The Oil and Gas Addendum

Let’s assume you own a 135 acre farm in Tioga County, Pennsylvania.  In 2020, you negotiate a new oil and gas lease with XYZ Drilling Company. During the negotiations, you insist on a cost free, no deduction royalty of 17%.  The landman tells you “no need to worry” as he inserts specific language in the addendum that says “the royalty shall be free of cost forever”.  You rely on his promise, accept the proposed language and sign the new lease. Last week you receive your first royalty check from XYZ Drilling Company. You are frustrated, angry and confused.  XYZ Drilling Company has deducted gathering, dehydration and processing costs from your production royalty.  These costs exceed $3,500. You call XYZ Drilling Company and inform them that there must be a mistake given the “free of cost forever” language in the addendum.  The representative from XYZ Drilling Company says there was no mistake as the addendum language only exempts production costs from the royalty calculation – post-production costs can still be deducted.  Is XYZ Drilling Company correct?  Is there a distinction between production costs and post-production costs?  A recent decision from the Fourth Court of Appeals in San Antonio, Texas addressed this critical distinction and the scope of “free of cost” clauses.

At issue in Fasken Oil and Ranch LTD v. Puig (No 04-23-00106, October 30, 2024) was a deed executed in 1960 concerning 11,973 acres in Webb County, Texas (the “1960 Deed”).  The 1960 Deed reserved, on behalf of the seller, a non-participating royalty of one-sixteenth (1/16^th) in and to:

“all the oil, gas and other minerals, except coal, in, to and under or that may be produced from the above described acreage, to be paid or delivered to Grantor, B.A. Puig, Jr. as his own property free of cost forever. . . .”

Thereafter, Fasken Oil and Ranch LTD (“Fasken”) acquired a leasehold interest in the 11,973 acres and operated numerous wells on the subject property. Pursuant to the 1960 Deed, Fasken tendered royalty payments to the Puig family but deducted post-production costs from said payments.  The Puig family objected to the deductions and filed suit in 2021 alleging a breach of the 1960 Deed.

In the fall of 2022, both parties filed cross-motion for summary judgment. The Puig family essentially argued that the scope of the “free of cost” language was controlled by the Texas Supreme Court’s seminal opinion in Chesapeake Exploration, LLC v. Hyder, 483, S.W. 3d 870 (Texas 2016).  In Hyder, the Texas Supreme Court opined that a royalty clause which provided for a “perpetual cost-free” royalty was sufficient to exempt the royalties from all post-production costs.  The Puig family contended that the “free of cost forever” language in the 1960 Deed should be construed and applied in the same manner (i.e. no deductions).  Conversely, Fasken argued that Hyder compelled the exact opposite result given a subtle distinction between the language in the Hyder royalty clause and the 1960 Deed. Fasken further argued that the “free of cost” language only applied to production costs and did not prohibit the deduction of post-production costs.

The trial court rejected Fasken’s suggested interpretation of the “free of cost” clause and entered judgment in favor of the Puig family.  The trial court opined that the “[P]uig royalties are free of post-production costs, with the exception of their pro-rata share of severance taxes. . .” On February 22, 2023, Fasken filed an appeal with the Fourth Court of Appeals in San Antonio (the “Court of Appeals”).

Before we address the substance of the Court of Appeals’ decision, a brief review of the distinction between production costs and  post- production costs is warranted.  It is well-settled that the driller generally bears all costs associated with the planning, construction and completion of an oil and gas well. These costs are not limited to the mere drilling of the well.  There are significant expenses and costs that must be spent before the drill bit ever touches the ground.  See, Types of Costs: Production Costs vs. Post-Production Costs (April 2024). For example, the driller will often incur costs related to the investigation and status of the chain of title of each drill site tract.  Seismic testing and other geologic studies must also be performed and evaluated.  And preliminary engineering work must be performed regarding the well pad design, the placement of pipelines and the location of access roads.  Additionally, there are costs associated with the preparation and submission of various environmental and municipal permits.  All of these costs are known as “production” costs and are the responsibility of the driller.  See, Heritage Resources, Inc. v. Nations Bank, 939 S.W.2d 118 (Tex. 1996)(“. . . royalties are not subject to the costs of the production. . .”); Bluestone Natural Resources v. Randle, 620 S.W. 3d 381 (Tex. 2021) (“[G]as royalties are generally free from the expenses incurred to extract raw gas from the land. . .”); Devon Energy Production Co. v. Sheppard, 668 S.W.3d 332 (Tex. 2023)(“[U]sually, the landowner’s royalty is free of the expenses incurred to bring minerals to the surface. . .”). In sum, the general rule is that driller is solely responsible for all of the costs of getting the gas out of the ground.  See, Kilmer v. Elexco Land Services, 990 A.2d 1147 (Pa. 2010)(“. . . the expenses of production relate to the costs of the drilling the well and getting the product to the surface. . .”).

Post-production costs, on the other hand, are those costs incurred between the wellhead and the downstream point of sale.  These expenses typically include the cost to dehydrate, separate, compress and transport the raw gas.  For many years, these costs were not incurred by gas drillers, as they typically sold their gas to pipeline companies at the wellhead.  The pipeline companies then processed and transported the gas as per federal regulations. Since the point of sale was essentially at the wellhead, calculating the value of the royalty was relatively straightforward and without controversy. This all changed in 1992. On April 8, 1992, the Federal Energy Regulation Commission issued Order No. 636, which directed the pipeline companies to “unbundle” transportation services from their own gas sales operations and, in effect, “provide common-carriage services” to gas drillers.  As a result of this deregulation, gas drillers, not the pipeline companies, now performed the processing, dehydrating and compression services. Moreover, the point of sale, which was formerly at the wellhead, moved downstream to the interstate pipeline connection or some other delivery point.  As we have written before, this had a profound effect on the manner in which production royalties were calculated.  See, Federal District Court Injects Confusion into Definition of Gross Proceeds Royalty Under Pennsylvania Law ( June 2021); Texas Supreme Court Issues Troubling Decision in Royalty Dispute (March 2022).  But, that is another topic for another day.

Back to the 1960 Deed. On appeal, Fasken reiterated its primary theory that the “free of cost” language referred only to production costs and did not exempt the royalty from post-production costs.  Fasken argued that, under Hyder and its progeny, a royalty “is free from production costs but must bear its share of post-production costs unless the parties agree otherwise”.  Hyder, 483 S.W.3d at 871. Fasken contended that the “free of cost” language in the 1960 Deed was insufficient to rebut this default rule.  In other words, because the 1960 Deed did not clearly and unequivocally articulate an express prohibition on the deduction of post-production costs, Fasken argued that the “free of cost” language, standing alone, was not enough to overcome the default rule under the Texas law.  As such, Fasken averred that the “free of cost” language was superfluous and merely repeated the general prohibition on the deduction of production costs.

In addition, Fasken argued that the deductions were nonetheless authorized because the 1960 Deed implicitly valued the royalty at the wellhead.  When the royalty valuation point is designated “at the wellhead”, drillers can utilize the “net-back” method to deduct the costs incurred between the wellhead and the downstream point-of-sale to arrive at a wellhead value.  See, Heritage Resources, Inc., 939 S.W. 2d at 130 (“. . . the value of the minerals ‘at the well’ is determined by subtracting reasonable post-production costs from the value of the minerals at the point-of-sale”).  Specifically, Fasken suggested that the use of the word “produced” in the 1960 Deed reflected an intent to value the royalty at the wellhead.  As support for this novel interpretation, Fasken noted that the term production typically refers to where “actual physical extraction from the land” occurs (i.e. the wellhead). Since the 1960 Deed stated that the royalty was based on “all the oil and gas and other minerals produced from the above-described land. . .” this implicitly created a valuation point at the wellhead, thereby inviting application of the “net-back” method.

The Court of Appeals rejected both arguments. First, the Court of Appeals concluded that the “free of cost forever” language was functionally no different from the “perpetual cost free” royalty in Hyder:

“[W]e likewise do not see a significant distinction between the language used in Hyder and the language in this case. Thus, just as in Hyder, the ‘free of cost forever’ language in the [1960] Deed here does not distinguish between production and post-production costs and thus literally refers to all costs”

Fasken, p.8.  Since Fasken had failed to adduce evidence demonstrating that the parties specifically intended to limit the clause to only production costs, the Court of Appeals was compelled to apply the clause as drafted and exempt all costs.

The Court of Appeals was also unpersuaded by Fasken’s valuation point argument.  The Court of Appeals observed that the term “produced” would likely have been used regardless of whether the valuation point was expressly referenced as being at the wellhead or at the point-of-sale.  The panel opined that “. . . regardless of the location of the valuation point, the minerals would still have to be produced at some point in time.”  As such, Fasken’s construction of the term “produced” was unreasonable: the mere use of the term “produced” did not magically create a valuation point at the wellhead. Accordingly, the Court of Appeals affirmed the trial court’s order granting summary judgment in the favor of the Puig family. 

The author submits that the Court of Appeals made the right call here.  Deeds and contracts should be construed as drafted.  The language in the 1960 Deed was clear and unambiguous: the royalty was to be free of all costs.  As noted by the Court of Appeals, the 1960 Deed did not limit this prohibition to production costs.  Given the absence of an express limitation, the Court of Appeals correctly applied the clause as drafted and exempted all costs. Moreover, the Court of Appeals wisely rejected Fasken’s attempt to find an implied royalty valuation point at the wellhead.  Implying valuation terms which dramatically alter and change the parties’ original agreement is simply bad policy.  The Fasken decision is good news for landowners and Pennsylvania courts should apply the same reasoning when, and if, confronted with similar “free of cost” language.