The Oil and Gas Addendum

Let’s assume you own 185 acres in Washington County. In 2020, you negotiate a new oil and gas lease with ABC Drilling. During the negotiations, you insist on a “gross royalty” which prohibits the deduction of post-production costs. The landman for ABC Drilling assures you that  the royalty clause will prohibit ABC Drilling from deducting costs. He suggests the following language: “Fifteen percent (15%) of the gross proceeds received by lessee at the point-of-sale…” Based on his representation that ABC Drilling will not deduct costs and given the proposed “gross royalty” clause, you sign the lease. Three years later, you receive your first royalty statement. Your excitement is soon replaced with shock and anger. The royalty is reduced by deductions for transportation, compression and processing. You call ABC Drilling and they simply say that those costs were incurred by ABC Drilling’s downstream buyer, Big Midstream, and that those costs are not technically being “deducted” by ABC Drilling. The representative further explains that the costs are not actually incurred by ABC Drilling but are instead incurred by Big Midstream which then subtracts those costs from the “gross proceeds” it pays to ABC Drilling.  ABC Drilling then simply reports those adjustments as “deductions” on your royalty statement. You are frustrated and confused – how can this be possible?

As we have written before, drillers often try to ignore “gross royalty” clauses by arguing that deductions are always permissible regardless of the actual language in the parties’ oil and gas lease.  (See, Why Is The Driller Deducting Post-Production Costs My Lease Doesn’t Allow? – June 15, 2020.)  Texas courts have recently frowned on this troubling practice.  (See, Texas Supreme Court Rules That Gross Royalty Clause Prohibits Driller From Deducting Post-Production Costs – March 16, 2021.)  Last month, the Texas Supreme Court again addressed this controversial topic and provided some good news for landowners.  

At issue in Devon Energy Production Company, et al. v. Sheppard (Texas Supreme Court, No. 20-0904, March 10, 2023) were two oil and gas leases (the “Subject Leases”) concerning acreage located in DeWitt County, Texas.  The royalty clause in the Subject Leases provided for a royalty of twenty percent (20%) based on “…the gross proceeds realized from the sale of such gas, free of all costs and expenses, to the first non-affiliated third party purchaser…”  The Subject Leases also contained a rather unique clause (“Paragraph 3(c)”) that provided as follows:

(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.

Consistent with the royalty clause, the driller, Devon Energy, did not deduct any costs incurred moving the gas from the well head to the processing plant.  Nor did Devon Energy deduct any costs incurred getting the raw gas ready for sale.  However, the dispute arose when the landowners discovered that certain fixed fees set forth in the sales contract between Devon Energy and the third-party buyer were being subtracted from the “gross proceeds’ received by Devon Energy at the point-of-sale.  For example, one of the sales contracts between Devon Energy and the third-party buyer based the sales price on a published index price.  The sales contract, however, then subtracted a fixed fee of $18.00 per barrel from the index price to account for the buyer’s downstream gathering and transportation costs.  The subtraction of this fixed fee reduced the amount of “gross proceeds” received by Devon Energy but was not depicted on the landowners’ royalty statement.  The landowners contended that Paragraph 3(c) required Devon Energy to “add back” the fixed fee (i.e., $18.00 per barrel) to the “gross proceeds” calculation.  In essence, the landowners argued that the fixed fee was an indirect post-sale cost that was expressly prohibited by the unique language in Paragraph 3(c).  Given this prohibition, the landowners demanded that their royalty be calculated on Devon Energy’s “gross proceeds” plus the fixed fee.  Devon Energy refused.

In December 2012, the landowners filed suit alleging that Devon Energy breached Paragraph 3(c) by failing to add the fixed fee amounts to the “gross proceeds” calculation.  The landowners argued that Paragraph 3(c) operated as a “proceed plus” clause:  if any downstream sales contract contained a “reduction or charge” for an enumerated cost, the amount of that cost must be added to the gross proceeds calculation even if the cost was not incurred by Devon Energy.  According to the landowners, such a broad application was consistent with Paragraph 3(c)’s mandate that the royalty “never be chargeable directly or indirectly with any costs…”  The trial court agreed and granted summary judgment to favor of the landowners.  The Corpus Christi Court of Appeals affirmed, in part, and reasoned that the “proceeds plus” nature of Paragraph 3(c) required post-sale costs to be “added back” to the royalty base.  Devon Energy appealed to the Texas Supreme Court.

On appeal, Devon Energy argued that Paragraph 3(c) was simply meant to confirm that it could not deduct post-production costs incurred between the well head and the point-of-sale.  Devon Energy further argued that the landowners’ interpretation of Paragraph 3(c), which essentially required the payment of a royalty on non-proceeds, was unreasonable and at odds with customary industry practice.  In a narrow, but nonetheless striking opinion, the Texas Supreme Court rejected Devon Energy’s arguments and ruled in favor of the landowners: 

“We thus agree with the landowners that [the Subject Leases] are proceeds plus leases that employ a two-prong calculation of the royalty base.  First, the producers must properly determine their gross proceeds from selling the production, which by definition must be free of post-production costs.  Second, when the producer’s contracts … state that enumerated post-production costs or expenses have been deducted in setting the sales price, those costs and expenses shall be added to the … gross proceeds.”

The Texas Supreme Court acknowledged that the unique language in Paragraph 3(c) required Devon Energy to calculate a royalty on an amount above and beyond the proceeds actually received at the point-of-sale.  Such an application was warranted between the “words chosen by the parties … demonstrate an intent and expectation that some amount must be added to the producer’s gross proceeds…”  Moreover, the panel ruled that Paragraph 3(c) was not “mere surplusage” as suggested by Devon Energy.  The Texas Supreme Court noted that Paragraphs 3(a) and 3(b) in  the Subject Leases already prohibited the deduction of costs incurred between the well head  and the point-of-sale.  As such, Paragraph 3(c) would be rendered meaningless if, as Devon Energy argued, it simply confirmed the gross nature of the royalty – it had to mean something more.  Along those lines, the panel opined that Paragraph 3(c) served the “distinct purpose of defining not what gross proceeds are but what must be added to that already defined term.”  Accordingly, the Texas Supreme Court affirmed the entry of summary judgment in favor of the landowners.

The Sheppard decision is a case of first impression which is now sending shock waves through the industry.  The opinion arguably recognizes a new type of royalty clause: the proceeds plus clause.  Even though not binding on Pennsylvania courts, the Sheppard decision is potentially good news for Pennsylvania landowners.  First and foremost, the Sheppard decision recognizes that landowners can request and negotiate unique and favorable royalty clauses. As the old saying goes “everything is negotiable” and the clause at issue in Sheppard certainly supports that notion.  Second, the Sheppard decision provides a blueprint for those Pennsylvania landowners currently seeking to further insulate and protect their royalty from downstream post-production costs.  By recognizing the “proceeds plus” clause as a new but legitimate and enforceable royalty mechanism, the Sheppard opinion has given all landowners a valuable and credible negotiating position.  Pennsylvania landowners should consider requesting similar language in future lease negotiations.  Third, the Sheppard opinion reinforces the rule that courts must enforce the parties’ contract as written.  Although unconventional and unique, the Sheppard panel nonetheless enforced Paragraph 3(c) as written and rejected Devon Energy’s effort to re-write (and ignore) the purpose of the clause.  In short, the Sheppard decision is exciting and good news for landowners.