In Carl v. Hillcorp Energy the Supreme Court of Texas addressed the relationship between the lessee’s use of gas off-premises under a free-use clause and the lessor’s burden to share post-production costs (PPCs) under the at-the-well gas royalty clause of an oil and gas lease. Spoiler alert: Lessee wins.   

The basics

Minerals that have been processed or transported are generally more valuable than the same minerals at the wellhead. The Supreme Court has long held that the holder of an at-the-well royalty must share proportionately in PPC’s expended on production from the well prior to sale.

Producer Hillcorp used gas produced from the well to power post-production activities conducted off the premises. Generally, the value of gas used for post-production activities is a PPC of the kind normally charged to the royalty owner. Hillcorp accounted for this value by subtracting the volume of gas used in post-production activities from the total volume of gas on which royalties were calculated.

The royalty clause

Hillcorp was to pay royalty “on gas … produced from said land and sold or used off the premises.”

Royalty owner Carl argued that Hillwood could not subtract volumes of gas used in post-production activities because the lease required payment of royalty on all gas produced from the well; gas sold or used off-premises must be calculated based on the market value of that gas at the well; and when volumes of gas are removed from the royalty calculation she is not being paid for all the gas sold or used off the premises.

Hillcorp countered that because this is an at-the-well royalty lease it may subtract the value of gas used in post-production activities before paying royalty.

The free-use clause

The royalty clause allowed Hillcorp to have “free use of … gas … from said land for “all operations hereunder, and the royalty on … gas … shall be computed after deducting any so used.” Carl argued that Hillcorp did not have free use of gas for off-lease post-production operations, which she argued were not “operations hereunder”. Thus, Hillcorp must pay royalty on that gas.

What the Court said

The Court concluded that Carl invoked a provision – the free-use clause – that has no impact on her obligation as a royalty holder of an at-the-well royalty to bear her proportionate share of PPCs.

To the Court, the question was not whether the lease entitled Hillcorp to free use of the gas used in post-production activities. The fact remained that Carl as a holder of an at-the-well royalty must share in PPC’s whether or not those costs include using some of the gas produced from the well. Carl was not claiming that gas used for post-production activities was not a genuine PPC of the kind that normally is shared by an at-the-well royalty holder.

The free use clause had no bearing on the outcome of the dispute over how to account for PPCs. The point was that Carl’s market-value-at-the-well royalty bears the usual cost of PPC’s including the cost of gas produced from the well and used off-premises to power postproduction activities.

Caveat from the Court

Attaching labels to general categories of lease clauses – eg. “off-lease-use-of-gas” and “free-on-lease-use” clauses gives the misimpression that all clauses to which those labels apply operate in the same way. To the contrary, all leases are to be interpreted based upon what they say and not based on labels.

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