On Friday the Texas Supreme Court rules that an unusual provision in an oil and gas lease entitled the lessor-landowners to a royalty “free of post-sale postproduction costs that add value after the point of sale but are not part of the producers’ ‘gross proceeds.’” The decision thus differs from those that determine disputes over the allocation of post-production costs prior to the first sale to an unaffiliated third-party.

Devon Energy Production Company, L.P. f/k/a GeoSouthern DeWitt Properties, LLC, et al. v. Michael A. Sheppard, et al. (No. 20-0904) involved an oil and 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.” The lease further provided an “add back” provision stating that “[i]f 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 deducation, 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.” An addendum to the lease provided that payments of “royalty under the terms of the lease shall never bear or be charged with, either directly or indirectly, any part of the costs or expenses of production, gathering, dehydration, compression, transportation, manufacturing, processing, treating, post-production expenses, marketing or otherwise making the oil or gas ready for sale or use . . . .”

As noted, this atypical lease language presented the Court with a matter of first impression. The lessors sued Devon in DeWitt County when they discovered that Devon had sold oil under contracts setting the sales price (i.e., the gross proceeds base) by “using published index prices at market centers downstream from the point of sale and then subtracting $18 per barrel for the buyer’s anticipated post-sale costs for ‘gathering and handling, including rail car transportation.’” The landowers sought payment of royalties that added back not only pre-sale costs and expenses, but those incurred by third-party downstream purchasers as well, that is, $18 per barrel. The trial court granted summary judgment for the royalty owner, and the Corpus Christi 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 pointed 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.”

SCOTX disagreed. Based on a plain meaning construction of the lease, the Court affirmed. In an opinion by Justice Devine, the Court held that the lease language did not limit the add-back to expenses incurred only by the producer prior to the point of sale. “Rather,” Justice Devine wrote, “those costs are encompassed by Paragraphs 3(a) and 3(b), which require to royalty to be paid on the producer’s gross proceeds. A plan and natural reading of Paragraph 3(c) unambiguously contemplates royalty payable on an amount that may exceed the consideration accruing to the producers. Furthermore, because Paragraphs 3(a) and 3(b) alone suffice to free the royalty from all pre-sale costs, Paragraph 3(c) serves no purpose at all if not to allow the amount on which the royalty payment is calculated to exceed gross proceeds.” Devon argued unsuccessfully that the Court should read Paragraph 3(c) as “mere surplusage” because, to paraphrase, no producer in their right mind would agree to a lease that paid more royalties than the producer received in gross proceeds from the sale. The Court didn’t buy this argument. “We are enforcing the leases exactly as they are written,” Justice Devine riposted, “according to their plain language, which also happens to avoid giving rise to a redundancy. As we have said time and time again, courts should avoid rendering contract language meaningless if possible, and it is possible and reasonable to construe the [leases] without rendering Paragraph 3(c) nugatory.”

Justice Blacklock dissented, opining that he would have held that the lease provides for a standard “gross proceeds” royalty. But as we have seen in so many of its decisions, this Court is not going to rewrite the parties’ contracts for them, even if it produces a result that varies widely from what a “standard lease” or “industry expectations” might otherwise provide. No doubt this decision will send landowners and producers alike scurrying to dig out their leases and refresh their memories. In any event, we read this opinion as consistent with the Court’s longtime approach to contract interpretation. The burden is on the drafters to make sure they say what they mean and mean what they say, for SCOTX is not going to bail them out down the road.

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