In a class action dispute between a producer and royalty owners, the Texas Supreme Court has advised the U.S. Court of Appeals for the Fifth Circuit that Texas law holds that a market-value-at-the well lease containing an off-lease-use-of-gas clause and free-on-lease-use clause allows the producer to deduct gas used off lease in the post-production process.
Anne Carl, as Co-Trustee of The Carl/White Trust, on behalf of itself and a class of similarly situated persons; Anderson White, as Co-Trustee of The Carl/White Trust, on behalf of itself and a class of similarly situated persons v. Hilcorp Energy Company (No. 24-0036; May 17, 2024) arose from a class action brought by the trustees of the Carl/White Trust against Hilcorp Energy Company for underpayment of royalties on gas produced from two leases in Brazoria County. Plaintiffs allege that Hilcorp failed to pay royalties on gas used off the lease for post-production processing. The lease contains an “off-lease clause” requiring Hilcorp “to pay royalties for gas ‘sold or used off the premises.’” It further contains a “free use clause” that allows Hilcorp the free use of gas for “operations” on premises only. Plaintiffs argue that the off-lease clause applies to Hilcorp’s use of the gas for processing, and thus requires it to pay royalties on that gas, and that free use clause restricts “free use” to the premises. Hilcorp filed a Rule 12(b)(6) motion for failure to state a claim, arguing that plaintiffs were not entitled to royalties on the off-premises use because the lease based royalty payments on the market value of gas at the wellhead (determined using the “workback method,” which calculates market value by deducting post-production costs). The district granted the motion. Plaintiffs appealed.
The 5th Circuit determined that Texas law is not yet settled the questions presented by this case. The heart of the dispute is “whether, under the workback method, the lessee must pay royalties on gas used off-lease as part of the post-production process.” Plaintiffs contended that the Texas Supreme Court’s decision in BlueStone Nat. Res. II, LLC v. Randle, 620 S.W.3d 380 (Tex. 2021) “does not limit or affect the off-lease and free-use clauses,” and even if Hilcorp could deduct the gas, “the deduction can only be applied to the value per unit of the gas, not “to reduce the number of units of gas on which royalties must be paid.” Hilcorp, on the other hand, asserted that Randle does not apply here “because it concerned a gross-value-received lease, rather than a value-at-the-well lease.”
The 5th Circuit determined that Randle, while it addresses free-use clauses, does not address what happens when a free-use clause interacts with an off-lease clause and market valuation at the wellhead. In this instance, the court decided that it could not make an Erie guess and certified two questions to SCOTX: (1) after Randle, can a market-value-at-the-well lease containing an off-lease-use-of-gas clause and free-on-lease-use clause be interpreted to allow for the deduction of gas used off lease in the post production process, and (2) if such gas can be deducted, does the deduction influence the value per unit of the gas, the units of gas on which royalties must be paid, or both?
In an opinion by Justice Blacklock, SCOTX responsed “yes” to the first question. The question turned on the longstanding Texas rule “that the holder of an ‘at-the-well’ royalty must share proportionately in the post-production costs expended on the products of the well prior to sale” (citations omitted). The parties agreed that this lease conveys an “at-the-well” royalty interest, so the dispute arose over accounting for post-production costs. Hilcorp used some of the gas produced from Plaintiffs’ leases to process a total volume of gas for the market. It then used the workback method to back those costs out of the market value of the total and apportioned the appropriate royalty to each owner. Undistracted by the royalty owners’ argument that the off-lease use could not be deducted because the lease entitles them to a royalty on “all the gas produced,” the Court noted that “in order to calculate the at-the-well value of all the gas produced, Hilcorp was entitled to account for reasonable post-production costs, which include the value of the gas used off the premises to prepare other royalty-bearing gas for sale.”
The Court observed further that the royalty owners’ reliance on Randle was misplaced because that case “[has no] particular impact on the outcome, except that it reiterates the longstanding rule that an ‘at-the-well’ royalty ‘bears its usual share of postproduction costs.” Instead, Randle “involved a ‘gross-proceeds’ royalty, which generally does not bear post-production costs—so the question of how to account for post-production costs was not before the Court at all in Randle.” The federal district court was thus correct in rejecting the royalty owners’ Randle argument and applying the general rule. The Court did not reach the second accounting question because the parties didn’t brief it and it wouldn’t have made any difference in the case anyway.
