Devon Energy Prod. Co., L.P. v. Sheppard, No. 20-0904 2023 Tex. LEXIS 223 (Tex. Mar. 10, 2023)
In this case, the Texas Supreme Court reviewed a “bespoke” oil and gas lease, and held that its “unique,” “unusual,” and “broad lease language” provided for a “proceeds plus” royalty base. The Court indicated that this broad and unusual language unambiguously called for a royalty base that may exceed the lessee’s gross proceeds, because it “plainly requires the producers to pay royalties on the gross proceeds of the sale plus sums identified in the producers’ sales contracts as accounting for actual or anticipated postproduction costs, even if such expenses are incurred only by the buyer after or downstream from the point of sale.”
The Court generally noted that, though leases operate against a backdrop of jurisprudence regarding “usual” rules, “we have consistently recognized that parties are free to make their own bargains.” One “usual” rule is that royalties are free of production costs, but not free of postproduction costs. However, “[l] and owners and producers can ‘agree on what royalty is due, the basis on which it is to be calculated, and how expenses are to be allocated.’”
Unconventional Provisions
The unique leases at issue in this case included a gas royalty provision on “gross proceeds realized from the sale, free of all costs and expenses, to the first non-affiliated third party purchaser under a bona fide arms length sale or contract.”
The leases also contained two “more unconventional” provisions, including a Paragraph 3(c) reading as follows:
(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.
The lease also contained a unique Addendum L, which read as follows:
L. ROYALTY FREE OF COSTS:
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 depreciation 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 312 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).
The lessees sold the oil and gas production to unaffiliated third parties at various downstream sales points. The lessees then paid royalties on the basis of their gross proceeds, without any deduction of expenses the lessee’s incurred to ready the production for sale. The lessees did not, however, include any post-sale costs incurred by the third-party buyers after the point of sale.
The lessors contended that this was a breach of the unique royalty provisions. The lessors contended that the unique leases require the lessee to “add to” “gross proceeds” any “reductions or charges” in the lessee’s sales contracts, so that the landowners’ royalty is never burdened by postproduction costs, not even “indirectly.” The lessors contended that the language was written to unburden the royalty interests from postproduction costs, irrespective of the lessee’s unilateral choices about where and in what condition to sell production, to the extent that “the royalty calculation [is made] consistent no matter where the producers choose to sell production.”
The lessees, on the other hand, argued that these unique provisions were “mere surplusage that emphasizes the cost-free nature of a ‘gross proceeds’ royalty by requiring them to ‘add back’ only pre-sale postproduction costs that may have diminished the sales price.” The lessees characterized the lessor’s interpretation as “untenably contrary to the industry’s expectation that a royalty free of postproduction costs means only those costs incurred up to the point of sale.”
The Court rejected the lessee’s construction, reasoning that “[a] reasonable person would not read [these] words” to “construe ‘added to...gross proceeds’ as the equivalent of ‘gross proceeds.’” Instead, in the Court’s view, the unique provisions in these leases “plainly require certain sums to be ‘added to’ gross proceeds.” The Court indicated that “parties to a mineral lease could unquestionably make [an] agreement” to “require[e] producers to pay royalty on postproduction costs incurred downstream from the point of sale.” The Court reasoned that it would not be unreasonable for Texas lessors to negotiate lease terms that provide something similar to the “marketable product” rule in other jurisdictions – where a producer is required to pay royalties on the value of the product in a commercially usable condition and in a commercial marketplace, regardless of where and in what condition the product is actually sold.
SCOTX's Ruling on the Unique Language
Ultimately, the Court held that the “inescapably broad language” in these unique provisions is “clear” in that “[i]t requires ‘any reduction or charge’ for postproduction costs that have been included in the producer’s disposition of production to be ‘added to’ gross proceeds so that the landowners’ royalty ‘never’ bears those costs even ‘indirectly.’” The Court went on to say, “Paragraph 3(c) is not textually constrained to the expenses incurred by the seller or prior to the point of sale.” Further, “Paragraph 3(c) unambiguously contemplates royalty payable on an amount that may exceed the consideration accruing to the producers.”
The Court agreed with the lessees that courts construe commonly used terms in a uniform and predictable way in order to assure continuity and predictability in oil and gas law. “But there is nothing common, usual, or standard about the language in Paragraph 3(c), which is quite clear in expressing the intent to deviate from the usual expectations regarding the allocation of postproduction costs” in two ways: (1) first by requiring royalties on gross proceeds, which departs from the general rule that a lessor bears a proportionate share of post-production costs, and (2) “by requiring an addition to gross proceeds for the stated purpose of freeing the landowners’ royalty from ‘any costs or expenses other than its pro rata share of severance or production taxes.”
Finally, the Court turned to the lessee’s contention that, even if some post-sale postproduction costs must be included in the royalty base, expenses for “transportation and fractionation” (or “T&F”) are not among them. The Court disagreed, reasoning that T&F is a term of art referring to transporting raw gas downstream for fractionation to separate raw gas into purer products. Because the unique royalty provisions in these leases expressly included expenditures to “process” production, that included “T&F” fees.
