Co-author, Gray Reed partner Jim Reed

The common thread throughout the myriad oil and gas royalty cases decided recently by Texas courts could be “harmony”, the reading of different, seemingly conflicting, contract provisions so as to give meaning to all.

In Enervest Operating, LLC v. Mayfield and Ingham the Fourth Court of Appeal harmonized a market-value-at-the-mouth-of-the-well royalty clause and a free-use provision to conclude that the royalty owners must bear their share of fuel gas, which the court deemed to be a post-production cost.

The facts

Gas royalties were to be paid on “ … gas … produced … and sold or used off the premises, … the market value at the mouth of the well of one-eighth of the gas … .”

The free-use provisionallwed the lessee to have ” …  free use of … gas … from said land … for all drilling operations hereunder, and the royalty shall be computed after deducting any so used.”

Enervest uses some of the gas sent downstream for sale as fuel gas to power compressors and dehydrators and does not pay royalty on that gas.  Lessors asserted that Enervest improperly deducted this fuel gas from their royalties. Enervest responded that the market-value-at-the-mouth-of-the-well provision requires the lessors to bear their share of PPC’s, including fuel gas, as a matter of law.

The result

The court of appeal concluded that “market-value-at-the-mouth-of-the-well” has a commonly accepted meaning in the industry that identifies the location for the calculation of royalties and requires royalty owners to share the burden of PPC’s.

The Court deemed fuel gas to be a PPC because it is used to facilitate the production of gas that is sold and contributes to the material enhancement of the value of the gas. Trial court judgment for lessors was reversed.

According to the court, the trial court’s judgment was based on an “isolated reading of the free use clause” that ignored the plain language of the royalty clause requiring that royalty be based on market value at the well.

Arguments rejected

The court denied lessors’ argument that Enervest’s predecessors paid royalty on fuel gas and therefore Enervest must do the same. When a contract is unambiguous, estoppel as a result of past conduct of the parties has no application.

The Court found a difference in the free-use language in Bluestone v. Randle “in all operations hereunder” compared to the language in the case at bar, “for all drilling operations hereunder” and did not find Bluestone to be instructive.

The court did not accept lessors’ comparison of the oil royalty clause, which states specifically that the lessor shall bear its proportion of oil treating expenses, to the gas royalty, which does not have that language to mean that the gas royalty must not bear PPC’s. Such a reading would ignore the gas royalty provision’s express language.

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