Devon Energy Production Company, L.P. v. Sheppard is a royalty dispute between several lessees, Devon Energy Production Co., L.P., et. al., and several lessors, Michael A. Sheppard, et. al., concerning a novel royalty term that may have a huge impact on the way oil and gas royalties are paid in the future.  See 13-19-00036-CV, 2020 WL 6164467, at *12 (Tex. App.—Corpus Christi Oct. 22, 2020, pet. filed).  The novel term, referred to as an “add-back” or “add-to-proceeds” provision, requires any deductions to the sale of production to be added back to the proceeds in order to determine the appropriate royalty base.  The lessors argue that under this term, the deductions in the lessees’ sales contracts attributable to the buyers’ post-transfer costs must be added to the gross proceeds in order to establish a royalty base above the gross proceeds.  The lessees disagree, countering that the clear intent of the provision is merely to prohibit the deduction of their own post-production costs, not the post-transfer costs of the buyers.  The lessors won in the trial court; the court of appeals affirmed.  Now the case is before the Texas Supreme Court, with a recently submitted amicus brief containing the argument that could turn the tides back in the lessees’ favor.

I. Factual Background and Issue

The lessees were selling oil and gas produced from the leases under contracts with third-party buyers that contained deductions in the sales price attributable to post-transfer costs incurred by the buyers such as gathering, handling, transportation, and other costs.  The royalty clause at issue required the lessees to pay to the lessors 1/5th of the “gross proceeds” as a royalty.   Accordingly, the lessees paid 1/5th of the gross proceeds.  However, the lease also contained the following “unique” provision:

If any disposition, contract or sale of oil or gas shall include any reduction or charge for [post-production costs] 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 . . . .

The lessors claim the lessees breached this “add-back” provision by failing to add to the gross proceeds the deductions in the purchase contracts attributable to the buyers’ post-transfer costs.  Consequently, the primary issue in the case is not whether the lessees can deduct their post-production costs from the gross proceeds to determine the royalty base at the well, which is usually the issue in royalty disputes.  Instead, the issue is whether the post-transfer costs incurred by the buyer must be added to the gross proceeds to establish a royalty base at the market center, above the gross proceeds.

II. Analysis and Holding of the Court of Appeals

The lessees argued before the court of appeals that downward adjustments to the sales price to account for post-transfer costs are not subject to the “add-back” provision because appellants never “directly or indirectly” incurred the costs at issue—instead, the downstream purchaser incurred those costs.  The lessees also argued that the clear intent of the “add-back” provision is merely to prohibit the deduction of the lessees’ post-production costs.  Indeed, the “add-back” provision explicitly states that its intent is “so that Lessor’s royalty shall never be chargeable directly or indirectly with any costs or expenses.”  The court disagreed with the lessees’ arguments, holding that the buyer’s post-transfer costs must be added to the gross proceeds to determine the appropriate royalty base, even though such a result was admittedly “difficult to fathom.”

The court provided three reasons in support of its holding.  First, the court emphasized that the “add-back” provision contemplates the addition of certain amounts to appellants’ gross proceeds before calculating the royalty, and this necessarily means that the royalty base may end up being larger than the gross proceeds.  Second, the court asserted that the language in the add-back provision “is exceptionally broad, and there is nothing in the leases suggesting that [the provision] is limited to pre-point-of-sale expenses.”  Finally, the court reasoned that if the parties intended to merely prohibit deductions from gross proceeds, there would be no reason to include the “add-back” provision because the royalty clause already required payment on the “gross proceeds” and, thus, the add-back provision would be rendered meaningless under the lessees’ proposed construction.

III. New Developments Before the Texas Supreme Court

On May 28, 2021, the Texas Oil & Gas Association, the oldest and largest oil and natural gas trade association in the state, submitted an amicus brief to the Texas Supreme Court.  The amicus brief raised the argument that the court of appeals’ construction of the “add back” provision, defining the royalty base as the sum of gross proceeds plus post-transfer costs, is inconsistent with the meaning of “gross proceeds.”  The amicus brief explains that the court of appeals inappropriately included the buyer’s post transfer costs in the calculation of the gross proceeds when those costs were not proceeds at all.  This argument could be crucial to the holding in light of the recent BlueStone decision, which was released on March 12, 2021, several months after the court of appeal’s decision in SheppardSee BlueStone Nat. Res. II, LLC v. Randle, 620 S.W.3d 380 (Tex. 2021).

In BlueStone, the lease at issue contained one term that required the royalty to be paid on the “gross proceeds” and another term that required the royalty to be paid “at the well.”  The Texas Supreme Court addressed the meaning of “gross proceeds,” finding that “[w]hen proceeds are valued in ‘gross,’ . . . the valuation point is necessarily the point of sale because that is where the gross is realized or received.”  Based on this meaning of “gross proceeds,” the Texas Supreme Court held that the “gross proceeds” language inherently conflicted with the “at the well” language because the “gross proceeds” language placed the valuation point at the point of sale and the “at the well” language placed the valuation point at the wellhead.

The amicus brief sheds light on the same inherent conflict concerning the location of the valuation point present in the court of appeals’ interpretation of the lease in Sheppard.  The court of appeals found that the “add-back” provision established the valuation point at the market center despite the presence of the “gross proceeds” language in the royalty clause, which BlueStone found places the valuation point at the point of sale.  Accordingly, it seems that there is an inherent conflict between the “gross proceeds” language and the “add-back” provision because they both place the valuation point in different locations, just like the “at the well” language and the “gross proceeds” language in BlueStone inherently conflicted because they placed the valuation point in two different locations.  This potential error in the court of appeals’ reasoning, which is now identifiable in light of BlueStone, could very well be the grounds upon which the Texas Supreme Court decides to reverse the court of appeals’ decision.

IV. Key Takeaway

Although the “add-back” provision is not currently an exceptionally common lease term, it is becoming more and more common over time, especially since the release of the court of appeals’ decision in Sheppard.  If the Texas Supreme Court affirms the Sheppard decision, it is possible that the majority of lessors will be advocating the addition of this term, which may lead to a substantial change to the way royalties are paid in the future.  Thus, it is important for lessees to realize that, depending on the Texas Supreme Court’s decision, more and more leases may place the valuation point after the point of sale, requiring the burdensome addition of post-transfer costs to the gross proceeds in calculating the royalty base.

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