State Supreme Court rules against driller; Texas’ budget emerges as a winner

Southwest Royalties was seeking to make metal pipes, tubing and other equipment used in drilling tax exempt.
Southwest Royalties was seeking to make metal pipes, tubing and other equipment used in drilling tax exempt. Odessa Reporter-Telegram

A Texas Supreme Court ruling has spared the state from having to issue billions of dollars in tax refunds to oil and gas drillers — a prospect that threatened to shake up the next legislative session.

The justices sided Friday with Texas Comptroller Glenn Hegar in an arcane tax dispute that Hegar, a Republican, feared could have far-reaching consequences for the state’s budget outlook.

Denying Midland-based driller Southwest Royalties' request for a refund, the court ruled that state law does not exempt metal pipes, tubing and other equipment used in oil and gas extraction from sales taxes.

“Southwest did not prove that the equipment for which it sought a tax exemption was used in “actual manufacturing, processing, or fabricating” of hydrocarbons within the meaning of the tax code, Justice Phil Johnson wrote for the majority in an opinion that affirmed decisions in lower courts. “Thus, Southwest is not entitled to an exemption from paying sales taxes on purchases of the equipment.”

Though Southwest Royalties, a subsidiary of Clayton Williams Energy, sought to recoup less than $500,000 from purchases between 1997 and 2001, the stakes were far higher.

A Texas loss could have spurred $4.4 billion in refund filings for 2017 alone, Hegar’s office estimated, and $500 million each subsequent year that the exemption remained in place.

In a statement released after the ruling, Texas Attorney General Ken Paxton praised the court's ruling.

“The Comptroller is faithfully executing the law and treating taxpayers fairly, in accordance with the wishes of the Texas Legislature,” Paxton said. “Bottom line: we saved the State, and taxpayers across the State, over $4 billion.”

Petroleum industry representatives expressed disappointment in the ruling.

“It is undeniable that oil and natural gas exploration and production today is more and more a manufacturing process,” Todd Staples, president of the Texas Oil and Gas Association, said in a statement. “For a healthy oil and natural gas industry, our operators, who compete globally, need equitable tax treatment.”

In oral arguments in March, attorneys on both sides sparred over the mechanics of petroleum extraction and how it related to a tax exemption for goods and services used in the “actual manufacturing, processing, or fabrication of tangible personal property.”

Southwest Royalties argued that the company’s equipment “processes” West Texas crude by separating it into marketable oil and gas. Once the crude is brought up from the ground, it is no longer part of a mineral owner’s estate, its legal team argued.

The state contended that minerals are not “tangible personal property” and that Southwest’s equipment was not necessarily responsible for transforming the crude.