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Texas Supreme Court Decision Impacts Royalty Payment Calculations: Postproduction Costs and Free-Use Clauses

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Aided by terms of art and a long history of precedent, parties entering an oil and gas lease can generally choose from common, time-tested clauses to serve their needs. Yet we know from practice that royalties and allocating postproduction costs are frequently litigated issues. A clause may be standard or common but that is no reason to let your guard down. Consider that even if individual royalty provisions are clear, their interaction in a lease may cause ambiguity. And what may appear time-tested can still raise novel issues. The parties in BlueStone Natural Resources II, LLC v. Randle grappled with these difficulties and fought them to the Texas Supreme Court.1 In its recent decision, the Court interpreted familiar language in royalty clauses and addressed, for the first time, how far a typical free-use clause reaches.

For Royalty Provisions, Context Matters

BlueStone Natural Resources pitted several mineral owners against their lessee over royalty calculations and the extent of the leases’ free-use clause. The leases had two parts: a short, form lease and an addendum. In the form lease, royalty payments were based on “the market value at the well,” while the addendum used “the gross value received.” The lease provided that in cases of conflict, the addendum would supersede.

For many years the lessee paid royalties without deduction for postproduction costs. But when BlueStone became responsible for paying royalties following its acquisition of the original lessee, it paid royalties based on the “at the well” language (i.e. after deduction). This resulted in lower royalty payments. BlueStone argued the lease provisions weren’t in conflict, and that the “at the well” language allowed it to pay the lower amounts based on the Court’s prior precedent in Burlington Resources.2

The Court rejected BlueStone’s argument, explaining that Burlington Resources neither altered the legal landscape nor created a rule of “at the well” supremacy. The bottom line: Context matters for royalty provisions. Alone, terms like “proceeds” and “amount realized” typically do not allow deduction of postproduction costs. Context can override that presumption, and explicit words like “net” or “at the well” typically allow a lessee to deduct postproduction costs in calculating royalties.3 BlueStone’s lease addendum used the term “gross,” which stood in contrast to the “at the well” language in the form lease. The Court saw an inherent conflict. Because the lease resolved conflicts in favor of the addendum, the Court found that the use of the term “gross” meant that postproduction costs could not be deducted.

What Counts as Free Use?

The owners also argued BlueStone was abusing the lease’s free-use clause. The lease allowed “free from royalty … the use of gas … produced from said land in all operations which Lessee may conduct hereunder[.]” BlueStone sent produced gas to an off-site, third-party processing plant to be used as fuel. Some of the processed gas was returned to the leased site to fuel compressors. BlueStone argued that both of these uses benefited the leases and were free from royalty, even if they occurred off site.

The Texas Supreme Court, in its first free-use decision, rejected BlueStone’s broader view. The Court noted that some jurisdictions had adopted a similar view to BlueStone’s for particular pragmatic reasons. But the Court found that, as a general rule, the broader view “would inject uncertainty” and require burdensome inquiries into “whether progressively more attenuated uses benefit or further the lease operations.”4 Ultimately, the Court relied on the lease’s plain language to restrict the clause to on-site uses. The off-site processing plant fuel was not royalty free.

What Now?

BlueStone’s dispute emphasizes the need for careful mineral lease negotiation and drafting, even if some clauses may be independently unambiguous or common. Oil and gas lease provisions often depend on context for full understanding, as this case and Burlington Resources tell us. The “upshot” is that parties remain free to contract around background rules and make their wishes explicit.5

1 – S.W.3d –, 2021 WL 936175 (Tex. 2021).

2 See Burlington Res. Oil & Gas Co. LP v. Tex. Crude Energy, L.L.C., 573 S.W.3d 198, 205 (Tex. 2019).

3 In Burlington Resources, the Court determined that the language “into the pipelines, tanks or other receptacles with which the wells may be connected” was like “at the well.” Id. at 210–11.

4 BlueStone Nat. Res. II, 2021 WL 936175, at *13.

5 Id. at *6.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.