In the case of Carl v. Hilcorp Energy Co., No. 24-0036, decided on May 17, 2024, the Texas Supreme Court ruled in favor of the operator in a royalty dispute involving post-production costs. The case addressed certified questions submitted to the Texas Supreme Court by the U.S. Fifth Circuit Court of Appeals where a class action lawsuit between Carl, et al., and Hilcorp Energy was pending. At issue was whether the operator, in computing royalty, could deduct gas used off the leased premises for post-production activities on other gas produced from the well.
The lease in question entitled the lessor to a royalty based on the “market value at the well” of the gas “produced from said land and sold or used off the premises.” The producer, Hilcorp Energy Co., used some of the produced gas to power post-production activities (such as transportation or processing) conducted off the leased premises, and it deducted such gas from the volume of gas on which the royalty was calculated. The royalty owners, Carl, et al., filed suit arguing that the producer could not make such a deduction since the lease entitled the lessor to a royalty on all the gas “sold or used off the premises.” (Emphasis added).
The Court disagreed with the plaintiffs and cited BlueStone Nat. Res. II, LLC v. Randle, 620 S.W.3d 380 (Tex. 2021), where it stated the “longstanding rule” that when a lease requires royalty to be computed “at the well,” the royalty interest must bear its proportionate share of post-production costs. This method of accounting, which involves backing out necessary and reasonable costs incurred between the wellhead and the sales point, is known as the “workback method.” The Court noted that the workback method is permissible in determining market value at the well. The Court stated that the gas used off the premises enhanced the value of the gas sold downstream and was therefore a reasonable post-production cost that could be deducted in calculating royalty when the lease contains an “at the well” royalty clause. The holding in Hilcorp confirms that gas used off premises for post-production activities on other gas produced from the well may be deducted in determining market value at the well. The Court noted that if some of the gas were used off the premises for other purposes, then royalty would be due.