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Federal District Court Addresses Post-Production Costs in Light of Devon v. Sheppard

The federal district court in Pecos, Judge David Counts, issued a memorandum opinion in H.L. Hawkins, Jr., Inc. v. Capitan EnergyInc., P:22-CV-DC[Hawkins] addressing Hawkins’ claim that Capitan had improperly deducted post-production costs from its royalty. The Court held that the reasoning in the recent Texas Supreme Court case of Devon v. Sheppard was of no help to Hawkins.

Hawkins’ lease reserved a royalty of “one-fourth of the gross proceeds received by Lessee,” and contained a free-royalty provision:

Lessor’s royalty shall not bear or be charged with, directly or indirectly, any cost or expense incurred by Lessee, including without limitation, for exploring, drilling, testing, completing, equipping, storing, separating, dehydrating, transporting, compressing, treating, gathering, or otherwise rendering marketable or marketing products, and no such deduction or reduction shall be made from the royalties payable to Lessor hereunder, provided, however, that Lessor’s interest shall bear its proportionate share of severance taxes and other taxes assessed against its interest or its share of production.

Hawkins conducted an audit of its royalty payments which detailed nine areas where Capitan’s payment of royalties deviated from the lease. Capitan filed a motion for summary judgment asking the Court to hold that it owes nothing more under these nine audit exceptions.

Capitan sells its production at or near the wells. Its contracts provide that the purchaser will deduct costs of transportation, fractionation and other downstream post-production costs. “Capitan receives a lower price for the captured minerals–which means a lower royalty base from which Hawkins takes its one-fourth royalty share–because the pricing formula in the third-party contract accounts for the third party’s postproduction costs.” Hawkins claimed these costs had to be added back to Capitan’s proceeds before calculating its royalty.

The Court held that Hawkins was not entitled to add back the post-production costs charged by the purchaser because those costs were not “incurred” by Capitan, but by the purchaser. Here, the parties agreed that “directly or indirectly” in the no-deducts clause modifies “charged,” so the clause says the lessee may not directly or indirectly charge the lessor with costs incurred by the lessee.

Hawkins’  counter that Capitan is ‘subject to’ deductions in the pricing formula would be more persuasive if ‘directly or indirectly’ modified ‘incurred’ because Capitan arguably ‘indirectly incurs,’ thus [is] subject to, postrproduction costs when it takes a lower price because of a pricing formula deducting such costs. but again, the Parties agree that “directly or indirectly” modifies ‘charged.’

The Court distinguished this case from Devon v. Sheppard because Sheppard’s lease contained add-back language requiring the lessee to add back costs charged by the purchaser.

The Court recognizes that this is a common accounting maneuver; companies large and small structure contracts or shift items on the P&L statement with accounting in mind. But decreasing revenue through taking a lower price is different from incurring an expense. And, critically, this accounting technique–which Hawkins has not alleged is fraudulent–does not violate the Lease’s plain language.”

Two of Hawkins’ audit exceptions state that Capitan failed to pay royalty on plant fuel and plant loss or on flared and lease-use gas. The lease provided that, on gas produced but not sold, Lessor’s royalty “shall be calculated by using the highest price paid or offered for gas of comparable quality in the general area where produced and when run.” Here, the Court denied Capitan’s motion for summary judgment, holding that, except for gas used on the lease (for which no royalty is owed under the lease’s “free use” clause), Capitan owed royalty on all gas not sold, including, plant fuel, plant loss, and flared gas.

As the Court points out, lessors may intentionally structure their sales contracts to provide for sale “at the well” so as to avoid having to pay royalty on gross proceeds before post-production costs. Texas courts have generally allowed such tactics, even where the purchaser is affiliated with the producer. The lease language in Devon v. Sheppard avoids this result–but only if the deductions made by the purchaser are identified as post-production costs.

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