Co-author Caleb White

After reading Devon Energy Production Company, L.P. v. Oliver if you’ recall a similar post-production cost dispute, it was last week. And the result was the same. Royalties under this lease are to be calculated at the wellhead (where there are no PPC’s) and not on a downstream market price (after PPC’s are incurred).  

The Facts

The Olivers are royalty owners in two leases covering over 3,700 acres in Dewitt County from which 110 oil wells produce. The leases contained a royalty provisions in the form and in the addendum. The addendum controls where the two are in conflict. The Olivers attempted in several ways to free themselves from the burden of PPC’s.

  • Form lease Paragraph 3: Lessee, at its option, will pay lessor “ … the average posted market price of such 1/5th part of all oil at the wells as of the day it is run to the pipe line or storage tanks, lessors interest, in either case, to bear 1/5th of the cost of treating oil to render it marketable pipe line oil …. “ (emphasis ours).
  • Addendum Paragraph 15: The lessor’s royalty on hydrocarbons shall never bear, directly or indirectly, any portion of the costs to save, store, gather, transport, treat, process, refine, manufacture, or market hydrocarbons, or the costs to construct, repair, or operate any related plant or facilities, or “any other costs or expenses whatsoever …,”
  • Addendum Paragraph 38:  Lessor reserved the right to take royalty oil in kind at the wells, … pending such election, the lessee shall purchase or market the lessor’s oil “at a cash price equal to the market value on the day of sale.”
  • Addendum Paragraph 35: All royalties are to be 20% of all oil and gas produced.

The Olivers sued alleging that Devon breached the leases by underpaying royalties. They argued that the free of “any other costs or expenses whatsoever” language in Addendum 15 superseded and eliminated the “at the wells” valuation point in Form 3. Devon responded that the addendum’s free-of-costs language did not establish a new valuation point. Therefore, the “at the wells” designation remained unchanged.  

The trial court granted summary judgment for the Olivers; the royalty interest was not valued “at the well” and the correct formula was “one-fifth of market value … on the day of sale.” After a trial on damages, the jury, obeying the judge’s erroneous instruction, awarded the Olivers $15,800,937.

The Analysis

The Court of Appeals began by citing the three components of any royalty clause:

  • a royalty fraction,
  • a yardstick (the pricing mechanism), and
  • a valuation point (the location at which the yardstick is applied).

Applying the reasoning of the Texas Supreme Court’s 1996 opinion in Heritage Resources, Inc. v. NationsBank, the Court concluded that the PPC language was mere surplusage when applied at the wellhead valuation point because no PPC’s are incurred at the well.

The default rule that royalties are free of production costs but not PPC’s is freely modifiable by the parties. The Court noted the leases did not specify an additional payment model to be remitted “in addition to” the royalty payment specified at the well; nor did they draft around Heritage. HINT to drafters: Heritage can be defeated by those who are paying attention.

Addendum 38 addresses only the yardstick (“market value”) and the lessor’s right to take in kind. Its silence on the valuation point does not render it in conflict with Form 3’s “at the wells” language.

Addendum 35 provides a royalty percentage of 20%. While under Addendum 15 the royalty shall not bear PPC’s, it does not establish a different valuation point. Accordingly, it merely supersedes and replaces the language in Form 3 that follows the valuation point language.

The Result

The Court determined that the leases established an “at the wells” valuation point, and the addendum’s PPC language did not create ambiguity or move the valuation point downstream. The jury award was improper because the damages were based on the downstream price, where crude oil is most valuable. The Court reversed and remanded for further proceedings.

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