Co-author Rusty Tucker

The Supreme Court of Texas has ruled that oil and gas leases under consideration in BlueStone Natural Resources II, LLC v. Walker Murray Randle, et al. did not permit deduction of postproduction costs from sales proceeds before royalties were computed, and a “free use” clause did not authorize the lessee to consume leasehold gas in off-lease operations without compensating the lessors.

The takeaway …

… at least that’s what they ruled in this cicumstance. The Court reiterated that regardless of a recitation here or an observation over yonder, it will not adjudicate the supremacy of one contract clause over another or one arbitrary rule of construction over another. Rather, it will construe each contract according to its terms.

The royalty clause

Several lessors executed identical leases, each with an addendum declaring that it “supersedes any provisions to the contrary in the [Lease].” The lease called for gas royalties based on “the market value at the well . . .  .”  By the addendum the lessee agreed to pay royalties on the “gross value received …”, and that “royalties  . . . shall be without deduction” of postproduction costs.

BlueStone acquired the leases and began deducting postproduction costs under an “at the mouth of the well” computation. Royalty payments declined dramatically and four lessor suits, combined into one, alleged that the lease required royalties to be calculated on “gross” receipts, “without deduction.”

Postproduction costs

BlueStone conceded that “gross value received” superseded the “market value” royalty measure, but argued that “at the mouth of the well” was the only language providing a valuation point, and because nothing in the addendum was contradictory, the provisions could be harmonized. The lessors maintained that the provisions were inherently inconsistent.

The court described the royalty clause as commonly having at least three components: the royalty fraction; the yardstick (market value, proceeds, price); and the location for measuring the yardstick. Bluestone argued the addendum lacked the third element – a valuation point – so the “at the mouth of the well” valuation point could be freely appended to the addendum’s “gross value received” without conflict.

The court concluded that “gross value received” is equivalent to gross proceeds and is self-inclusive of both the yardstick and the valuation point, with “received” referring to the proceeds actually obtained at the point of sale and “gross” meaning without deduction.

Burlington Resources distinguished

When the location for measuring market value is “at the well” (or equivalent phrasing), the workback method permits an estimation of wellhead market value by using the proceeds of a downstream sale and subtracting postproduction costs incurred between the well and the point of sale. Sales proceeds is a starting point and postproduction costs are netted back to the wellhead.

“Proceeds” or “amount realized” clauses require measurement of the royalty based on the amount the lessee receives under its sales contract, regardless of whether it is more or less than market value. “Proceeds” of a sales transaction may be either the gross amount received or the net amount remaining after deduction, depending on the contract language.

An “amount realized” clause, standing alone, creates a royalty interest that is free of postproduction costs. But a royalty based on “the amount realized” might bear postproduction costs depending on the contractual context.

The Court concluded that the net-proceeds-equivalent formulation could not be harmonized with the addendum’s gross-proceeds language.  “At the well” is a net-proceeds equivalent that contemplates deductions while gross proceeds “indicates just the opposite.”

The Court distinguished its opinion in Burlington Resources v. Texas Crude Energy, which construed an “into the pipelines” clause as an “at the well” calculation that functions as a net-proceeds calculation.  The royalty owner was not relieved of the obligation to share postproduction costs. The Court explained that the valuation clause in Burlington did not specify whether “amount realized” was gross or net, so giving effect to other language in the lease requiring royalties to be delivered “into the pipelines” created no inconsistency.  And unlike the lease at issue here, Burlington did not involve conflicting royalty formulas, “gross” valuation language, or a provision directing how to resolve conflicts. The contract terms in Burlington did not inherently conflict, whereas the terms in BlueStone’s lease did.

Plant fuel and compressor fuel

BlueStone was not paying royalties on commingled gas used as plant fuel by a third-party processor or gas that fueled compressors on and off the leasehold. The lessee was not required to pay for gas used in “ … operations which Lessee may conduct hereunder, . . . .”  BlueStone claimed the right to free use of gas that benefitted or furthered leasehold operations and that plant fuel and compressor fuel were for that purpose. But the lease’s plain language did not make free royalty gas used to “benefit” or “further” lease operations.  Accordingly, the free‑use clause did not authorize royalty‑free use of gas off‑lease.

The trial stipulations about compressor fuel use were vague in certain respects, so that portion of the judgment was remanded to determine damages, if any, for off‑lease compressor-fuel use.

Your musical interlude, an Easter song, believe it or not. And it works for Good Friday.