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By: Caroline K. Featherstone 

In the recent case of Devon v. Sheppard, the Texas Court of Appeals addressed a highly unique royalty provision. The lease at issue provided that the royalty could be calculated based on a percentage of Devon and BP's gross proceeds from the sale of minerals produced under such lease. However, the royalty provision also contained the following unique language: 

3(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 or marketing of the oil or gas, then such deduction, expense or cost shall be added to the market value or 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 appellants argued that the royalty was to be calculated based on the gross proceeds without any deductions at the point of sale, and they were not required to add “reduction[s] or charge[s]” incurred by downstream purchasers, as the appellees contended.  The Court of Appeals reasoned that there was nothing contained in paragraph 3(c) limiting the royalty calculation to deductions made prior to the point of sale. Furthermore, limiting paragraph 3(c) to deductions made prior to the point of sale would render the provision meaningless. The Court of Appeals stated, “[t]he royalty is paid as a fraction of the value of the oil and gas produced from the leases, but that value increases as the minerals are processed, fractionated, and transported to the market center, where they are finally put on the open market and prices are standardized.” Paragraph 3(c) allows the royalty to be calculated by including “value added by post-production costs” and therefore, the royalty amount may be larger than the proceeds received by the producer. The Court of Appeals concluded that paragraph 3(c) was a “proceeds plus” provision, with the valuation at the market center as opposed to the point of sale.

The Court of Appeals reviewed twenty-three reductions or charges which were, arguably, a “reduction or charge” to be added to the gross proceeds under paragraph 3(c).  The court categorized such reductions as follows:

1. Adjustment of Fixed Amount With Stated Purpose

2. Adjustment of Fixed Amount Without Stated Purpose

3. Adjustment Based on Processor’s Actual Costs

4. Adjustments For Unit Fuel/Lease Fuel

5. Adjustment for Production Retained or Lost by Third Parties

6. Excess Value Resulting From Application of Contractually Fixed Recovery Factors

The first category referred to sales contracts by which the price for oil and gas is calculated by deducting a fixed amount for a stated purpose. For example, a 2011 agreement between GeoSouthern Energy Corporation and Enterprise Crude Oil, LLC, contained an $18.00 reduction for “gathering and handling, including rail car transportation.” The Court of Appeals concluded that the fixed deduction was a “reduction or charge” under paragraph 3(c) because it is a deduction for the expressly stated purpose of gathering and handling. Therefore, the amount deducted was to be added to the to the gross proceeds in order to calculate the royalty. 

On the contrary, several deductions were of fixed amounts without a stated purpose. In a 2012 agreement between GeoSouthern and Enterprise, the price of crude oil and condesate was shown as a published index price “plus amount shown per barrel.” In this case, the “amount shown per barrel” was a -$9.15 or -$8.15, which was alleged by the appellees to be a deduction. Although the parties agreed that this constituted a “reduction or charge” as defined in paragraph 3(c), the charges did not appear to be for the stated purposes set forth in paragraph 3(c). As a result, such reductions were not entitled to be added back to the gross proceeds in order to calculate the royalty.

The court subsequently addressed agreements by which the downstream purchaser’s post-production expenses are deducted from a published price. These deductions reflected the actual “transportation, processing, and marketing costs of the third-party purchaser.” As discussed above, there was nothing contained in paragraph 3(c) which limited it to deductions made prior to the point of sale and incurred only by the appellants. Therefore, post-production costs borne by a third-party purchaser for the express purposes set out in paragraph 3(c) were to be added back to the gross proceeds.

The last three categories do not concern the deduction of post-production costs either by the appellants or third-party purchasers. The Court of Appeals concluded that under paragraph 3(c), appellants were not required to add amounts to the gross proceeds for (i) their use of gas for unit fuel or lease fuel, (ii) production retained or lost by a third-party purchaser, and (iii) excess value resulting from the application of contractually fixed recovery factors.

Once again, the court emphasized the importance of using clear and concise language in leases. “We can only speculate as to how many dollars and hours would have been saved had the parties drafted the leases, in Justice Blacklock’s words, “to say exactly what [they] intend[ed], without resort to industry jargon, outdated legalese, or tenuous assumptions about how judges will interpret industry jargon or outdated legalese.””

This case is Devon Energy Production Company, L.P. fka Geosouthern Dewitt Properties, LLC, BPX Properties (NA) LP, Geosouthern Energy Corporation, and BPX Production Company v. Michael A. Sheppard, et al., case number 13-19-00036-CV, in the Thirteenth Court of Appeals of Texas.