Oil and Gas Lawyer Blog
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.”
Courts in oil-producing jurisdictions have split on lease construction into two camps: “marketable condition” states and “plain terms” states – Texas falling into the latter camp. Those courts in “marketable condition” jurisdictions have considered oil and gas leases as “relational” contracts, in which parties have generally described their purpose and intent without attempting to define exactly how the purpose of the contract is to be carried out. Under this approach, the specific language of a lease is less important than the general purpose of the contract. As applied to royalty clauses, this approach means that courts are less concerned with the particular language of the royalty clause and more willing to impose general rules and implied obligations in an attempt to obtain uniformity in how royalty clauses are construed and enforced. Colorado, Oklahoma and Arkansas are in this camp.
Courts in the “plain terms” camp have instead focused more on the actual language in the lease, to discern the “plain meaning” of those words and thereby the presumed intent of the parties.
This leads us to Boulder County v. Crestone Peak. The case concerns construction of a temporary cessation clause in a lease. That provision states:
If, after the expiration of the primary term of this lease, production on the leased premises shall cease from any cause, this lease shall not terminate provided lessee resumes operations for re-working or drilling a well within sixty days from such cessation and this lease shall remain in force during the prosecution of such operations and, if production results therefrom, then as long as production continues.
The gas wells on the lease were shut in for 122 days because the pipeline required repairs. Boulder County sued, claiming that the lease had terminated. (The lease also contained a shut-in royalty clause but Crestone Peak did not pay shut-in royalty.)
The Court held that the leases did not terminate. It reasoned that, because the clause only referred to operations for re-working or drilling to preserve the lease when production ceased, it must apply only to permanent cessations of production and not temporary cessations, as had occurred here. “A literal application of the clause to every temporary cessation of production could lead to absurd and unintended results. … An interpretation that harmonizes the phrase ‘from any cause’ with the contemplated remedy of ‘drilling or reworking’ most effectively enforces the intent of the original parties.” The Court refused to follow the contrary result reached by the court in Sun Operating Partnership v. Holt, 984 S.W.2d 277 (Tex. App. 1998), calling its result “illogical.”
Our interpretation reflects the general purpose of all oil and gas leases. Oil and gas leases are intended to promote productivity and development “for the mutual benefit of the lessor and lessee”.
The Crestone opinion thus illustrates the approach taken by the Court in Westerman; the parties’ intent is governed by the overall purpose of the lease, not by any particular phrase or word. One can argue, especially based on Heritage, that Texas courts have strayed too far into the “plain meaning” camp and have lost sight of the purpose and intent of oil and gas leases.