Two decisions this year address when a Texas royalty owner bears post-production costs. In April, the Texas Supreme Court held in Fasken Oil & Ranch v. Puig that a royalty reserved “free of cost forever” is not, on that language alone, free of post-production costs. In May, a federal court in San Antonio applied the Court’s 2023 decision in Devon Energy v. Sheppard and required a lessee to add a buyer’s price deductions back into the royalty base.
Both decisions turn on the same two questions: where the instrument values the royalty, and whether it adds anything back to that value.
The General Rule
Texas values a royalty at the well unless the parties agree otherwise. Under Heritage Resources v. NationsBank, a royalty valued at the well bears its share of the costs incurred after production to make the product marketable, and a clause prohibiting “deductions” from that royalty does not change the result.
In Sheppard, the Court confirmed that parties may agree to a different allocation, but they must express that intent “plainly and in a formal way.” Parties generally do so by moving the valuation point downstream, usually with gross-proceeds or amount-realized language, by specifying that something is added to the royalty base, or both.
Cost-Free Language
Fasken involved a 1960 deed reserving a nonparticipating royalty “free of cost forever.” The Court held that the language did not shift post-production costs to the operator because, absent a reference to another valuation point or calculation method, “cost-free language merely restates the rule that a royalty interest is free of costs incurred in exploring for and producing the raw minerals.”
The Court distinguished Chesapeake v. Hyder, the 2016 decision holding an overriding royalty free of post-production costs. The Hyder lease contained three features the Fasken deed did not: (i) a parenthetical excepting production taxes from the cost-free language; (ii) other royalty clauses that used downstream valuation points; and (iii) an express right for the royalty owner to choose between payment in cash and in kind.
Gross Proceeds and Add-Back Clauses
A royalty on gross proceeds at the point of sale is free of the lessee’s own costs before the sale. Under Sheppard, it generally is not free of the buyer’s costs after the sale. The buyer accounts for those costs in the price it pays, often by paying an index price less transportation, fractionation, or similar adjustments. If the lease has no add-back clause, courts have generally calculated the royalty on that reduced price, so the royalty owner bears those costs.
An add-back clause changes that result. In Sheppard, the Texas Supreme Court held that a lease requiring the buyer’s deductions to be added back to gross proceeds required royalty on those amounts, even though the buyer incurred the costs after the sale. That holding reached only price reductions made for the purposes the lease listed. The court of appeals ruled for the producers on adjustments with no stated purpose, and because the royalty owners did not appeal that ruling, the Supreme Court did not review it.
Federal Courts and Add-Back Clauses
Since Sheppard, federal courts have followed the lease language. In Gringita, Ltd. v. Ineos USA Oil & Gas (W.D. Tex. May 8, 2026), the add-back language appeared in the lease’s definition of gross proceeds, a term the royalty clause did not use. The court held that the definitions still informed the royalty clause and that the lessee must add to the royalty base the value of sales-price deductions meant to account for post-production costs. The court construed the lease only; it did not decide whether any amount was owed.
In YMC Royalty Co. v. WPX Energy Permian (W.D. Tex. July 28, 2026), the court reached the opposite result because the lease “contains no language comparable to that in Sheppard.” H.L. Hawkins, Jr., Inc. v. Capitan Energy (W.D. Tex. 2023) is to the same effect. That lease had no add-back clause and protected the royalty only from costs “incurred by Lessee.”
Lessees sometimes argue that a deduction built into a pricing formula is part of the price, not a cost. Before Sheppard, a bankruptcy court rejected that argument under a broad add-back clause in Petty Business Enterprises v. Chesapeake Exploration (Bankr. S.D. Tex. 2021). The purchaser there paid an index price less a transportation and fractionation fee. The court held that “[t]he fact that the reduction does not represent the purchaser’s actual cost is irrelevant.” The Texas Supreme Court later cited Petty in Sheppard.
Practical Considerations
For royalty owners, the first questions are where the instrument values the royalty and whether it contains an add-back clause. If the royalty is valued at the well and there is no add-back clause, cost-free language is unlikely to help after Fasken. If there is an add-back clause, the purchase contracts and check statements will show which adjustments relate to transportation, processing, or marketing.
Operators and payors should run the same review. A lease with an add-back clause, particularly one reaching adjustments taken by “the purchaser,” may require royalty on more than gross proceeds, and in Petty the argument that a deduction is simply part of the price did not succeed.
Parties drafting new instruments should state where the royalty is valued and what, if anything, is added back, rather than relying on cost-free language.
For questions about how these decisions affect a royalty you hold or pay, contact Kevin Colpoys.