Producers disappointed by the Supreme Court’s holding in Devon Energy Production v. Sheppard might have reason to feel vindicated. The question in HL Hawkins Jr., Inc. v. Capitan Energy Inc. et al. was whether producer Capitan deducted impermissible post-production costs from gross proceeds used to calculate royalties. Lessor Hawkins‘ royalty was one fourth of gross proceeds. A paragraph entitled “Royalty to be Free of Expenses” said,

“Lessor’s royalty shall not bear or be charged with, directly or indirectly, any cost or expense incurred by Lessee, including, without limitation [enumerated PPCs] and no such deduction or reduction shall be made from the royalties payable to Lessor hereunder …. “

Hawkins alleged that Capitan underpaid royalties by netting gross oil prices for transportation; netting PPCs from NGL values, failing to pay royalties on plant fuel and plant loss, valuing flared and lease-use volumes using residue prices reduced for downstream PPCs, and valuing residue gas reduced for downstream PPCs. 

Did Capitan “incur” PPCs? Hawkins argued that Sheppard required a conclusion that it did. The court determined that Sheppard did not apply. The Sheppard lease was far more encompassing than Hawkins’ because of an “add-back” clause in Sheppard. And Sheppard’s “proceeds plus” clause, unlike Hawkins, expressly and unambiguously contemplated the addition of certain sums to gross proceeds in order to arrive at the proper royalty base.

Hawkins alleged that Capitan’s contracts with purchasers indirectly charged Hawkins’ royalty with costs that are not allowed under the lease. But that reading omitted a condition precedent: the costs must be incurred by Capitan. The evidence was undisputed that the way Capitan conducted its operations supported the fact that Capitan not “incur” PPC’s.  According to the lease’s plain meaning, the words “directly or indirectly” modified “charged”, not “incurred”.

Read the lease

The court concluded that construction of royalty provisions must ultimately be based predominantly on the particular clause at issue construed within the context of the lease as a whole. The court warned against applying the reasoning from one lease to another, distinct lease. 

Pricing formulas prevail

Under Capitan’s contracts with unaffiliated third parties, oil and gas are sold at the lease. Capitan receives a lower price for production than if the production were sold downstream. This means a lower basis for Hawkins’ royalty because the pricing formulas in Capitan’s third-party contracts accounted for third parties’ PPCs.

The court concluded that the result of third parties incurring PPC’s is a decrease in Capitan’s revenue, which the court distinguished from an increased in costs or expenses. Capitan did not violate the lease when pricing formulas in its contracts accounted for PPCs to be incurred by those third parties.

Gas not sold

The court denied summary judgment for Capitan for failing to pay royalties on volumes used in plant fuel and plant loss and for flared gas and lease-use gas, opining on a common lease clause:  “ … provided, … in the event gas is not sold under an arms length transaction, Lessor’s royalty on such gas shall be calculated  using the highest price paid … “

Capitan argued that gas must be sold for royalty to be due. So what happens if gas is not sold under an arms-length transaction? The court determined that the clause was divided into two parts: 1. gas sold in arms-length transactions, and 2. gas not sold arm’s-length transactions. Another clause gave Capitan the right to free use of gas on the premises. Giving effect to all provisions of the contract the court concluded that if only gas sold triggers the need to pay royalties, the free-use clause had no purpose.

Full disclosure:  Your co-authors represented Capitan in this litigation.

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