No Off-Lease Gas Use Recovery For Royalty Owners

Gray Reed
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Gray Reed

The question is presented again but in a different format: In Texas is a lessee allowed to deduct post-production costs (PPC’s) from the lessor’s gas royalty? In Carl v. Hilcorp, the answer was “yes” based on the language in the oil and gas lease at issue. The question was for gas used by the lessee off the lease premises.

The lease provisions

Gas royalty owners brought a class action in the U. S. District Court for the Southern District of Texas alleging underpaid royalties on two wells. Paragraph 3 of the lease addresses gas royalty and free use of gas:

  • The royalties to be paid by Lessee are: … on gas, … 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, … from said land, …, for all operations hereunder, and the royalty on oil, gas and coal shall be computed after deducting any so used.

Hilcorp did not pay royalty on gas used off the lease premises. Plaintiffs alleged that the royalty clause requires royalty to be paid on any gas used off the premises and that, even absent the royalty provision, the free use clause independently and expressly allows gas to be used only on the lease premises, so royalty must be paid for gas used off the premises.

Hilcorp responded that the market-value-at-the-well valuation means that royalties need not be paid on gas used off the premises that increases the value of the raw gas in preparation for downstream sale. The “off-lease use” and “free use” provisions do not change this structure.

A refresher on “market value at the well”

The court reviewed the seminal Texas cases: BlueStone v. Randle, Heritage, Burlington Resources, French, and from Mississippi, Piney Woods. When the location for measuring market value is “at the well,” market value may be estimated by subtracting from proceeds of a downstream sale PPC’s incurred between the well and the point of sale. Because these costs add value to the gas, backing out the necessary and reasonable costs between the sales point and the wellhead is an adequate approximation of market value at the well. Therefore, for gas that is subsequently treated, processed and transported for sale at a remote location, necessary and reasonable value-enhancing PPC’s are properly deducted from the royalty calculation.

Gas royalty

Applying that methodology, the court found that reasonable and necessary PPC’s may be deducted from the royalty calculation. As the Texas Supreme Court explained in Burlington Resources, the term post-production costs generally applies to processing, compression, transportation, and other costs expended to prepare raw oil or gas for sale at a downstream location. The lease in this case did not define “post-production expenses” in any unique way. The Complaint as much as acknowledged the standard arrangement. The Court concluded that these “off-lease” uses are PPC’s that are properly excluded from the royalty calculation.

Free use

The Court agreed with Hilcorp that despite that free-use was only for on-lease operations, Hilcorp was not precluded from deducting gas used as fuel or in-kind payment for post-production services in this market-value-at-the-well lease. The Court determined that under Texas case law, the market-value-at-the-well provision is the critical clause. The court interpreted Paragraph 3 as a matter of law and determined that Hilcorp was entitled to deduct reasonable and necessary value-enhancing PPC’s.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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