Oil and Gas Lawyer Blog
The Texas Supreme Court recently refused to consider the case of Devon Energy Production Company v. Apache Corporation, decided by the Eastland Court of Appeals – 550 S.W.3d 259. The case presents issues that, remarkably, have not previously been considered by a Texas appellate court.
Norma Jean Hester leased her one-third mineral interest in lands in Glasscock County to Apache, reserving a 1/4th royalty. The other mineral owners in the land (the Lessor Plaintiffs) leased their two-thirds mineral interest to Devon, reserving a 1/4th royalty. Apache and Devon were unable to agree on terms for a joint operating agreement to develop the property, and Apache drilled seven producing wells on the land without Devon’s participation. Devon became what is commonly called a “non-consenting co-tenant.” Devon became entitled to two-thirds of the net revenue from each well after Apache had recovered the costs of drilling and production (“payout”). But Devon did not pay its Lessor Plaintiffs their royalty on production, claiming that Apache owed the royalties to the Lessor Plaintiffs. The Lessor Plaintiffs sued Devon and Apache for their royalties.
The trial court ruled that Apache owed no royalty payments to the Lessor Plaintiffs, and that Devon owed the Lessor Plaintiffs royalties, but only on revenues received by Devon after the wells had paid out. The Lessor Plaintiffs then settled their claims against Devon, and Devon appealed.
The court of appeals held that Apache owed no royalties to Devon’s lessors. Devon argued that Section 91.402 of the Texas Natural Resources Code required Apache to pay royalties to Devon’s lessors from date of first production. The court held that the statute did not apply to Apache because it was not a “payor” of royalties owed to Devon’s lessors.
The lessors of a non-consenting co-tenant lessee are placed in a difficult position. If the trial court in Devon v. Apache is correct, they get no royalties on production until a well has reached payout. Once payout is reached, do they receive all royalties they should have received had their lessor participated in the well, or only their royalty share of the net revenue received by their lessee? If the lessors are not entitled to royalties on production before payout, then does production from the well keep their lease in force, or does it terminate at the end of its primary term – putting the lessors in the position of non-consenting co-tenants? If the well never reaches payout, do the non-consenting lessee’s royalty owners receive no royalty?
I think a good argument can be made that, if the non-consenting lessee wants its lease to remain in effect, it must pay royalties to its lessors from date of first production. The operator who drills the well pays only its royalty owners. In Devon v. Apache, Apache received 100% of revenues, paid royalty only to its lessor, and so received revenues that would have been paid to Devon’s lessors if Devon had participated in the wells. If Devon owes its lessors no royalties until after payout, it gets the benefit of its lessors’ share of royalties, by accelerating payout, without giving its lessors any of the benefit. If after payout Devon owed royalties only on its share of net revenues, then its royalty owners never receive royalty on 100% of the wells’ production.
These issues were thoroughly explored in an excellent article by Caleb A. Fielder, a Houston attorney, published in the Texas Tech Law Review in 2017, “Blood and Oil: Exploring Possible Remedies to Mineral Cotenancy Disputes in Texas,” 50 Tex. Tech L. Rev. 173. Mr. Fielder suggests including language in the lease to address this issue. His suggested language is:
If, at the expiration of the primary term or at any time or times thereafter, Operations, as the term is herein defined, are conducted on the leased premises to which lessee is not a party, this lease shall continue in force as though Operations were being conducted by lessee on said land. In the event production of covered minerals is obtained from a well drilled on the leased premises to which lessee is not a party (a “Third-Party Well”), Lessee covenants to pay or tender, by check or draft of Lessee, as royalty, a sum consistent with the Royalty Payment as provided in paragraph [x], equal to the amount which would be due [to] Lessor as royalty from the production of the same quantity of oil, gas or other hydrocarbon produced by Lessee (based on the quantity of production from the Third-Party Well which is reported to the regulatory agency having jurisdiction).
I have recently seen a couple of examples of wells being drilled by one lessee and carrying the interest of another lessee because the lessees have failed to agree on a joint operating agreement — so the practice appears to be becoming more common. Perhaps a future case will clarify the obligations of the parties to the lessor of the non-consenting co-tenant. Until then, it might be a good idea to address the issue in the lease.