Articles Posted in Recent Cases

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In January the US 5th Circuit Court of Appeals submitted a “certified question” to the Texas Supreme Court. Federal courts have jurisdiction over cases involving only state-law issues if the parties are from different states – diversity jurisdiction. This is one such case. Carl v. Hilcorp Energy Company, No. 24-0036.

The trustees of the Carl/White Trust sued Hilcorp Energy on behalf of royalty owners with language in their leases providing that the lessee must pay royalties on gas “sold or used off the premises.” The suit seeks class-action status on behalf of these royalty owners. The Trust’s lease also provides that royalty on gas should be paid on the “market value at the well.” Hilcorp moved to dismiss the claim, arguing that under a “market-value-at-the-well” lease, Hilcorp was allowed to deduct all post-production costs and therefore had no obligation to pay for gas used in processing. The trial court agreed with Hilcorp and dismissed the case; the Trust appealed to the 5th Circuit.

When a case in federal court is governed by state law, a federal appeals court may ask the state’s top court to opine on a question of law critical to its case – to submit the question as a “certified question” to the state court.  The 5th Circuit did so here, asking the Texas Supreme Court: “can a market-value-at-the-well lease containing an off-lease-use-of-gas clause and a free-on-lease-use clause be interpreted to allow for the deduction of gas used off lease in the post-production process?” The Texas Supreme Court agreed to consider the question, and the parties have submitted briefs. Two amicus briefs, one from Texas Oil & Gas Association supporting Hilcorp’s arguments, and one by Texas Land & Mineral Association and National Association of Royalty Owners-Texas, Inc., supporting the Trusts’ arguments.

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This year the Texas Supreme Court decided Van Dyke v. The Navigator Group, trying to give some structure to cases construing conveyances and reservations of royalty interests-whether fixed or floating. I wrote about the case last February. Since then two court of appeals cases have grappled with the issue: Royalty Asset Holdings II, LP v. Bayswater Fund III-A LLC, in the El Paso Court of Appeals, No. 08-22-00108-CV; and Thomson v. Hoffman, in the San Antonio Court of Appeals, No. 04-19-00771-CV.

In Royalty Asset, the court construed the following royalty reservation:

EXCEPT that Grantors, for themselves and their heirs and assigns, retain, reserve and except from this conveyance and [sic] undivided 1/4th of the land owner’s usual 1/8th royalty interest (being a full 1/32nd royalty interest) payable or accruing under the terms of any existing or future oil, gas or mineral lease pertaining to or covering the oil, gas and other minerals on, in or under the above described [sic] land. It is distinctly understood and agreed that the interest in royalties hereby retained and reserved by Grantors does not participate in any bonus or delay rentals payable for or accruing under the terms of any such oil, gas and mineral lease or leases, and it shall not be necessary for Grantors to join in, execute or ratify any oil, gas and mineral lease covering said above described tract, the right and privilege to execute any oil, gas and mineral lease or leases covering the full mineral interest in the above described tract being hereby granted and conveyed to Grantees herein, their heirs and assigns.

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Last year the Texas Supreme Court decided Mitchell v. MAP Resources, holding that a mineral owner whose interest was sold at a tax foreclosure could collaterally attack the judgment and introduce extrinsic evidence that he had not been properly served with notice of the suit and therefore was deprived of due process under the 14th Amendment of the US Constitution. Gill v. Hill is another such case. The El Paso Court of Appeals ruled against the plaintiff, with one judge dissenting. The Texas Supreme Court agreed to hear the case, where it is now pending.

The tax foreclosure in Gill v. Hill took place in 1999. Suit seeking to set aside the foreclosure was filed in 2019. The El Paso Court of Appeals distinguished the case from Mitchell v. MAP Resources. In both cases the taxpayer was served by posting on the courthouse door. In Mitchell, both sides moved for summary judgment, and the party seeking to set aside the foreclosure introduced extrinsic evidence that she could easily have been personally served because her name and address were in courthouse deed records and appraisal district records. In Gill v. Hill, the defendant moved for summary judgment on the ground that the suit was barred by limitations. The plaintiff alleged that he could have been personally served but did not move for summary judgment or introduce any extrinsic evidence.

The Court of Appeals held it was plaintiff’s burden to raise a fact issue on whether adequate notice of suit was given by introducing extrinsic evidence. The dissent would hold that the defendant had the burden on summary judgment to show that proper notice of the suit was given.

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In this case, decided last April, the Texas Supreme Court held that the force majeure clause in an oil and gas lease could not be relied on to extend the date by which a well had to be commenced to keep the lease in force.

The facts are these:

MRC owned a lease covering 4,000 acres in Loving County. The lease provided that, at the end of the primary term, the lease would terminate except as to designated production units around existing wells unless MRC engaged in “continuous drilling”—spudding a well within 180 days after the spud date of the previous well. Prior to the end of the primary term MRC had drilled five wells on the lease. Under continuous drilling clause, MRC had to spud a well by May 21, 2016 to avoid partial termination of the lease.

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Twenty years ago I wrote an article, “Issues Concerning Royalty Valuations and Deductions,” published in the Petroleum Accounting and Financial Management Journal. One of those issues I discussed was the recurring problem of post-production cost deductions. In the article I contrasted the approaches to lease construction illustrated by two cases: Heritage Resources v. NationsBank, 939 S.W.2d 118 (Tex. 1996), and Rogers v. Westerman Farm Co., 29 P.3d 887 (Colo. 2001). A recent decision from the Colorado Supreme Court, Board of County Commissioners of Boulder County, Colorado v. Crestone Peak Resources Operating, LLC, 2023 WL 8010221 (Nov. 20, 2023), further illustrates the contrasting approaches taken by Texas and Colorado courts in construing oil and gas leases.

First, Heritage v. NationsBank and Rogers v. Westerman. Both decided whether post-production costs could be charged to the royalty owner in two oil and gas leases. The NationsBank lease provided that “there shall be no deductions from the value of the Lessor’s royalty by reason of any required processing, cost of dehydration, compression, transportation or other matter to market such gas.” But because the lease provided for gas royalties based on “market value at the well,” the Texas Supreme Court held that transportation costs were deductible from NationsBank’s royalty. The Westerman lease provided that the royalty would be “one-eighth of the gross proceeds received from the sale of such produced substances where same is sold at the mouth of the well, or … if not sold at the mouth of the well, … one-eighth of the market value thereof at the mouth of the well, but in no event more than one-eighth of the actual amount received by the lessee for the sale thereof.” The Colorado Supreme Court held that the lessee must bear all post-production costs necessary to get the gas into “marketable condition.”

The Heritage court hung its opinion on the term “at the mouth of the well.” Since royalty is to be based on the market value at the well, there can be no deductions from that value, so the no-deductions clause was “surplusage.” The Westerman court instead said the term “at the mouth of the well … says nothing about the parties’ intent with respect to allocation of costs,” and concluded that the lease is “silent with respect to allocation of costs.”

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This case illustrates an increasing problem related to salt water disposal in the Permian Basin. Recent articles in Texas Monthly and other publications have documented leaks from old abandoned wells caused by injection of massive quantities of salt water into shallow formations.Iskandia Energy Operating, Inc. v. SWEPI LP, No. 08-22-00103-CV, El Paso Court of Appeals, October 31, 2023.

Iskandia acquired oil and gas leases covering some 5,000 acres in Loving County, along with more than 100 producing wells. Iskandia planned to re-stimulate the wells and increase production.  The wells produce from formations in the Delaware Mountain Group in the Delaware Basin lobe of the Permian Basin–the Cherry Canyon, Bell Canyon and Brushy Canyon formations. These formations are just above the Bone Springs and Wolfcamp formations, which are the principal formations being drilled by operators in the Delaware lobe. Iskandia’s wells produce oil and salt water; the salt water is re-injected into the producing formation. Iskandia produces and re-injects about 6,000 barrels per day on its leases, which maintains the formation pressure and facilitates continued oil production.

SWEPI owns and operates leases adjacent to the Iskandia leases and is drilling wells in the Bone Springs and Wolfcamp. These wells also produce large volumes of salt water, and SWEPI has drilled disposal wells on its leases that inject that water into the Delaware Mountain Group formations. Iskandia produced evidence that SWEPI is injecting more than 2 million barrels per month into the DMG, and has injected more than 75 million barrels in just three years.

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In 2014 the City of Denton banned drilling of wells within its city limits. In response the Texas Legislature quickly passed HB 40, giving the Texas Railroad Commission exclusive jurisdiction to issue drilling permits within municipalities and allowing cities to regulate oil and gas activity only if their ordinances relate to “aboveground activity .. at or above the surface of the ground, including … fire and emergency response, traffic, lights, or noise, or imposing notice or reasonable setback requirements,” are “commercially reasonable,” and “do not effectively prohibit an oil and gas operation conducted by a reasonably prudent operator.”

The hubbub over drilling in municipalities arose after companies developed the technology to tap the Barnett Shale, which underlies the cities of Dallas and Fort Worth, as well as Denton. Dallas did not prohibit wells in its limits but required operators to obtain a city permit for a well. Dallas also owns substantial lands within its limits and in 2007 issued a request for proposals to lease municipal lands owned by the City. The City eventually leased more than 2,000 acres to Trinity East Energy in 2008, receiving a $19 million bonus; the lease designated potential drillsites from which multiple horizontal wells could be drilled.

By March 2010 Trinity was ready to start drilling and in 2011 it submitted applications for drill site locations on two sites identified in the City’s lease. The City Planning Commission considered those applications and denied them in December 2012. Trinity appealed to the City Council, but it failed to reverse the Planning Commission’s denial. Trinity then sued the City, alleging a “regulatory taking.” The trial court ruled that the City’s denial of the permits resulted in a regulatory taking; the amount of damages was submitted to a jury which found the City liable for $33,639,000 in damages. The City appealed, and last year the Dallas Court of Appeals affirmed that judgment. 2022 WL 3030995. This week the Texas Supreme Court denied the City’s petition for review.

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The federal district court in Pecos, Judge David Counts, issued a memorandum opinion in H.L. Hawkins, Jr., Inc. v. Capitan EnergyInc., P:22-CV-DC[Hawkins] addressing Hawkins’ claim that Capitan had improperly deducted post-production costs from its royalty. The Court held that the reasoning in the recent Texas Supreme Court case of Devon v. Sheppard was of no help to Hawkins.

Hawkins’ lease reserved a royalty of “one-fourth of the gross proceeds received by Lessee,” and contained a free-royalty provision:

Lessor’s royalty shall not bear or be charged with, directly or indirectly, any cost or expense incurred by Lessee, including without limitation, for exploring, drilling, testing, completing, equipping, storing, separating, dehydrating, transporting, compressing, treating, gathering, or otherwise rendering marketable or marketing products, and no such deduction or reduction shall be made from the royalties payable to Lessor hereunder, provided, however, that Lessor’s interest shall bear its proportionate share of severance taxes and other taxes assessed against its interest or its share of production.

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Production of oil and gas is often accompanied by production of water from the same formation. In recent years, water has been injected into wells in the process known as hydraulic fracturing, or “fracking.” Much of the frac water returns with oil and gas during the initial production of the fracked well. Fracking of horizontal wells requires huge quantities of water, and when this water—and water native to the formation—returns to the surface, something must be done with the water.

Historically produced water has been treated as waste—a substance that contains not only water but also salts, chlorides, sodium, carbon dioxide, and heavy metals. Produced water has typically been disposed of by injection into underground formations. Well operators may drill their own disposal wells or may contract with third parties to dispose of produced water for a fee.

Water used in fracking has typically been obtained from formations containing fresh groundwater. The huge quantities of fresh water used for fracking have taxed some aquifers, and the practice has been criticized as wasting a precious resource.

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The Amarillo Court of Appeals recently decided PBEX II, LLC, et al. v. Dorchester Minerals, L.P. et al., addressing an interesting issue on adverse possession of a non-operating working interest. One justice dissented.

The Court’s opinion relies on two Texas Supreme Court decisions that were controversial: Natural Gas Pipeline co. of America v. Pool, 124 S.W.3d 188 (Tex. 2003) and BP America Production Co. v. Marshall, 342 S.W.3d 59 (Tex. 2010) Pool held, to everyone’s surprise, that an operator could adversely possess or revive an oil and gas lease that had expired by continuing to operate and pay royalties on production. Marshall held that an operator’s continued payment of royalty on an expired lease “establish[ed] as a matter of law that [the mineral owner] was on notice that [the operator] claimed to own the leasehold ….”

In Dorchester, Torch was the owner of a 25% interest in an oil and gas lease covering a section of land in Midland County. Torch was party to an operating agreement under which it was a non-operating working interest owner. In 1990 Torch signed an assignment to Dorchester’s predecessors which Torch later claimed erroneously included its working interest in the lease. But from 1990 to 2016 Dorchester and its predecessors participated as working interest owners in the lease, paying their share of costs and receiving their share of revenues, in effect claiming to own Torch’s working interest.

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