Trudging the Rocky Landscape of Royalty Dispute Litigation with the Texas Supreme Court Yet Again in BlueStone

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With the prevalence of cases involving royalty disputes in Texas, the state’s Supreme Court has never hesitated to address these issues.  But the Court’s sporadic holdings regarding royalty clauses, each so specific to the particular language of the lease, have left lessees on unsteady footing.  BlueStone primes the Court to resolve a Texas appellate court split regarding whether a lease provision requiring royalties to be paid based on “gross” profits or value received from the sale of oil and gas production nullifies an “at the well” valuation point elsewhere in a lease.

One aspect of royalties that gets a significant amount of attention from Texas royalty owners is post-production costs.  Ordinarily, royalties are free of production expenses for bringing the minerals to the surface but “usually subject to post-production costs, including taxes, treatment costs to render it marketable, and transportation costs.”  Heritage Res., Inc. v. NationsBank, 939 S.W.2d 118, 120-21 (Tex. 1996).  Parties are, of course, free to bargain otherwise; the clauses to prohibit deduction of post-production costs – the no-deductions clauses – are the basis of a line of jurisprudence from the Texas Supreme Court that continues to confound the industry today.

In 1996, the Court issued the first of its now infamous holdings on the deductibility of post-production costs from oil and gas royalties.  Heritage Resources, 939 S.W.2d at 120-21.  Heritage Resources is the underlying case that must be understood to decipher the Supreme Court’s logic as it continues to rectify the numerous creative royalty provisions across Texas today.  In Heritage Resources, the Court held that deduction of post-production transportation costs were proper, despite a no-deduction clause, where the lease required royalties to be measured “at the well.”  An “at the well” valuation point necessarily excluded any additional costs required to make the production marketable, including transporting the production away from the well and processing it.

Two decades later, the Court touched on this issue again.  Chesapeake Expl., L.L.C. v. Hyder, 483 S.W.3d 870, 876 (Tex. 2016) (holding that a disclaimer of Heritage Resources “cannot free a royalty of postproduction costs when the text of the lease itself does not do so” and that such disclaimer did not influence the Court’s decision).  The Texas Land and Mineral Owners’ Association and the National Association of Royalty Owners-Texas filed an amicus brief in Hyder seeking clarification on how to apply Heritage Resources, but critics claim the Court’s controversial follow-up did not clarify the issue.  In fact, the Hyder opinion includes a footnote reminding readers that on rehearing, the Court in Heritage realigned itself.  Further, Justice Hecht writes, “Heritage Resources does not suggest, much less hold, that a royalty cannot be made free of postproduction costs.  Heritage Resources holds only that the effect of a lease is governed by a fair reading of its text.”

With that invitation, the royalty disputes in Texas are picking up speed.  In 2019, the Court heard Burlington Res. Oil & Gas Co. LP v. Tex. Crude Energy, LLC, 573 S.W.3d 198, 203 (Tex. 2019), reh’g denied (May 31, 2019).  In Burlington, the Court held that royalties valued when delivered “into the pipeline, tank or other receptacle” created an “at the well” valuation point and allowed the lessee to deduct post-production costs when calculating royalties because “royalty on products at their downstream point of sale is more valuable than a royalty on the same products at the well.”  Burlington, 573 S.W.3d at 203.

Alas, we have arrived at BlueStone Natural Resources II, LLC v. Walker Murray Randle, No. 19-0459, which the Texas Supreme Court agreed to review on May 29, 2020.  BlueStone tackles two hot-button royalty issues.  As a secondary issue, the parties ask whether production used as plant fuel or compressor fuel qualifies as volumes used in “operations which Lessee may conduct hereunder” and is therefore royalty-free.  The primary dispute poses a follow-up question to Burlington similar to the way Hyder sought clarification on how best to apply Heritage Resources:  whether an addendum to the lease providing for royalties based on “gross value received” modifies the lease’s requirement for royalties to be paid on “market value at the well.”

The trial court and court of appeals both found that “gross value received” could not be harmonized with “market value at the well.”  They reasoned that the gross value received was at the point of sale, downstream of the well, once the production was transported and treated and its value increased, and therefore, the “gross value received” addendum superseded the “market value” language.  BlueStone Nat. Res. II, LLC v. Randle, 02-18-00271-CV, 2019 WL 1716415, at *1 (Tex. App.—Fort Worth Apr. 18, 2019, pet. granted).  Interestingly, the BlueStone appellate court “agree[s] that Burlington Resources contains a clear lesson on the power of an ‘at the well’ valuation point to control the allocation of post-production costs, no matter whether the yardstick utilized is market value or pure proceeds.” BlueStone, 2019 WL 1716415, at *13.  Despite that conclusion, the court of appeals held that “gross value received” supersedes “at the well” because the “at the well” language is not included in the “gross value received” paragraph (i.e., the result may have been different had the addendum required royalties paid on the gross value received at the well).  See id. at *13-14.  It is almost as if the Fort Worth Court of Appeals infers from the “gross value received” paragraph’s statement that it “supersedes” contrary provisions that it intended to supersede the “market value” provision particularly.

Now on appeal to the Texas Supreme Court, the BlueStone Petitioner pleads for the Court to “ensure that lower courts understand its guidance from Burlington, but perhaps more important, . . . to explore what it takes to amend an express ‘at the well’ valuation point.” The Petitioner extrapolates from the earlier Supreme Court precedent, stating

The Respondent argues that “gross” means “without deductions,” and that to rule otherwise would serve to overrule longstanding precedent in Hyder and Judice v. Mewbourne Oil. Co., 939 S.W.2d 133, 135 (Tex. 1996) (holding “gross proceeds” royalties are without deductions).

The Texas Oil & Gas Association filed an amicus brief in support of the Petitioner but reminds the Court of the larger issue at play – regardless of the answer, the industry needs guidance on conflicting precedent.  The Association asks, which court of appeals should we follow?  The El Paso Court of Appeals, relying on Heritage Resources, has held that a no-deductions clause requiring royalties on the “gross value received” is mere surplusage in a lease requiring royalties based on “market value at the well.”  Comm’r of Gen. Land Office of Tex. V. SandRidge Energy, Inc., 454 S.W.3d 603, 608-09 (Tex. App. – El Paso 2014, pet. denied).  The SandRidge opinion directly conflicts with the Fort Worth Court of Appeals’ holding in BlueStoneBlueStone, 2019 WL 1716415.  Still further, the Association reminds the Court that Burlington’s holding that an “amount realized” from the sale valuation method does not conflict with an “at the wellhead” valuation point, allowing deduction of post-production costs, conflicts with the Supreme Court’s 1996 holding in Judice, which held that a “gross proceeds” valuation method is in “inherent conflict” with an “at the well” valuation point.”

If BlueStone is to Burlington what Hyder was to Heritage Resources, will the Court actually just muck up the waters of the Texas royalty dispute even more?  Or will the volume of conflicting jurisprudence require the Supreme Court to decide once and for all that “gross proceeds” and “at the well” either always conflict or never conflict?  A point of issue from various legal commentators across the country who look to Texas courts as the primary source of understanding oil and gas contracts seems to be whether “gross proceeds” or “gross value received” is merely a valuation method or whether it additionally supplies the valuation point at the sale and therefore inherently conflicts with a valuation point at the well.  The Court’s cavalier use of valuation point and valuation method will generate additional confusion; if these two terms are not interchangeable and do not necessarily imply the other, then the Court should outline how and when to determine as much.

With the wide range of royalty disputes at play in leases today, it is unlikely that the Court’s decision will clarify all royalty disputes.  Rather, a look toward Hyder and Burlington clarified only one aspect of Heritage Resources that would apply here and going forward – the Court is always looking to stay true to the very specific text of each lease.  In fact, Burlington has been cited for this broad premise regarding unambiguous and harmonious contract language more often than it has been cited for its analysis of royalty disputes.  Are Heritage Resources and its progeny just another line of contract cases without significant valuable precedent for the oil and gas industry?  Certainly, this cannot be true with royalty dispute jurisprudence in the conflicting state it is in today.

BlueStone has not been set for oral argument.  The BlueStone briefings to the Texas Supreme Court can be found here:  http://www.search.txcourts.gov/Case.aspx?cn=19-0459&coa=cossup

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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