In Devon Energy Production Company, LP et al v. Sheppard et al, the Supreme Court of Texas construed what it referred to as a “bespoke” and “highly unique” royalty clause in several oil and gas leases to prohibit the producers from deducting out of the lessor’s royalty post-production costs incurred downstream of the point of sale to unaffiliated third parties.

The provisions (redacted; read them yourself):

The royalty clause

Under 3.(a) and 3.(b), : Lessor’s royalty was 1/5th of the gross proceeds realized from sales.

3.(c): “If any … sale of oil or gas shall include any reduction or charge for the expenses or costs of … [specified PPC’s] … then such deduction, expense or cost shall be added to . . . gross proceeds so that Lessor’s royalty shall never be chargeable directly or indirectly with any costs or expenses… .”

Addendum L: Payments of royalty … shall never bear or be charged with, either directly or indirectly, any part of the costs or expenses of …  [specified PPC’s], post-production expenses, marketing or otherwise making the oil or gas ready for sale or use, …” 

The terms of L were controlling over 3.(c).

The general rules …

The court reiterated the rule that unless agreed to the contrary, the lessor shares in the burden of PPC’s, and proceeds leases ordinarily authorize the lessee to deduct from royalties PPC’s incurred after the point of sale to an unaffiliated third party.

However, the Court also reiterated the rule of contract construction that unambiguous contracts in Texas will be enforced according to the plain language of the instrument.  

… applied to this case

The court construed the royalty provisions as requiring an “add back”, and the key provisions in the lease plainly required that certain sums be “added to” the producers’ gross proceeds for royalty calculation purposes. The cost at issue was an $18 per barrel deduction for the buyer’s anticipated post-sale costs for “gathering and handling, including rail car transportation.” The producers did not add the $18 to the royalty base.

The question was not whether a buyer’s PPC’s were gross proceeds under the leases or the law. They weren’t. The question was whether the leases nonetheless required the producers to pay royalty on those costs. The broad language in paragraph 3.(c) was clear in requiring any reduction or charge for PPC’s that were included in the producers’ disposition of production to be added to gross proceeds so that the landowner’s royalty would never bear those costs, even indirectly. The leases contemplated royalties payable on amounts that may exceed the consideration received by the producers.

The Court denied the producers’ assertion that paragraph 3C was surplusage because the payment of royalty on non-proceeds is so at odds with the usual expectations that it could not be required unless such an intent was stated plainly and in a formal way, The court agreed that for continuity and predictability of oil and gas law the courts should construe commonly used terms in a uniform and predictable way; however, there was nothing usual or standard about the language in 3(c), which was clear in expressing the intent to deviate from the usual expectations.

The Court also denied the producer’s argument that leases’ references to Heritage Resources and Judice was surplusage.

There was some relief for the producers.  The lessors didn’t challenge the trial court’s summary judgment for the producers on:

  • adjustments for volumes of gas used for the producers’ operations and never sold;
  • adjustments for volumes of production deemed to be lost or unaccounted-for by third parties; and
  • value retained by the producers as a result of contractually fixed recovery factors. 

The dissent

Justice Blacklock dissented, reasoning primarily that the transaction between Devon and the purchaser did not involve a reduction or charge from PPCs that reduced the proceeds received by Devon or the royalty received by the royalty owners.  It is an accounting gimmick when Devon is required to pay an inflated royalty just because it left behind a paper trail indicating that it calculated its initial sales price with reference to a downstream market.

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