Texas Supreme Court Clarifies Allocation of Post-Production Costs in Oil and Gas Royalties in BlueStone Natural Resources II, LLC v. randle | Skadden, Arps, Slate, Meagher & Flom LLP

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On March 12, 2021, the Texas Supreme Court issued a unanimous opinion that clarifies when a lessee is entitled to deduct post-production costs from royalties paid to the lessor under oil and gas leases. Interpreting a lease and an addendum to the lease, the court of BlueStone Natural Resources II, LLC vs. Randle, No. 19-0495 held that the wording of “gross value received” in the addendum constituted a point of valuation at the point of sale (which does not allow the deduction of post-production costs) which was in conflict with the “at the well” of the lease form. provision (which generally permits such deductions). Because the addendum provided that it would have control in the event of a conflict, the BlueStone lessor was not permitted to deduct post-production costs from royalties paid to the lessor. The court referred but distinguished its recent decision in Burlington Resources Oil & Gas Co., LP vs. Texas Crude Energy LLC573 SW3d 198 (Tex. 2019), who argued that “at the well” valuation points allow post-production costs to be deducted. Burlington did not dictate the result in BlueStone because the “value received” clause in the lease in Burlington had no modifier, whereas the term “value received” in BlueStone’s lease was modified to the word “gross”, which “gives rise to an ‘inherent conflict'” with a royalty clause “at the well » (BlueStone sliding op. at age 15 (citing Judge v Mewbourne Oil Co., 939 SW2d 133, 136 (Tex. 1996) (Owen, J.) (op. plurality))). The court pointed out that traditional rules of contract construction apply to oil and gas leases.

1. Overview of royalty provisions: “market value at the well” versus “results” leases

Texas courts employ standard contract construction rules to interpret oil and gas leases, “begin[ning] with the express language of the contract” and by reviewing the whole of the writing to harmonize the provisions of the contract (Burlington, 573 SW3d at 202-03). At the same time, however, certain basic principles affect Texas courts’ interpretation of the language used in oil and gas leases. For example, royalty holders generally do not pay production costs, such as geophysical surveys and drilling wells, but are generally required to pay post-production costs, such as transportation, processing and compression that are incurred to bring gas from the head end well downstream to market. (See Burlington, 573 SW3d at 203.) This typical allocation of costs between royalty owner and lessee is often reflected in a “market value at well” lease clause. (See Chesapeake Expl., LLC v. Hyder483 SW3d 870, 873 (Tex. 2016).) The market value at the well can be thought of as the commercial market value minus the expenses incurred in bringing the oil or gas from the well to market.1

The parties can, however, “incur a royalty calculated on the basis not of the value of the oil and gas at the well but of its value at the point of sale”. (See Burlington573 SW3d 204.) If a royalty is based on the amount realized on a sale, the lessee generally cannot deduct post-production costs from the royalty payment.2 This is called an “income” lease,3 and this can have a huge impact on the amount of royalties a royalty holder receives because the value of the oil or gas increases as it is processed and moved from the wellhead downstream.

In Burlingtonthe court clarified that royalty provisions in oil and gas leases may have a separate assessment point and valuation method.4 The leases in Burlington provided that the royalties were calculated on the basis of the “realized amount” of the sale, that is to say., the actual amount of money received for the sale instead of the typical “market value”.5 But the leases also included what the court found to be an “at the well” provision.6 The court read the provisions together to create a valuation point at the well based on the method of valuing the amount realized from the downstream sale.seven The court found that Burlington had “the right to subtract post-production costs from the ‘realized amount’ in the downstream sale price in order to calculate the value of the product” at the wellhead.8 In other words, Burlington argued that there may be a valuation point at the sink tied to a valuation method based on the amount realized on the downstream sale.

2. The dispute in BlueStone: whether BlueStone can deduct post-production costs from royalty payments

A key problem in BlueStone was whether the lessee was entitled to deduct post-production costs from its royalty payments to the lessors. The original tenant, Quicksilver, did not deduct post-production expenses for nearly a decade. After BlueStone acquired the leases, it began deducting post-production costs from its royalty payments. The royalty holders sued BlueStone.9

At issue was the interaction between a standard lease (the “printed lease”) and an addendum to that lease. The printed lease contains a royalty clause for “the market value at the well of one-eighth of the gas so sold or used”. The addendum states that it controls provisions to the contrary in the printed lease and includes a clause which states that “the lessee agrees to calculate and pay royalties on the gross value received…”.ten If the “at the pit” clause of the printed lease is not replaced by the “gross value received” clause in the addendum, BlueStone is entitled to deduct reasonable post-production costs from royalty payments to royalty holders. But if the “gross value received” clause is both a valuation method and a valuation point, then the addendum controls the printed lease, and BlueStone would not be allowed to deduct post-production costs from Royalties.

The Fort Worth District Court and Court of Appeals both ruled that the addendum replacement clause was applicable, resulting in a “pure product” royalty calculation that did not allow BlueStone to deduct post-production costs of its royalty payments.11 BlueStone appealed.

3. Texas Supreme Court rules addendum “gross value received” clause conflicts with lease “at well” clause and provides that BlueStone cannot deduct post-production costs from its payments royalties.

The Texas Supreme Court determined that the “gross value received” clause of the addendum conflicted with the “at the well” provision of the printed lease, upholding the appeals court’s decision.12 The court began with a reaffirmation of the basic interpretation of the contract, noting that the courts of Texas “interpret the mining lease as a whole and interpret the language according to its clear, ordinary and generally accepted meaning…”.13 The court concluded that “where the product is valued ‘gross’…the point of valuation is necessarily the point of sale because that is where the gross is made or received.”14 The court rejected BlueStone’s argument based on Burlington that the language “at the well” acts as an “asset” which replaces the raw language realized.15 The court distinguished the lease in question in Burlington, which did not use “gross” language to alter the valuation of “amount realized” in the lease. The addendum in question in BlueStonehowever, included a “gross value received” clause. The terms, the court found, cannot be reconciled: “the terms ‘gross’ and ‘net’ do not coexist peacefully.”16 The court held that the lease was unambiguous, that the “gross value received” clause of the addendum prevailed and that it provided for (i) a “method of valuation” of “the royalty based on the amount that the lessee actually receives under its contract sales for gas”” and (ii) a “valuation point” which is “necessarily the point of sale” because of the “gross” modifier.17 As a result, BlueStone was not allowed to deduct post-production costs.18

Key points to remember

  • When drafting contracts in general, and oil and gas leases in particular, drafters should be careful to state the terms of the contract explicitly and not rely on terms commonly understood in the industry.
  • Drafters should carefully note that the method of valuation is separate from the point of valuation, and both should be explicitly detailed in leases. Additionally, writers should be careful when using the terms “gross value received,” which will disallow post-production deductions of royalty payments, and “at the sink,” which allows such deductions.
  • Parties (or acquirers) to oil and gas leases should review existing leases to determine whether such agreements contain conflicts between “gross value received” and “at well” clauses, and whether alternative clauses could affect the interpretation.
  • Many standard contracts are governed by endorsements or riders, similar to the printed lease and rider at issue in BlueStone. For example, the Edison Electrical Institute (EEI) Master Agreement, which is a “Standard Commercial Electricity Purchase and Sale Agreement”, includes optional appendix provisions and provides in its cover the ability to identify any personalized contract addendum that modifies the terms. of the framework contract.19 The North American Energy Standards Board, Inc. (NAESB) also provides a basic contract for the purchase and sale of natural gas, which is modified by the cover page, special provisions and transaction confirmations.20
  • While BlueStoneRegarding oil and gas royalties, it provides an overview of how the Texas Supreme Court views contract modifications through endorsements or addenda. Editors should be aware of the possibility of creating conflicting terms through amendments or addenda and plan to resolve these contradictions.

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1 See Chesapeake Expl., LLC v. Hyder483 SW3d 870, 873.

2 See Burlington573 SW3d 204.

3 Chesapeake Exploration, LLC483 SW3d to 873.

4 Burlington573 SW3d to 211.

5 Identifier.

6 Identifier.

seven Identifier. at 205, 211.

8 Identifier. at 211.

9 See BlueStone Nat. Resources II, LLC vs. Randle601 SW3d 848, 853 (Tex. App. — Fort Worth 2019, pet. granted).

10 There is also a dispute over a “free use” clause that allows BlueStone to use “royalty free…oil, gas and coal produced from said land in all operations that the lessee may carry out hereunder”. The Texas Supreme Court, in a first impression case, held that the free use clause was limited to rental uses. BlueStone, op. at 26 years old.

11 ID. at 869.

12 BlueStoneop. slip, to 2.

13 ID. at 8.

14 ID. at 14.

15 ID. at 15-16.

16 Identifier. at 15.

17 ID. at 12, 14, 17 (emphasis in original) (quoting Bowden vs. Phillips Petroleum Co.., 247 SW3d 690, 699 (Texas 2008)).

18 ID. at 17 years old.

19 Andrew S. Katz, Using the EEI-NEM framework contract to manage electricity marketing risks, Energy Law Journal, vol. 21, 269 and 275 (2000).

20 See, for example7A William B. Burford, West’s Tex. Forms, Minerals, Oil and Gas § 17:10 (4th ed.).

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