Applying Post-Production Costs when sale was at the mouth of the well

Oil and Gas Leasing Help
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After reading lots of articles, blogs, and posts - a big question came to mind. If a Lessee is deducting post-production costs from your royalty, and based on the following facts being true (or thought to be true):

- Lessee sells gas at the mouth of the well (not further down the pipeline, so it was sold before any treatment, transportation, or other cost could reasonably be considered "post production")

- Lessee sells to an affiliate they own or control

- Lessee has not disclosed actual sales price, but it is likely below market value in the area

- Gas produced is dry gas with very little impurities and /or treatment necessary to place it into pipeline

If the following were true, why even bother with post-production costs? The lessee claims the point of sale is at the mouth of the well, where are the post-production costs incurred by them? Why play games with all the math when they could (reasonably) sell it at the mouth of the well - which would have to be less than market price (due to the purchaser having to incur expenses to transport, and possibly treat / compress the gas), and just give straightforward numbers to all of the persons involved? I am making a big assumption that if the Lessee sold the product at the well, in an arms length transaction, you could arrive at a reasonable market value by this method.

Obviously in my example above, the Lessee owns the well, the affiliate who is "purchasing" the gas at the well, and the pipelines that carry the gas away, where it is eventually sold in an arms length transaction - their reasoning behind the way they do it is simple - profit.

They are essentially selling gas below market value, to a company they own, through pipelines they own, and charging the royalty interest owners for all of their business expenses in getting the gas to market (from the affiliate companies) - when those costs should have already been accounted for by the below market sales price at the mouth of the well. How far from reality am I in thinking this way??

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They do not sell it at the mouth of the well. The price for royalty is computed at the mouth of the well. Big difference.

Buddy

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Kitchen,

I truly hope that what I am about to tell you is not too upsetting, so at the end I will give you some good news to make up for it a little bit.

Buddy is right, that the value of the gas is applied at the mouth of the well, as owned by the well owner (called a "producer") to the company buying the gas (called a "purchaser"). Valued "as is" essentially, as soon as it is severed from the earth. The point of sale is NOT at the wellhead, it is at the "point of sale" which can be at entry into a pipeline or processing plant, or whatever point of sale specified in the marketing contract between the producer and the purchaser.

But for natural gas, dry or wet, up to six distinctly different types of costs can be incurred to get that gas from the mouth of the well to the "point of sale" (known as post-production costs): marketing (MKT), treating (TRT), compression (COMP), gathering (GATH), dehydration (DEH), and fuel cost (FUEL). Your royalty share of the gas becomes your personal property when it reaches the mouth of the well. It's your responsibility to pay your share of the costs to get it from the mouth of the well to the point of sale, which generates the money to pay you. Sort of like winning a prize, but you have to pay for the shipping and handling to get it sent to you.

This issue is why many landowners today are only signing leases that contain what is called a "cost-free royalty" clause. It is an added sentence or two in the royalty clause in the lease that says the Lessor's royalty is to be free and clear of all costs incurred beyond the mouth of the well, that those costs are to be borne entirely by the Lessee.

Now for the good news: even if your current lease does not contain a clause like that, there's a chance that you can get it added if at any time in the future the company comes back to you asking for any kind of permission related to the land under lease. You can tell them that you won't give the permission they are asking for (whatever it is) unless they also amend the lease to add a "cost-free royalty" clause. Horizontal drilling causes a whole lot of reasons why the company may need to come back to you to get some kind of permission from you to allow them to drill the well. Royalty owners with older leases are using this strategy every day to get a better deal on the amount of royalty they see in every revenue check.

P.S. Wet gas is actually more valuable than dry gas right now, because the "wet" means it contains liquids that are priced pretty much as high as oil per barrel. You would be receiving much higher royalty checks if you were producing wet gas instead of dry gas. Just thought I'd let you know.

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I appreciate all the responses so far. I was under the impression (from reading several articles) that CHK was selling to their affiliate CEMI directly at the mouth of the well, and then the gas was transported through pipelines owned by another affiliate which I cannot remember the name. I believe the case in point was in Pennsylvania. If they are reporting the "actual sales price" to be the transaction between CHK and CEMI, which changed hands exactly at the mouth of the well, then how could post production costs be added back to the the sale (which is already below market value of an arms length sale) when there was no chance for post production costs to incur to CHK since it was sold exactly where it came out of the well?

In the case that I am mistaken, then take this topic and my question - and just call it a "hypothetical situation" not necessarily to be true in reality. Either way, I just want someone to verify if I am on the right track. Thanks!

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CHK has paid a much lower rate but have no post-production expense...so it all comes out the same... you get something less than the royalty you thought you were getting...

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If people knew how much they were really likely to keep from the production of their minerals many would be less eager to lease and some would negotiate much harder than they have done.

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http://www.gpo.gov/fdsys/pkg/USCOURTS-txnd-3_12-cv-01596/pdf/USCOURTS-txnd-3_12-cv-01596-0.pdf

Gas was sold at the mouth of the well, but because the royalty language was so vague, they still lost. That is my take on it anyways. This is a Texas case.

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