on the matter.  Devon’s position was that they should be allowed to deduct the post-CDP dehydration and compression costs from the royalty calculation, but the DOI asserted that the Board’s conclusions were ambiguous and that the Board did not have the authority to issue a binding interpretation of the marketable condition rule on the DOI’s behalf.  Devon claimed that the Board’s guidance merely constituted a new application of the marketable condition rule (taking into account technological advances of coalbed methane extraction) that was binding on the DOI.  The DOI disagreed, noting that the guidance was inconsistent with numerous agency policy statements and interpretations as well as caselaw concerning the marketable condition rule, and that the DOI had never affirmatively adopted the guidance.  The court agreed with the DOI, holding that the guidance was only a policy statement that was not binding on the DOI.  Devon Energy Corp. v. Norton, No. 04-CV-0821(GK), 2007 U.S. Dist. LEXIS 61709 (D.D.C. Aug. 23, 2007).