The still commonly used “production payment” may get some judicial attention from our own Supreme Court soon. The simple issue is whether a production payment can be proportionately reduced when a portion of the leases that are burdened by it expires.

A production payment is usually defined as a portion of oil or gas as produced, free of costs, which terminates once either a stated amount of production has been paid or an agreed upon amount of money has been paid. As such, like overriding royalty reservations, a production payment is a non-operating interest that burdens a leasehold estate. Under Texas law, a non-operating interest terminates upon the expiration or surrender of the lease.

However, in March of this year, the Eighth District Court of Appeals in El Paso reversed a trial court’s judgment that allowed for a reduction in a production payment upon the expiration of some of the leases that the production payment was tied to. In its reversal, the Court found that without language in the Assignment that allowed for a proportionate reduction in the production payments, the Operator was not entitled to reduce them.

The case at issue, McDaniel Partners, Ltd, v. Apache Deepwater, LLC, centers on the following facts. An Assignment of four leases, executed in 1953, reserved a substantial production payment in favor of the Assignor, stating:

[Assignor] reserves unto himself, his heirs, representatives and assigns, and there is expressly excepted from this conveyance as a production payment interest, the title to and ownership of one-sixteenth of thirty-five sixty-fourths of seven-eighths (1/16th of 35/64ths of 7/8ths, being one sixteenth of the entire interest in the production from said lands to which Assignor claims to be entitled under the terms of said respective oil and gas leases) of the total oil, gas, casinghead gas and other minerals in and under and which may be produced from the above described land, i.e., from each and both of said Surveys 36 and 37, Block 40, Township 5 South, T&P Ry. Co. Lands, until the net proceeds of said reserved interest . . . shall have amounted in the aggregate to the sum of Three Million Five Hundred Fifty Thousand Dollars ($3,550,000.00) . . . [and] one million four hundred twenty thousand (1,420,000) barrels . . . .

In 1994, two of the four leases expired for lack of production. The two remaining leases were held by production on lands that were a part of the lease but not a part of the Assignment.

Apache acquired the interest on the two leases, and the lands subject to the production payment, and began producing in late 2009 or early 2010. Apache sent a division order to the McDaniel, successor in interest of the production payment, that provided for a production payment that was proportionately reduced to the interests still under lease.

McDaniel sued Apache, claiming that it was owed a production payment that was to “be calculated and paid based upon 100% of production from the above described lands” which would be 1/16th of 35/64ths of 7/8ths of production. Despite McDaniel’s argument, the trial court found that “the production payment, per the terms of the Assignment, stems from four separately identifiable sources--namely, the minerals produced under each of four underlying leases.” As a result, the trial court held that “the production payment must be proportionately reduced in the event one or more of the leases expires.”

McDaniel appealed the decision to the Eighth Circuit Court of Appeals in El Paso. The Court of Appeals noted that “it is unambiguous that the entire fractional equation (1/16 of 35/64 of 7/8) is to be calculated against the total production of oil and other minerals from each and both of said Surveys 36 and 37.” The Court even noted that “[w]hile Apache disagrees with McDaniel about what the fractional equation should be, it nonetheless agrees that the equation must be calculated against the entirety of Surveys 36 and 37.” The real question, the Court provides, “is whether the terms of the Assignment permit a reduction of the production payment in the event any of the assigned leases expire.” Ultimately, the Court held that since there was no language allowing for the proportionate reduction of the fractional equation, in such a multiple lease situation, it was not allowed. As such, the Court reversed the trial court’s judgment.

On July 14, 2014, Apache filed a petition for review with the Texas Supreme Court. Apache argues that the Appellate Court’s decision changes settled law which provides for the expiration of the production payment upon the expiration of the lease that is burdened by it. In doing so, Apache argues, the Court of Appeals characterized production payments as a debt by the oil produced, rather than an interest in land.

Anyone with non-operating interests in oil and gas leases should be especially keen to see what the Supreme Court will do with this case. If the Court denies the review, or grants it and if it upholds the Court of Appeals’ reversal, then it is possible that an argument could be made that overriding royalty interests and the like should not be proportionately reduced in the event of a lease termination if it stemmed from a multi-lease assignment. And those that are paying those non-operating interests? They may be shackled much longer than anticipated! A response brief is due in August, and we will have a better idea after that what the Court will do with this issue. Until then, maybe washing those interests out is not the best solution.