On March 12 the Texas Supreme Court issued its opinion in BlueStone Natural Resources II, LLC v. Walker Murray Randle, No. 19-0459, affirming most of the judgment of the court below in favor of the royalty owners. The Court’s opinion contains a summary and discussion of its prior cases on post-production costs and attempts to reconcile those prior opinions and clarify its views on the issue. I believe the opinion does provide clarification and substantially reduces the precedential value of its first case addressing post-production costs, Heritage v. Nationsbank. The Court also discusses when royalties must be paid on gas used as fuel. Because I consider this an important case on post-production costs, I will examine the opinion in some detail.
Randle’s leases are a printed form with an exhibit. The printed form provides that royalties on gas are “the market value at the well of one-eighth of the gas so sold or used …” Exhibit A provided that “the language on this Exhibit A supersedes any provisions to the contrary in the printed lease hereof.” One provision in Exhibit A deals with post-production costs:
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.
BlueStone argued that, under the precedent of the Court’s prior opinions in Burlington Resources v. Texas Crude Energy and Heritage v. Nationsbank, because the lease provides for royalties based on “market value at the well,” all other language in the lease is “surplusage” and has no effect, and post-production costs can be deducted. The Court disagreed. It held that the printed-form “market value at the well” royalty provision clearly conflicts with the no-deduction clause in Exhibit A and Exhibit A must therefore control, requiring royalty to be paid on the “gross value received.”
In the Court’s summary of its prior opinions on this issue, it reaffirmed a statement it made in Burlington that “an ‘amount realized’ clause, standing alone, creates a royalty interest that is free of post-production costs.” The Court distinguished its Burlington opinion: the royalty clause there required royalty to be paid on the “amount realized” but also included language requiring royalties to be delivered “into the pipelines,” which the Court equated (wrongly, I think) with “at the well.” Unlike the Randle leases, the royalty clause in Burlington did not clearly say that, notwithstanding the “into the pipeline” language, royalties would be based on “gross value received,” without deductions.
The Court appeared to acknowledge that its prior opinions concerning post-production costs may not have been perfectly clear:
When used in conjunction with “amount realized” or similar language, “at the well” is as much a valuation method as it is a valuation point. When proceeds are valued in “gross,” however, the valuation point is necessarily the point of sale because that is where the gross is realized or received. If our jurisprudence is less than precise in articulating some of these concepts, it is nonetheless clear that royalties computed on gross amounts received means royalties are paid based on point-of-sale proceeds without deduction of postproduction costs.
The Court then addressed BlueStone’s argument that “at the well” makes all other language surplusage.
BlueStone nonetheless contends that Burlington Resources treats “at the well” as a “trump” card that supersedes “amount realized” language without regard to other lease terms requiring royalty calculation on the “gross” and without regard to the parties’ own agreement about what language controls in the event of a conflict. … The contract terms Burlington Resources evaluated did not inherently conflict, but the terms used in BlueStone’s lease do. Nothing in Burlington Resources can reasonably be viewed as repudiating the notion that “gross” and “net” are opposite calculations or as favoring one over the other when both are present. Here, the parties expressly agreed to resolve the conflict in favor of a royalty free of postproduction costs, and courts must enforce unambiguous contracts as written. We accordingly hold that BlueStone wrongfully deducted postproduction costs in satisfying its royalty obligations to the Lessors.
The lease construed in Heritage v. Nationsbank provided that:
The royalties to be paid Lessor are …
on gas, .. the market value at the well of 1/5 of the gas so sold or used, … provided, however, 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.
The Court held that Heritage could deduct post-production costs. It read the above clause to in effect say that “there shall be no deductions from the market value at the well by reason of any required processing, cost of dehydration, compression, transportation or other matter to market such gas.” Because the market value at the well is determined before any post-production costs are incurred, there can be no deductions from that value and therefore, according to the Court, the no-deductions language is “surplusage.” The Court ignored the words “provided however.” Arguably, those words mean that, regardless of how royalties would otherwise be paid, there can be no deduction of post-production costs–just as the language in the Randles’ leases that the Exhibit A provisions overcome the printed-lease terms and thereby prevail over the “at the well” language in the printed lease. Although the Court was ultimately divided 4 to 4 on the result in the case, lessees’ lawyers have sought to expand the scope of Heritage to mean that, whenever the term “at the well” is in a lease, any other language in the lease to the contrary can be ignored as “surplusage.” Perhaps the Court’s opinion in BlueStone will finally limit the precedential value of Heritage to the inartfully drawn language of that particular royalty clause.
The Court’s opinion also addressed whether BlueStone could use gas used for compressor fuel and plant fuel without paying royalty on those volumes. The lease provided:
Lessee shall have free from royalty or other payment the use of … gas … produced from said land in all operations which Lessee may conduct hereunder, including water injections and secondary recovery operations, and the royalty on … gas … shall be computed after deducting any so used.
Gas used as fuel for compression was consumed on the leased premises. BlueStone contracted with a processor to process the gas off the leased premises and the processor used a part of the gas delivered to it as fuel in its plant. The Court agreed with the Court of Appeals that the above language entitled BlueStone to use gas for compression on the lease, but that it must pay royalty on gas consumed as plant fuel–not consumed on the lease. The Court parsed the language “all operations which Lessee may conduct hereunder” as meaning under–and therefore on–the leased premises. The Court remanded the case to the trial court to determine what volumes of compressor fuel were produced from the leases.