The North Dakota Supreme Court has sided with the state in a ruling against Newfield Exploration Co., now part of Encana Corp., which it said had underpaid oil and gas royalties.

The state had appealed a previous decision by the Northwest District Court of McKenzie County, ND, which favored Newfield, in the case Newfield Exploration Co. et al, v. State of North Dakota et al, No. 2018-CV-00143.

Newfield had filed a lawsuit after the state’s Department of Trust Lands, which holds leases with multiple oil and gas operators, concluded in a 2016 audit that the producer had underpaid royalties to the agency and its affiliates. The state contended that Newfield contradicted its lease agreements and deducted post-production costs from the royalty payments. Post-production costs typically include payments to midstream operators to gather, transmit and process the produced gas.

Newfield said in its initial letter to the district court in February 2017 royalties should be based on gross proceeds received from an unaffiliated third-party purchaser, not on the gross amount paid to the unaffiliated third-party by a downstream purchaser. The state counterclaimed that gas royalty provisions under the Newfield leases did not allow expenses to be deducted from royalty payments for gas produced.

The agreement that Newfield submitted to the court with its original lawsuit was one in which it sold produced gas to Oneok Midstream LLC at a 20-30% discount for gathering and processing services. The difference in percentage constituted the different sales figures underpinning each party’s interpretation of the royalty agreement.

The state’s high court ultimately reversed the lower court decision, which means Newfield may not deduct the 20-30% in post-production costs from its royalty payments. The decision could have implications for operators across the state.

“It does mean a small drop in profitability since the oil companies will have to pick up all of the tab for post-production,” said North Dakota’s top oil and gas regulator Lynn Helms, director of the Oil and Gas Division. "Texas ruled that you can deduct post-production costs. It is going to make Bakken crude a little less competitive with the Permian Basin.”

Industry insiders responded with disappointment at the higher court’s decision.

“Requiring an oil company to pay royalties on the end price of their product is like taxing a farmer on the price of bread rather than the price of wheat,” said North Dakota Petroleum Council’s Ron Ness, president. “The court’s reversal adversely impacts all operators in North Dakota, especially at a time when we are faced with gas capture and flaring challenges.”