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Corpus Christi Court of Appeals Opines on Post-Production Costs

On June 25 the 13th Court of Appeals in Corpus Christi issued is opinion in Devon Energy Production Co. v. Michael A. Sheppard, et al., No. 13-19-00036-CV making a deep dive into when post-production costs can be deducted from the plaintiffs’ royalty.

Plaintiffs’ leases provided for royalties on oil and gas to be based on gross proceeds of sale received by the lessee. The leases also contained the following provision:

Payments of royalty under the terms of this lease shall never bear or be charged with, either directly or indirectly, any part of the costs or expenses of production, gathering, dehydration, compression, transportation, manufacturing, processing, treating, post-production expenses, marketing or otherwise making the oil or gas ready for sale or use, nor any costs of construction, operation or depreciation of any plant or other facilities for processing or treating said oil or gas. Anything to the contrary herein notwithstanding, it is expressly provided that the terms of this paragraph shall be controlling over the provisions of Paragraph 3 of this lease to the contrary and this paragraph shall not be treated as surplusage despite the holding in the cases styled Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996) and Judice v. Mewbourne Oil Co., 939 S.W.2d 135-36 (Tex 1996).

Top-TenFinally, the lease had this “unique” paragraph 3(c):

If any disposition, contract or sale of oil or gas shall include any reduction or charge for the expenses or costs of production, treatment, transportation, manufacturing, process[ing] or marketing of the oil or gas, then such deduction, expense or cost shall be added to the market value or gross proceeds so that Lessor’s royalty shall never be chargeable directly or indirectly with any costs or expenses other than its pro rata share of severance or production taxes.

This last provision–the “add-back” clause–is the clause on which the case turned.

Plaintiffs initially sued Devon over the price at which Devon was paying royalties on oil. Their suit alleged that Devon was selling the oil produced from Plaintiffs’ leases under contracts which contain an $18-per-barrel reduction in the sales price attributable to “gathering and handling, including rail car transportation.” Plaintiffs argued that this $18-per-barrel charge had to be added back to Devon’s gross price under paragraph 3(c). Plaintiffs later added other claims for costs and deductions charged by purchasers of gas, alleging that those costs also had to be added back to Devon’s proceeds for purposes of calculating royalties.

The parties agreed on a set of twenty-three issues for different marketing practices and contracts in which Plaintiffs claimed the add-back clause applied, under different oil and gas sales and processing agreements. The trial court ruled in Plaintiffs’ favor on all twenty-three issues. The Court of Appeals agreed with the Plaintiffs on nine of those issues and reversed the trial court on the other fourteen.

The Court discussed each of the different contractual deductions in Devon’s marketing agreements, and a review of those provisions shows the variety of ways oil and gas are marketed and sold by producers—a rare peak into detailed contract provisions not usually reaching the public eye. The contractual provisions themselves were produced under seal and are not a part of the public record, but the Court’s description of them shows how complex gas marketing can be.

The Court first discusses prior opinions of the Texas Supreme Court, and one opinion from the 5th Circuit Court of Appeals, dealing with deductibility of post-production costs: Heritage, Judice, Chesapeake v. Hyder, and Burlington v. Texas Crude—all of which I have written about before—and the 5th Circuit case Yturria v. Kerr-McGee, 291 Fed.App’x 626 (2008) (in which our firm represented the royalty owners). Then the Court discussed the parties’ arguments concerning construction of the add-back clause. Devon argued that the clause was not intended to refer to post-production costs incurred after the point of sale, but only those incurred before the point of sale. The Court disagreed:

There is nothing in the leases suggesting that paragraph 3(c) is limited to pre-point-of-sale expenses. Further, if the point of sale were the deciding factor in determining whether paragraph 3(c) applies, appellants could choose to sell all of their production at the wellhead and thereby unilaterally transform the royalty into a “market value at the well” royalty, which appellants acknowledge would be contrary to the parties’ intent. … If we were to adopt appellants’ construction, paragraph 3(c) would be meaningless.

The Court concluded:

The royalty is paid as a fraction of the value of the oil and gas produced from the leases, but that value increases as the minerals are processed, fractionated, and transported to the market center, where they are finally put on the open market and prices are standardized. It is not unreasonable to construe the leases as ensuring the lessors’ royalty is based on the standardized value of the gas at the market center, and that is effectively what the Sheppard and Crain Leases accomplish. The value of the minerals at the market center will likely be more than the gross proceeds received by the producer—how much more depends on the terms of the contracts between the producers and the downstream purchasers.

The Court then grouped the twenty-three issues presented by type. The first type was contract provisions making adjustments to the price paid to Devon “of a fixed amount with stated purposes.” As an example, one of the contracts set the price per barrel of oil sold as a weighted average of published index prices “minus $18.00 gathering and handling, including rail car and transportation.” Because these contract provisions stated that the deductions were for post-production costs, the Court held that they had to be added back to the proceeds before calculating Plaintiffs’ royalty.

A second group of issues related to contract provisions providing for deductions based on the gas processor’s actual costs. An example was a gas processing agreement that allowed deductions for “actual transportation and fractionation cost.” Again, the Court held that these costs had to be added back to Devon’s proceeds before royalties are calculated.

A third group of issues related to contract deductions “of a fixed amount without a stated purpose.” Example: a contract for sale of oil and condensate at index prices less a “differential of 7.15 US dollars.” The Court concluded that, because these contracts do not specify the purpose for the reductions, they are not added back: The add-back clause “applies only if the specific charge is ‘for the expenses or costs of production, treatment, transportation, manufacturing, processing or marking of the oil or gas.’”

Finally, the Court dealt with Plaintiffs’ claims that royalty should be paid on fuel consumed in post-production operations and gas retained by the processor or lost and unaccounted for. The Court ruled that no price adjustment should be made for such gas under the requirements of paragraph 3(c).

The Court concluded by chastising the parties for failing to be clear in their drafting of the lease:

It is difficult to fathom that the parties, when executing the leases, shared a mutual common conception of what was to be covered by [the add-back clause]. We can only speculate as to how many dollars and hours would have been saved had the parties drafted the leases, in Justice Blacklock’s words, “to say exactly what [they] intend[ed], without resort to industry jargon, outdated legalese, or tenuous assumptions about how judges will interpret industry jargon or outdated legalese.”

On the date of this writing the case is still pending on motions for rehearing. It undoubtedly will be appealed to the Supreme Court.

It seems to me difficult to distinguish between the contracts making deductions “with a stated purpose” and those making deductions “without a stated purpose,” especially in light of the Court’s statement that “It is not unreasonable to construe the leases as ensuring the lessors’ royalty is based on the standardized value of the gas at the market center, and that is effectively what the Sheppard and Crain Leases accomplish.” All of the contracts discussed based the sale price on a market index or indices, less a defined amount; that amount, whether stated or not, was intended to reflect the difference between the value of the oil or gas being sold at the point of sale and the value of the oil or gas at the “market center,” as evidenced by the index pricing.

Another good example is a gas processing agreement that provided for the processor to pay Devon based on a published price for NGLs extracted from Devon’s gas. But Devon would be paid only for a percentage of the NGL components extracted, called a “Component Recovery Factor,” ranging from 75% to 98% depending on the product. It is common for a processor to retain a percentage of the NGL components extracted as part of its fee for processing. But because the processing agreement did not explicitly say that the NGL components not paid for were part of the fee for processing, the Court concluded that the add-back clause did not require Devon to pay royalty on 100% of the NGL component prices, thereby allowing Devon to pass on to the royalty owner a part of the processing cost.

Another example is the two oil contracts discussed in the opinion: one provided for an index price less $18 per barrel for “gathering and handling, including rail car transportation,” and the other provided for a deduction from an index price of “a differential of 7.15 US dollars,” without specifying its purpose. The Court held that the deduction had to be added back for sales under the first contract but not under the second. Both price adjustments reflect the same differential between the price paid and the market-center price, and adding back the deduction would accomplish paragraph 3(c)’s purpose of basing the royalty on “the standardized value of the [oil] at the market center,” but the Court allows one deduction and disallows the other.

If the Court’s opinion is affirmed, producers will be sure to delete language in their contracts specifying the purpose of deductions made to index prices in their oil and gas sales and processing contracts.

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