TOUGH LEASE AGREEMENT TRIPS UP EXXON

Mobile Register

When then-Exxon Corp. bought leases to drill for natural gas and oil off Alabama's coast, it signed a lease with the state Conservation Department to pay royalties to the state, which is the owner of the ocean floor and the natural gas under it.

In that lease, Exxon agreed to a number of restrictive terms that may have proved the company's undoing in court.

A day after a Montgomery jury grabbed the nations' attention by ruling that the world's largest oil company owed the state of Alabama $3.5 billion in natural gas royalties and punitive damages, observers of the case were still debating just how that lease should be read. The issue will probably bubble on in appeals for years.

While Alabama appears to have much tougher leases than usual, a national expert said the state's suit was part of a larger trend of legal claims against oil companies for cheating landholders out of their fair share of royalties.

The case against Exxon Mobil Corp. has pushed the state to the forefront of the movement to collect what's owed, said Danielle Bryan, executive director of the Project on Government Oversight, based in Washington, D.C.

The group is compiling a report on underpayments of natural gas royalties, after helping to force $300 million in settlements from oil companies for underpaying oil royalties to the federal government and American Indian tribes.

"We think this is a terrifically important break-through," Bryan said.

Bob Macrory, the Alabama official who wrote the leases in 1980, said he purposefully wrote a very different lease than oil companies were used to in an effort to pull in the most money for the state.

"While we have the opportunity, let's maximize the value of the gas to the state," was his thinking at the time, Macrory said.

Macrory still works for the state, as an assistant attorney general with the Conservation Department. At the time, he was the department's chief lawyer and later oversaw the lands division and served as assistant commissioner under the-Gov. Fob James.

Macrory, who testified extensively at the two-week Exxon trial, said the didn't have much experience with oil and gas leasing but read up on the subject. His studies led him to decide that the state's original batch of leases, sold to Mobil Corp. in 1969 were too permissive.

They promised the state a 16.67 percent (one sixth) royalty rate, but let Mobil discount a number of costs associated with production.

The Mobil leases were similar to what's known in the industry as "wellhead" leases. Such agreements call for the drillers to pay the landowners some percentage of what the gas is theoretically worth at the well, taking out costs for processing and transporting.

But Macrory decided to move toward a "gross proceeds" lease. Leases in that format don't allow for nearly as many costs to be charged off, allowing the state to collect more royalties. Macrory also recommended two additional provisions that tripped Exxon up and could trip our other companies sued by the state in 1999 in Mobile Circuit Court.

Those companies-Shell, BP, Amoco, Mobil and Hunt Oil-could owe up to $40 million. That's less than Exxon, which is the biggest operator in Alabama state waters.

None of these cases has come to trial, and the earliest one could begin next spring, lawyers for the state said Wednesday. The Exxon and Mobil cases were kept separate, despite the companies' merger into Exxon Mobil, because the merger was not complete by the time the state sued.

The gas drillers say the state's lease is hard to understand, and they shouldn't' be penalized for sticking to standard practices.

"This dispute is and always has been one between Exxon Mobil and the department over the proper interpretation of a lease form never before used in any U.S. jurisdiction," Exxon spokesman Tom Cirigliano said in a Tuesday statement.

Jack Williams, a retired Mobil engineer, who hepled plan part of that company's drilling effort in Mobile Bay, concurred.

"The dispute is a legitimate dispute in my opinion," Williams said. "I think the state's wrong about the position they've taken."

Macrory, not surprisingly, disagrees, saying what really happened is that gas companies that were used to doing business under more favorable terms largely ignored Alabama's contracts.

When the state brought in an outside auditor, George Kaess of Houston, Macrory said, Kaess correctly predicted that the gas companies would be out of line, because he knew the companies' computer systems weren't set up to deal with most of Alabama's rules.

"I think the writing is on the wall with what those leases mean," Macrory said.

The state won $87.7 million in actual damages. The state contended at trial that Exxon cheated the state six different ways. The most important way was by not paing royalties on gas that the company used to fuel its operations.

Natural gas processors burn a lot of their own product to cook water out of raw gas, pipe it ashore and remove impurities such as poisonous hydrogen sulfide at South Mobile County processing plants.

The next most important claim, and the one that really gets the industry's dander up, is that companies have to get the best price realizable with reasonable effort. The state claimed in the case that Exxon passed up higher prices, a claim which industry leaders say is silly, because that means Exxon passed up a chance at higher profits for itself.

"I've seen the clause that determines the pricing system, and it's almost indecipherable," Williams said.

The state also rapped Exxon for charging off expenses not directly related to production, such as office space in Houston and New Orleans.

Also at issue were royalties on power sales to Alabama Power of surplus energy generated at Exxon's Deakle Road plant, royalties on sulfur extracted from hydrogen sulfide and royalties on condensate oil extracted from the natural gas.

Bob Cunningham, one of the three Mobile attorneys who handled the case, said such systemic behavior justified the big damages number, because Exxon could have cheated the state out of more than $1 billion over the life of the field. Cunningham again cited Exxon documents with internal warnings that the company was out of step with state leases.

"They made a conscious, intentional decision to underpay royalties," he said.

Along with Cunningham, John Crowder and Richard Dorman were hired by the state to try the case for a 14 percent commission. All are with the Mobile firm of Cunningham, Bounds, Yance, Crowder and Brown.