Ivo Lindauer; Sidney Lindauer; Ruth Lindauer; and Diamond Minerals, LLC, on behalf of themselves and all others similarly situated, Plaintiffs-Appellees,
Williams Production RMT Company, n/k/a WPX Energy Rocky Mountain, LLC, Defendant-Appellant.
Garfield County District Court No. 06CV317 Honorable Denise K. Lynch, Judge.
Dufford, Waldeck, Milburn & Krohn, LLP, Nathan A. Keever, Grand Junction, Colorado, for Plaintiffs-Appellees.
Holland & Hart LLP, John F. Shepherd, Christopher A. Chrisman, Denver, Colorado, for Defendant-Appellant.
¶ 1 This case raises two undecided questions of Colorado law regarding the payment of royalties to lessors of oil and gas leases. First, must costs incurred to transport natural gas to markets beyond the first commercial market "enhance" the value of that gas, such that actual royalty revenues increase, in order to be deductible from royalty payments? Second, if the enhancement test applies to such transportation costs, must the enhancement, and the reasonableness of the costs, be shown on a month by month basis? We answer the first question "no" and therefore do not reach the second question.
¶ 2 Defendant, Williams Production RMT Company n/k/a WPX Energy Rocky Mountain, LLC (WPX), appeals the district court's entry of judgment after a bench trial in favor of plaintiffs, Ivo Lindauer, Sydney Lindauer, Ruth Lindauer, Diamond Minerals, LLC, and all those similarly situated. We reverse and remand with directions to enter judgment in favor of WPX.
¶ 3 Plaintiffs (the lessors) own royalty interests under oil and gas leases for wells operated by WPX (the lessee) in northwest Colorado. They brought this class action in 2006 challenging WPX's calculation and payment of royalties.
¶ 4 The parties reached a partial settlement agreement in 2008 that resolved all but two reserved claims. Only the second claim is before us in this appeal, namely, plaintiffs' assertion that WPX improperly deducted transportation costs incurred beyond the first commercial market when calculating royalties on natural gas in certain months from July 2000 to July 2008.
¶ 5 The facts underlying this claim are largely undisputed. The natural gas on the lands subject to plaintiffs' leases was produced in an area known as the Piceance Basin. WPX incurred costs to transport the natural gas from the wellhead to the point of sale. These included costs for compressing the gas, gathering it through small pipelines, and processing it at a plant. Once processed, the gas reached the "tailgate" of the processing plant and entered a large mainline pipeline. The costs of processing and transporting the gas up to the point it reached the tailgate are not deducted from royalties paid to plaintiffs.
¶ 6 Although there is a commercial market for gas at or near the tailgate in the Piceance Basin, WPX has sold some of the produced gas in "downstream" markets where higher prices are sometimes available. The gas sold downstream must be transported to the point of sale. WPX entered into long-term contracts with pipeline companies to reserve capacity on the mainline pipelines to transport the gas from the tailgate to the downstream markets.
¶ 7 The downstream transportation charges involve two components. First, there is a "demand charge, " which is a charge paid by WPX to reserve space on the mainline pipelines. The demand charge is paid by WPX whether or not it uses the pipeline to ship gas, but according to WPX's procedures, demand charges are deducted from plaintiffs' royalties only in months where gas is shipped. The second component is a "commodity charge, " which is paid by WPX per unit volume actually shipped on the pipeline. WPX deducts these commodity charges from the revenues before paying royalties to plaintiffs.
¶ 8 It is undisputed in this appeal that plaintiffs' leases are silent regarding the allocation of transportation costs. Accordingly, the parties agree that the framework set forth in Garman v. Conoco, Inc., 886 P.2d 652, 661 (Colo. 1994), and Rogers v. Westerman Farm Co., 29 P.3d 887, 903 (Colo. 2001), governs this issue. The parties also agree that the tailgate of the processing plant is the first commercial market for the gas and that transportation costs incurred before that point are not deductible from royalty payments under that framework. At issue in this case are the costs incurred to transport the gas to downstream markets beyond the first commercial market.
¶ 9 Relying on both Garman and Rogers, plaintiffs contend that costs incurred to transport gas downstream are deductible only if WPX can show that (1) the costs are reasonable and (2) actual royalty revenues increase in proportion with the costs assessed against the royalties ("enhancement"). Plaintiffs do not contest the reasonableness of the amounts of the transportation costs (the first element), but they dispute whether actual royalty revenues increased in proportion to those costs (the second element).
¶ 10 Specifically, plaintiffs argue that WPX must show enhancement on a month by month basis by comparing the downstream prices at the point of sale to the price of gas in the Piceance Basin. They argue that transportation costs are not deductible during any given month in which the additional transportation costs exceed any increase in royalty revenue achieved from selling the gas downstream.
¶ 11 WPX contends that the enhancement test does not apply to costs incurred to transport the gas to downstream markets. Alternatively, WPX argues that, even if the enhancement test applies, it must be determined based on the "prudent operator rule" rather than a month by month price comparison. According to WPX, the court should consider the overall reasonableness of WPX's decisions to enter into long-term transportation contracts, as well as the long-term benefits to royalty owners such as plaintiffs as a result of WPX's downstream marketing strategy.
¶ 12 The district court issued two written orders before trial resolving these legal issues in favor of plaintiffs. The court agreed with plaintiffs that the enhancement test applied to the costs of transporting the gas beyond the first commercial market. It interpreted Garman and Rogers to require that all costs incurred after the gas becomes marketable meet the enhancement test in order to be deducted from royalty payments. Accordingly, the court ruled that WPX bore the burden of proving that its transportation costs were reasonable and resulted in an actual increase in royalty revenues.
¶ 13 In its second order, the district court required that WPX apply the enhancement test on a month by month basis to determine whether its transportation costs were deductible. The court relied heavily on section 34-60-118.5(2)(a), (2.3)(h), (2.5), C.R.S. 2015, which requires lessees to pay royalties and report deductions on a monthly basis and provide a written explanation of those deductions upon request. The court rejected WPX's contention that the enhancement test should be evaluated based on the prudent operator rule.
¶ 14 The court then held a bench trial to determine the only remaining issue - the price of gas at the first commercial market against which the downstream sales price would be compared. At the bench trial, WPX presented evidence that its downstream marketing strategy allowed it to substantially increase the volume of production from plaintiffs' wells during the eight-year period at issue. WPX also maintained that, in many months, the increase in royalty revenue resulting from higher downstream prices exceeded the deduction for transportation costs, so that the overall revenues for the eight-year period as a whole were approximately $6, 000, 000 higher than if the gas had been sold at the tailgate market.
¶ 15 At the close of evidence, the district court, applying the enhancement rule, concluded that WPX did not establish enhancement in thirty-five months during the eight-year period, made factual findings on the price differentials in those months, and ordered a post-trial accounting. Based on that accounting, the court entered judgment against WPX for $5, 136, 296.95.
¶ 16 Neither party appeals the court's findings regarding the prices of gas, or ...