Search results for: sheppard

Co-author Gunner West

City of Crowley v. TotalEnergies E&P USA, is a post-production cost (PPC) case with a predictable result. The Fort Worth Court of Appeals confirmed its reasoning in Shirlaine W. Props. Ltd. v. Jamestown Res., L.L.C from 2021, that under a market-value oil and gas lease, gas sold at the wellhead means that other promises within the lease that royalties will never bear PPCs don’t matter. The lessee will bear its share of costs incurred to make the gas marketable.

Background and legal framework

The lessor’s share of production depends on two factors: the valuation metric (market value, proceeds, or price) and the point of valuation (at the well or other point of the). Together, these factors determine whether the royalty bears PPCs.

Gas sold at the wellhead is valued before PPCs are incurred and the royalty owner typically shares those costs through the workback method (which estimates wellhead value by subtracting PPCs from prices received downstream). In contrast, a gross-proceeds royalty is measured by the lessee’s actual receipts at the point of sale and is free of PPCs when the sales occur downstream.

The lease provisions

The court examined four key provisions of the royalty clause:

  • Payment will be the “Royalty Fraction of the market value at the point of sale, use, or other disposition”. The point of sale here was the wellhead;
  • The market value “will never be less than the total proceeds received by Lessee in connection with the sale  …” .
  • “[I]f Lessee realizes proceeds of production after deduction for any expense of [postproduction] . . . then the reimbursement or the deductions will be added to the total proceeds”; and
  • “Lessor’s royalty will never bear, either directly or indirectly,  . . . any part of [PPCs].”

Shirlaine controls

The court found the lease provisions to be nearly identical to those in Shirlaine. The valuation provision fixed market value at the wellhead – the point of sale. Moreover, adopting the lessor’s reading would improperly rewrite an at-the-well market-value lease into a “total proceeds” lease.

The court’s analysis

The Shirlaine reasoning was logically, legally, and linguistically sound, said the court.

The City’s argument that PPCs constitute “deductions” because gas buyers anticipate incurring them “twists commonsense economics into something it is not.”  Treating the gas buyer’s expectation of downstream costs as a “deduction” from the seller’s proceeds conflates price formation with expense recovery. While the commonly-used workback method anticipates PPCs to estimate wellhead market value, this doesn’t mean the seller actually “realizes proceeds . . . after deduction” of those costs. The workback method is merely a proxy for market value.

Market value at the well means the value before gas is prepared for market. There are no marketing costs to deduct from the value. Post-sale expenses are, by definition, post-sale. Therefore, with the wellhead as the valuation point the lessees do not “realize proceeds . . . after deduction for any [postproduction] expenses.”

The add-on and no-PPC clauses did not apply to these facts; perhaps those clauses could apply if the point of sale was a place other than the wellhead.

The court affirmed summary judgment for the lessees. The lessees did not breach the lease by calculating the lessor’s royalty without including PPCs.

Caveat

Don’t read too much into this or any other PPC case. Our Supreme Court reminds us frequently that the effect of any royalty clause depends on the language of the clause itself. Beware of general statements of the law.

Your musical interlude.

Lagniappe

Its bedtime and your stash of melotonin is depleted? We can help! Read these summaries of cases cited in the opinion to learn more about PPCs:

BlueStone Nat. Res. v. Randle

Burlington Res. Oil & Gas Co. v. Tex. Crude Energy

Devon Energy Production Co. v. Sheppard

Shirlaine

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.

Your musical interlude

Co-author Rusty Tucker

Devon Energy Prod. Co., et al. v. Sheppard, et al is your kind of case if you are in search of:

  • A roadmap for slicing and dicing royalty calculations in myriad ways,
  • Pretty good summaries of the Supreme Court’s notable decisions in Heritage Resources v. NationsBank, Judice v. Mewborne Oil, Chesapeake Exploration v. Hyder and Burlington Resources v. Texas Crude. (pp 12-19)
  • A description of the gas fractionation process.
  • For you scriveners: Reference to the Supreme Court’s lament for “the considerable time, money and heartache” expended due to the use of “industry jargon, outdated legalese, or tenuous assumptions about how judges will interpret industry jargon or outdated legalese”.

Continue Reading When is a “Gross Proceeds” Royalty not Paid on Gross Proceeds?