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Burlington v. Texas Crude – another Supreme Court Case on Post-Production Costs

The Texas Supreme Court has denied motion for rehearing of its opinion in Burlington Resources Oil & Gas Company v. Texas Crude Energy, No. 17-0266. The case addresses deductibility of post-production costs in the context of an overriding royalty. The case may, however, have implications for post-production-cost deductions in oil and gas royalty clauses.TexasBarToday_TopTen_Badge_Small

Texas Crude acquired oil and gas leases in Live Oak, Karnes and Bee Counties, and entered into an agreement with Burlington to develop those leases. The parties agreed that any oil and gas lease acquired by either party within the designated area would be part of the development agreement, and that Texas Crude would receive an overriding royalty interest in all leases within the development area. Texas Crude subsequently sued Burlington over various alleged breaches of the development agreement, including the deduction of post-production costs from Texas Crude’s overriding royalties. The parties filed summary judgment motions asking the trial court to construe the language in the assignments of overriding royalty, and the trial court ruled that post-production costs were not deductible.  The parties agreed to seek an interlocutory appeal of this issue, which the court granted. The Corpus Christi Court of Appeals agreed to hear the case, and it affirmed the judgment of the trial court.  516 S.W.3d 638. Burlington then appealed to the Texas Supreme Court, which reversed and remanded, holding that the language of the overriding royalty assignments permits deduction of (some?) post-production costs.

The pertinent language of all of the overriding royalty assignments is identical:

The overriding royalty interest share of production shall be delivered to ASSIGNEE or to its credit into the pipeline, tank or other receptacle to which any well or wells on such lands may be connected, free and clear of all royalties and other burdens and all costs and expenses except the taxes thereon or attributable thereto, or ASSIGNOR, at ASSIGNEE’S election, shall pay to ASSIGNEE, for ASSIGNEE’S overriding royalty oil, gas or other minerals, the applicable percentage of the value of the oil, gas or other minerals, as applicable, produced and saved under the leases. “Value”, as used in this Assignment, shall refer to (i) in the event of an arm’s length sale on the leases, the amount realized from such sale of such production and any products thereof, (ii) in the event of an arm’s length sale off of the leases, the amount realized for the sale of such production and any products thereof, and (iii) in all other cases, the market value at the wells.

The unanimous decision, opinion by Justice Blacklock, held that the controlling language of the assignments is “delivered to ASSIGNEE or to its credit into the pipeline, tank or other receptacle to which any well or wells on such lands may be connected …” Texas Crude argued that the controlling language was in the definition of “Value”: “the amount realized from such sale of such production and any products thereof.” Texas Crude contended that under the court’s prior opinion in Chesapeake v. Hyder, 483 S.W.3d 870 (2016), a royalty based on the “amount realized,” without more, is free of post-production costs, and that the “into-the-pipeline” language would not be relevant unless Texas Crude elected to take its royalty share of production in kind.

Justice Blacklock said Texas Crude’s construction of the clause would lead to “strange results”:

If, as Texas Crude contends, the references in the Granting and Valuation Clauses to delivery “into the pipelines, tanks or other receptacles” only cover in-kind transfers, then an in-kind distribution would give Texas Crude its royalty percentage of production at the well. But an arms-length sale off the lease would give Texas Crude a higher royalty based on the downstream price after post-production enhancements. Under this construction, Burlington would be penalized for marketing Texas Crude’s share of production, finding a third-party buyer, transporting the product, and performing other post-production enhancements. It is difficult to fathom why either party would have intended such a result.

There are several troubling aspects to this statement. First, it seems to conflate “into the pipeline” with “at the well.” Second, Justice Blacklock considers that requiring Burlington to bear all post-production costs would “penalize” Burlington. Third, the opinion seems to be construing the language in a way that would reach a result the court deems reasonable, rather than enforcing the language as written. The clause clearly provides that Texas Crude may take its royalty in kind, or may require Burlington to pay royalty based on the “Value” of the production, the “amount realized” from its sale. Yet because the court considers this to be a “strange result,” it concludes that Burlington may deduct post-production costs from the “amount realized.”

“Into the pipeline” and “at the well” are not equivalent. Even if the “valuation point” for measuring the “amount realized” for purposes of calculating the amount due Texas Crude for its royalty were at the point where the production enters “into the pipeline, tank or other receptacle” to which the well is connected, that point is not “at the well.” No appellate case has heretofore addressed the meaning of “into the pipeline” language in the context of a royalty clause.

When the “at the well” and “into the pipeline” language was first used in oil and gas lease royalty clauses, almost all oil and gas production was sold by the producer at or near the well. Gas pipelines were purchasers. The separation of the gas transportation and gas purchase function had not yet occurred. Likewise, if the well was connected to an oil pipeline, the pipeline company was also the purchaser and the point of sale was when the oil was delivered “into the pipeline.”

Here is the royalty clause in a commonly used oil and gas lease form first published in 1950:

The royalties to be paid by Lessee are: (a) on oil, one-eighth of that produced and saved from said land, the same to be delivered at the wells or to the credit of Lessor into the pipe line to which the wells may be connected: Lessee may from time to time purchase any royalty oil in its possession, paying the market price therefore prevailing for the field where produced on the date of purchase; (b) on gas, including casinghead gas or other gaseous substance, produced from said land and sold or used off the premises or for the extraction of gasoline or other product therefrom, the market value at the well of one-eighth of the gas so sold or used, provided that on gas sold at the wells the royalty shall be one-eighth of the amount realized from such sale.

This same language, with some variation, appears in lease forms used today. Under these typical clauses, the lessor’s oil royalty is an in-kind royalty, but the lessee may purchase the lessor’s royalty oil at a specified price. The lessor’s gas royalty is only a right to money, a share of proceeds from the sale of the gas or products extracted therefrom. The phrase “into the pipeline” appears only in the in-kind oil royalty provision. The gas royalty is based on the “amount realized” from the sale. So “into the pipeline” relates to in-kind royalty, and “amount realized” relates to royalty taken as a share of proceeds of sale.

The phrase “into the pipeline” has become more problematic as methods of gathering, treating, processing and selling oil and gas have become more sophisticated. Today, an operator may have an extensive gathering system for its production, and oil and gas may be treated before being delivered to the purchaser.  If “into the pipeline” is synonymous with “at the point where production is delivered to the purchaser,” then the costs incurred to gather and treat production before sale would not be chargeable to the royalty owner. As A.W. Walker (a prominent oil and gas attorney who wrote extensively on the development of oil and gas law) wrote more than 50 years ago, the phrase “into the pipeline” in a royalty clause was intended to make the royalty free of any cost incurred to get the production “into the pipeline” – at that time the point of sale:

When the royalty upon oil is payable in kind it is usually stipulated that the royalty oil shall be delivered, free of cost, in the pipe line to which the lessee may connect the wells. The lessor by his division order contract with the pipe line company provides for its receipt at that point and for the time and manner of payment by the purchaser. This clause obviates the necessity of any expenditures by the lessor in connection with the storage, treatment, and transportation of his royalty oil to his purchaser, and requires these expenses, sometimes of considerable proportions, to be borne by the lessee. It is, therefore, a vitally important provision from the standpoint of the lessor.

Why does this matter to royalty owners?  The court’s opinion in Heritage Resources v. NationsBank, 939 S.W.2 118 (1996), its first foray into the construction of royalty clauses and post-production costs, held that, when a lease provides for royalties payable “at the well,” any later language attempting to prohibit deduction of post-production costs is “surplusage”. Likewise, the court’s opinion in this case may be construed to hold the same for “into the pipeline”; whenever that phrase appears in a royalty clause, any later language regarding post-production costs may also be “surplusage.” And “into the pipeline” may be equated with “at the well,” even if the pipeline into which production is delivered is many miles from the well.

Finally, this case appears to me to be a second example of how the court strays from the language of the contract to reach a result the court deems “reasonable.” The most recent example prior to this case is Murphy v. Adams, decided last year.

Our firm assisted Texas Crude’s counsel in the Supreme Court briefing of this case.



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