Recently, the Texas Supreme Court revisited the often questioned and certainly confusing issue regarding the proper deduction of post-production costs from royalties in Burlington Resources Oil & Gas Company LP v. Texas Crude Energy, LLC. Six short weeks later, the Fort Worth Court of Appeals had to analyze and apply the “hot off the presses” decision in Bluestone Natural Resources II, LLC v. Randle, et al. Not surprisingly, the parties disagreed with how to interpret and apply the decision in Burlington. Bluestone, the party the Court of Appeals ruled against, filed a petition for review with the Texas Supreme Court on May 30th of this year claiming that the Court of Appeals misinterpreted and misapplied the Burlington decision. Here is a brief synopsis of the main issues that were (and are still) in front of the Court.
A quick explanation of royalty: when an operator takes a lease from a mineral owner, he agrees to pay the mineral owner a percentage of the value he receives from the minerals he extracted from the owner’s lands. The operator also agrees to bear all of the costs associated with extracting the minerals from the earth (the “production costs”). However, after the minerals are brought to the surface, the general rule is that, barring any contractual modification, both the operator and mineral owner proportionately share the costs associated with getting the oil and gas processed/compressed and transported to a sales point (“post-production costs”).
Royalty provisions in oil and gas leases define at least three important terms: (i) how much royalty is to be paid (i.e. the percentage); (ii) how the royalties are valued – also called the “yardstick” or “valuation method” (e.g. market value, amount realized, proceeds, etc.); and, (iii) where the royalties are valued – the “valuation point” (e.g. at the well, at the point of sale, etc.) Disagreements often arise with both the valuation method and valuation point.
Common valuation methods in leases include market value and amount realized (or proceeds). The market valuation method looks to either comparable sales or uses the “workback” method which is calculated by subtracting the post-production costs from sales price obtained at the market. The amount realized method has been consistently interpreted by the courts as a method that does not allow for the deduction of post-production costs from royalty (i.e. the royalty owner gets his share without having to share the costs).
But, before you are done, you also have to agree on where the royalties are valued. As the Court pointed out, when the minerals first come out of the ground they are worth less than when they are ready to sell due to the need to prepare and transport them to the point of sale. Royalties paid under a lease that provides that the valuation point is at the well are worth less than leases that provide that the valuation point is at the point of sale because in the former the value is set when the minerals come to the surface and the mineral owner is then responsible for his share of the costs to get the minerals to the point of sale. In the latter, the value is set at a point that is after those costs have been paid, so the mineral owner does not share the burden of post-production costs.
Confusion can set in if there is an amount realized valuation method (as noted above, usually interpreted to be free from post-production costs) and an “at the well” valuation point (which requires owners to share in the post-production costs). However, the Court has been clear, and even reiterated in Burlington, that “a contractual ‘amount realized’ valuation method [has never been construed] to trump a contractual ‘at the well’ valuation point. To the contrary, prior decisions suggest that when the parties specify an ‘at the well’ valuation point, the royalty holder must share in post-production costs regardless of how the royalty is calculated.”
In Bluestone, the parties were subject to a pre-printed lease form that called for royalties be valued by “market value at the well”. Exhibit “A” provided the following:
LESSEE AGREES THAT all royalties accruing under this Lease (including those paid in kind) shall be without deduction, directly or indirectly, for the cost of producing, gathering, storing, separating, treating, dehydrating, compressing, processing, transporting, otherwise making the oil, gas[,] and other production hereunder ready for sale or use. Lessee agrees to compute and pay royalties on the gross value received, including any reimbursements for severance taxes and production related costs.
Furthermore, the lease provided that “Exhibit ‘A’ supersedes any provision to the contrary in the printed lease hereof[.]”
The Court of Appeals determined that the two provisions were contrary to one another by looking to a prior Texas Supreme Court case that “highlighted that an instrument using the term ‘gross proceeds’ is at odds with ‘at the well’ language and with its mechanism to place the burden of post-production costs on the lessee. […]’ and that there is an ‘inherent, irreconcilable conflict between ‘gross proceeds’ and ‘at the well’ in arriving at the value of the gas which is a ‘conflict [that] renders the phrase ambiguous.’” Because Exhibit “A” superseded the pre-printed form if there were contract provisions, the Court of Appeals found that the valuation method in Exhibit “A” (“gross proceeds”) trumped the valuation method and valuation point in the pre-printed lease form (“market value at the well”) and that the royalty owners were not responsible for any post-production costs.
Bluestone appealed, arguing that Exhibit “A” may have replaced the valuation method (“market value” is replaced with “gross proceeds”) but that the valuation point had not changed. However, it appears that the Court of Appeals melded the two (method and point) into one in instances where the leases were (as coined by the Court of Appeals) “pure-proceeds” leases – that is, they provided for a valuation method (proceeds) but not a valuation point. The Court of Appeals then held that the “pure-proceeds” was contrary to and replaced both the valuation method and point of the pre-printed lease form due to the provision that called for the same.
Operators and mineral owners alike must watch for how the Texas Supreme Court treats this type of lease and argument. Many of us deal with situations exactly like this – a pre-printed form with a cobbled together addendum. It may not mean what you think it means.