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Texas Court Rules That Gross Royalty Clause in Addendum Supersedes Royalty Clause in Pre-Printed Lease Form

Texas Court Rules That Gross Royalty Clause in Addendum Supersedes Royalty Clause in Pre-Printed Lease Form

Texas Court Rules That Gross Royalty Clause in Addendum Supersedes Royalty Clause in Pre-Printed Lease Form

By: Robert J. Burnett, Esquire

Assume you own 147 acres in Tioga County, Pennsylvania. In 2017, you negotiated an oil and gas lease with XYZ Drilling. During the negotiations, you specifically requested a 16.5% gross royalty. Consistent with your request, XYZ Drilling agreed to an addendum which contained a “Gross Royalty” clause. The pre-printed lease form, however, retained XYZ Drilling’s standard royalty clause, which necessarily authorized deductions by valuing the royalty “at the wellhead”. The landman told you not to worry because the “Gross Royalty” clause in the addendum would control. You signed the lease because it was your understanding that this addendum clause protected you and prohibited XYZ Drilling from deducting any post-production costs from your royalty. Last week you received your first royalty statement. Much to your surprise, XYZ Drilling deducted compression, gathering and transportation costs from your royalty. You are angered and confused – how can XYZ Drilling simply ignore the gross royalty language in your addendum? A recent decision by the Court of Appeals in Texas suggests that a “gross royalty” clause in the addendum will supersede an “at the wellhead” clause in the pre-printed lease.

At issue in Bluestone Natural Resources, LLC v. Walker Murray Randle, et al, (Court of Appeals – Ft. Worth, April 18, 2019) were twelve (12) identical oil and gas leases signed in 2003 (the “2003 Leases”). Paragraph 3 of the 2003 Leases contained the lessee’s standard royalty clause which stated that the royalties were to be based on “the market value at the well of 1/8th of the gas sold or used…” (the “Base Lease Royalty Clause”). Attached to the 2003 Leases was an addendum which contained two critical clauses. The first clause, which is typical of most addendums, clarified that the addendum terms would control over the pre-printed lease terms:

“[I]t is understood and agreed by all parties that the language on this addendum supersedes any provisions to the contrary in the printed lease hereof…”

The addendum also contained a royalty clause. Paragraph 26 of the addendum provided as follows:

“LESSEE AGREES THAT all royalties accruing under this Lease (including those paid in kind) shall be without deduction, directly or indirectly, for the cost of producing, gathering, storing, separating, treating, dehydrating, compressing, processing, transporting, and otherwise making the oil, gas[,] and other products hereunder ready for sale or use. Lessee agrees to compute and pay royalties on the gross value received, including any reimbursements for severance taxes and production related costs.”

For over a decade, the original lessee did not deduct any post-production costs from the landowners’ royalties. In 2016, Bluestone Natural Resources, LLC (“Bluestone”) acquired the 2003 Leases and immediately began to deduct post-production costs. Within two years, Bluestone deducted approximately $1.5 million from the landowners’ royalties. The landowners then brought suit in Hood County, Texas asserting that no deductions were authorized or permitted under the 2003 Leases because Paragraph 26 required the royalty to be based on the “gross value received”. The trial court agreed and granted the landowners’ motion for summary judgment. Bluestone appealed to the Texas Court of Appeals in August 2018.

The threshold issue on appeal was whether the Base Lease Royalty Clause and Paragraph 26 were “contrary” to one another so as to trigger the addendum’s Superseding Clause. If the two clauses were inconsistent and could not be read together, then Paragraph 26 would control. In order to determine whether there was an actual conflict, the Court of Appeals examined the royalty valuation language set forth in each clause.

The panel observed that the Base Lease Royalty Clause utilized a “market value” approach to royalty valuation. Under this approach, drillers utilize two appraisal methods to value the gas at the wellhead: i) the comparable sale method or ii) the netback method.

Under the comparable sales method, the value of the gas at the wellhead is calculated by averaging the prices that the driller and other producers have received in the same production field for gas of comparable quality and quantity. Evidence of comparable sales, however, is often difficult to ascertain, so the workback or netback method developed as the preferred alternative. Under this method, the value of the gas at the wellhead is calculated by taking the downstream point of sale and subtracting the processing costs in­curred between the wellhead and the point-of-sale. See, Atlantic Richfield v. State, 262 Cal. Rptr. 683, 688 (Cal. Ctr. App. 1989) (noting that the royalty is calculated “by work­ing back from the price of the point-of-sale, deducting the cost of processing and transportation from the wellhead.”) Thus, when there is no actual market for gas at the wellhead or when there is insufficient evidence of comparable sales, the netback method allows a driller to calculate the value of the gas at the wellhead by subtracting the in­tervening processing costs. See, Kilmer v. Elexco Land Services, 980 A.2d 1147 (Pa. 2010) (“…we must work backward from the value-added price received at the point-of-sale by deducting the companies’ cost of turning the gas into a marketable commodity”). Both methods assume that the royalty valuation point is at the wellhead, even though the ac­tual point-of-sale is further downstream.

The Bluestone panel further observed that this method generally allows the driller to deduct post-production costs from the royalty calculation. See, Burlington Resources Oil & Gas v. Texas Crude Energy, 573 S.W.3d 198 (Tex. 2019) (“…when the parties specify an ‘at the wellhead’ valuation point, the royalty holder must share in post-production costs…”); Judice v. Mewbourne Oil Co., 939 S.W.2d 133 (Tex. 1996) (noting that the phrase ‘market value at the well’ means the “value at the well, net of any value added by compressing the gas after it leaves the wellhead”); Heritage Resources, Inc. v. Nationsbank, 939 S.W.2d 118 (Tex. 1997) (“[t]his method involves subtracting reasonable post-production marketing costs from the market value at the point-of-sale”). As such, the Bluestone court determined that the Base Lease Royalty Clause itself authorized deductions, which would result in a net royalty to the landowners. The court then examined Paragraph 26 to ascertain whether that clause altered the royalty valuation methodology set forth in the Base Lease Royalty Clause.

Unlike the Base Lease Royalty Clause, the court observed that Paragraph 26 was a “proceeds clause”. Specifically, the court put great weight on the second sentence of Paragraph 26 which clearly stipulated that the royalty was to be calculated “on the gross value received” by the lessee. Because Paragraph 26 based the royalty on the amount received by the lessee, the Bluestone court opined that Paragraph 26 was best characterized as a “proceeds clause”. Under this approach, the royalty is valued at the point-of-sale and not the wellhead. The Texas Supreme Court has consistently held that under a “proceeds” clause or an “amounts realized” clause, the landowner is granted “the right to a percentage of the sale proceeds with no adjustment for post-production costs.” See, Burlington Resources, 573 S.W.3d at 204. See also, Chesapeake Exploration, LLC v. Hyder, 483 S.W.3d 870, 871 (Tex. 2016) (noting that under a ‘proceeds lease’, the “price-received basis for payment in the lease is sufficient itself to excuse the lessors from bearing post-production costs”); Warren v. Chesapeake Exploration, 759 F.3d 413 (5th Cir. 2014) (stating that an “amount realized” clause, standing alone, will create a royalty interest free of post-production costs); Bowden v. Phillips Petroleum Co., 247 S.W.3d 690, 699 (Tex. 2008) (“[P]roceeds clauses requires measurement of the royalty based on the amount the lessee in fact receives under its sales contract for the gas”). The Bluestone court concluded that a “proceeds clause”, like Paragraph 26, forecloses application of the net-back method and typically results in the landowner receiving a gross royalty.

Given the strikingly different valuation methodologies set forth in each clause, the panel determined that there was, in fact, a conflict between the two clauses. The court noted that “there is inherent, irreconcilable conflict between ‘gross proceeds’ and ‘at the wellhead’ in arriving at the value of the gas.” As such, the Bluestone court held that the Superseding Clause in the addendum was triggered and Paragraph 26 governed the calculation of royalties.

Because Paragraph 26 valued the royalty at the point-of-sale, the court held that Bluestone could not “net-back” the post-production costs. Consequently, Bluestone’s practice of deducting such costs constituted a material breach of the 2003 Leases. Given this conclusion, the panel affirmed the trial court’s entry of summary judgment in favor of the landowners.

Although not binding on Pennsylvania courts, the Bluestone decision is encouraging news for landowners here in Pennsylvania. The author submits that the Bluestone panel reached the correct decision: the parties specifically negotiated a clause which based the royalty on the amount “received” by the lessee. When the royalty valuation point is at the point-of-sale, there is no legal basis to utilize or apply the net-back method. The Bluestone court correctly rejected the lessee’s attempt to re-define the royalty valuation point under the 2003 Leases as being at the wellhead. If you have a royalty clause that bases the royalty calculation on the “proceeds received” or the “amount realized,” you should carefully and regularly monitor your royalty statements since a persuasive argument can be made that no deductions are authorized or permitted under such clauses.

1Bluestone filed a “Petition for Review” with the Texas Supreme Court on June 18, 2019. On October 18, 2019, the Texas Supreme Court requested that Bluestone file a “brief on the merits” by November 18, 2019.

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