On November 22, 2021, the Fort Worth Court of Appeals upheld a trial court grant of summary judgment in favor of the lessees to an oil and gas lease. The lessors alleged that the lessees failed to properly calculate and pay royalty. The lease at issue required royalty payment based on “25% of the market value at the point of sale, use, or other disposition of all such gas produced or sold from the leased premises.”
The lease also required that if the lessees “realize[] proceeds of production after deduction for any expenses of production, gathering, dehydration, separation, compression, transportation, treatment, processing, storage or marketing, then the proportionate part of such deductions shall be added to the total proceeds received . . . for purposes” of royalty.
The lessees sold gas at the wellhead to affiliates, and the affiliates transported and sold the gas downstream at higher prices. The lessees sold the gas to the affiliates at the downstream sales prices less certain costs and expenses incurred in bringing the gas from the wellhead to the downstream sales location. The lessees calculated and paid royalty on the basis of the price received for the gas at the wellhead.
In evaluating whether the lessees properly paid royalty, the Fort Worth Court of Appeals began by determining the valuation point for royalty under the lease. The terms of the lease required the payment of royalty at the point of sale—or the wellhead.
The court next examined the lessors’ contention that the lease required that any deductions “be added to the total proceeds received” for royalty purposes. Specifically, the lessors contended that by selling the gas to affiliates with postproduction costs deducted from the purchase price (and by then failing to add the postproduction costs back for royalty calculation purposes), the lessees breached the “add back” provision. The Fort Worth Court of Appeals held that requiring the lessees to add deductions to proceeds received would “create an internal conflict between the” requirement that the lessees calculate royalty at the point of sale (i.e., the wellhead) and the “add back” provision.
The Court relied on the Texas Supreme Court’s decision in Burlington Res. Oil & Gas Co. v. Tex. Crude Energy, LLC, 573 S.W.3d 198 (Tex. 2019) for the proposition 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.” The Court also reasoned that it could “harmonize” the at the well valuation point with the “add back” provision by holding that the “add back” provision only applies when the point of sale is not at the wellhead (although the Court did not give any specific examples).
Any appeal of the Fort Worth decision will be closely watched as a direct challenge to the proposition that a lessor and lessee cannot simultaneously agree to a wellhead valuation point and an arrangement where the lessee bears the burden and expense of bringing production to the first non-affiliate sale. The case is Shirlaine West Properties Limited, et al. v. Jamestown Resources, LLC, et al., No. 02-18-00424-CV, 2021 WL 5367849 (Tex. App.—Fort Worth Nov. 18, 2021, no pet. h.).
Michael Reer is a shareholder with the firm Harris, Finley & Bogle, P.C. and may be reached at mreer@hfblaw.com.