A Salty Chapter in the Ongoing Saga of Post-Production Costs (and a Bonus Discussion of Subsurface Cavern Ownership)

AUTHOR(s)

Salt Mine

 

In Myers-Woodward, LLC v. Underground Servs. Markham, LLC,[1] the Corpus Christi – Edinburg Court of Appeals once again turned its attention to the Sisyphean task of interpreting post-production cost provisions.  Myers-Woodward (“Myers”) owned the surface estate, along with a 1/8th nonparticipating royalty interest in salt production on 160 acres of land in Matagorda County, Texas. Underground Services Markham, LLC and United Brine Pipeline Company, LLC (referred to in the court’s opinion as the “Company” or “Companies”) owned the mineral estate, including the executive rights, underlying the same 160 acres.

Various disagreements arose between Myers and the Companies concerning (i) the deduction of post-production costs from its salt royalty and (ii) who could lay claim to the caverns under the property, which were created by the Companies’ salt mining operations. Although this case concerns salt brine production, it highlights common concerns in the oil and gas industry relating to post-production cost calculations.  It also has some interesting implications regarding the ownership of pore space and underground hydrocarbon storage.

Citing established caselaw,[2] the court noted that the general rule for determining royalty calculations is that oil and gas royalty interests are free of production expenses but are usually subject to post-production costs, which include processing, compression, transportation and other costs incurred in moving the oil or gas downstream.[3]  Additionally, these costs are usually calculated at the well or wellhead, before the products have been “altered for sale.”[4]  The exception to this general rule is that royalties may be calculated at some agreed-upon point of sale downstream.[5]

Myers contends that its royalty payments should have been calculated using the “amount realized” approach, which would have provided for “an enhanced value of the salt production at a downstream location.”[6]  The Court of Appeals disagreed with Myers’ argument, noting the amount realized approach is one of the exceptions to the general rule. If the parties wanted to calculate royalties using the amount realized approach, they should have included specific language to that effect in the lease.[7] The court notes such terms might require, for example, striking any wellhead reference in the lease and including a provision that expressly requires royalty payment to be based on the price lessee received at a downstream point of sale.

Perhaps more compelling is the parties’ disagreement over subsurface cavern ownership.  Myers, as the surface owner, asserted that it owns all the physical land, which includes not only the surface, but the “subsurface, the matrix of the underlying earth, and the reservoir storage space beneath the surface.”[8]  The Company argued that it owns a fee simple interest in the minerals, without limitation per the vesting deed, and thus owns the ancillary right to use the caverns created by its salt mining operations.[9]

The court ruled against the Company on this issue, holding that Myers owns the subsurface of the property, including the caverns at issue.[10]  Texas law provides that surface ownership includes the subsurface geological structures.  Thus, it is the surface owner, not the mineral owner, that “owns all non-mineral ‘molecules’ of the land, i.e., the mass that undergirds the surface estate,” and the conveyance of mineral rights does not convey the entirety of the subsurface.  Although the surface owner retains ownership and control of the subsurface materials, a mineral lessee owns a property interest—a determinable fee—in the oil and gas in place in the subsurface materials.[11]

In the instant case, the Company merely owns the mineral estate, which includes ownership of the salt found in the subsurface materials.  Per the court, although the mineral owner may have a real property interest in the minerals in place, it does not “own” any specific minerals while they are still in the ground.  Rather, “[t]he mineral owner is entitled, not to the molecules actually residing below the surface, but to ‘a fair chance to recover the oil and gas in or under his land, or their equivalents in kind.’”[12] The mineral estate owner is entitled to extract the minerals, lease to a producer the right to extract the minerals, receive royalty payments for minerals that are extracted, receive delay rentals, and receive any other compensation for the minerals.  There is no case law that supports a conclusion that a mineral estate owner who does not own the surface estate owns the subsurface of the property and may then use the subsurface for its own monetary gain even after extracting all the minerals.[13]

 The court finally ruled that the Company may not use the property for any other use besides “mining, drilling, and operating for salt, and the maintenance of facilities and means necessary or convenient for producing, treating, and transporting salt . . .”  The Company is therefore disallowed from using the subsurface caverns to store hydrocarbons.[14]

In conclusion, the discussion of post-production royalty calculation remains at the forefront of operator and royalty owner minds alike. The general rule for calculating royalties will be applied unless there is specific contract language in the lease or other agreement that provides otherwise.

Of possible greater import in this case are the holdings regarding ownership and use of the subsurface caverns created by the Company’s salt mining operations.  Although Texas has not adopted a pore space use and ownership statute,[15] these underground ownership and storage rights are increasing in value in the era of carbon sequestration or carbon capture and storage (CCS).  The holding in Myers-Woodward, LLC highlights the Texas trend toward adopting the so-called “American Rule.” The American Rule states that the mineral estate does not include ownership of the geological formation or “matrix of earth” underlying the surface.[16]  The American Rule still allows the mineral estate owner the right to use the pore space until the minerals are depleted.  Although the surface owner has the sole right to lease underground pore space, he generally cannot do so until mineral extraction has been exhausted.  The holding in this case would appear to extend the American Rule concept to not only pore space, but underground caverns created in the wake of salt mining operations.  In other words, the court declined to distinguish between naturally existing pore space and caverns that were artificially created by virtue of the Company’s efforts.[17]

A petition for review was filed on January 20, 2023, and is pending before the Texas Supreme Court as of the date of this article.  The Supreme Court has been asked to resolve a split of authority between this case and the 1991 case of Mapco, Inc. v. Carter.[18] In Mapco, the Ninth District Court of Appeals held that the owner of a fee interest in salt retains a property interest in the subsurface caverns created by mining activities.  The question posed to the Supreme Court is whether the right to us such caverns is owned by the mineral whose salt-extraction and development activities created the caverns or the surface owner.  It is noteworthy that in Myers-Woodward the Thirteenth District Court of Appeals expressly declined to follow Mapco, stating that the Mapco court did not cite to any actual authority for its holding that “under well-recognized, decisional law, the continued ownership interest in the mineral estate in an underground storage facility is acknowledged and harmonious with the decisional law of our state.”[19]

Underground salt domes are commonly found throughout the Gulf Coast of Texas and western Louisiana.  As noted above, salt extraction creates caverns within these domes that are valuable for storing oil, gas, or for CCS activities.  It remains to be seen whether the Supreme Court will weigh in on this split in authority.

 

[1] 2022 Tex. App. LEXIS 4082 (Tex. App.—Corpus Christi-Edinburg 2022, pet. filed).

[2] See, e.g., Burlington Res. Oil & Gas Co. LP v. Tex. Crude Energy, LLC, 573 S.W.3d 198, 203 (Tex. 2019).

[3] 2022 Tex. App. LEXIS 4082 at 11.

[4] Id. at 12.

[5] Id. at 13.

[6] Id. at 17.

[7] Id. at 15.

[8] Id. at 25. Per Myers, “the grant of the mineral estate in the [deed] expressly granted ‘the right of ingress and egress and possession at all times for the purpose of mining, drilling and operating for said minerals and the maintenance of facilities and means necessary or convenient for producing, treating and transporting such minerals.’ Those are the sole purposes for which the Grantee or its successors could use the Myers Land. There is nothing—not a sentence, phrase or word in the [deed] which could be interpreted as granting the [Company] the right to use the Myers Land for storage.”

[9] Id. In the trial court, the Company argued that: “The cavern that will result from [the Company’s] mining operations will be created entirely out of the salt formation that [the Company] owns. Unlike naturally existing pore space, [the Company] must maintain the artificially created cavern in order for it to be utilized for storage purposes.”

[10] Id. at 27-28.

[11] Id. at 29.

[12] Here, the court makes a curious assertion that would appear to contradict the fundamental Texas mineral law concept of “absolute ownership” or “ownership in place.” These statements seem more aligned with the “non-ownership” theories more commonly found in states like Oklahoma and Louisiana.

[13] Id.

[14] Id. at 30.

[15] Like Montana, North Dakota, Oklahoma, and Wyoming.

[16] Contrast this with the “English Rule” that allocates pore space ownership to the mineral owner.

[17] Note that, as always, courts will primarily look to the deeds, leases, and other agreements between the parties to discern their rights.

[18] 808 S.W.2d 262, 274 (Tex. App.—Beaumont 1991, rev’d in part on other grounds, 817 S.W.2d 686 (Tex. 1991) (per curiam).

[19] Id.at 278.

 

Brad represents clients in connection with upstream energy transactions, complex mineral titles, pooling issues, lease analysis, joint operating agreements, surface use issues, title curative and general oil and gas business matters.

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