The Texas Supreme Court recently released its opinion in Devon Energy Production Company, L.P. v. Sheppard, — S.W.3d —, No. 20-0904, 2023 WL 2438927 (Tex. 2023), in which it held that lessees owed royalties in excess of their gross proceeds, specifically “adding back” costs incurred by third-party buyers that were enumerated in the sales contract and subtracted from the sales price.
The lessees owned working interests in certain oil and gas leases that were executed in 2007. The leases contained the following royalty provisions:
3. The royalties to be paid by Lessee are:
(a) on oil, [1/5th of production for the Sheppard or 1/4th of production for the Crain leases] to be delivered, free of all costs and expenses to the Lessor into the pipeline, or other receptacle to which the Lessee may connect its wells or the market value thereof, at the option of the Lessor, such value to be determined by … the gross proceeds of the sale thereof …;
(b) on gas … [1/5th for the Sheppard or 1/4th for the Crain leases of] … the gross proceeds realized from the sale of such gas, free of all costs and expenses, to the first non-affiliated third party purchaser under a bona fide arm’s length sale or contract. “Gross proceeds” (for royalty payment purposes) shall mean the total monies and other consideration accruing to or paid the Lessee or received by Lessee for disposition or sale of all unprocessed gas proceeds, residue gas, gas plant products or other products. Gross proceeds shall include, but is not limited to advance payments, take-or-pay payments (whether paid pursuant to contract, in settlement or received by judgment) reimbursement for production or severance taxes and any and all other reimbursements or payments.
(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.
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 3 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 paid royalties to the lessors based on their gross proceeds. In fact, if the lessees’ gross proceeds were reduced when purchased by third-party processors at the tailgate of a processing plant to account for the cost of transportation and processing said production, the lessees would add those deducted costs to the stated sales price before computing the lessor’s royalties. The parties agreed that those additions back to the price received by the lessee were proper under the terms of the leases. The lessees did not, however, include costs incurred by unaffiliated third-parties after the point of sale. This became a point of contention with the lessors.
Specifically, the lessors discovered that the lessees sold oil under contracts that calculated the sales price by taking an index price at market centers downstream from the point of sale and subtracting eighteen dollars per barrel for the purchaser’s anticipated post-sales costs. The lessees did not add that eighteen dollars back to the lessors’ royalty base. The lessees also engaged in other transactions with similar complicated pricing formulas employing a market-center index price as the starting point for the price to be received and then subtracting similar deductions where the contract did not describe what the subtracted amount was supposed to represent.
The lessors filed a declaratory judgment action against the lessees alleging that Paragraph 3(c) (the “add-back provision”) required the lessees to add the costs subtracted from the market-center index price to their royalty bases, resulting in prices that exceeded the gross proceeds actually received by the lessees. The lessees, on the other hand, argued that the add-back provision was mere surplusage that emphasized the cost-free nature of a gross-proceeds royalty. The trial court granted a summary judgment in favor of the lessors, and the court of appeals affirmed to the extent that the sales contracts contained price adjustments for a stated purpose that fell within the confines of the add-back provision. Consequently, if a sales contract subtracted eighteen dollars from a market index price without explaining what those eighteen dollars were meant to represent, the lessees would not be required to add that to its gross proceeds to calculate royalties under these leases. The lessees appealed the court of appeals’ decision only as it related to price adjustments for a stated purpose, and the Court limited its opinion to discussion of only that issue, as it affirmed the court of appeals’ ruling otherwise.
The Court began its analysis by stating that the question was not whether postproduction costs incurred downstream were “gross proceeds” under the lease or under the law, but rather whether the lease nonetheless required royalties to be paid on those costs. The Court looked to the plain language of the add-back provision and stated that it was “inescapably” broad enough to require that any reductions or charges included in the lessees’ disposition of production to be added back to the gross proceeds so the royalty never bears costs, even indirectly. Further, because paragraphs 3(a) and 3(b) were sufficient in themselves to free the royalties from all postproduction costs incurred from the wellhead to the point of sale, the add-back provision would have served no purpose if it were intended only to ensure royalties were free from all postproduction costs incurred by the lessees between those points. Instead, “an obvious and reasonable purpose” for the add-back provision was to give the lessees the flexibility to sell production at any point downstream while discharging the lessors from the burden to share in any of the costs of rendering that production marketable, regardless of whether those costs were incurred by the lessees or third parties.
The Court then addressed the lessees’ three arguments against including such costs in turn. Specifically, the lessees argued: (1) the leases did not state that royalties were to be paid on costs incurred after the point of sale “plainly and in a formal way”; (2) the rule against avoiding surplusage was not applicable because the leases were replete with surplusage emphasizing that “gross” meant “gross”; and (3) Addendum L showed that the parties were concerned only with prohibiting deductions for the lessees’ postproduction costs incurred between the wellhead and the point of sale.
The Court determined that the add-back provision stated “plainly and in a formal way” that costs incurred after the point of sale were to be added to the royalty bases because it clarified that costs were to be added to gross proceeds. Construing the add-back provision differently would have equated “added to gross proceeds” to “gross proceeds,” and no reasonable person would have construed those two phrases synonymously. The Court also stated that its construction of the add-back provision did not rely on avoiding surplusage and that, regardless, its construction was confirmed by the fact that it did so. Finally, Addendum L did not convey an intent to override the add-back clause, and it was not inconsistent with the add-back provision.
Ultimately, the Court labeled the leases as “proceeds plus” leases that required a two-prong calculation to find the royalty base: (1) the lessees must properly determine their gross proceeds from selling the production; and (2) when the lessees’ sales contracts state that the buyer’s enumerated postproduction costs or expenses have been deducted in setting the sales price, those costs and expenses must be added to the gross proceeds. But the Court also clarified that it did not hold that any “reduction or charge” incurred by buyers must be included in royalty bases ad infinitum, but rather that the add-back provision in the leases at issue was tethered to the time and place where gross proceeds were realized, which rendered costs enumerated in the relevant sales contracts includable in the lessors’ royalty bases. Costs incurred by subsequent purchasers, however, would not be included because they were not included in the lessees’ contract at the point of sale.
The lone dissenting opinion, authored by Justice Blacklock, viewed the majority’s decision as fundamentally changing the nature of the royalty interest at issue by allowing the lessors to improperly convert their royalties on the gross proceeds at the initial point of sale to royalties on a more fully-refined product sold at a downstream market center. It argued that the royalty provisions established that the lessors were entitled to royalties based on whatever value the product had at the point of initial sale. Justice Blacklock further reasoned that the majority opinion improperly focused on the method of calculating the value of the products by viewing subtractions of future costs from the market-center price as “reductions” or “charges.” Those subtractions were only used as a mechanism for arriving at the price to be received by the lessees at that specific location, and nothing in the leases entitled the lessors to royalties only because the sales contracts listed certain of the buyer’s costs to arrive at a market price. The dissenting opinion also construed the add-back provision as being included to ensure that no clever lessee or wayward court would deprive the lessors of the full benefit of their gross-proceeds royalty, and because the sales at issue did not include any reductions or charges prior to the initial point of sale, it did not apply. Finally, the dissenting opinion argued that Addendum L emphasized the cost-free nature of the royalty and did not transform it from a “gross proceeds” royalty to a royalty based on the market-center price of the production regardless of where it was sold. Holding otherwise elevated form over substance, and Justice Blacklock provided two examples to make his point: In the first example, if the relevant sales contract was for $100 per barrel of oil without explaining how that production was calculated, the royalty would be payable at $100 per barrel. But, if the relevant sales contract specified the $100 price was calculated by taking a $120 market price and subtracting $20 in estimated post-sale costs, then the royalty would be payable at $120 per barrel, even though the market value of the production and gross proceeds are identical. To change the royalty price based on whether or not the method of calculating the sales price was reflected in the sales contract was not, in Justice Blacklock’s view, required by the plain language of the leases.
In light of the Sheppard opinion, producers should carefully review all leases containing any form of an add-back provision and determine what costs that provision is tethered to. The add-back provision in Sheppard was tethered to dispositions, contracts, and sales of oil or gas to a purchaser by the lessees. If a lease is similarly tethered to the sales price included in a producer’s sales contract, and if that contract states that any deductions were taken to reach that sales price, then those deductions should be added to the sales price to calculate the royalty base. On the other hand, if those contracts do not specify how the sales price was calculated, then the narrow holding in Sheppard arguably does not apply, meaning producers, in such a case, should value royalties based on the gross proceeds realized at the point of sale.
Regardless, upstream producers who own working interests in leases containing add-back clauses would benefit from contacting an experienced attorney for further evaluation on this evolving area of the law and on whether Sheppard applies to its leases.
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