In a case with potentially far-reaching implications for the oil patch, the Texas Supreme Court has granted review of a decision of the Corpus Christi Court of Appeal construing an add-back provision in an oil and gas lease as entitling the lessor to royalties on expenses incurred by third-party purchasers after production is sold by the lessee. As a consequence of the court of appeals decision, a lessee may well be liable for royalty payments in excess of the gross proceeds of the sale of oil and gas to downstream purchasers.

Devon Energy Production Company, L.P. f/k/a GeoSouthern DeWitt Properties, LLC, et al. v. Michael A. Sheppard, et al.(No. 20-0904) involves a fairly standard gas lease containing a so-called “add-back” clause, which entitles the lessor to royalties based on the “gross proceeds realized from the sale of the gas, free of all costs and expenses, to the first non-affiliated third party purchaser under a bona fide arms length sale or contract.” A parallel provision in oil leases can likewise base royalty payments on gross proceeds, determined either the highest posted price, plus premium, or the gross proceeds of the sale, whichever is greater. The add-back clause in question provides that the royalty payments “shall never bear or be charged with, either directly or indirectly, any part of the costs or expenses of production” and other costs specified in the clause.

Here the lessor sued Devon in DeWitt County seeking payment of royalties that added back not only pre-sale costs and expenses, but those incurred by third-party downstream purchasers as well. The trial court granted summary judgment for the royalty owner, and the court of appeals affirmed. Its decision turned on the interpretation of the term “indirectly” in the add-back clause. The court came to the conclusion that because downstream costs “affect” the price a third-party purchaser will pay the lessee, they are “indirect” costs covered by the add-back clause—even if the royalties would thereby exceed the gross proceeds of the sale paid to the lessee. This interpretation, as Devon points out in its petition for review, would frustrate the purpose of the lease and produce an absurd result because “no producer would enter into the deal the court of appeals has hypothesized.”

We are pleased that SCOTX has taken the opportunity to reaffirm the principle that oil and gas leases should be construed according to their plain language in the context of the “objects and purposes intended to be accomplished . . .” [citing Garcia v. King, 164 S.W.2d 509, 512 (Tex. 1942). As the nation’s primary authority on oil and gas law, SCOTX is the right forum to make this call.

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