Chapter 6A Are Royalties Due on Gas that is Flared or Vented, Used as Fuel or Lost? A Review of Recent Cases on Post-Production Costs Under Texas, New Mexico, and Federal Law
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CHRYSTA CASTANEDA is a go-to lawyer for high-stakes litigation in the energy industry and beyond. She is an engineer with a deep understanding of energy operations, finance and markets, as well as a sought-after speaker and author on energy issues and litigation matters. With more than 25 years' experience, she has built a solid reputation for adeptly handling technical litigation, often serving as lead trial counsel in high-profile disputes of media interest. Chrysta not only has more than two decades of experience litigating energy and oil and gas matters, but also holds a degree in engineering. Her technical training, in combination with her experience in crisis communications, frequently proves invaluable to clients, enabling her to effectively explain complex scientific concepts to judges and juries. Her win for T. Boone Pickens' Mesa Petroleum Partners was recognized as the 12th largest verdict in 2016 in the nation by The National Law Journal and earned her a spot as one of the NLJ's Elite Trial Lawyers of 2018, as well as induction into Texas Lawyer's Texas Verdicts Hall of Fame. Following this series of high-profile recognitions, Chrysta was inducted as a fellow of the Texas Bar Foundation in the beginning of 2020. She was also named a "Trailblazer" by The National Law Journal. She is also the co-author of The Last Trial of T. Boone Pickens, which recounts the events leading up to, and the trial of, the Mesa lawsuit. Outside of the oil and gas and energy industries, Chrysta has extensive experience in commercial litigation, trade secrets, products liability, pharmaceutical, medical device, and toxic tort litigation. In 2020, she was the Democratic nominee for the Texas Railroad Commission.
I. Statement of the issue
Whether post-production costs can be permissibly deducted from royalties is a frequently litigated issue in Texas and other states. A less-frequently litigated issue is whether the volumes upon which the royalty is based are complete and accurate, which can overlap with the issue of post-production costs. Indeed, in today's world of operations, the overlap between whether a post-production cost is permissible and whether said cost involves a deduction from volumes is ever present.
This paper examines the lease obligations governing the duty to pay royalties on gas in particular, with an eye towards evaluating obligations to account for all production. In particular, it discusses whether royalty is due on gas used for fuel or flare and "lost" gas. Under the most recent Texas Supreme Court cases interpreting modern lease forms, sound arguments may be made that gas that is used as fuel or flare and gas that is vented or lost bears royalty. While fewer New Mexico cases have addressed the issues, similar results could be anticipated under New Mexico, Federal and Native American lands leases.
II. Relevant lease provisions
In analyzing the basis for royalty payments, the particular lease language is controlling. The Texas Supreme Court has made it clear that despite whatever baseline is assumed by historical treatment of the royalty obligation, the parties are free to contract otherwise. Wenske v. Ealy, 521 S.W.3d 791, 797 (Tex. 2017) ("Parties are free to contract for whatever division of the interests suits them. Their intent, as expressed in the deed, controls. [But i]f they want their agreement to operate differently from this basic principle of mineral conveyance, ... they should 'plainly and in a formal way express that intention.'") (quoting Benge v. Scharbauer, 152 Tex. 447, 453, 259 S.W.2d 166, 169 (1953)).
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Below are three examples of royalty provisions that bear on the determination as to whether the lessee must pay royalty on all volumes produced from the lease.
A. Royalty payment provisions
The typical Producers 88 lease provides for the following royalties:
3. In consideration of the premises the said Lessee covenants and agrees:
1st To deliver to the credit of Lessor, free of cost, in the pipe line to which Lessee may connect wells on said land, the equal one-eighth (1/8) part of all oil produced and saved from the leased premises.
2nd. To pay Lessor one-eighth (1/8) of the net proceeds at the well from the proceeds received for gas sold from each well where gas only is found, or the market value at the well of such gas used off the premises.
3rd. To pay Lessor one-eighth (1/8) of the market value at the well for gas produced from any oil well and used off the premises, or for the manufacture of casing-head gasoline or dry commercial gas.
4th To pay Lessor one-eighth (1/8) of the proceeds received from the sale of any substance covered by this lease, other than oil and gas and the products thereof, which Lessee may elect to produce, save, and market from the leased premises.
Thus, the Producers 88 form specifies "market value at the well" as the basis for payment of royalty.
Many modern leases use different language to describe the royalty obligations, transforming the obligation from "market value at the well" to a "proceeds" basis or "proceeds plus" basis. Here is an example from the Eagle Ford area in Texas circa 2010:
(a) On all oil and on all liquid hydrocarbons extracted from gas under the provisions of Subsection (b) below, twenty-five percent (25%) of that produced and saved from the leased premises, the same to be delivered to LESSOR free of cost into the storage tanks or into the pipeline to which the wells may be connected...
(b) On gas produced from the leased premises, including casinghead gas and residue gas at the tailgate of any plant through which gas produced from the leased premises may be processed, twenty-five percent (25%) of the market value of the gas at the place of use or sale by LESSEE...
At first reading, it is clear that the obligation to pay royalty on all gas volumes produced differs from the oil royalty, which is based on oil that is "produced and saved." The gas royalty contains no such limitation. The 2010 Eagle Ford lease described above also contains the following
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definition of market value:
The market value of any gas, condensate or other products of gas shall never be less than the total proceeds received by LESSEE or by any affiliated or subsidiary company by reason of the sale of such gas, condensate or other products and/or the dedication of reserves. The total proceeds received shall include, but not be limited to, the fair value of all consideration received by LESSEE or by any affiliated or subsidiary company ...Except as specifically provided in Subsection (c) above, all royalties payable under Subsections (a), (b), (c), (d) and (e) of this Section 3 shall be without deduction for any costs of drilling, operating, testing, marketing, gathering, transporting, separating, processing, dehydrating, compressing or other costs involved in making the oil or gas ready for sale or use... LESSEE shall act as LESSOR'S representative in negotiating and implementing sales arrangements for royalty gas in accordance with principles of good faith and fair dealing and the provisions of this lease....LESSOR'S royalty hereunder shall be free and clear of all costs and expenses whatsoever, including but not limited to costs of drilling, operating, testing, marketing, separation, dehydration, compression and transportation; provided, however, LESSOR shall pay any ad valorem, production and other lawful taxes upon LESSOR'S royalty.
Thus, the 2010 Eagle Ford lease makes it clear that market value is to be measured at the place of use or sale by Lessee; and that the market value can never be less than all proceeds received by Lessee, with all costs and deductions added back to the amount received in order to render royalty.
An even more recent and more lessor-friendly version of the royalty obligation found in an exemplar Permian lease states as follows:
3. Royalty Share. For the purposes of this Lease, the term "Royalty Share" shall mean a fraction equal to 25% of the gross production without deduction....
4. Royalties. In respect of oil and gas which may be produced from the Lands or lands with which the Lands or any part
