Burlington Resources Oil & Gas Co LP v. Texas Crude Energy, LLC, 2019 Tex. LEXIS 196 (Tex. March 1, 2019)
In Burlington Resources, the Texas Supreme Court held that an oil and gas royalty assignment that required the royalty to be delivered “into the pipeline” permits the payor to deduct post-production costs from the royalty owners’ payment, even if the agreement purports to prohibit such a deduction.
For years, Texas courts have found that when an oil and gas lease provides that royalty will be paid “at the well” or “at the mouth of the well,” the lessee generally can pay royalties net of all reasonable postproduction costs — even if the lease purports to prohibit such deduction. The reasoning has been that such language places the “valuation point,” (ie, where the production must be valued for royalty payment purposes) at a point before any post-production costs would have been incurred. In leases with a valuation point “at the well,” the Supreme Court has held that language prohibiting deductions for post-production costs as “surplusage” — or meaningless. In Burlington Resources, the Supreme Court held that the phrase “into the pipeline” mirrors the “at the well” designation and requires the same result.
Burlington Resources Oil & Gas LP (“Burlington”) executed several agreements with Texas Crude Energy, LLC (“Texas Crude”), one of which was an assignment of an overriding royalty interest (“ORRI”). Texas Crude later assigned the ORRI to its affiliate, Amber Harvest, LLC. All ORRI assignments contained a similar “Granting Clause” and “Valuation Clause.”
The Granting Clause provides:
[Assignor] does hereby assign, transfer and convey unto [Assignee], its successors and assigns, those certain overriding royalty interests, as set out below, in the quantity described below in all oil, gas, condensate, drip gasoline and other hydrocarbons that may be produced and saved from those lands covered by those certain oil, gas and mineral leases described in Exhibit “A” attached hereto and made a part hereof for all purposes, and pursuant to the terms and conditions of the said oil, gas and mineral leases. Said overriding royalty interests shall be delivered to assignee 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. However, assignee shall in every case bear and pay all windfall profits, production and severance taxes assessed against such overriding royalty interest. (Emphasis added by the Supreme Court).
The Valuation Clause provides that the assignment “shall be subject to the following terms and conditions”:
The overriding royalty interest share of production shall be delivered to assignee or to its credit into the pipeline, tank or other receptacle to which any well or wells on such lands may be connected, free and clear of all royalties and all other burdens and all costs and expenses except the taxes thereon or attributable thereto, or assignor, at assignee’s election, shall pay to assignee, for assignee’s overriding royalty oil, gas or other minerals, the applicable percentage of the value of the oil, gas or other minerals, as applicable, produced and saved under the leases. “Value”, as used in this Assignment, shall refer to (i) in the event of an arm’s length sale on the leases, the amount realized from such sale of such production and any products thereof, (ii) in the event of an arm’s length sale off of the leases, the amount realized for the sale of such production and any products thereof, and (iii) in all other cases, the market value at the wells. (Emphasis added by the Supreme Court).
Texas Crude sued Burlington, alleging that it was entitled to receive its royalty free and clear of post-production costs. Texas Crude argued that the Valuation Clause entitles Texas Crude to a share of royalty measured by the “amount realized” at the point of sale. It was uncontested that Burlington was selling its production downstream of the wellhead, though there was some dispute as to how for downstream production was being sold. Regardless, Burlington was incurring post-production costs prior to the point of sale and passing a portion of those costs along to Texas Crude. Texas Crude acknowledged the “into the pipeline” language, but argued that it was applicable if Texas Crude took its production in kind, which would then physically be delivered into the pipeline.
Burlington defended its decision to pay royalties net of post-production costs by arguing that the phrase “into the pipeline” is synonymous with phrases such as “at the well” or “at the mouth of the well” which previous cases have held denote the valuation point for royalty payment purposes. Burlington reasoned that the “into the pipelines” reference marks the physical location at which Texas Crude’s interest in the product arises. Burlington also pointed the Supreme Court to language in other agreements entered into by the parties, which suggested that the royalty would be the “net proceeds” of the amount realized from the actual sale price.
Ultimately, the Supreme Court agreed with Burlington and held that the agreement permitted Burlington to pay royalties net of post-production costs. The Supreme Court referenced other commentators that seemed to acknowledge that the phrase “at the pipeline” can be used to identify the point where royalty is valued. Additionally, the Supreme Court explained that, though the phrase “amount realized” is used in the context of paying a cash royalty, that phrase has never been held to necessarily mean amount realized at the point of sale. After all, many cases involve royalty provisions requiring payment of royalty measured by the amount realized at the well, which would permit a lessee to tender royalties net of any post-production costs. The agreement at issue in Burlington did not expressly state that the “amount realized” would be determined at the point of sale. Instead, the Supreme Court concluded that in the context of these agreements, the phrase “amount realized” would be determined at the “pipeline.”
While acknowledging that Texas Crude made good arguments and describing the assignment as “opaquely worded,” the Supreme Court held that the proper reading of the documents was that the valuation point for royalty payments was set at the “pipeline” and permitted Burlington to pay royalties based on the amount realized from any sale, net of any post-production costs incurred between the pipeline and the point of sale.