Let’s assume you own 165 acres in Tioga County. In 2019, you sign a new oil and gas lease with ABC Drilling. You negotiate an 18% net royalty. The royalty clause, however, requires ABC Drilling to calculate the royalty on all gas “sold and used off the premises”. During the negotiations, ABC Drilling also requests permission to construct and operate a well pad on your 165 acres and also the ability to divert certain volumes of produced gas to power the well pad operations. ABC Drilling proposes a clause known as a “free use” clause which allows them to divert and use produced gas without paying a royalty on that gas. You agree to the well pad but specifically limit the “free use” clause – they can only divert and use produced gas to fuel and power the operations on your well pad.

In 2023, you receive your first royalty statement. You are shocked to see a significant deduction for “fuel”. You contact ABC Drilling and they inform you that the fuel cost deduction represents the “value” of the produced gas used to fuel a processing plant located ten (10) miles from your farm. They also inform you that the 2019 Lease does not limit or prohibit them from deducting the value of that fuel gas as a post-production “cost”. You point out to ABC Drilling that the royalty clause in the 2019 Lease specifically says that a royalty is owed on all gas “sold or used off premises.” ABC Drilling dismisses that language and notes that the off-lease operations are necessary to process, enhance and otherwise market your gas. And since the 2019 Lease allows for the deduction of post-production costs, no royalty is owed on the diverted volume of off-lease fuel gas. How can post-production use of produced gas be simultaneously considered a post-production cost? And is ABC Drilling obligated to pay a royalty on that volume of fuel gas used for off-lease operations? As we have written before, the answer often depends on the precise language in the underlying oil and gas lease. See, Tenth Circuit Rules That Obligation To Pay Royalty On Fuel Gas Depends on Lease Language (February 2018); Oklahoma Federal Court Rules That Drilling Must Pay Royalty On Fuel Gas (April 2019). And now this troubling and complex issue is pending before the Texas Supreme Court on the certified questions from the United States Court of Appeals for the Fifth Circuit in the Carl v. Hilcorp Energy Corporation appeal. Landowners and drillers alike should monitor that this unique proceeding as it could influence the application of “free use” clauses here in Pennsylvania.

At issue in Carl is the interplay between two common lease clauses: the royalty clause and the “free use” clause. A “free use” clause typically gives the lessee/driller the right to use gas produced from the leasehold to fuel and power drilling-related operations. When a lease authorizes the driller to use gas to power operations, it is generally recognized “that the gas used for these purposes should be excluded [from] the calculation of the lessor’s royalty.” See, 2 W.L. Summers, The Law of Oil and Gas §33-12 at 160. This authority is not unlimited. Many leases stipulate that the operations fueled by the diverted gas must be actually located on the leasehold itself or in close proximity. See, Tidewater Associated Oil Co. v. Clemens, 123 S.W.2d. 780 (Tex. App. 1938) (the clause “limits the lessee’s free use of the residue gas to that provided from the land and to that used for operations thereon”); Bluestone Natural Resources II LLC v. Randall, 620 S.W.3d 380 (Texas 2021) (“The right to freely use gas is often limited to the leased premises. . . “). The use of gas is “free” only in the sense that the driller is not obligated to pay any royalty on that volume of gas. In sum, “free use” clauses arecommonbut often contain a geographic limit as to where such “free” gas can be used. Gas used on the leasehold is generally “royalty free” but gas used elsewhere is not. In other words, the driller can still theoretically use produced gas to power distant or off-lease operations but the driller remains obligated to calculate and pay a production royalty on those diverted volumes of gas.

In Carl, the driller, Hilcorp Energy Corporation (“Hilcorp”), was using produced gas to power off-lease operations and refused to pay a royalty on that volume of gas. As we have written before, the plaintiff, the Carl/White Trust (the “Trust), brought suit in Federal Court in Texas alleging that Hilcorp had breached the parties’ oil and gas lease by failing to pay such royalties. See, Texas Federal Court Rules No Royalty Due on Gas Used to Fuel Off-Lease Operations (March 2022). The Trust’s argument was two-fold. First, the Trust argued that the royalty clause in the parties’ lease required a royalty to be paid on all gas “sold” or “used off the premises”. The Trust’s position correctly recognized that gas produced from a well is either “sold” or “used”. Under either scenario, a royalty is owed. Since the purported fuel gas was being “used” off-premises, the Trust contended that Hilcorp’s refusal to pay a royalty on that volume of gas was a clear material breach. Second, the Trust argued that the “free use” clause in the parties’ lease was inapplicable because that clause had a geographic limitation: gas could only be used “free” if the gas powered operations on the actual leasehold. Since the processing facility was located miles away, a persuasive argument was made that the “free use” clause was simply inapplicable. As such, the “used off the premises” language in the royalty clause controlled and mandated the payment of a royalty on that volume of gas.

Hilcorp’s defense was rather novel. Hilcorp argued that no royalty was due on the fuel gas volume because the parties’ lease authorized the deduction of post-production costs. Since the fuel gas volume was being used to power equipment and operations that processed and allegedly enhanced the value of the residue gas, Hilcorp argued that the fuel gas volume was essentially a post-production cost that could be legitimately deducted from the Trust’s royalty. Instead of deducting the fuel gas volume as a “cost”, however, Hilcorp simply excluded that volume from the royalty calculation. Hilcorp’s theory, however, ignored the clear and unambiguous geographic limitation in the “free use” clause. According to Hilcorp, the “at the wellhead” language in the royalty clause superseded the “sold or used” language in the royalty clause and “free use” clause.

The District Court agreed with Hilcorp and dismissed the Trust’s complaint. The District Court’s analysis began with the royalty clause and noted that the clause set the royalty valuation point “at the wellhead.” Given this language, the District Court opined that when “the location for measuring value is at the wellhead, the work-back method permits an estimation of wellhead value by . . . . subtracting post-production costs incurred between the wellhead and the point-of-sale.” While this is technically accurate, the District Court failed to recognize that while the “at the wellhead” language may affect the amount of royalty to be paid (i.e. the net royalty due after deducting actual costs), it does not control or define whether a royalty is, in fact, due and owing on a certain volume of gas. The District Court’s opinion suggested that the mere presence of the “at the wellhead” language in the underlying lease gave the Hilcorp blanket authority to treat post-production “use” as an imaginary post-production “cost”. The District Court compounded this error when it ignored the “sold or used” language in the royalty clause as well as the geographic limitation set forth in the “free-use” clause. The District Court’s conclusion was not only contrary to the express language in the underlying lease but was also entirely inconsistent with the most basic rule of contract interpretation: all provisions of a contract must be read together and given effect. In light of these errors, the Trust appealed the to the United States Court of Appeals for the Fifth Circuit (the “Fifth Circuit”).

After the parties filed their respective briefs in the appeal, the Fifth Circuit issued an opinion on January 12, 2024 essentially saying that the issue before the court (i.e. obligation to pay royalty on fuel gas used off-lease) was unclear under Texas law. When questions of state law are unclear or unsettled, federal courts can submit the questions to the Supreme Court of the applicable jurisdiction. See, Texas R.A.P. 58.1 (the Supreme Court of Texas is authorized to “answer questions of law certified to it by any federal appellate court if the certifying court is presented with determinative questions of Texas law having no controlling Supreme Court precedent”). The Fifth Circuit concluded that it was unclear whether the Texas Supreme Court’s decision in Bluestone National Resources II LLC v. Randle, 620 S.W.3d (Tex. 2021) applied to “at the wellhead” lease like the one in Carl. The Trust argued that the holdingin Randle (i.e., there is an obligation to pay a royalty on fuel gas used off-lese) was binding and dispositive to the instant appeal. Hilcorp, conversely, argued that the lease in Randle was a “gross proceeds” lease and, therefore, Randle was not applicable or controlling. The Fifth Circuit observed:

“[H]ilcorp contends that, as the District Court held, Randle is inapplicable because it concerned a gross proceeds received lease, rather than a value at the wellhead lease. While Randle does concern a different type of lease, the section of that opinion addressing the free-use clause can be read to address free-use clauses generally. This raises a question of whether the free-use clause here, when read in conjunction with the rest of the lease, permits the deduction of gas used off-lease . . .”

Given this ambiguity concerning the scope and effect of the Randle opinion, the Fifth Court certified the issue for resolution by the Texas Supreme Court. See, Carl v. Hilcorp Energy (No. 22-20226, January 12, 2024). The Texas Supreme Court promptly accepted the certification on January 19, 2024 and immediately implemented an expedited briefing schedule. Oral argument on the certified questions was recently held on March 19, 2024. The Trust, Hilcorp and the Fifth Circuit, as well as landowners and drillers across the United States, now eagerly await the Texas Supreme Court’s decision.

The author submits that the District Court’s ruling warrants careful review by the Texas Supreme Court. The “at the wellhead” language in the royalty clause relied upon by the District Court merely sets the royalty valuation point. It does not decide or determine if a royalty is to be paid. On the contrary, the workback method required by such language merely guides how the royalty value is calculated. Nor does it automatically supersede or trump other express terms in the parties’ lease. The District Court, however, expanded the scope and reach of such language and inexplicitly ignored the “sold or used” language in the same royalty clause. The Texas Supreme Court should correct this misapplication of the workback method and give effect to the express terms set forth in the parties’ lease.