Reasonable fees OK to deduct from gas royalty payments

Jessica M. Karmasek Oct. 18, 2011, 3:40pm


JACKSON, Miss. (Legal Newsline) - The Mississippi Supreme Court ruled last week that an oil company can deduct reasonable processing and investment costs from payments to royalty owners.

However, the Court determined in its ruling, filed Thursday, that a lower court erred in failing to apply a section of Mississippi Code to calculate the damages owed to royalty owners for unreasonable deductions.

In the 1960s, Shell Oil Co. built the Thomasville Gas Plant in Mississippi, at a cost of $41 million, to process "sour" gas and turn it into marketable "sweet" gas and its by-product, marketable sulfur.

To recover the costs of operation and its investment, Shell developed and implemented an equation that contained two primary components. The first consisted of the actual capital investment combined with a return on that investment, and the second represented the cost per day of operating the plant.

Using this formula, Shell charged all royalty owners with a proportionate share of processing and investment costs by deducting a fee from the royalty owners' checks. In 1974, royalty owners challenged the use of the formula in Piney Woods Country Life School v. Shell Oil Co.

The district court found for Shell, and the plaintiffs appealed. On appeal, the U.S. Court of Appeals for the Fifth Circuit determined that the royalty owners could be taxed with costs of processing their gas as long as the fees were reasonable.

The Fifth Circuit remanded the case to the district court to address the reasonableness of Shell's costs. The district court found the costs to be reasonable, thus approving Shell's formula. At the time of the Piney Woods case, Shell had not recovered the full $41 million of its investment. Shell completed recovery of the $41 million capital investment in 1990.

In 1978, Pursue Energy Corp. commenced sour gas development activities in Thomasville. That same year, Pursue built its own gas processing plant at a cost of $53 million, which was recovered from its royalty owners.

By December 1995, Pursue had recovered the full amount of investment for its Thomasville plant, and in early 1996, Pursue purchased Shell's plant, the associated wells, reserves and related facilities for $28,130,000. As a result of the purchase, Pursue decided to use the Shell plant for all production and dismantled its own plant.

That same year, Pursue moved into the Shell plant and began using the Shell gas processing formula to deduct costs from the royalty owners. Although Pursue had paid only $28,130,000 for Shell's processing plant, associated wells, reserves and related facilities, Pursue continued to use the Shell $41 million capital investment as part of the formula for recovery of the cost of production.

In December 2000, James B. Sykes and 36 other plaintiffs filed a lawsuit in Simpson County Chancery Court, requesting that the court order an accounting of capital-investment charges withheld since Pursue had assumed ownership and determine whether the amount of capital investment was assessed correctly.

In December 2001, an amended complaint was filed, increasing the number of plaintiffs to 49.

In February 2002, the case proceeded to trial. However, because of a voluntary bankruptcy petition filing by Pursue, the chancery court case was stayed numerous times and the court was prevented from entering a final judgment.

It wasn't until June 2009 that the chancery court entered a final judgment on all issues.

It awarded the plaintiffs actual damages of $684,717.13, their pro rata share of $42,482,919.47, prejudgment interest on actual damages at 6 percent simple interest, attorneys' fees based on 40 percent of actual damages, litigation expenses and interest on all amounts from the date of judgment at 6 percent per annum.

On appeal, Pursue questioned, among other things, whether the chancery court erred in finding that the company was liable to the plaintiffs for unreasonable processing fees deducted from royalty payments on poisonous sour gas produced from wells operated by Pursue.

The state's high court said it agreed with the Fifth Circuit's analysis in Piney Woods.

The oil company, the Court said, can deduct reasonable processing and investment costs from the payments made to royalty owners.

But it is unreasonable for the plaintiffs to pay for their share of investment costs repetitively, it said.

However, the Court said the chancery court erred when it compounded the interest and made a distinction between prejudgment and post-judgment interest.

"The principles of judicial discretion on which the court relied do not apply to Section 53-3-39," Justice Leslie D. King wrote for the Court.

"Section 53-3-39 does not provide for an interest rate to be 'set by the judge.' The plain and unambiguous language of Section 53-3-39 provides that the 'rate of interest shall be 8 percent per annum' with no authorization for the interest to be computed on a compound instead of a simple-interest basis."

The Court affirmed the chancery court's final judgment as it relates to actual damages, attorneys' fees and litigation expenses.

However, it remanded the case for recalculation of damages.

From Legal Newsline: Reach Jessica Karmasek by email at

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