Lithium Rights in Connection With Oil and Gas Operations

Introduction

With the rise of battery technologies in electric vehicles, electronics, utility-scale electrical energy storage and other industrial applications, there has been increased demand for lithium, cobalt and other minerals. In response to the increased demand, sources of such minerals that have previously gone unutilised have attracted increased interest. Most notably, produced water from oil and gas wells, previously viewed as a waste product, is now attracting interest for the lithium, cobalt and other minerals contained therein.

Since this is a new area of interest, the law in many jurisdictions relating to whether the surface owner or the mineral lessee is entitled to own produced water from oil and gas operations (and the resulting lithium, cobalt and other minerals contained in the water) remains unsettled. Where there is potential money on the table, actual litigation often follows. 

The current Texas case that is being most closely followed relating to mineral ownership in connection with oil and gas operations is Cactus Water Services, LLC v COG Operating, LLC. A Texas appellate court has already rendered a decision in this case. In the Cactus Water case, a majority of the El Paso Court of Appeals determined that the lessee mineral interest owners had superior rights to the produced water in dispute. The dissent favoured the rights of the surface owners and the case has since been appealed to the Texas Supreme Court. Major industry players, including the Texas Land & Mineral Owners Association, the Texas and Southwestern Cattle Raisers Association, the Texas Farm Bureau, the Texas Oil & Gas Association and the National Association of Royalty Owners – Texas, Inc, have filed or are expected to file amicus curiae briefs on the case. The decision of the Texas Supreme Court in this case will be closely followed by many industry players.

In this article, we focus on the Cactus Water case, and add some highlights from other states relating to this issue; certain Inflation Reduction Act incentives for mineral production; and a few practical issues for oil and gas operators to keep in mind relating to mineral production.

The Cactus Water case

COG Operating, LLC (“COG”) was the lessee of a property in west Texas. Its leases on the applicable property (the “COG Leases”) involved a grant of “oil, gas and other hydrocarbons” and similar variants. Under the COG Leases and other agreements, COG had the obligation to dispose of produced water and the landowner granted rights-of-way and easements to COG so it could transport such produced wastewater off the land. However, under the COG Leases, COG expressly did not have the right to “use water which is on or under the described land, except it may itself drill a water well and then use the water from that well in its conduct of drilling operations that actually are conducted on land covered by [the lease.]”

Several years after the landowner leased their interests to COG, the landowner also leased their interest in their water estate to Cactus Water Services, LLC (“Cactus”), including the rights to sell all water “produced from oil and gas wells and formations [on the covered properties.]”

COG and Cactus filed declaratory suit against one another to find out who held the rights to the produced wastewater from the land (as well as the substances contained therein).

The trial court found for COG and the appellate court in this case affirmed, primarily falling back on statutory interpretation, regulatory understanding and industry practice. In its decision, the appellate court held that produced wastewater is not groundwater (which is part of the surface estate), but instead is “oil and gas waste”, which typically under oil and gas leases belongs to and is the obligation of the mineral interest lessee. As a result, produced water is within the mineral interest lessee’s grant of “oil, gas and other hydrocarbons” and the mineral interest lessee had the exclusive right to the produced water under its leases. The court held this (i) even though the COG Leases specified a grant of “oil, gas and other hydrocarbons” rather than the formulation of “oil, gas and minerals”; and (ii) despite the limitation on COG’s use of water on the land.

Note that this case does not expressly address lithium and that for leases executed after 8 June 1983, the determination of “mineral” under Texas law is done on a mineral-by-mineral basis under the “ordinary and natural meaning” test (in the absence of lease language clearly specifying one way or another). However, pending further activity on this item, it would be reasonable to assume that this case lends support to the idea that lithium contained in produced wastewater from oil and gas operations would also belong to the oil and gas operator in the absence of lease language to the contrary.

The dissent in this case took a different view of produced water ownership. The dissent noted that “water” and “oil and gas waste” were not expressly granted under the leases, and that without express granting language conveying the surface estate’s water rights, Texas law provides that such water remains part of the surface estate. As a result, water would not be impliedly conveyed in the grant of “oil and gas”.

Many commentators expect that ultimately this issue will be determined by the Texas Supreme Court. An appeal has been filed to the Texas Supreme Court as of the writing of this article and the Texas Supreme Court has requested briefs on the merits of the issue. If the Texas Supreme Court does issue a decision, it will probably not be until late 2024 or 2025.

Other states

Many of the major oil and gas states across the country do not have well-developed legal regimes pertaining to the ownership and benefits allocation of lithium and other critical minerals in produced water from oil and gas production, as the produced water itself has typically been viewed as a waste product and a burden to allocate. Other states with significant lithium deposits have well-developed regimes for the allocation of brine and the lithium and other minerals contained therein (see, for example, Arkansas’ Smackover Formation and the Strohacker Doctrine). As other states see the development of major lithium deposits, such as California with its Salton Sea lithium field, new or modified legal doctrines and regulations may come about in connection with lithium extraction, ownership and utilisation, whether it is water produced in the extraction of oil and gas, direct water extraction or some other method of production.

The Inflation Reduction Act

Although most of the attention from the oil and gas industry regarding the Inflation Reduction Act of 2022 (IRA) has been directed towards the corporate minimum tax, carbon capture, hydrogen and the methane fee, the IRA also provides incentives – an investment tax credit under Section 48C and a production tax credit under Section 45X – for the domestic production of lithium (and approximately 50 other “critical minerals”).

Section 48C provides for an investment tax credit for the re-equipment, expansion or establishment of an industrial facility for the processing, refining or recycling of critical minerals, like lithium, into statutorily defined forms and purities. Section 48C does not provide an investment tax credit for the production or extraction of raw lithium brine or ore. Although oil and gas well heads probably would not qualify, associated ancillary facilities for large-scale lithium processing and refining from oil and gas wastewater could be eligible for the Section 48C credit. Unlike most other incentives provided by the IRA, the Section 48C investment tax credit requires an application to the US Department of Energy and the Internal Revenue Service and an award of the credit.

Separately, Section 45X of the IRA provides for a production tax credit in an amount equal to 10% of the “costs incurred” by a taxpayer with respect to the production of any applicable critical mineral – including lithium converted to lithium carbonate or lithium hydroxide, and lithium purified to a 99.9% purity level by mass. While the Department of the Treasury and the Internal Revenue Service have released proposed regulations under Section 45X, there is still substantial uncertainty about what “costs” can be considered in calculating the Section 45X credit. Like Section 48C, Section 45X does not directly incentivise the production or extraction of raw materials, but, unlike Section 48C, Section 45X does not require an application to the US Department of Energy or Internal Revenue Service in order to claim the credit.

Considerations relating to lithium extraction in produced water

In addition, there are several matters an oil and gas operator needs to consider in connection with the development of lithium and other minerals from produced water in its oil and gas operations.

Granting language

• Regardless of the outcome of the Cactus Water case, the best practice is to explicitly state lithium, cobalt, brine, etc, in the granting language of a lease or severing instrument, and to avoid such minerals being part of the reservation language in a lease or severing instrument.
• In some cases, depending on the lease granting language, the rights to lithium and other minerals are more likely to be part of the mineral estate if they are produced in connection with the same operations that are being undertaken to extract oil and gas. If an operator were to seek to extract lithium and other minerals as part of operations that do not involve the extraction of oil and gas, then some lease language would provide that such lithium and minerals are not included as part of the lease grant. As a result, it is important to further consider the lease granting language if lithium and mineral production were to occur separately from oil and gas operations.

Joint operating agreements

Oil and gas production is often subject to joint operating agreements (JOAs). An oil and gas operator should consider if the cost and revenue-sharing terms under JOAs will apply to lithium and other non-oil and gas mineral extraction, including as to the development of lithium extraction facilities separate from oil and gas production and gathering facilities.

Produced water treatment and disposal agreements

Often produced water treatment and disposal agreements contain clauses that grant all right, title and interest in the produced water (including all minerals contained therein) to the party disposing of and treating the water. An oil and gas operator should consider the terms of these agreements and title transfer provisions. Even if legally possible, it may be commercially and/or logistically difficult to sever title to the lithium and other rare earth minerals from the produced wastewater. What would the wastewater processor’s obligations be to extract lithium? If the lithium title is held by someone other than the oil and gas producer (eg, the landowner), how will such person maintain a proper agency relationship with the produced water processor without a separate form of privity of contract? Ultimately this may turn into a royalty-style arrangement like that often seen between natural gas gatherer and processor services companies. 

Royalty considerations

To what extent does the royalty language in the applicable lease apply to lithium extraction from produced water? Royalty amounts often differ depending on whether the royalty item is a “liquid” or a “mineral”. Given that lithium is contained in the saltwater brine of produced water, it is unclear which applies. Further, given lithium extraction from produced water requires processing, it is unclear where in the production chain the value of the lithium is determined and how the allocation of processing costs is determined. There may be some additional disputes in this area as lithium extraction operations increase.

Tax considerations

The Internal Revenue Code and other federal income tax regulations contain a robust set of tax rules relating to both (i) oil and gas drilling, development, and production activities; and (ii) non-oil and gas mineral exploration, development, and operating activities. However, many of the statutory, administrative, and judicial authorities that apply to the oil and gas industry are separate and distinct from those that apply to activities involving non-oil and gas minerals, and those rules were not developed with produced water lithium extraction in mind. As a result, it will be important for taxpayers engaging in both oil and gas operations and produced water lithium extraction to work closely with their tax advisers to determine how to properly allocate and report overlapping exploration, development, and operating activities.

Conclusion

Given the significance of the interests, the Texas Supreme Court will likely consider the Cactus Water case or a similar case in the near future and provide further clarification regarding the law on the ownership of produced water from oil and gas production. In addition to a Texas Supreme Court decision, it is also possible that the Texas State Legislature could take up further consideration of produced water and brine ownership in future legislative sessions. Regardless of a Texas Supreme Court decision or a state statute on the ownership matter, a slew of further legal questions is likely to ensue, and surface owners and producers alike should keep a keen eye on legal developments in this area.