Originally published by John McFarland.
Last April the Fort Worth Court of Appeals issued its opinion in Bluestone Natural Resources II, LLC v. Randle, No. 02-18-00271-CV, 2019 WL 1716415. The Court decided that, under Randle’s lease, Bluestone could not deduct post-production costs and owed royalty on plant fuel and compressor fuel. Bluestone has petitioned the Supreme Court for review and the Court has asked for briefs on the merits.
Randle’s lease was a printed form with an exhibit. The printed form provided that royalties on gas would be “the market value at the well of one-eighth of the gas so sold or used …” Exhibit A provided that “the language on this Exhibit A supersedes any provisions to the contrary in the printed lease hereof.” One provision in Exhibit A dealt with post-production costs:
Lessee agrees that all royalties accruing under this Lease (including those paid in kind) shall be without deduction, directly or indirectly, for the cost of producing, gathering, storing, separating, treating, dehydrating, compressing, processing, transporting, and otherwise making the oil, gas and other products hereunder ready for sale or use. Lessee agrees to compute and pay royalties on the gross value received, including any reimbursements for severance taxes and production related costs.
The trial court held that Bluestone could not deduct post-production costs, and the Fort Worth Court of Appeals agreed. The Court distinguished Heritage Resources v. NationsBank, 929 S.W.2d 118 (Tex. 1996) and held that the no-deduction clause in the lease’s exhibit modified the royalty clause – in particular, the second sentence of that clause. The second sentence, not present in Heritage, provided an alternate measure of value for royalties – “gross value received” rather than “market value at the well” – and “gross value received” means proceeds prior to deduction of post-production costs. This part of Exhibit A conflicts with the printed royalty clause and so must supersede that clause.
Bluestone argued that the second sentence in the Exhibit A provision did not establish an alternate “valuation point” for the royalty, so the valuation point must still be “at the well” as provided in the printed form. The Court disagreed:
[Bluestone] argues that once an “at the well” measure is baked into the royalty provision, it requires super clarity in any provision that attempts to alter its effect. We construe this argument to mean that once a royalty provides an “at the well” point of valuation, a lease can alter that scheme of valuation only by clearly altering its terms to provide a different point of valuation, such as by striking the words “at the well” when they appear in a lease. …
We do not see how we would be giving Exhibit A its controlling role if we were to cut and past the words “at the well” from Paragraph 3 of the Printed Lease into Paragraph 26 of Exhibit A. In fact, that approach would seem to take exactly the opposite approach mandated by the superseding provision in Exhibit A; we would be resolving the conflict by giving superseding effect to the terms of the Printed Lease. …
In essence, Appellant’s position boils down to the argument that once it appears, the “at the well” measure is so “baked into” the royalty calculation that it has to be physically removed by going to the length of actually striking those words wherever they appear.
The Court noted that the Supreme Court has recognized that “a proceeds measure–not tied to particular point of sale–creates a measure that does not allow the lessor to net-back its post-production costs,” citing Judice v. Mewbourne Oil Co., 929 S.W.2d 133, 136 (Tex. 1996): Burlington Res. Oil & Gas Co. LP v. Texas Crude Energy, LLC, 2019 WL 983789 at 5; Chesapeake Expl. LLC v. Hyder, 483 S.W.3d 70, 873 (Tex. 2016); and Heritage Res., 939 S.W.2d at 130.
The Court noted that its conclusion may be contrary to that of the El Paso Court of Appeals in Commissioner v. SandRidge, 454 S.W.3d 603 (Ct.App.-El Paso 2014, no pet.), which construed very similar language to allow deduction of post-production costs.
The Court also held that Bluestone had to pay royalty on plant fuel and compressor fuel. Plant fuel was gas produced from the leased premises and burned in the gas plant that processed the lessee’s gas. The compressor fuel was a commingled gas stream that included gas produced from the lease and other leases and was sent to compressors on Plaintiff’s lease and other leases to compress gas produced from the leases. The lease provides that “Lessee shall have free from royalty or other payment the use of … gas … produced from said land in all operations which Lessee may conduct hereunder .. and the royalty … shall be computed after any so used.” The Court held that this provision applied only on gas used on the leased premises. “Hereunder means “under or in accordance with this writing or document.” Plant fuel was not used to operate the lease or produce oil or gas from the lease, but to process gas in the third-party gas plant.
The Court also reasoned that the lease required payment of royalty on “gross value received” from the production; that the lessee received value from the processo in exchange for free use of the gas as fuel; and that Bluestone owed royalties on that value.1
The Court recognized that some of the gas produced from Plaintiff’s lease was used in compressors on the lease and therefor would be covered by the “free from royalty” clause. But the Court held that, because the lessee commingled gas from the lease with other gas, it had a duty to account for the aliquot share of the gas that is burned in compressors on the lease, citing Humble v. West, 508 S.W.2d 812 (Tex. 1974), and had failed to do so, and so was obligated to pay royalty on all production from the lease used as compressor fuel.