Oil & Gas and natural resources: “Deductible Costs” under a Deed of Grant of Overriding Royalty Interest
In Walter Oil & Gas UK LLP v Waldorf CNS (II) Limited [2024] EWHC 3183 (Comm), the Court gave a rare insight into the proper approach to construing the terms of an oil and gas royalty agreement. The Court was asked to determine what costs a producer was entitled to deduct from the proceeds of sale of petroleum before paying the holder its royalty interest share. Royalty agreements are widely used around the globe, in the oil and gas and mining industries. However, it is rare for these types of agreements to come before the courts. This judgment will be of interest to parties to such agreements, providing insight into potential areas of disagreement and how these might be resolved through clearer drafting.
Facts
The producers, Waldorf CNS (II) Limited (“Waldorf”) and EnQuest Heather Limited (“EnQuest[1]”), granted the holder of the royalty interest, Walter Oil & Gas UK LLP (“Walter”), a right to 3% of all petroleum produced from certain blocks in the North Sea (the “Royalty Interest Petroleum”) under a Deed of Grant of Overriding Royalty Interest dated 19 September 2005 (the “Deed”).[2] Amounts payable in respect of the Royalty Interest Petroleum represented Walter’s percentage interest of gross proceeds, less permitted deductions (the “Deductible Costs”). Known as a ‘net profit interest’ form of royalty agreement,[3] the meaning attributed to ‘deductible costs’ is of significant importance, with the producer/grantor wishing to pass on as many of its costs as can be agreed, and the holder of the interest favouring a narrower position.
Ultimately, only one block went into production (the “Block”). Petroleum from the Block was produced and transported to the UK mainland (where it was sold) in five stages, including via the Kittiwake Platform, the Kittiwake-Unity Pipeline and the Forties Pipeline System. EnQuest and/or its affiliate held an interest in the Kittiwake Platform and owned the Kittiwake-Unity Pipeline whereas Waldorf had no stake in any of the aforementioned infrastructure.
As is common in the oil and gas industry, the operation of the Block and the processes involved in producing, transporting and extracting petroleum were governed by a number of agreements. Waldorf and/or EnQuest entered into these agreements with owners of the relevant infrastructure, as well as entering into a Joint Operating Agreement between themselves, to govern production of petroleum from the Block.
As EnQuest held interests in some of the infrastructure, when entering into some of the agreements, it did so in more than one capacity (as is common in the industry): for example, under the transportation and processing agreement for the Kittiwake Platform, EnQuest and Dana Petroleum were the owners of the platform, EnQuest was the operator of the platform, EnQuest and Waldorf were shippers (being the parties purchasing the transportation, processing and operating services supplied by the platform owners) and EnQuest was also shippers operator. In respect of the costs of the relevant transportation, processing and operating services, this resulted in EnQuest invoicing itself: it issued the invoice as platform operator (on behalf of itself and Dana Petroleum) to itself as Shippers Operator (acting on behalf of itself and Waldorf as the Shippers). EnQuest then paid the invoice (as Shippers Operator) and Waldorf ultimately paid its share of the costs to EnQuest.
Waldorf and EnQuest were obligated to lift and separately dispose of, and were entitled to separately sell, their respective share of the total petroleum produced from the Block. Following the sale of the Royalty Interest Petroleum; Waldorf and EnQuest (as Grantors) were then each required to pay Walter its share of the respective proceeds, less the “Deductible Costs”, which was defined as follows:
“(a) all Tax which may be levied now or in the future in respect of the production of all Royalty Interest petroleum produced from the Blocks, the transportation of that Petroleum and the processing and initial storage of that Petroleum at any terminal, in each such case as such tax so levied arises prior to its delivery to any purchaser thereof;
and (b) the actual amounts, if any, as may be reasonably required to be paid by the Grantors, the Agent (acting in its capacity as such) and/or the Operator for the processing, transportation, dehydration, compression, recycling or any other similar cost or expenses incurred in making [Royalty Crude Oil, as defined in Clause 1] or [Royalty Gas, as defined in Clause 1] as the case may be ready or available for market or transporting same to the point of sale and which are charged to the Grantors, the Agent (acting in its capacity as such) or the Operator by third parties who are not Affiliates of such party for such services; and if such amounts have not been incurred in respect of [Royalty Crude Oil] or [Royalty Gas] specifically, such proportion as the quantity of [Royalty Crude Oil] or [Royalty Gas] bears to the total quantity in respect of which such amounts have been incurred”.
“Affiliate” was in turn defined as follows:
“in relation to a Party, a subsidiary or holding company of that Party and includes the ultimate holding company of that Party and any subsidiary of that holding company and for the purposes of this definition "holding company" and "subsidiary" shall have the meanings respectively given to them by section 736 of the Companies Act 1985, as amended by section 144 of the Companies Act 1989”
The parties disagreed as to whether certain categories of costs fell within the meaning of ‘Deductible Costs’ in the Deed. The main categories of costs were sums paid for production/transportation of the petroleum, send or pay charges (which were payable where the quantity of petroleum required to be delivered fell below the agreed minimum quantity) and Emissions Trading Scheme tariffs.
Decision
The judgment addressed the following issues:
Third party Issue
Walter contended that certain costs charged to Waldorf by EnQuest were not charged by ‘third parties who are not Affiliates of such party for such services”, thereby falling outside of the meaning of Deductible Costs. This was on the basis of Walter arguing that the costs were charged by EnQuest (as operator of the relevant infrastructure) to EnQuest (as operator of the Block) and were therefore not charged by a third party to EnQuest. Walter also sought to rely upon the fact that EnQuest and Waldorf were jointly and severally liable for the costs (such that, in theory, EnQuest could be required to pay Waldorf’s share even though, in practice, the sums in question were paid by Waldorf).
The Court did not agree with Walter’s characterisation of the relevant payments; first, the Court noted that it was “not helpful to try and reach some broad characterisation of the nature of Walter’s relationship with the Grantors … and then seek to interpret the Deed in the manner which best reflects the overarching characterisation”. Instead, having found that the Deed “contemplate[d] that the same legal persons may pay amounts which fall to be deducted in different capacities”, the Court considered that it was necessary to assess whether or not a particular transaction fell within the meaning of “Deductible Costs” by carrying out a “party-by-party analysis”. This involved looking at the amount paid by the relevant person, in their relevant capacity, and asking whether such amounts had been paid to third parties (such that they were Deductible Costs) or otherwise. Having carried out that exercise, the Court found that the relevant sums in question had been paid by Waldorf to EnQuest (who was not an affiliate of Waldorf). Such sums were, therefore, Deductible Costs.
The Court also determined that such conclusion was supported by considerations of commercial purpose and consequence. Here, the Court considered that Walter’s construction placed “far too much weight on the identity of the [infrastructure] operator from time-to-time”, which (if adopted) would have led to an uncommercial outcome.
The Send or Pay Issue
The second issue concerned whether ‘Send or Pay’ charges were costs of “processing, transportation, dehydration, compression, recycling or any other similar cost or expenses” incurred in making the petroleum ready for market or transporting it to the point of sale, and therefore “Deductible Costs”.
Send or pay charges, which are commonplace in such agreements, are effectively a minimum charge payable by the user of the infrastructure or service in exchange for the guaranteed reservation of capacity in the infrastructure and the guaranteed provision of the services by the owner of that infrastructure. Waldorf argued that the send or pay charges were an essential element of the overall commercial arrangement required to ensure that petroleum can be transported when required (and were therefore a “transportation” cost).
Although the Court considered the issue to be finely balanced, it ultimately decided that these charges were not “Deductible Costs” under the Deed. The Court acknowledged that this concept involved a “blunt and to some extent crude process of identifying what is paid “for” the identified matters” which was “suggestive of a direct link between the charge and the service received, rather than embracing all costs incurred in achieving a desired end.”
In considering this question, the Court was guided by Lord Hoffmann's hypothetical “domestic example” in Charter Reinsurance Co Ltd v Fagan,[4] which the Court put as follows: “if a husband brings home new trousers, and his wife asks “what did you pay for them?”, the answer would not naturally embrace not simply the price of the trousers but the petrol consumed driving to the shops to purchase them, and the costs of parking.” Drawing on this hypothetical scenario, the Court determined that such charges were not directly linked to the transportation of the Royalty Interest Petroleum (noting, instead, that they were incurred only to the extent the Royalty Interest Petroleum was not transported through the relevant infrastructure).
The ETS Issue
The Court was also required to consider whether tariffs under the Emissions Trading Scheme (“ETS”) were deductible as a “Tax” under the Deed, where “Tax” was defined as follows:
“without limitation tax, levy, royalty, rate, duty, fee or other charge imposed directly or indirectly in respect of the Royalty Interest and/or the Royalty Interest Petroleum and/or the Net Proceeds thereof, or the assets, income, dividends or profits of the Grantee (without regard to the manner of collection or assessment and whether by withholding or otherwise) by any governmental, semi-governmental or other body authorised by law to impose such Tax”,
Waldorf argued that the ETS tariffs were deductible as they were environmental taxes incurred in respect of the transportation of petroleum. Walter disagreed.
Whilst the Court considered that the ETS tariff was a ‘Tax’ (as defined in the Deed), the Court did not consider that it fell within limb (a) of “Deductible Costs”, on the basis that this limb required a more direct link to the production or treatment of the Royalty Interest Petroleum than a tax on the operation of third party infrastructure through which the petroleum is transported (i.e. the Court adopted the same position as it did with the send or pay charges).
However, the Court considered that ETS tariffs were sufficiently directly referable to the Royalty Interest Petroleum to fall within limb (b) of “Deductible Costs” on the basis that they constituted amounts paid for processing of the same.
Whereas counsel for Walter submitted that these conclusions were inconsistent, the Court clarified that the application of limb (a) of the definition of Deductible Coss is concerned with the target of the Tax, whereas the second limb is concerned with the amount paid “for” a particular service and that the application of the two limbs, involving different enquiries, were susceptible to different outcomes.
Comment
Royalty agreements have long been used to facilitate development, financing and divestment of projects;[5] however, there is no standardised wording or form for royalty agreements and it has been remarked that such agreements “sometimes … be ill-disciplined, poorly-crafted documents which display deficiencies in how they are worded, and they can depend for their effectiveness on the application of broad concepts and detailed drafting whose intention is best known only to the original authors”.[6] This inevitably leads to disputes over intended meanings, as was the case in this matter.
Given that these types of agreements will require bespoke drafting (and noting their increased use), during the drafting stage, parties would therefore be well advised to consider the full range of costs incurred in relation to petroleum (or mineral) production, and how these are to be allocated. In particular, parties should ensure that key terms are clearly defined and aligned with commercial expectations. Given such agreements are usually long-term, parties should also bear in mind that circumstances may change over time and seek to allow for this during the drafting stage. Issues of complexity might include: taxes, government imposed levies (which might not be construed to be a tax), costs of transportation or sale that do not relate to a specific molecule of production (such as send-or-pay or take-or-pay costs) and decommissioning costs. Further, careful thought should be given to the use of ‘third party’ costs where infrastructure may be provided on an arms-length basis by an infrastructure owner that is also a joint venture participant.
David Davies KC (instructed by CMS Cameron McKenna Nabarro Olswang LLP) acted for Waldorf.
[1] There was no dispute between Waldorf and EnQuest and EnQuest was not a party to the proceedings.
[2] Walter assigned part of its entitlement to Eagle H C Limited making it the Second Claimant in this claim. References to Walter in the judgment includes the Second Claimant’s derivative entitlement.
[3] The other form of royalty agreement is a ‘gross overriding royalty’ in which the royalty interest is “calculated as a defined percentage of the gross proceeds of sale of the produced petroleum which are realised by the producer, without the deduction of any of the costs and expenses which were incurred by the producer in relation to producing that petroleum.” See Roberts, P; Oil and Gas Contracts Principles and Practice 3rd edition [18-06].
[4] [1997] AC 313, 391-92.
[5] Roberts, P; Oil and Gas Contracts Principles and Practice, 3rd edition [18-13].
[6] Roberts, P; Oil and Gas Contracts Principles and Practice 3rd edition [18-01].
