The federal appeals court in Denver has ruled in favor of Devon Energy in its fight with the Department of Interior over royalties from gas production in New Mexico.
The challenge of the results of an audit involved more than $2.8 million and the Oklahoma City-based energy company took the federal government to court. The dispute arose from Devon Energy’s production of natural gas from two units in New Mexico, the Northeast Blanco Unit and the San Juan 32-9 Unit.
As the 10th U.S. Circuit Court of Appeals pointed out, the dispute itself had arisen from the federal government’s lease of land to Devon Energy Production Co., L.P. The lease allowed Devon Energy to produce gas in exchange for royalties, which were subject to certain deductions. To ensure proper payment of the royalties, the federal government authorized state officials to audit Devon Energy’s production of gas and related deductions.
With that authority, state officials conducted an audit in 2009 and disallowed some of the deductions taken over a four-year period (2004–2008). Devon Energy objected to the state officials’ conclusions, but a federal agency (the Office of Natural Resources Revenue) overruled those objections and ordered Devon Energy to either pay the amount in dispute ($2,841,264.58) or to supply greater support for the deductions.
The challenge arose from certain deductions related to Devon’s treatment and transportation of the natural gas over the four-year period. The charges for these services were bundled, making it difficult to separate deductible from non-deductible costs. A related Devon entity had previously resolved a similar dispute with the government through a settlement agreement, which established formulas for calculating allowable deductions.
The Office of Natural Resources Revenue, a federal agency, reviewed Devon Energy’s objections to the audit and upheld the disallowance, ordering payment of the contested royalties or further documentation. Devon Energy sought review in the United States District Court for the Western District of Oklahoma, arguing that the agency acted arbitrarily and capriciously by not considering the prior settlement agreement. The district court affirmed the agency’s decision, reasoning that the agreement did not cover all disputed royalties.
The United States Court of Appeals for the Tenth Circuit reviewed the case de novo, applying the arbitrary-and-capricious standard. The Tenth Circuit found that the agency erred by failing to consider the prior settlement agreement, which may have had significant legal and factual implications for the calculation of deductions. The court also found that the record was insufficient to support the government’s alternative arguments for affirmance, such as the identity of the contracting entity and the expiration of the agreement’s terms. The Tenth Circuit reversed the district court’s judgment and remanded the case for the district court to determine the appropriate remedy—whether vacatur of the agency’s decision or a remand to the agency is warranted.
At least one appellate court judge dissented in the ruling.