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The United States Court of Appeals for the Fifth Circuit’s recent decision in Carl v. Hilcorp Energy Company, —F.4th—, No. 22-20226, 2024 WL 137038 (5th Cir. Jan 12, 2024) concerns how three related provisions in an oil and gas lease interact: (1) a royalty clause; (2) a free-use clause; and (3) an off-lease clause.

When parties to an oil and gas lease reserve royalties, they stipulate where those royalties are to be valued—sometimes referred to as the “valuation point”—in the royalty clause. When royalties are valued “at the well,” royalties must be calculated based on either comparable sales or, when comparable sales are not readily available (which is often the case), by subtracting the post-production costs incurred to prepare production for sale from the proceeds received by the lessee from the sale of that production. “Post-production costs” include any costs incurred by a lessee after production is brought to the surface to make the production marketable. Common examples of post-production costs include gathering, transportation, processing, and compression.

Related to royalty provisions are “free-use clauses” and “off-lease clauses.” When oil and gas lessees produce oil and gas, that process requires fuel to power the production process and subsequent processes to treat the production and prepare it for sale. Lessees often use gas produced from a leased premises to power those processes. In recognition of this practice, many oil and gas leases contain free-use clauses, which generally grant lessees the right to use gas produced from a leased premises as fuel for operations on the leased premises without paying royalties on that gas. But to ensure lessees remain obligated to pay royalties on gas that is not used as fuel on the leased premises, leases may also contain an off-lease clause requiring lessees to pay royalties on any gas sold or used off the premises.

These clauses can conflict, though, when royalties are valued at the well because the royalty provision would permit all post-production costs to be deducted from the value of royalties, whereas the off-lease clause would provide, without limitation, that royalties must be paid on gas that is used for a post-production purpose off the leased premises. As such, if gas is used as fuel off the leased premises to power the process of treating production in preparation for sale, is that gas deductible as a post-production cost under the royalty provision, or is it subject to royalty payments under the off-lease provision? This was the question presented to the Fifth Circuit in Carl.

Carl concerned an oil and gas lease between the Carl/White Trust, as lessor, and Hilcorp Energy Company, as lessee (the “Lease”). The Lease required royalties to be valued at the well, and it contained a free-use clause and an off-lease clause. When Hilcorp produced gas on the Leased Premises, it transported the gas off the Leased Premises, where it used some of the gas produced from the Leased Premises to make the remaining gas marketable. Hilcorp viewed the gas used as fuel as a post-production cost that could be deducted from the value of the Trust’s royalties because the fuel was used to make the gas marketable and the Lease’s at-the-well valuation point allowed for costs used to make the gas marketable to be deducted. The Trust, on the other hand, argued that royalties were owed on the gas Hilcorp used as fuel pursuant to the off-lease clause because the off-lease clause expressly stated that royalties were owed on gas “sold or used off the premises.”

The Fifth Circuit determined that it could not confidently make an Erie guess as to how the provisions should be interpreted. The Fifth Circuit’s uncertainty centered around the Texas Supreme Court’s decision in BlueStone Natural Resources II, LLC v. Randle, 620 S.W.3d 380 (Tex. 2021). The Court in Randle held that a lease’s free-use clause, which was nearly identical to the free-use clause at issue in Carl, was limited to the free use of gas on the leased premises—not off the leased premises—and, as such, royalties were owed on any gas used as fuel off the leased premises. The royalty provision in Randle, however, valued royalties based on the gross value received by the lessee, moving the valuation point to the place of sale. Consequently, that lease’s royalty clause did not permit the lessee to deduct post-production costs from its proceeds. As such, whether an off-lease clause required royalties to be paid on gas used as fuel off the leased premises was irrelevant—as long as the free-use clause did not apply, royalties were owed pursuant to the royalty provision. The effect of the off-lease clause in Carl, however, was crucial, because even if the free-use clause did not apply, the royalty clause would nonetheless permit gas used as fuel off the leased premises to be deducted from the value of the royalties. Thus, Randle was not directly applicable, and no other Texas precedent existed concerning whether off-lease clauses prevail over royalty clauses that fix the valuation point of the well.

The Texas Rules of Appellate Procedure permit the Texas Supreme Court to answer questions of law certified by a federal appellate court when no controlling Supreme Court precedent answers the question. The Fifth Circuit utilized that Rule and certified to the Supreme Court the question of whether gas used off a leased premises may be deducted from a royalty’s value when the controlling lease values royalties at the well and contains both a free-use clause and an off-lease clause. Additionally, the Fifth Circuit certified the question of whether, if such gas may be deducted, the deduction should influence the value per unit of gas, the total number of units of gas on which royalties must be paid, or both.

Contact Liskow attorneys Sam Allen, J.T. Kittrell, and Jana Grauberger for further questions regarding this topic.

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