Oil and Gas Royalty Deductions and Underpayments

When landowners lease their mineral rights to an oil and gas company, they often eagerly await their first of what they hope will be many royalty payments. If the lease was not negotiated well, they did not read their lease, or the oil and gas company makes a mistake, landowners may be surprised to see royalty payments that are much smaller than they anticipated. More important, the landowner who believes their royalty payment is less than it should be due to underpayments or wrongfully-taken deductions has a limited amount of time in which to make a claim and recover the royalties they are owed. The statute of limitations in Oklahoma for these claims is five years.

At Graft & Walraven, we have the knowledge and experience to assist you in reviewing, negotiating, and understanding your lease and your royalty payments so you will be able to recognize when something is not right.

Do not risk losing the money you are entitled to under the law and the terms of your lease by trying to handle it on your own. Call our Clinton office at (580) 323-1516, our Weatherford office at (580) 772-7721, or our Oklahoma City office at (405) 253-6444 to book a consultation to review your lease and the payments you receive.

The Implied Duty to Market

The specific terms and conditions of a landowner’s lease will dictate the deductions that can be taken, but in general, most Oklahoma gas and oil leases contain what is called the “implied duty to market.” However, there is no clear definition of what makes the gas and oil “marketable.” The implied duty to market means that under Oklahoma law, the oil and gas company cannot deduct the costs of gathering, transporting, compressing, dehydrating, or blending from royalty payments if those costs are required to create a marketable product. As explained by the Oklahoma Bar Journal, the Oklahoma Supreme Court noted that to take oil, natural gas, or other minerals from the ground and have a marketable product, gathering, transporting, compressing, and other steps are almost always going to be required. Therefore, oil and gas companies technically cannot deduct those costs from a landowner’s royalty payments.

However, if the lease contains clauses that allow the lessee (the oil and gas company) to take those deductions from the royalty payments, Oklahoma law does not prevent that. This is why it is crucial that landowners consult with an oil and gas attorney to review the lease and ensure they understand all the terms of the lease. An attorney can also assist with explaining why a particular term or condition benefits the lessee more than the lessor (the landowner) and how they may negotiate to make the term or condition more beneficial to them.

Common Deductions

Before the royalty payment is finalized and sent to the landowner, they are often subject to certain deductions by the operating company. While these deductions are common, they are not necessarily unavoidable. With some negotiation and competition from multiple offers, landowners may be able to get a lease that does not include these standard deductions from their royalty payments.

However, even if they sign a lease that does not include these deductions, the lessee can still make an error when preparing royalty payments and deduct them anyway. That is why lessors must be aware of and fully understand the terms of their lease and must thoroughly examine each royalty payment to ensure its accuracy.

Some of the more common deductions that may come out of royalty payments include:

Operating Expenses: These are often the costs associated with managing the mineral rights, such as administrative costs.
Post-Production Costs: These are expenses incurred once the oil or gas has been extracted from the well, including transportation, gathering, compression, dehydration, and processing costs. These are the costs referred to in the implied duty to market.
Production Taxes: These are state-imposed taxes on the extraction of natural resources. Oklahoma levies severance, or gross production, taxes on oil, gas, and other natural products taken from land or water. These taxes vary depending on the amount of minerals extracted and the price of those minerals.
Depletion Allowance: As mineral reserves are extracted, their value decreases. This deduction accounts for this decrease.

Royalty Underpayments

Royalty underpayments occur when the landowner receives less than the full amount they are entitled to based on the lease agreement and any applicable regulations. Underpayments can occur due to the deduction issues. They can also occur as a result of:

Miscalculations: These can result from incorrect application of the royalty rate or errors in calculating gross or net revenue.

Incorrect Market Prices: The oil and gas company may calculate royalty payments using lower than current market prices.

Failure to Account for Revenue: This is when the oil and gas company does not account for all revenue generated from the sale of the oil and gas from the landowner’s property.

Improper Deductions: This occurs when the oil and gas company applies unjustified or excessive deductions from the gross revenue before calculating royalty payments.

Understated Production Volume: The oil and gas company may understate the actual volume of oil and gas extracted from the landowner’s property so they can pay reduced royalties.

Addressing These Concerns

Royalty deductions and underpayments can be complicated and confusing matters, especially when a landowner’s royalty payments seem to be lower than they should be, but the landowner is not certain. However, landowners may have several options available to them for confirming whether there is an issue and addressing that issue.

These options include:

Reviewing the Lease: A thorough understanding of the lease’s terms and conditions, especially regarding royalty rates, deductions, and payment schedules, will make it much easier to identify potential issues with royalty deductions and underpayments.

Tracking Production and Royalty Payments: Landowners should regularly review production reports provided by the operator and compare these reports against royalty statements and sales data to ensure all the numbers add up. When doing so, it is essential to remember that under Okla. Stat. § 52-570.1, bonus payments, delay rentals, and shut-in royalties are not considered royalty payments for purposes of calculating royalties.

Auditing the Company’s Books and Records: An attorney can help a landowner get an audit clause added to the lease, which allows the landowner to audit the operator’s books and records. Landowners can exercise this right to request an inspection or audit the books and records to verify their accuracy.
Consulting With Legal Counsel: If all else fails, or a landowner suspects improper deductions or underpayments but is not sure how to confirm it, they can consult with legal counsel. An oil and gas attorney can assist them with reviewing records, navigating the complexities of disputing royalties, and initiating legal action if it becomes necessary.

Your Advocates in Protecting Your Royalties

Whether it is an improper or impermissible deduction or an underpayment, even a single royalty payment that is not the full amount owed to a landowner can cost them substantially. At Graft & Walraven, we can assist in reviewing leases and other documentation to determine whether there is an issue, bringing the issue to the operator’s attention for correction, and if necessary, filing a lawsuit and representing landowners in court. Contact our Clinton office at (580) 323-1516, our Weatherford office at (580) 772-7721, or our Oklahoma City office at (405) 253-6444 to book a consultation and review your case.