By Sean T. McLaughlin

The overriding royalty interest (commonly known as “ORRI”) is prevalent in the oil and gas industry. A party who obtains an ORRI in a lease will receive a set percentage of the production that is obtained from the lease. The lease between the landowner and the lessee usually reserves an ORRI to the landowner as compensation for granting the lease, and the lease also specifically describes how that ORRI will be calculated.

Since the Outer Continental Shelf (“OCS”) off the coast of the United States is owned by the U.S. government, parties wishing to drill for oil and gas on the OCS are required to obtain those leasing rights from the U.S. government. Pursuant to federal regulation, the U.S. government, as lessor, receives a set royalty on all production that is obtained from an OCS lease.

Other parties besides the landowner can obtain ORRI’s. For instance, an investor may contribute funds towards the project in the hopes that the lease will be productive. Also, a geologist may perform surveys of a lease and receive an ORRI as compensation. Or, the lessee may wish to reduce its risk and capital outlay by sub-letting the drilling operation to another entity. In these instances, the ORRI is created by way of an agreement separate and apart from the lease between the landowner and the lessee. Oftentimes those ORRI agreements will state that the ORRI it grants “shall be calculated and paid in the same manner and subject to the same terms and conditions as the landowner’s royalty under the lease.” Ordinarily, that language makes calculating everyone’s (the landowner and any investors) ORRI a matter of simple mathematics.

However, if the lease is on the OCS, depending upon when the lease was issued, the Deep Water Royalty Relief Act (“DWRRA”) can reduce or limit the U.S. government’s royalty on the lease’s production. If a party obtains an ORRI in an OCS lease pursuant to an ORRI agreement that states that the ORRI is calculated in the “same manner and subject to the same terms and conditions as the landowner’s royalty,” does this mean that the party’s ORRI is also subject to the DWRRA?

In Total E&P USA, Inc. v. Kerr-McGee Oil & Gas Corp., 2010 WL 5207591 (E.D. La. Dec. 14, 2010), that was the issue before the Court. In that case, the U.S. government granted Total a lease covering a specified portion of the OCS. (1)  Total then granted Kerr-McGee an ORRI of 4% in the lease which stated that Kerr-McGee’s ORRI would be calculated “in the same manner and subject to the same terms and conditions as the landowners’ royalty under the lease.” (2)  Per the DWRRA, Total was not obligated to pay the U.S. government its ORRI on the lease’s first 87.5 million barrels of production (the lease’s “first production”).

Since the U.S. government (i.e., the “landowner”) was not entitled to receive an ORRI on the lease’s first production, Total argued that this limitation also applied to Kerr-McGee’s ORRI. Kerr-McGee disagreed, and cited other provisions of the Total/Kerr-McGee agreement as support for their contention that the ORRI it owned was not subject to suspension under the DWRAA.

The district court rejected Kerr-McGee’s arguments and found that Total was entitled to use the DWRAA to avoid paying Kerr-McGee an ORRI on the lease’s first production. Kerr-McGee has appealed the district court’s decision – which is not surprising since the value of the ORRI at issue was in excess of $230 million. Oral argument was heard on February 7, 2012, and a decision could be issued very soon.

Regardless of how the U.S. Fifth Circuit rules, this case illustrates that it is important for the recipients of ORRIs to carefully scrutinize the manner in which the agreement states that the ORRI will be calculated. Relying upon general assumption language like that used in the Total case can lead to unintended consequences – consequences that can greatly affect the monetary value of the ORRI.

(1) The lease was technically issued to Total’s predecessor-in-title.
(2) The ORRI was technically issued by Total’s predecessor-in-title to Kerr-McGee’s predecessor-in-title.