I always counsel my clients to provide in their oil and gas leases that they have the right to inspect and copy all documents of the lessee necessary to determine whether royalties have been paid correctly, and to audit the records of the lessee to confirm accurate payment of royalties. Royalty owners generally assume that the royalty payments they received have been calculated and paid as required by their leases. This is not always the case, as illustrated by a recent case, Shell Oil Company SWEPI LP v. Ross, 2010 WL 670549 (Tex.App.-Houston [1st Dist.], decided February 25, 2010. The case illustrates typical schemes used by producers to underpay royalty owners, and their efforts to prevent royalty owners from knowing how royalties are calculated and, when the royalty owners discover the underpayment, to prevent royalty owners from recovering the underpayment.
In Shell v. Ross, the trial court and Houston Court of Appeals held that Shell had underpaid royalties due to Ross. Shell has appealed to the Texas Supreme Court. The Texas Supreme Court refused to consider the case, but Shell has filed a motion for re hearing that is still pending. Other producers are very interested in the case: friend-of-the-court briefs have been filed by Chesapeake, Texas Oil & Gas Association, and the American Petroleum Institute asking the Court to reverse the Court of Appeals.
The facts of the case require some explanation but illustrate well the importance of verifying the correct calculation of royalties.
The oil and gas lease sued upon, entered into in 1961, provides for royalties on gas of 1/8th of the “amounts realized from the sale of the gas.” One-half of this royalty was paid to the lessor, and 1/2 to the State of Texas, a royalty owner under the tract. In 1970, Shell placed a portion of the lease in a pooled unit, the Lasater Unit, and paid royalties to the lessor and the State based on the tract’s share of the gas produced from the pooled unit.
In 2002, an attorney formerly employed by the Texas General Land Office (responsible for collecting and verifying royalty payments made to the State of Texas), told Ross, the lessor, that the Land Office had received a settlement payment from Shell based on underpayment of royalties on gas produced from the unit. Ross then investigated and concluded that Shell had underpaid his royalties as well. He sued Shell for the additional royalties due.
The working interest in the leases pooled into the Lasater unit were owned by Shell and Forest Oil. Forest Oil and Shell each sold their unit gas separately. Shell was responsible for paying royalties due on unit production to the royalty owners in the Ross lease. Shell paid those royalties based on a weighted average price for gas sold by both Shell and Forest Oil from the unit. Forest Oil’s price was generally lower than Shell’s price, so as a result royalties on the Ross lease were paid based on a price less than the price received by Shell from its share of gas produced from the unit.
After filing suit, Ross learned that Shell had underpaid Ross in another way as well. Up until 1995, Shell paid royalties based on a “transfer price” — the price paid by Shell’s affiliate, Shell Gas Trading Company, to its producing company, rather than on the price paid to Shell by an unrelated third party. In 1995, Shell sent a letter to 2,246 royalty owners in Texas, including Ross, enclosing a check; it explained that it had recalculated their royalties based on the price received from the third-party purchaser, and it decided to pay all past and future royalties based on the price actually realized by shell in an arm’s length sale. But Ross discovered after he filed suit that, notwithstanding this letter, Shell continued to use the “transfer price” in calculating the weighted-average price of gas sold by Shell from the Lasater Unit. Shell said that this had been a clerical error, and it conceded that it should have used Shell’s actual sale price. But Shell continued to contend that its weighted-average-price methodology was proper under the Ross lease.
Before the trial, the trial court ruled as a matter of law that Shell had breached its lease contract with Ross in paying royalties based on the weighted average price and that it should have paid royalties based on the price it actually received for its share of the unit gas.
Shell also contended that Ross had waited too long to assert his claim and that the claim was barred by the four-year statute of limitations applicable to suits on a written contract. The statute of limitations provides that any claim for breach of contract must be brought within four years of the breach. Since Shell’s underpayments to Ross occurred more than four years after he filed suit, his claims would be barred unless Ross could prove that Shell had fraudulently concealed its failure to pay royalties correctly and that Ross had no reason, in the exercise of reasonable diligence, to discover the underpayment until a point in time less than four years prior to his filing of suit. The jury found, in answer to written questions, that Shell had fraudulently concealed its underpayment of royalties and that Ross should have discovered this underpayment in the exercise of reasonable diligence in 2002, when he learned of Shell’s settlement with the Texas General Land Office. Based on those findings, the trial court entered a judgment in Ross’s favor for the underpaid royalties plus interest. Shell appealed.
The Texas Court of Appeals, Houston 1st District, issued its opinion in the case on February 25, 2010. The three-judge panel, with one judge dissenting, affirmed the judgment. The Supreme Court initially refused to hear the case, and Shell has asked the Court to reconsider. As of this writing, the case remains pending on Shell’s motion for rehearing.
On appeal, substantially all of the arguments have revolved around the statute of limitations issue. Ross’s argument is that Shell fraudulently misrepresented the gas price on the check stub sent with his royalty payment. One of the items of information on the check stub is under the heading “unit price.” Under Texas Natural Resources Code Section 91.501 (the “check stub statute”), Texas producers are required to include “the price per barrel or per MCF of oil or gas sold.” Ross contended that Shell’s check stub was a fraudulent concealment of the gas price on which royalties were due under the oil and gas lease. Remarkably, Shell argued to the Court of Appeals that the incorrect value or unit price on the check stub “cannot be fraudulent concealment” because Shell had no “duty to state or disclose the exact price [it] received in an arms-length sale” in its royalty statements. In other words, you can’t rely on the check stubs. The Court of Appeals reasoned that the price used by Shell on the check stubs had no basis in the lease “according to any method of calculation,”, and that Shell at least had a “duty to provide a unit price [on the check stubs] that was not arbitrary.” The court held that the price shown on the check stubs was some evidence on which the jury could have determined that Shell fraudulently concealed the correct gas price.
Shell also argued that Ross should have discovered that it was paying royalties incorrectly because (among other arguments) Ross could have found out by reviewing records at the Texas General Land Office. The Court of Appeals reasoned that Ross had no reason to look at those records.
The dissenting justice believed that Ross should have discovered Shell’s underpayments by requesting information from Shell. Under Natural Resources Code Section 91.504, a royalty owner is entitled to request information from the payor concerning his/her royalties. Shell’s witness testified that, if Ross had asked, Shell would have told him how the royalties were being calculated. But the statute is very limited as to what the payor is required to provide in response to a royalty owner’s request. There is nothing in the statute requiring the payor to provide information as to how the “unit price” shown on the check stub was determined. The only remedy provided by the statute for failure to provide requested information is a suit against the payor to obtain the information.
The law in Texas is that a royalty owner has no right to audit records of the producer regarding royalty payments absent a contractual provision giving that right. Producers are usually unwilling to provide access to gas contracts, which they consider confidential information. Gas contracts often contain confidentiality provisions. In my experience, it is difficult to obtain the information necessary to verify whether the royalty price shown on a check stub is accurate absent a contractural right in the lease.
The Texas Supreme Court has generally viewed royalty owners’ efforts to avoid the statute of limitations with suspicion. See for example, Wagner & Brown, Ltd. v. Horwood, 58 S.W.3d 732 (Tex. 2001), and HECI Exploration Co. v. Neel, 982 S.W.2d 881 (Tex. 1998). It behooves royalty owners to be diligent in investigating the basis for their royalty payments and be mindful that claims for unpaid royalties more than four years old may not be collectable. Oil and gas leases should in any event provide that the lessor has the right to inspect, copy and audit all records of the lessee necessary to determine whether royalties have been paid in accordance with the requirements of the lease.