In 1998, an Alberta Court of Queen’s Bench judge considered the issue of whether costs to make oil marketable were properly deductible from freehold oil royalties in a pre-CAPL freehold lease agreement. In Acanthus v. Cunningham, the freehold owner-lessor had reserved unto himself a “gross royalty of seventeen (17) per cent of the leased substances produced and marketed from” his lands to be calculated based on “the current market value at the wellhead”. The trial judge rejected the freeholders’ argument that the royalty provision was “internally ambiguous since it provides for a "gross" royalty which suggests no deductions”. According to the trial judge, there was no latent ambiguity and, as a result, evidence of industry practice at the time the lease was entered into was inadmissible. The judge interpreted the royalty provision in the lease to mean that costs to gather, treat and store oil prior to its sale were properly incurred costs which could be deducted by the oil company-lessee. In assessing how these costs should be calculated, the trial judge accepted evidence that “the Jumping Pound calculation” is “commonly used”, and suggested that it would be appropriate to include the operating costs of all facilities downstream from the wellhead to the point of sale plus a rate of return on capital invested.1
‘Gross’ means without deduction and, in FHOA’s view, there is a clear and obvious latent ambiguity in the royalty provision before the trial judge in Acanthus. Furthermore, the Jumping Pound calculation is only ‘commonly used’ in the calculation of deductions from freehold and Crown gas royalties. Neither the Alberta Government nor any other government in the prairie provinces allows energy company-lessees to deduct water disposal costs, tank storage costs or any other gathering, treating or storing costs from Crown oil royalties. For more than 50 years, the common and accepted industry practice has been to make no deductions other than trucking charges from freehold oil royalties and, in particular, to make no deductions for the costs of gathering, treating and storing oil.
A lease with a royalty clause worded identically to that considered in the Acanthus decision came before the Manitoba Court of Queen’s Bench in 2005. In Missilinda of Canada Ltd. v. Husky Oil Operations Ltd., Husky had acquired Missilinda’s freehold lease from another company that had been deducting only trucking costs from Missilinda’s oil royalties for years. Apparently in reliance upon the Acanthus decision, Husky began to deduct oil facility capital costs and a return on invested capital from Missilinda’s oil royalties. Missilinda initiated a legal action asserting that the Acanthus decision had been wrongly decided. The trial judge disagreed and again ruled that there was no latent ambiguity in the wording of the royalty clause2. However the trial judge’s ruling was overturned by the Manitoba Court of Appeal who, in a 2007 ruling, stated that the royalty clause “suffers from latent ambiguity” and that “evidence of the circumstances as they exist at the time the agreement is made, and, … of subsequent conduct of the parties…” was admissible.3 Incredibly however, the late John B. Ballem, Q.C., Husky’s expert witness at trial, author of the Oil and Gas Lease in Canada and principle proponent of CAPL leases, had somehow convinced the trial judge that industry practice in 1984, when the lease was signed, was to deduct from oil royalties not only transportation costs but facility operating expense, capital cost allowance and a return on investment. Although this was not industry practice in 1984 or at any other time, the Manitoba Court of Appeal accepted the trial judge’s conclusions with respect to industry practice.
In calculating Crown royalties on oil, the governments of Alberta, Saskatchewan and Manitoba allow deductions for the cost of transporting oil from its point of production to its point of sale but do not allow deductions for operating expenses associated with storage, separation or water handling facilities nor do they allow capital cost allowance or any rate of return on investment in these facilities. Why should freehold owners be burdened with these costs?
FHOA recommends that you amend the royalty clause in CAPL leases to protect yourself from these deductions (see “CAPL 99 Suggested Modifications", "CAPL 91 Suggested Modifications”). In the FHOA Lease, only trucking charges may be deducted from oil royalties (see “Freehold Friendly (FHOA) Lease”).
1. Acanthus Resources Ltd. v. Cunningham,  A.J. No. 25
2. Missilinda of Canada Ltd. v. Husky Oil Operations Ltd.,  M.J. No. 87
3. Missilinda of Canada Ltd. v. Husky Oil Operations Ltd.,  M.J. No. 51