$100M Lawsuit Filed Testing TX SC Ruling on Post-Production Costs – See why it matters!

Texas Supreme Court Ruling Restricting Post-Production Deductions in New Royalty Clauses Now Being Tested in $100M Lawsuit

Pay attention – there are some new royalty clauses in town and the Texas Supreme Court is interpreting them against oil and gas companies who attempt to deduct post-production costs from their lessor’s royalty payment.  What’s unique about these provisions is that they prohibit deductions AFTER the point of sale to third-party affiliates.

• Devon v. Sheppard Lawsuit

Landowners and oil and gas companies in Texas are facing a significant legal battle over the interpretation of new royalty clauses. The recent ruling by the Texas Supreme Court has restricted post-production cost deductions, causing turmoil in the industry. This groundbreaking decision has sparked a $100 million lawsuit against Devon Energy and BPX Properties, with landowners alleging underpaid royalties. In this article, we will delve into the details of this case and explore the implications of the court’s ruling on the oil and gas sector.

In the case of *Devon et al. v. Sheppard (No. 20-0904, March, 2023), the Texas Supreme Court affirmed the lower court’s ruling that the clear language of the lease provision unambiguously prevented deductions of post-production costs from a third-party affiliate who deducts costs from published index prices downstream from the point of sale.

* Devon  Energy  Production  Co.,  L.P.,  f/k/a  GeoSouthern  DeWitt  Properties, LLC;  BPX  Properties  (NA)  LP;  GeoSouthern Energy Corp.; and BPX Production Co. are all being sued under these leases.

The recent test case highlights the impact of this new ruling.  Specifically, Devon Energy and BPX are facing lawsuits from numerous landowners in DeWitt County, southeast of San Antonio. These landowners in the Eagle Ford Shale allege that they have been underpaid royalties and interest amounting to $100 million, citing the Texas Supreme Court opinion as supporting evidence.  (See Houston Chronicle article by Amanda Drane of July 3, 2023)

• New Royalty Provisions

So, what are these new provisions?  First, it’s important to understand that the plaintiff in the Supreme Court case and the newly filed case is Michael Sheppard, an attorney and mineral owner who created the provisions not only for his lease but for other lessors in the area.  Second, the parties all agree that per the “gross proceeds” language of the traditional royalty clause in the lease, no post-production costs are deductible to the point of sale.  At issue are these new, bespoke provisions affecting whether oil companies can take the posted price of the product and deduct costs for “gathering and handling, including rail car transportation, of $18” as discussed in the case, from the per barrel posted price and use this figure to calculate royalties.

Here are the two provisions:

3(c)  If any disposition, contract or sale of oil or gas shall include any reduction or charge for the expenses or costs of production, treatment, transportation, manufacturing, process[ing] or marketing of the oil or gas, then such deduction, expense or cost shall be added to…gross proceeds so that Lessor’s royalty shall never be chargeable directly or indirectly with any costs or expenses other than its pro rata share of severance or production taxes.

AND

Payments of royalty under the terms of this lease shall never bear or be charged with, either directly or indirectly, any part of the costs or expenses of production, gathering, dehydration, compression, transportation, manufacturing, processing, treating, post-production expenses, marketing or otherwise making the oil or gas ready for sale or use, nor any costs of construction, operation or deprecation of any plant or other facilities for processing or treating said oil or gas.  Anything to the contrary herein notwithstanding, it is expressly provided that the terms of this paragraph shall be controlling over the provisions of Paragraph 3 of this lease to the contrary and this paragraph shall not be treated as surplusage despite the holding in the cases styled Heritage Resources, Inc. v. NationsBank, 939 S.W. 2d 118 (Tex. 1996) and Judice v. Mewbourne Oil Co., 939 S.W. 2d [133,] 135-36 (Tex. 1996).

• Royalty Payment Based on Index Price

Typically, a royalty owner is paid on the posted index price less any costs incurred by the oil and gas company to move the product to a refinery.  For oil, this can be done by rail and so the railroad charges a fee to the oil and gas company and this fee is deducted from the per barrel price.  The royalty owner’s decimal interest is multiplied by the number of barrels produced at the reduced (after deducting transportation costs to get it to the refinery) per barrel index price.

In the olden days, during my time at Exxon, it was a requirement to include the index price and any deductions, such as transportation costs, on the division order. This allowed royalty owners to understand how their payments were calculated and replicate the calculation if needed. For instance, if the posted index price for oil was based on WTI (West Texas Intermediate), but “gathering and handling, including rail car transportation” amounted to a total deduct of $18 fee, we would display the posted price as WTI minus the $18 gathering and handling, including rail car transportation fee on the division order. As a result, the royalty payment would be based on $52 per barrel, if the WTI posting was $70 per barrel that particular month. Deducting transportation costs from the posted price and paying the royalty owner based on the actual price is still a standard practice in the industry today; however, today most companies use the NADOA Model Form Division Order with no added provisions.

Example:

Formula for Royalty Owner:
               Decimal Interest X # barrels produced x $62/barrel

*Royalty Payment Typically Based on this

• Impact of New Interpretation

According to the Houston Chronicle article, there are about 5 leases in the new lawsuit with this key language, but it could affect up to 200 leases with the same provisions in the area.  And, of course, any new leases negotiated with these added provisions will be affected.

Example: Let’s do a current example of one month for a large landowner to see how this issue might affect one individual lessor who owns 100% of the minerals in an Eagleford well with a ¼ RI:

(See the chart below for a new well’s production in the Eagleford shale.  The well will also produce gas, but we will examine just the oil in this example.)

1. Calculation Based on Standard Royalty Provision:1500 bbls per day x 30 days = 45,000 bbls x posted price of $70 per bbl less the $18 gathering and handling, including rail car transportation fee sited in the case = 45,000 * ($70-$18= $52) = $2,340,000 * ¼ RI = $585,000 due royalty owner, with also a deduction for severance tax
2. Calculation Based on New Devon v. Sheppard Royalty Provision:1500 bbls per day x 30 days = 45,000 bbls x posted price of $70 per bbl = 45,000 * $70 = $3,150,000 * ¼ RI = $787,500 due royalty owner, with also a deduction for severance tax

This is a difference of roughly $200,000 per month to this particular royalty owner.

• Posted Price

Its long been held that landowners and producers have the opportunity to reach an agreement regarding the rightful amount of royalty, the criteria for its calculation, and the allocation of expenses. It is important to note that a landowner’s royalty, which excludes postproduction costs, holds greater value for the royalty holder but is more costly for the producer. This is because the landowner will benefit from the increased value of production without having to bear the expenses incurred in achieving it. Consequently, disputes over the terms of mineral leases and the distribution of postproduction costs are quite common. However, the specific application of the royalty clause in this lease are unique and, according to the Texas Supreme Court, “unprecedented.”

• Analysis

So why is the Texas Supreme Court who is historically “pro-industry” ruling against an oil and gas company?  In my opinion, the Texas Supreme Court has gone to such extremes to rule in favor of oil and gas companies that it is to the point of being ridiculous.  They swung the pendulum too far in favor of oil and gas companies.  Take the 1995 Texas Supreme Court case quoted in the lease provision, Heritage v. Nations Bank.  In that case, the royalty clause had a market value language but also included this language:

…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.

That’s pretty unambiguous language in my opinion.  Yet in Heritage, the court ruled that this language was “surplusage” and that the lease language really meant that oil and gas royalty were to be paid on net proceeds and deductions were allowed.

One could argue that if one part of the royalty clause called for a market valuation and another part said “no deductions,” this creates an ambiguity.  Under contract law, an ambiguity in a lease is construed against the lessee.  Despite this, the court ruled in the oil and gas company’s favor.

This paved the way for a skilled attorney and mineral owner to carefully craft language designed to counter the ruling in the Heritage case, ultimately leading to the present outcome. I would contend that the financial burden on the oil and gas company is significantly higher when they are obliged to pay post-deduction costs to a third-party affiliate, as opposed to if the court had permitted post-production deductions prior to sale. These deductions are minor, ranging from a few cents to 19 or 21 cents per barrel, rather than nearly $20 per barrel. Nevertheless, this is the current situation we find ourselves in.

• Impact on Land Professionals

This affects all land professionals.  For the landman, be aware of this provision and its impact on your company’s bottom line.  For lease analysts, make sure you note these provisions well when analyzing the oil and gas lease.  For division order analysts, this may require manual handling of checks for lessors with this lease language.  Typically, when the revenue accountant gets a posted index price, that price is applied to all the owners in a deck.  That won’t work for lessors with this language creating a whole new administrative burden (not to mention financial) to the oil and gas company.

• Conclusion

In conclusion, the recent Texas Supreme Court ruling restricting post-production cost deductions in new royalty clauses has sent shockwaves through the oil and gas industry. With landowners now armed with a powerful legal precedent, oil and gas companies will need to carefully review their lease agreements and navigate the complexities of calculating royalties. This landmark ruling serves as a reminder that the balance between landowners and producers is constantly evolving, and the interpretation of lease provisions can have significant financial implications.  It remains to be seen how this ruling will shape future lease agreements and the relationship between landowners and oil and gas companies.  This is why it is crucial for all stakeholders to stay informed and seek expert guidance to ensure fair and equitable agreements moving forward.

Eagle Ford Pricing for Month of July, 2023