An Oklahoma district court judge last week affirmed a decision by the U.S. Department of Interior (DOI) that was challenged by a ConocoPhillips unit, determining the producer owed more royalties on natural gas sold from federally owned lands.

In an administrative appeal of DOI’s action against the producer, U.S. District Court Judge Claire V. Eagan of the Northern District of Oklahoma wrote that the Interior Board of Land Appeals (IBLA) reasoning had been sound in its case against Burlington Resources Oil & Gas Co LP (Burlington Resources Oil & Gas Co. LP v. U.S. Department of the Interior, No. 13-CV-0678-CVE-TLW).

Burlington, which operates multiple wells on federal leases in North Dakota, argued that it had properly interpreted and applied the marketable condition rule for its produced gas. It sold unprocessed gas at the wellhead under an arm’s length percentage of proceeds (POP) contract to Bear Paw Energy Inc., a predecessor company of Oneok Rockies Midstream LLC (ORM).

The midstream business processed the gas into residue and natural gas liquids (NGL), and paid Burlington a percentage of the sales proceeds.

Burlington said it had “valued the residue and NGLs, for royalty purposes, using the actual proceeds payable to it by ORM, reporting certain expenses as part of transportation and processing allowances,” which included treating and compression expenses that later were disallowed.

Audits by North Dakota regulators and Interior’s predecessor regulator the Minerals Management Service (MMS) determined that Burlington had “taken deductions from royalty that should be disallowed.”

Orders directed the producer to pay additional royalties and restructure its accounting. The regulators said Burlington had sold gas to processors under POP contracts and had failed to place the gas in marketable condition at no cost to the government.

Burlington appealed both orders. MMS successor, the Office of Natural Resources Revenue (ONRR), granted in part and denied in part Burlington’s appeals. ONRR affirmed that Burlington had improperly deducted some costs necessary to put the gas it sold to ORM into marketable condition by dehydrating, compressing and sweetening it. ONRR also found there was “no evidence of a competitive market.”

Burlington appealed to IBLA, which found that the operator had not provided “any evidence that the unprocessed gas would be acceptable to a typical third-party purchaser at the well, before it has been compressed, dehydrated, sweetened, and then processed” nor “any affirmative evidence in support of its assertion that the costs of performing those conditions were not necessary to place the gas in marketable condition.”

The IBLA determined that, since dehydration, compression and sweetening also were necessary to render the gas marketable, Burlington was responsible for those costs.

The appeals board said Burlington had not cited a “single case” rejecting Interior’s interpretation of the market condition rule, “relying instead on the language of the rule itself and the preamble to the regulation implementing the rule.”

Regarding the preamble to the regulation, MMS lawyers had said they believed “the definition [of marketable condition] is clear, concise and equitable.The definition is not subject to manipulation… Furthermore, the suggestion that a uniform standard be developed for what is ‘marketable’ is unrealistic because the gas marketplace is dynamic.

“The definition, as written, allows MMS the latitude to apply the concept of ‘marketable’ in a fair and correct manner, now and in future gas markets. Also, MMS adheres to its long-standing policy that costs incurred to place production in a marketable condition are to be borne solely by the lessee.”

The original court’s conclusion that the agreement “suggested that the gas was not marketable prior to being processed is sound; the processor bought the gas not for its own use, but to sell to another party after placing it in a condition — through processing — that the other party would be willing to purchase,” stated Eagan. “Whether gas is marketable depends on the requirements of the dominant end-users, and not those of intermediate processors.”