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Two Texas Federal District Courts Weigh In On Post-Production Costs

Two recent decisions from two federal judges in the Southern District of Texas, Houston Division, dismissed suits alleging class actions against Apache and Hilcorp for failure to pay royalties on gas used in gas processing plants. Both construed identical lease provisions.

In Carl v. Hilcorp Energy, No. 4:21-CV-02133, Judge Keith Ellison construed a lease with the following provisions:

The royalties to be paid be Lessee are: … on gas, including casinghead gas or other gaseous substance, produced from said land and sold or used off the premises or in the manufacture of gasoline or other product therefrom, the market value at the well of one-eighth of the gas so sold or used ..

Lessee shall have free use of oil, gas, coal, wood and water from said land, except water from Lessors’ wells, for all operations hereunder, and the royalty on oil, gas and coal shall be computed after deducting any so used.

In Fitzgerald v. Apache Corp,No. H-21-1306, Judge Lee Rosenthal construed a lease with exactly the same language as the Carl lease.

The issue was whether the lessee had to pay royalty on gas used in “off-lease” operations. The gas was being used to power equipment for compression, treatment and processing services not on the leased premises. The lessee entered into processing agreements with a third party providing that a portion of the lessee’s gas would be used in the plant for operations, as part of lessee’s cost of processing.

Both courts’ opinions discussed the recent Supreme Court decision Bluestone v. Randle, 620 S.W.3d 380 (Tex. 2021). The lessors argued that Randle controlled and requires Hilcorp and Apache to pay royalty on gas used off-lease. Both courts disagreed. Although the royalty clause requires the lessee to pay royalty on gas “used off the premises,” the free-use clause allows use of free use of gas “for all operations hereunder.” As long as the off-lease use gas is being used to benefit the lease, the free use clause excuses the lessee from paying royalty on that gas. Even if the royalty clause requires payment of royalty on gas used off the premises, the lessee can deduct the market value of the gas used as a post-production cost because the royalty is based on market value at the well, in effect netting out any benefit to the lessor–again, as long as the off-lease use benefits production from the lease.

The opinions distinguish Randle: there, the royalty was not based on market value at the well but on “the gross value received, including any reimbursements for severance taxes and production related costs.” Randle’s lease also had a free gas use clause for “all operations which Lessee may conduct hereunder.” The Supreme Court said this clause entitled the lessee to use gas free of royalty only for costs incurred on the lease and not for processing costs off the lease. Under the market value royalty clause in Carl and Fitzgerald, the lessee could deduct all post-production costs, including the market value of gas used off-lease, whereas in Randle the lessee could not.

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