In the recent Texas Supreme Court (“Court”) decision in BlueStone Natural Resources II, LLC v. Randle,[1] the Court once again addressed the practice of deducting postproduction costs in oil and gas royalty calculations. The Court also, for the first time, directly addressed the effect of a lease’s “free use” clause, applying such a clause more narrowly than some would have anticipated. Ultimately, based primarily on what the Court concluded the plain meaning of the words of the lease required, the Court affirmed the lower court’s rulings in favor of the lessors on all issues.
The dispute in this case arose due to a change in the calculation of royalty payments to a number of lessors. BlueStone Natural Resources II, LLC’s (“BlueStone”) predecessor in title had been paying the lessors (“Lessors”) gas royalties calculated on its gross sales proceeds without subtracting any costs for gathering, processing, or otherwise handling the gas after its production (commonly known, as postproduction costs). After BlueStone acquired the leases (“BlueStone Leases”) in 2016, BlueStone took a different interpretation of the leases and began deducting postproduction costs to calculate the gas royalties. Subsequently, the royalty payments declined, and the lessors sued. During the ongoing litigation, the Lessors also argued that BlueStone had failed to pay them for certain volumes of gas used in operations that occurred off of the leased premises and the issue was made part of the suit.
Postproduction Costs
Texas courts frequently state that gas royalties are usually free of production costs, or the expenses incurred in extracting the product from the ground, but are not free of the additional expenses incurred to prepare and transport the gas for downstream sales.[2][3] However, while the general rule is that lessors are responsible for their share of postproduction costs, many lessors attempt to modify this general rule to avoid the deduction of postproduction costs. The attempts to allocate postproduction costs have become a frequently litigated issue and the Court has tackled the issue of the permissibility of the deduction postproduction costs from gas royalties a number of times.[4]
In the instant case, there were two provisions that addressed royalty payments. The first was in the printed lease form (Paragraph 3) and the pertinent part stated as follows:
(b) on gas, including casinghead gas, or other gaseous substance produced from said land and sold or used off the premises or for the extraction of gasoline or other product therefrom, the market value at the well of one-eighth of the gas so sold or used, provided that on gas sold by Lessee the market value shall not exceed the amount received by Lessee for such gas computed at the mouth of the well, and on gas sold at the well the royalty shall be one-eighth of the amount realized by Lessee from such sale .... (emphasis added)
Neither party disputed that if this provision were the only clause regarding royalty computation, the Lessors’ royalty would be based on the value of the gas at “the well” and would be calculated inclusive of any postproduction costs incurred downstream from the wellhead. However, the BlueStone Leases contained a second provision regarding the payment of royalties, which the lessors argued modified this general rule and required a different result.
The second relevant provision is located in the addendum attached to the printed form. The addendum included an introductory paragraph providing that “[i]t is understood and agreed by all the parties that the language on this [Exhibit] supersedes any provisions to the contrary in the printed lease hereof[.]” Paragraph 26 of the addendum, states in whole as follows:
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. (emphasis added)
Contrary to the paragraph in the printed lease, if this provision were the only clause regarding royalty computation, the Lessors’ royalty would not have to pay their share of the postproduction costs incurred.
Accordingly, the heart of the dispute between the parties was whether the provisions in the printed lease and the addendum conflicted or whether the two provisions could be harmonized. If there was a conflict, pursuant to the introductory paragraph of the addendum, the language in the addendum would control and the result would be a prohibition on the deduction of postproduction costs. If there was no conflict, then according to BlueStone, the provisions would be reconciled and the Lessors would have to pay their share of the postproduction costs, as paragraph 3 of the printed lease form provided the royalties should be paid “at the mouth of the well.”
In order to best illustrate the arguments put forth by BlueStone and the Lessors, the Court described a typical royalty clause as a three part constructions: (1) the royalty fraction, (2) the yardstick, and (3) the valuation point or location for measuring the yardstick.[5] A royalty provision must have all three parts for a royalty to be calculated.
BlueStone argued that the relevant provisions in the printed lease form and addendum could be harmonized because “at the mouth of the well” was the only language providing a valuation point. BlueStone contended that the “gross value received” in the addendum could be understood with the “at the well” valuation point in the printed lease form to produce a “net proceeds calculation.”[6] In addition, BlueStone argued that pursuant to the Court’s prior holding in Burlington Resources, the mere presence of the “at the mouth of the well” language gave it a controlling effect.
The Lessors argued that the royalty provisions could not and should not be harmonized because “gross value received” in the addendum contained both a yardstick and a valuation point. Since the royalty provision in the addendum contained all necessary information to compute the royalty, the Lessors argued the addendum provision superseded the printed lease form and prohibited the deduction of postproduction costs.
The Court rejected BlueStone’s argument in favor of harmonizing the two provisions, finding that the requirement to value royalties on the “gross” value inherently conflicted with the requirement to value royalties at the well. To address the question of where the royalty clause’s valuation point was, the Court pointed to the use of the “gross” as setting the valuation point. The Court clarified that “[w]hen proceeds are valued in ‘gross,’…the valuation point is necessarily the point of sale because that is where the gross is realized or received.”
BlueStone cited Burlington Resources as support for its argument that the “at the well” is controlling and requires the holding that royalties are to be subject to postproduction costs. The Court explicitly rejected this interpretation of the Burlington Resources holding and stated that BlueStone had failed to acknowledge that the provision in Burlington Resources did not state whether the amount realized was “gross” or “net”, thus the Court had to give effect to other language.[7] The Court stated that its holding in Burlington Resources was made using general contract construction principles to construe the meaning of the agreement and did not make “at the well” language a magic bullet to allow for the deduction of postproduction costs in all cases.
Ultimately, the Court affirmed that the use of “gross” in the addendum creates a valuation point at the point of sale and the “at the well” language was not the only valuation point. Due to this conflict, the language of the addendum controlled and prohibited the deduction of postproduction costs.
Free Use of Fuel
The second issue the Court reviewed was whether BlueStone was entitled to a royalty-free right to use gas in off-lease operations if those operations benefited the lease, specifically plant fuel and compressor fuel. The base royalty clause in the BlueStone Leases stated that it applied to all gas “sold or used off the premises or for the extraction of gasoline or other product therefrom.” However, the leases also contained a “free use” clause, providing 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, including water injections and secondary recovery operations, and the royalty on . . . gas . . . shall be computed after deducting any so used. (emphasis added)
When included in a lease, courts generally hold that a “free use” clause controls a lessee’s right to use production from the lease premises in the operation of that lease. If the lessee has the free right to use certain volumes of gas, such gas will be excluded from the volumes used to determine the lessor’s royalty.
Accordingly, the crux of the dispute centered on whether the free use clause in the BlueStone Leases, which permitted use in all “operations… hereunder,” permitted BlueStone to use gas for operations that benefited the leases, regardless of where that use physically occurred, or whether such right to use gas without paying royalties was limited to only that use that physically occurred on the premises of the BlueStone Leases. The court of appeals held that the BlueStone Leases limited the free use of gas to solely operations actually conducted on the leased premises.
The Court had not previously resolved a dispute regarding a free use clause and so turned to case law from other jurisdictions. Ultimately rejecting the jurisprudence from other oil and gas producing states, such as North Dakota, which have traditionally been more aligned with Texas in issues royalty clause interpretation, the Court relied heavily on the reasoning of the federal Tenth Circuit, which reached different conclusions after applying New Mexico and Colorado law to two sets of free use clauses similar to the ones currently before the Court.
The Tenth Circuit in Anderson Living Trust examined two groups of leases (one set for properties in New Mexico and one set for properties in Colorado), and ultimately concluded that the New Mexico leases permitted a broader royalty-free use of gas than the Colorado leases.[8]
The free use provision in the New Mexico leases provided “the right to use free of cost, gas, oil and water found on said land for its operations thereon, except water from the wells of the lessor.” (emphasis added) The Tenth Circuit found that New Mexico precedent provided that “the phrase ‘operations thereon’ in the . . . ‘free use’ clause [in the New Mexico leases] is not a limitation on where the use of the gas may occur but rather a limitation on the purposes for which the gas may be used—furtherance of the lease operations.”[9] The Tenth Circuit held that the New Mexico lease provision included providing gas to third-party processors as under the umbrella of free use, as that action ensured a market for the product. It is noted that the court included a footnote stating that its holding was in part due to the favorable citing of Bice v. Petro Hunt, L.L.C., 768 N.W.2d 496 (N.D. 2009) by the New Mexico Supreme Court.[10]
Conversely, the Colorado leases contained a clause providing the lessee “free use of oil, gas and water from said land . . . for all operations hereunder.” Using general contract construction principles, and unrestrained by prior Colorado precedent, the Tenth Circuit held that the ordinary meaning of the language limited operations to those that occurred on the leased lands. The court further pointed to the royalty clause that required the royalty to be paid on gas “…used off the leased premises” as additional support for its holding.
The Court here followed the Tenth Circuit’s holdings as related to the Colorado leases due to the fact that language in the BlueStone Leases was similar and the Court saw no reasonable way to extend the language to off-lease uses. As support for its limitation of the free use clause to uses on the leased premises, the Court noted the lack of any limitation to the application of the free use clause would create a “fact-finding mission to determine whether progressively more attenuated uses ‘benefit’ or ‘further’ the lease operations.”[11] Without further parameters provided in the clause, the Court refused to broaden any interpretation of the free use clause in the BlueStone Leases to include uses of gas that did not occur “hereunder” (or under) the lease premises. The Court affirmed the court of appeals holding that the free use of gas was limited to operations conducted on the leased premises and royalties were owed on all gas used off of the lease premises.
The Court then reviewed the two uses of the gas that BlueStone claimed were free of royalty under the free use clause. First, the “plant fuel” was gas that BlueStone’s processor used to fuel the plant operations that processed the gas delivered by BlueStone. The parties stipulated that the plant fuel had been used off the leased premises, so the Court held that royalties were due on all of the plant fuel.
The second and more difficult use at issue, according to the Court, was the “compressor fuel” or gas that returned by the processor to BlueStone to power compressors on the leased premises. As part of its agreement with its processor, BlueStone contracted for redelivery of processed gas back to BlueStone, which BlueStone used for various purposes, including compressor fuel for compressors located on both the plaintiffs’ and BlueStone’s other leases. Notably, it was undisputed that at least some of the compressor fuel was used on the leases at issue for operations on those leases and would therefore be covered by the free use clause. However, the Court determined that since the gas used as compressor fuel was commingled and aggregated with gas from other properties prior to its use by BlueStone, BlueStone could not use gas from one lease for operations on a different lease and was required to produce evidence linking each leases’ fractional share of the commingled, processed gas to consumption by compressors on each of the leased premises. Accordingly, the Court remanded to the trial court to determine the damages “if any” owed for the off-lease use of compressor fuel.
Ultimately, the Court reemphasized that the plain meaning of the words chosen would continue to control the result in cases concerning postproduction costs. And in the Court’s first review of a “free use” clause case, the Court signaled that it may be unlikely to read a broad meaning into the free use clause without further indication of the parties intent. Drafting of the royalty clause and free use clauses should be carefully reviewed to ensure that the intention of the clause is clearly being described.
Download BlueStone Natural Res. II LLC v. Walker Murray Randle Decision
[1] No. 19-0459, 2021 WL 936175 (Tex. Mar. 12, 2021).
[2] Id. at *3 (citing French v. Occidental Permian Ltd., 440 S.W.3d 1, 3 (Tex. 2014)).
[3] It is noted that any discussion regarding postproduction costs is normally only discussing gas royalties. This is because the postproduction costs for oil are minimal as oil is typically sold to a refinery from the storage tanks at the well and just need to be transported/trucked to the refinery for processing.
[4] See also Burlington Res. Oil & Gas Co. LP v. Tex. Crude Energy, LLC, 573 S.W.3d 198 (Tex. 2019); French v. Occidental Permian Ltd., 440 S.W.3d 1 (Tex. 2014); Chesapeake Expl., L.L.C. v. Hyder, 483 S.W.3d 870 (Tex. 2016); and Heritage Res., Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996).
[5] BlueStone Nat. Res. II, LLC, 2021 WL 936175 at *4 (citing BlueStone Nat. Res. II, LLC v. Randle, 601 S.W.3d 848, 856 (Tex. App.—Forth Worth 2019) (quoting Byron C. Keeling, In the New Era of Oil & Gas Royalty Accounting: Drafting a Royalty Clause That Actually Says What the Parties Intend It to Mean, 69 Baylor L. Rev. 516, 520 (2017))).
[6] Id. at *3.
[7] Id. at *7.
[8] See Anderson Living Trust v. Energen Res. Corp., 886 F.3d 826 (10th Cir. 2018).
[9] BlueStone Nat. Res. II, LLC, 2021 WL 936175 at *12 (citing Anderson Living Trust, 886 F.3d at 845).
[10] See ConocoPhillips Co., 299 P.3d 844.
[11] BlueStone Nat. Res. II, LLC, 2021 WL 936175 at *13.
Brooke Sizer, Josh Downer and Anna Boyer
Thompson & Knight, LLP