Co-author Chance Decker
Burlington Resources Oil & Gas Company, LP. v. Texas Crude Energy, LLC et al is another chapter in the back-and-forth over deduction of post-production costs from royalty payments. In “clarifying” (royalty owners might say “retreating from”) Chesapeake Exploration & Production, LLC v. Hyder, the Texas Supreme Court held that a royalty delivered into the pipeline or tanks is akin to a royalty delivered “at the wellhead.” The lessee was entitled to deduct post-production costs from its royalty calculation, notwithstanding that the calculation was based on the “amount realized” from downstream sales.
Don’t read too much into it?
The Court said the question “resembles” the question in Hyder but reminded litigants and lower courts that “… the effect of a lease is governed by a fair reading of its text …” and “ … the decisive factor in each case is the language chosen by the parties to express their agreement.”
In other words, this result is only what this particular contract requires. (Query: Have the producers arrived at Dan Jenkins’ 10th stage of drunkenness?)
Texas Crude affiliate Amber Harvest owns overriding royalty interests in leases operated by Burlington in several Texas counties. The overrides were to be:
“delivered to [Amber] into the pipelines, tanks or other receptacles with which the wells may be connected, free and clear of all development, operating, production and other costs.”
“Value” was defined in the override assignment as the “amount realized” from the sale of the oil or gas produced.
For years, Burlington deducted post-production costs from the amount realized on downstream sales. After the 2016 opinion in Hyder, disagreements arose. Citing the definition of “value”, Texas Crude alleged it was entitled to royalties based on the price derived from downstream sales with no deduction for post-production costs. Relying on Hyder, the trial court granted summary judgment for Texas Crude and Amber, and the court of appeal affirmed. The Supreme Court granted review.
A primer on post-production accounting
Absent an agreement to the contrary, oil and gas royalty interests are free of production expenses, but subject to post-production costs such as processing, compression, transportation and other costs to prepare raw oil or gas for sale downstream.
Post-production processing enhances oil and gas’s value after it leaves the well. Therefore, accounting for those costs becomes necessary when a royalty is valued at the wellhead, but the sale used to calculate the royalty occurs downstream. In this situation, the lessee is generally entitled to deduct post-production costs from the downstream sale price prior to calculating the royalty.
Of course, parties are free to contract for a royalty valued downstream without deduction of post-production costs. In Hyder, for example, the Court held that a royalty based on the “amount realized” from a downstream sale of oil or gas grants the royalty holder a right to a percentage of the sale proceeds with no adjustment for post-production costs.
Into the pipeline = At the wellhead
Texas Crude and Amber Harvest argued the “amount realized” language creates the kind of cost-free royalty that won the day in Hyder. The operative clause required Burlington to pay a royalty based on the “value” of the oil and gas produced, and defined “value” as the “amount realized” from sales.
Siding with Burlington, the Court disagreed: Though the language is not a model of clarity, the Court concluded that the royalty clause is akin to delivering a royalty at the wellhead. When a royalty is delivered, and thus valued, at the wellhead, the payee is entitled to deduct post-production costs, even when the sales used to calculate the royalty occur downstream.
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