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Post-Production Costs in Texas – Part II

Last week I introduced the term “post-production costs” and attempted to explain what those costs are and how oil companies account for such costs in calculating royalties.  I said that Texas courts have construed the standard gas royalty clause to allow oil companies to deduct post-production costs from royalties. The Texas Supreme Court had occasion in 1996, in Heritage Resources, Inc. v. NationsBank, to address the deductibility of post-production costs.  NationsBank (now Bank of America) was named trustee of trusts created under the will of David Tramell. NationsBank signed oil and gas leases covering lands owned by those trusts, and Heritage Resources drilled gas wells on the leases. Heritage deducted transportation costs from the royalties it paid to the trusts, and NationsBank sued to recover those deductions, based on the following language in its leases:

The royalties to be paid Lessor are …

;on gas, .. the market value at the well of 1/5 of the gas so sold or used, … provided, however, 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.

The court, with two justices dissenting, held that Heritage had properly deducted transportation costs in calculating the royalties.  The court’s reasoning went something like this: (1) The royalties are to be calculated based on the “market value at the well.” (2) The proper method of calculating royalties “at the well” is to deduct transportation costs from the gross proceeds of sale of the gas at the point of sale. (3) The “value of Lessor’s royalty” is therefore the gross proceeds of sale less transportation costs.  (4) Heritage is not deducting transportation costs from the “value of Lessor’s royalty,” and so is not violating the lease. If this sounds a little bit circular to you, you aren’t alone. The court concluded:

We recognize that our construction of the royalty clauses in … the … leases arguably renders the post-productions clause [the no-deductions clause] unnecessary where gas sales occur off the lease. However, the commonly accepted meaning of the “royalty” and “market value at the well” terms renders the post-production clause in each surplusage as a matter of law.

“Surplusage” is a fancy term for “meaningless.” I agree with the dissenting opinion, which said of the no-deductions clause in the leases:

What could be more clear? This provision expresses the parties’ intent in plain English, and I am puzzled by the Court’s decision to ignore the unequivocal intent of sophisticated parties who negotiated contractual terms at arm’s length.

On rehearing, four justices voted to rehear the case.  One justice recused himself, so the court was deadlocked 4 to 4 on whether the case was correctly decided. As a result, the motion for rehearing was denied. Although it may be argued that the case has little precedential value, it is in the books, and it is cited regularly by oil companies on this issue. 

What is the lesson in this case for royalty owners? Be careful how you draft a lease clause prohibiting deduction of post-production clauses. Some lawyers go so far as to say in their no-deduction clause that “it is the intent of this provision to prohibit deductions from Lessor’s royalty despite the holding in Heritage Resources v. NationsBank.” A better practice is to avoid the term “market value at the well” altogether. Change it to “market value at the point of sale.” And expressly prohibit any deduction of post-production costs from that value.

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