On April 27, 2026, the United States Court of Appeals for the Tenth Circuit reversed the district court in Devon Energy Production Co., L.P. v. United States Department of the Interior, No. 24-6132. A majority of the panel held that the Office of Natural Resources Revenue (“ONRR”) acted arbitrarily and capriciously when it disallowed certain gas treatment deductions without considering a prior settlement agreement between Devon Energy Production Co., L.P. (“Devon”) and the federal government. The panel held that the settlement agreement constituted “an important legal and factual part of the problem” because it legally controlled over otherwise applicable regulations and factually affected over 80% of the disputed royalties.
Background
Devon held federal leases to produce natural gas from two units in New Mexico. The gas formations beneath these units presented distinct treatment challenges. For example, coalbed methane from one gas formation typically contains excessive carbon dioxide that must be removed before the gas is marketable, a cost that is generally non-deductible from royalty calculations under federal regulations. The companies that treated Devon’s gas bundled deductible charges (such as transportation) with non-deductible charges (such as carbon dioxide removal), making it difficult for Devon to segregate costs.
One of Devon’s predecessors encountered this same bundled-cost problem during an audit in the 1990s. That entity entered into a settlement agreement with the government, which established specific rates for transportation and treatment of coalbed gas. When state officials audited Devon’s production for the 2004–2008 period and disallowed approximately $2.84 million in deductions, Devon responded that it had calculated its treatment costs using the formula set out in that settlement agreement.
The ONRR’s decision, which omitted any mention of the settlement agreement, ordered Devon to either separate its bundled charges or identify the deductible costs through another method. Devon sought judicial review and the district court affirmed, reasoning that the settlement agreement would not have covered all of the disputed royalties.
The Tenth Circuit’s Analysis
Applying de novo review, a Tenth Circuit panel reversed, holding that an agency acts arbitrarily and capriciously when it “fail[s] to consider an important aspect of the problem,” and that the settlement agreement was precisely such an aspect. The panel identified two dimensions of significance: legally, the settlement agreement “controlled over regulations that would otherwise conflict” pursuant to 30 C.F.R. § 206.150(b); and factually, the agreement bore on a substantial portion of the disputed royalties.
The government advanced three arguments, each of which the panel rejected. First, it contended that the settlement agreement involved a different Devon entity than the party in this case. The panel found the administrative record insufficient to resolve whether a merger had united the two entities and declined to affirm on a ground that the agency never considered.
Second, the government argued that even if a merger occurred, the surviving entity might not have assumed the settlement agreement. Again, the incomplete record precluded reliance on this argument.
Third, the government argued the settlement agreement’s treatment rate expired before the audit period. The panel engaged in a detailed textual analysis of the settlement agreement. The agreement’s body provided that rates “for transporting coalbed gas” would continue until the expiration of Devon’s underlying contract. Meanwhile, Exhibit B to the settlement agreement separately identified a treatment rate of 7.78 cents per thousand cubic feet. The panel found the agreement ambiguous as to whether the expiration provision encompassed only transportation rates or also the treatment rate. Because the government itself had previously characterized the 7.78-cent figure as “the agreed cost of CO2 removal under the . . . Settlement Agreement,” the panel concluded that all parties understood the agreement to have established a treatment rate—leaving the sole question as when that rate terminated. Given this ambiguity, the panel held the expiration issue was neither “clear” nor “indisputable,” and thus could not sustain an alternative affirmance.
The panel ultimately reversed and remanded to the district court with instructions to determine the appropriate remedy under a two-factor test which considers (1) the seriousness of the agency’s deficiencies and (2) the disruptive consequences of an interim change.
Judge Tymkovich dissented, finding that the settlement agreement’s treatment rates had indisputably expired before the audit period. In his view, the agreement’s rate-setting provision and its expiration clause were inextricably intertwined: whatever rates the agreement fixed were subject to defined termination triggers that had already occurred. Judge Tymkovich would have affirmed the agency’s decision on harmless error grounds.
Significance
The panel’s holding carries two significant implications. First, the decision reinforces that a prior settlement agreement between a lessee and the federal government can supersede otherwise applicable regulatory provisions governing royalty deductions. Under 30 C.F.R. § 206.150(b), such agreements control over conflicting regulations. In addition, and although this dispute involved New Mexico leases and the specific deductions concerned New Mexico gas production, the panel’s reasoning rests squarely on federal regulatory law, suggesting the holding would extend to federal leases throughout the circuit.
Second, the decision underscores the principle that agencies must grapple with all material aspects of a regulated party’s objections during the administrative process. Where a lessee points to a settlement agreement as the basis for its deduction methodology, the agency cannot simply ignore it and demand alternative substantiation. Failure to engage with such arguments renders the agency’s order vulnerable to reversal as arbitrary and capricious. Lessees with existing settlement agreements governing royalty calculations should ensure those agreements are prominently invoked during any audit or administrative proceeding.
The case is Devon Energy Production Co., L.P. v. United States Department of the Interior, No. 24-6132, __ F.4th __ (10th Cir. 2026). The decision was authored by Judge Bacharach, joined by Judge Hartz, with Judge Tymkovich dissenting.
For questions about this legal alert, please contact a member of the Davis Graham Appellate Group.