Background

Devon Energy Production Co., L.P. claimed $2.8 million in gas treatment deductions on federal lease royalties, which the Office of Natural Resources Revenue (ONRR) disallowed. The dispute centered on whether Devon could deduct certain downstream costs from royalty calculations on production from federal leases. Devon had previously entered into a settlement agreement with the agency that addressed the treatment of similar deductions, creating a potential conflict between the settlement's terms and the regulatory provisions ONRR sought to apply.

The Dispute

ONRR applied regulations codified at 30 C.F.R. § 206.150(b) to disallow Devon's claimed deductions, rejecting Devon's argument that a prior settlement agreement controlled the royalty calculation methodology. The core legal issue was whether the settlement agreement's terms—which Devon contended permitted the deductions—took precedence over the regulatory framework ONRR sought to apply. Devon argued the agency's refusal to honor the settlement terms constituted arbitrary and capricious agency action under the Administrative Procedure Act. The dispute implicated over 80% of the contested royalty amounts, making the settlement agreement's scope and enforceability the dispositive issue.

The Tenth Circuit's Analysis

The Tenth Circuit panel reversed ONRR's determination, holding the agency acted arbitrarily and capriciously by applying conflicting regulatory provisions under 30 C.F.R. § 206.150(b) when a controlling settlement agreement governed the treatment of the disputed deductions. The court found that the settlement agreement legally controlled over the regulatory provisions and that the settlement governed over 80% of the disputed royalties, effectively resolving the bulk of the controversy in Devon's favor. Rather than reinstating Devon's deductions outright, the court remanded to the agency for determination of the appropriate remedy, applying a two-factor vacatur test that weighs the seriousness of the agency's errors against the disruptive consequences of vacating the challenged action.

Implications for Federal Lease Operators

This decision provides critical guidance for operators holding federal oil and gas leases who have entered into settlement agreements with ONRR regarding royalty calculation methodologies. The ruling establishes that settlement agreements can legally control over conflicting regulatory provisions when the agency attempts to apply those regulations to matters governed by the settlement. Operators facing ONRR audits or order assessments should carefully review whether prior settlements may constrain ONRR's ability to apply regulatory interpretations that conflict with settlement terms.