It has become increasingly common for modern oil and gas lease forms and addenda to include a “cost-free” royalty provision – but as the Texas Supreme Court stated in Chesapeake Exploration, L.L.C. v. Hyder, 483 S.W.3d 870 (Tex. 2016), “lease drafters are not always driven by logic,” and such provisions do not always effectively reflect the parties’ intent.
It is industry standard that royalties – including nonparticipating royalties and overriding royalties – do not bear the costs of producing oil and gas, but do bear proportionate burdens of post-production costs (“PPCs”) such as transport, taxation, and marketing. As oil and gas leases have modernized and drafters have attempted to take advantage of provisions establishing which party is responsible for PPCs, courts have had to consider and define a number of new, untested terms.
Consider Chesapeake Exploration, L.L.C. v. Hyder, wherein one party argued that “cost-free royalty” was surplus language, simply repeating that the royalty was free of production costs. The adverse party countered that since it is already understood that royalties are free of production costs, the use of “cost-free royalty” had to establish a royalty which is also free of PPCs. Even the simplest of terms can cause confusion and conflict where they are not used clearly and properly.
The Texas Supreme Court’s very recent decision in BlueStone Natural Resources II, LLC v. Randle, 2021 WL 936175 (Tex. 2021) is yet another case which focuses on the finest of details in cost-free royalty provisions.
Foundational caselaw spanning back to Judice v. Mewbourne Oil Company, 939 S.W.2d 133 (Tex. 1996) in 1996 established that when a royalty is stated to be based on value of the product “at the well,” valuation will be net of any PPCs. Conversely, the seminal Texas cases of Warren v. Chesapeake Exploration, L.L.C., 759 F.3d 413 (2014) and Burlington Resources Oil & Gas Co. v. Texas Crude Energy, LLC, 516 S.W.3d 638 (Tex. App. 2017) found that royalties based on the “amount realized” by lessee, including those termed “gross value received,” are based on what value the lessee actually receives for the product, without deduction of later PPCs.
The contested lease provision at issue in BlueStone stated that gas royalty would be based on “the market value at the well,” with a superseding addendum stating that gas royalties would be based on “gross value received, including any reimbursements for severance taxes and production related costs.” The Court noted that the two provisions conflicted – “market value” provides for deduction of PPCs, while “gross value received” does not. Because the addendum provided that provisions on the addendum superseded those in the printed lease form, the “gross value received” language won out, and BlueStone was not allowed to deduct PPCs from the lessor’s royalty.
The cases highlighted above are only a sample of those heard in Texas courts to determine what, exactly, the terms included in so-called “cost-free royalty” provisions mean for determining who bears the burden of PPCs. Simply tacking the modifier “cost-free” to the front of the term royalty would not be sufficiently clear, and using an incorrect term here or an addition of too many provisions there may result in costly litigation between landowners and operators over who must paying for the cost of transporting gas.
Kuiper Law Firm, PLLC specializes in oil and gas. Our attorneys are well-versed in the history of royalty valuation litigation; if you have any questions about the information in this article or need assistance drafting or interpreting lease provisions, do not hesitate to contact us.
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