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Nettye Engler Energy v. Bluestone Natural Resources: Texas Supreme Court affirms ruling against royalty owner

Last week the Texas Supreme Court handed down its opinion in Nettye Engler Energy, LP v. Bluestone Natural Resources II, LLC, No. 20-0639, affirming the lower court’s ruling that Engler’s royalty interest bears its share of gas gathering and processing costs.

Engler owns a royalty interest in a section of land in Tarrant County on which Bluestone owns a lease and operates gas wells. Engler’s royalty interest originated in a deed in which the grantor reserved a one-eighth non-participating royalty interest. The deed provides that the grantor reserves “a free one-eighth (1/8) of production … to be delivered to Grantor’s credit, free of cost in the pipe line, if any, otherwise free of cost at the mouth of the well or mine.”

Bluestone contracted with Crestwood Equity Partners to gather its gas through a gathering system owned by Crestwood and deliver it to various delivery points through a processing plant and into a pipeline owned by Energy Transfer, where the gas is sold. Bluestone deducted the gathering fees charged by Crestwood from Engler’s royalty, and the plant processing fees incurred before the gas was sold.

Engler argued that the “pipe line” referred to in the royalty reservation is Energy Transfer’s transmission line, not Crestwood’s gathering lines, and that Crestwood’s fees could not be deducted from its royalty. The trial court agreed, but the Court of Appeals reversed, relying on the Texas Supreme Court’s opinion in Burlington Resources Oil & Gas Co. LP v. Texas Crude Energy, LLC, 573 S.W.3d 198 (Tex. 2019). In Burlington v. Texas Crude, the Court held that the term “into the pipeline” in a grant of overriding royalty was equivalent to “at the well,” and under the Court’s previous holding in Heritage Resources v. NationsBank, Burlington could deduct post-production costs from Texas Crude’s overriding royalty even though the assignment provided that the royalty would be “free and clear of … all costs and expenses except the taxes thereon.”

Justice Divine wrote the Texas Supreme Court’s opinion. He summarized the Court’s decision:

We affirm the court of appeals’ judgment. A gas gathering pipeline is a “pipeline” in common, industry, and regulatory parlance, and the deed does not limit the delivery location to any specific pipeline nor prohibit delivery to a pipeline at or near the well, if any. The court of appeals reached the correct result but misconstrued our opinion in Burlington Resources Oil & Gas Co. v. Texas Crude Energy LLC as establishing a rule that delivery “into the pipeline,” or similar phrasing, is always equivalent to an “at the well” deliver or valuation point. Rather, the opinion merely emphasized that all contracts, including mineral conveyances, are construed as a whole to ascertain the parties’ intent from the language they used to express their agreement.

Our firm joined in representing Texas Crude in its appeal to the Supreme Court in Burlington. In that case, Texas Crude assigned leases to Burlington, retaining an overriding royalty interest in production. The assignment provided:

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 Court in Burlington addressed two issues related to construction of the above language: first, does the language that the royalty share of production shall be delivered in kind, “into the pipeline,” apply if Texas Crude elects to take its share of royalty in the form cash, its percentage of the “value” of the production. On this point, the Court ruled (erroneously, I believe) that the “into the pipeline” language determines how the value of production is determined even if Texas Crude does not take its royalty in kind.

Second, the Burlington Court construed the meaning of “into the pipeline”. Like the facts in Engler, Burlington’s gas went through a gathering system to a processing plant and then into a transmission line. The Court held that “into the pipeline” means into the gathering line, not into the transmission line, and so post-production costs incurred after the gas entered into the gathering line could be deducted. The Court’s opinion in Burlington did not discuss in any real detail the distinction between a transmission pipeline and a gathering pipeline.

The Engler opinion does discuss in more detail the difference between transmission lines and gathering lines. It concludes that the plain meaning of “pipe line” in the Engler deed reservation includes a gathering line.

The opinion mentions that the reservation in Burlington used the phrase “into the pipeline, tank or other receptacle to which any well or wells on such lands may be connected“. The Court seems to imply that this additional language reinforced the Court’s opinion in Burlington that the pipeline referred to was the gathering line “to which the well is connected” and not the downstream transmission line. The opinion remarks that the absence of this additional language in Engler’s reservation “makes it broader, not narrower, than the provisions construed in other cases, confirming rather than repudiating that a gathering system is, or at least includes, a pipeline for delivery.”

I mentioned in my previous post that the court of appeals did not discuss an expert’s opinion submitted by Engler to the effect that the term “pipeline” in industry usage at the time of the deed meant the transmission line. The Supreme Court does discuss this expert’s opinion but concludes that it “says nothing about the industry meaning of ‘pipe line’ in 1986 or about surrounding circumstances extant when the deed was executed.

Rather, the expert’s affidavit merely discusses how “most” gas was “usually” processed and sold under “traditional” gas gathering agreements at that time. Because the proffered evidence does not elucidate the meaning of the 1986 deed’s words, we do not consider it.

It appears to me that the expert’s opinion does indeed discuss the “surrounding circumstances extant when the deed was executed”: how gas was usually sold and processed in 1986. That seems to me evidence of surrounding circumstances.

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.

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”. When Burlington was decided, I was concerned that 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 transmission pipeline into which production is delivered is many miles from the well. The Court’s opinion in Engler has confirmed my fears. Heritage lives on.

At the end of its opinion, the Court denies that it is adopting a rule that equates an “into the pipeline” delivery point with an “at the mouth of the well” valuation.

To the contrary, we explained [in Burlington] that “the decisive factor in each [contract-construction] case is the language chosen by the parties to express their agreement.” Just as in Burlington Resources, our analysis here turns not on an immutable construct but on the parties’ chosen language.

Regardless of this disclaimer, I think we will see that the industry will indeed argue that “into the pipeline” is the same as “at the well,” and under Heritage, just as in Burlington, whenever either phrase appears in a royalty clause all other language about non-deductibility of post-production costs is “surplusage” and those costs are shared with the royalty owner.

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