“Royalty-Valuation Disputes in Texas Oil and Gas Leases, and Post-Production Deductions Against Royalties: A Royalty Pirate Looks at 50.” Third Installment:

The following article by James Holmes completes his review of Texas oil and gas law for royalty valuations, as it has evolved over 30 years and as it exists today.  This Installment summarizes Holmes’s practical advice for royalty owners in light of seven “Pillars” of Texas law, appearing in the first Installment released March 22, 2021 and second Installment released March 29, 2021.  In this final Installment, Holmes explains how Texas royalty owners can best learn of royalty-valuation problems and can best protect their rights. He offers hope that Texas law my be turning towards favoring royalty owners’ rights once again.

Holmes hugs his favorite oil company

Addressing the First and Second Pillars, Holmes does not believe Texas royalty law will remain terribly lopsided in the lessees’ favor and points to Chesapeake Exploration, L.L.C. v. Hyder, 483 S.W.3d 870 (Tex. 2016), for hope.  (In Hyder, the Texas Supreme Court allowed this language to free gas royalties from bearing post-production deductions: “[i]n no event shall the volume of gas used to calculate Lessors’ royalty be reduced for gas used by Lessee as fuel for lease operations or for compression or dehydration of gas[,] including but not limited to, production, gathering, separating, storing, dehydrating, compressing, transporting, processing, treating, marketing, delivering, or any other costs and expenses incurred between the wellhead and Lessee’s point of delivery or sale of such share to a third party.”  Hyder, 483 S.W.3d at 871 nn. 4-5.) Memories on the battle of “Industry vs. Aggressive Lawyers” – which caused the tremendously pro-lessee law – are fading.  And, even if some opportunistic lawyers returned to Texas oil and gas patches to make money off of lawsuits, they no longer have the class-action procedure or outlandish damages models to unfairly burden the industry.  Also, royalty owners are more educated about the deterioration of their rights and expect better prospective treatment from Texas appellate courts and from the legislature.

As to the Third through Fifth Pillars, Holmes expects that Texas will adhere to its default rule that royalty bears a proportionate share of post-production costs. Texas law will continue to enforce with rigor “at the well” type language and, when such language appears in the lease, to pass over contrary language seeking to minimize/eliminate post-production deductions.  However, the “market value” standard (discussed in the Fifth Pillar) will protect royalty owners from valuations that grossly depart from market prices. For instance, if $4/MMBTU is the market value for royalty gas based upon a net-back assessment (e.g., tracing the price at the WaHa Hub back to the well and deducting pipeline costs), and the producer pays $2/MMBTU for no good reason, the market value standard will vindicate the lessor’s rights, entitling the lessor to gas royalties at $4/MMBTU. But the differential from market value must be wide, and the net-back method to derive that market value must be accurate.

Likewise, the “duty to market” in proceeds leases (discussed in the Sixth Pillar) will protect royalty owners from valuations that result from self-dealing or gross incompetence.  For instance, if $4/MMBTU is the market value for royalty gas based upon a net-back assessment (e.g., tracing the price at the WaHa Hub back to the well and deducting pipeline costs), and the producer pays $2/MMBTU because it sells at below-market prices to its affiliated marketing company, the duty to market will vindicate the lessor’s rights, entitling the lessor to gas royalties at $4/MMBTU.  But the differential from market value must be wide, and the producer’s self-interested motivations (or gross incompetence) must be clear.

Whether litigating over “market value”-style leases or “proceeds”-style leases, Holmes recommends that royalty owners challenge only egregiously low royalty valuations.  If pressed for rules of thumb, litigation is warranted when prices for gas and gas products are 30% or more below market value, and prices for oil at $3/BBL or more below field prices.  Also, litigation may be warranted for lower differentials than these when producers are selling to affiliated marketing companies.As to the Seventh and final Pillar, Holmes continues to recommend that royalty owners protect themselves from post-production deductions at the time of lease negotiation and drafting.  Drafting language against post-production deductions is much preferable to utilizing Texas common law to remedy such deductions.  However, he emphasizes – in the strongest terms possible – that royalty owners attempting to draft pro-lessor language without involving a specialized attorney are likely to fail to protect themselves.  Also, any trace of “at the well” type language (or other language contemplating that a producer may sell royalty oil or gas near points of production) will frustrate and potentially will vanquish pro-lessor language in the same lease to free royalties from bearing post-production deductions.