Texas Supreme Court Highlights Need for Careful Contractual Language, Otherwise Resulting in “Proceeds-Plus” Royalty Base
Devon Energy Production Company v. Sheppard, 668 S.W.3d 332 (Tex. Mar. 2023).
This case will have important implications for those practitioners in the energy industry. The Texas Supreme Court has ruled that producers must pay royalties based on amounts greater than the gross proceeds received in selling oil and gas. It is important to note that this unexpected windfall for royalty owners is only required when the lease contains a unique "add-to-proceeds" or "proceeds plus" language to a royalty clause. Indeed, the circumstances in which this would occur are narrow. Nonetheless, this case shows the importance of carefully construing and drafting language in any type of agreement.
In Devon Energy Prod. Co. v. Sheppard, the Texas Supreme Court reviewed a case centered around an oil-and-gas dispute, determining whether a bespoke royalty provision required the inclusion of a third-party purchaser’s postproduction costs in the royalty base before calculating the landowners’ royalty. Id. at 335. It is important to note that the language in this specific provision is highly unique. Id. at 340.
This was unlike typical post-production-cost disputes because the parties agreed that under the leases: (1) the landowners’ royalty is free of costs to the point of sale; and (2) the producers cannot directly or indirectly charge the royalty holders with a proportionate share of those expenses. Id. at 335. However, the lease provision in dispute also included the following language:
“If any disposition, contract, or sale of oil or gas shall include any reduction or charge for the expenses or costs of production, treatment, transportation, manufacturing, processor marketing of the oil or gas, then such deduction, expense or cost shall be added to . . . gross proceeds so that Lessor’s royalty shall never be chargeable directly or indirectly with any costs or expenses other than its pro rata share of severance or production taxes.”
Id. at 351. This Texas Supreme Court coined this as a “proceeds-plus” royalty base. The Court framed the issue in the case as: whether this unusual lease language manifests contractual intent to include in the royalty base post-sale postproduction costs that are not part of the producers' gross sales proceeds. Id. at 391.
The Texas Supreme Court affirmed the Court of Appeals determination, holding the broad lease language unambiguously contemplates a royalty base that may exceed gross proceeds and required the producers to pay royalties on the gross proceeds of the sale plus sums identified in the producers’ sales contracts as accounting for actual or anticipated postproduction costs. Id. at 348. The broad lease language contemplates this even if such expenses are incurred only by the buyer after or downstream from the point of sale. Id.
Simply put, the Texas Supreme Court determined that the lease provides language which would employ a two-prong calculation of the royalty base. Id. at 348. First, the producers must determine their gross proceeds from selling the production. This, by definition, must be free of postproduction costs. Id. Second, when the producers’ contracts, sales, or dispositions state that enumerated postproduction costs or expenses have been deducted in setting the sales prices, the costs and expenses shall be added to the gross proceeds. Id. The Court reasoned that the parties in these unique provisions demonstrate an intent and expectation that some amount may be added to the producers’ gross proceeds when calculating royalties. Id.
The Court based this reasoning and decision on the fact that the parties expressly deviated from the usual allocation of postproduction costs. Id. 349. The Court looked to the fact that there is significant precedent of interpretation of royalty provisions; and the fact that royalty provisions are often times uniform. Id. Based on basic contract laws, the Court reasoned that a different royalty provision must indicate a different meaning, and the provision must be interpreted based on the particular clause at issues and construed within the context of the lease as a whole. Id.
The key takeaway from the Devon Energy case is its narrow application to the unique “add-to-proceeds” or “add back” royalty provisions. The Court reiterated multiple times within the opinion that the basic law on postproduction costs does not change. Thus, leases containing ordinary "gross proceeds" royalty language will not be impacted by this decision.