Four takeaways for Texas oil and gas producers from Burlington Resources v. Texas Crude

One of the most prolific areas for Texas oil and gas law has been post-production royalty litigation. It makes up a significant part of my litigation docket, and a recent CLE I attended claimed that royalty lawsuits make up the plurality of all oil and gas litigation in the country. Hence, the Texas Supreme Court’s decision on Friday in Burlington Resources v. Texas Crude should be of particular interest to oil and gas producers and attorneys.

Without getting into too much background detail, Texas law permits producers to deduct post-production costs for oil and gas such as transportation, processing, and marketing costs. But Texas law also permits this arrangement to be changed via contract language. The costs tied to these deductions can be significant, with millions of dollars at issue for larger leases.

More than twenty years ago, Texas Supreme Court Justice Owen’s concurrence in Heritage Resources v. NationsBank set the current landscape in Texas for royalty deductions. Justice Owen’s opinion (the Court’s plurality opinion) permitted producers to take post-production deductions despite express lease language eliminating deductions. The key for Justice Owen was the lease’s requirement that the producer pay a royalty based on market value “at the wellhead.” This language permitted post-production cost deductions, and rendered the no-deductions clause ineffective. Applying Heritage Resources, ensuing decisions like Potts v. Chesapeake Exploration and Warren v. Chesapeake Exploration continued to permit producers to deduct post-production costs.

The picture changed three years ago, when the Texas Supreme Court issued its 5–4 decision in Chesapeake Exploration v. Hyder. In Hyder, the Court held that a producer could not deduct post-production costs from a “cost-free . . . overriding royalty.”

Hyder was the last major Texas Supreme Court decision on royalty deductions until the Court issued its ruling in Burlington Resources v. Texas Crude. In a 9–0 decision, the Texas Supreme Court reversed the Corpus Christi Court of Appeals and held that the assignment at issue did, in fact, permit Burlington Resources (the producer) to deduct post-production costs related to overriding royalty interests that Texas Crude held.

While I would not personally consider Burlington Resources a total game-changer when it comes to Texas royalty law, there are several key points that I think producers should consider when evaluating whether to deduct post-production costs in the future.

1. “Into the pipeline” may be the new “at the wellhead.” Judge Owen’s opinion in Heritage Resources focused on the lease’s requirement that the producer pay a royalty based on market value “at the wellhead.” The assignments in Burlington Resources assigned Texas Crude its interest when the products were delivered “into the pipelines, tanks or other receptacles with which the wells may be connected, free and clear of all development, operating, production and other costs.” (emphasis added). Neither party cited any Texas caselaw interpreting this “into the pipelines” phrase, but Burlington argued that it was nearly identical to “at the wellhead” language from Heritage Resources. The Court agreed, finding that this language “fixes the royalty’s valuation point at the physical spot where the interest must be delivered—at the wellhead or nearby.” Accordingly, this language gave Burlington the contractual right to take post-production costs. Takeaway: Producers should look for more than just “at the wellhead” lease language when determining whether they can take post-production deductions. “Into the pipelines” or other similar phrases may have the same impact under Texas law.
2. “Proceeds lease” language is not dispositive. In Heritage Resources and follow-on decisions, courts have distinguished “market value at the wellhead leases” with “proceeds leases,” which base royalty payments on the monies the producer actually realizes for hydrocarbons sold. In Hyder, the Court noted that proceeds-lease language “is sufficient in itself to excuse the lessors from bearing postproduction costs.” The lease at issue in Burlington Resources had language that based royalty payments on “the amount realized for the sale,” and the court of appeals found that was enough to create a royalty free of post-production costs. But the Texas Supreme Court disagreed. Instead, the clause had to be read with the “into the pipeline” language from the assignment: “We have never construed a contractual ‘amount realized’ valuation method to trump a contractual ‘at the wellhead’ valuation point.” Takeaway: The fact that a lease has “proceeds lease” language is not dispositive of whether post-production costs are permitted. A wider reading of the lease is needed to see if other royalty-valuation language is present.
3. Related agreements matter. Often in royalty disputes, the only language that is analyzed is that of the lease or assignment at issue. The assignments in Burlington Resources had been issued subject to a JOA between Burlington and Texas Crude. This JOA contemplated that each party would account to each other based on the “net proceeds received,” the same kind of language that the Texas Supreme Court previously held allows for post-production deductions. The Court held that the language of the assignments needed to be harmonized with that of the JOA. And because the JOA used the “net proceeds” language, this confirmed the Court’s view that Burlington could take deductions. Takeaway: While every royalty dispute in Texas should start with the language of the lease or assignment at issue, parties should also look to related agreements to see if they impact whether post-production costs can be taken.
4. Accepting deductions does not foreclose a later challenge. Burlington noted that for years, Texas Crude had received royalty payments with deduction and never complained. Burlington claimed that this course of performance supported its reading. But the Court noted that both parties (and the Court itself) believed the language at issue was unambiguous, and in those instances the Court does not consider course of performance. There is no discussion in the opinion about whether Burlington argued waiver or some other affirmative defense based on this earlier behavior. Perhaps that would have changed the analysis. Takeaway: A landowner’s acceptance of post-production cost deductions might not foreclose that landowner challenging deductions down the road, but be sure to consider affirmative defenses like waiver when confronted with this situation.

Keeping these points in mind, producers in Texas should be able to use the Court’s decision in Burlington Resources to assist in future royalty litigation.

Chris Hogan focuses his litigation practice on resolving complicated disputes for corporate and individual clients, including those in the energy industry.  Chris has substantial experience in federal court, state court, and arbitration proceedings.  He has been honored to represent as lead counsel major energy companies such as Marathon Oil, BPX, BHP Billiton, and Carrizo Oil & Gas.  These clients rely on Chris for his thoughtful approach to cases and extraordinary work ethic.