Texas Supreme Court holds that oil and gas royalties are owed on more than gross proceeds under unique “proceeds plus” lease provision

In a new decision, 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. This windfall for royalty owners is only required when the lease contains a unique "add-to-proceeds" or "proceeds plus" royalty clause. Because the Court's opinion made clear that this rule would not apply to a standard "gross proceeds" royalty provision, the case will have limited precedential effect.

On March 10, 2023, the Court issued its opinion in Devon Energy Production Company, L.P. v. Sheppard.¹ At issue was the interpretation of a "bespoke lease provision" that the plaintiff-royalty owners claimed made their royalty free of not only routine pre-sale postproduction costs of the producer, but also free of post-sale postproduction costs of the purchaser.² The Court held that the producer was required to add to royalty payments the costs identified in the contract formula determining the sales price of the oil and gas at the point of sale if the formula used downstream market-hub index prices minus stated downstream costs. The Court emphasized that its holding was based on the unique lease provision, and therefore the narrow holding by the Court should have limited application in other cases involving standard royalty provisions in leases.

A unique "add-to-proceeds" lease provision

The first part of the royalty payment provision found in the lease was a "relatively standard" gross proceeds clause:

[O]n gas ... [1/5th for the Sheppard or 1/4th for the Crain leases of] ... the gross proceeds realized from the sale of such gas, free of all costs and expenses, to the first non-affiliated third party purchaser under a bona fide arms length sale or contract. "Gross proceeds" (for royalty payment purposes) shall mean the total monies and other consideration accruing to or paid the Lessee or received by Lessee for disposition or sale of all unprocessed gas proceeds, residue gas, gas plant products or other products. Gross proceeds shall include, but is not limited to advance payments, take-or-pay payments (whether paid pursuant to contract, in settlement or received by judgment) reimbursement for production or severance taxes and any and all other reimbursements or payments.³

The lease also contained additional "unconventional language" with an "add-to-proceeds" royalty provision, which provided:

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, process[ing] or 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.⁴

The addendum to the lease also provided: "Payments of royalty under the terms of this lease shall never bear or be charged with, either directly or indirectly, any part of the costs or expenses of production, gathering, dehydration, compression, transportation, manufacturing, processing, treating, post-production expenses, marketing or otherwise making the oil or gas ready for sale or use, nor any costs of construction, operation or depreciation of any plant or other facilities for processing or treating said oil or gas."⁵

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."⁶

The Court issues a narrow opinion, requiring the producer to "add-to-proceeds" any "price adjustments for a stated purpose"

Under the gross proceeds clause in the lease, the producers here did not deduct, directly or indirectly, any amount from the gross proceeds they received under their contracts for sale of the oil and gas produced, and even added back to the sales price the transportation and processing costs incurred by the producer before sale of the processed gas at the tailgate of the gas processing plant.⁷

What was not "added-to-proceeds" in calculating the royalty payments were costs incurred by the purchaser after the point of sale. The crux of the dispute between the parties was thus whether the producers had to add to royalties the costs that would be incurred by the purchaser and identified as cost adjustments in contracts for the sale of oil and gas between the producer and the purchaser. The oil sales contracts at issue determined the sales price "by using published index prices at market centers downstream from the point of sale and then subtracting US$18 per barrel for the buyer's anticipated post-sale costs for 'gathering and handling, including rail car transportation.'"⁸

At the summary judgment stage, the parties asked the trial court to determine 23 different issues related to what post-sale costs needed to be added to the royalty payments. These 23 issues encompassed six categories of post-sale costs:

1. price adjustments of a fixed amount with a stated purpose corresponding to production, treatment, transportation, manufacturing, processing or marketing expenses;
2. price adjustments of a fixed amount without a stated purpose;
3. price adjustments based on the actual costs incurred by third-party purchasers for production, treatment, transportation, manufacturing, processing or marketing expenses;
4. adjustments for volumes of gas used by the producers for their own operations and never sold to third parties;
5. adjustments for volumes of production deemed to be lost or unaccounted-for by third parties; and
6. value retained by the producers as a result of the application of contractually fixed recovery factors.⁹

The trial court held in favor of the landowners on each of the 23 issues. The Court of Appeals affirmed in part and reversed in part, holding that no "add back" was required for costs in categories 2, 4, 5, and 6, but finding for the landowners as to issues in categories 1 and 3 ("price adjustments for a stated purpose").¹⁰

The Supreme Court affirmed, taking great care to emphasize just how unique this "add-to-proceeds" royalty provision was, describing the lease as "unusual,"¹¹ "unique,"¹² "bespoke"¹³ and as presenting an issue of first impression.¹⁴ Ultimately, the majority concluded that the broad language in the add-to-proceeds royalty provision was not limited to the gross proceeds received by the producer and "contemplate[d] royalty payable on an amount that may exceed the consideration accruing to the producers."¹⁵ The "indirectly" language in the provision was only effective because of the intent to add post-sale postproduction costs in the context of the specific lease provision.¹⁶

The calculation under this bespoke "proceeds plus" lease is thus two-pronged: first, the producer is required to determine gross proceeds (free of pre-sale postproduction costs), and second, "when the producers' contracts, sales, or dispositions state that enumerated postproduction costs or expenses have been deducted in setting the sales prices, those costs and expenses 'shall be added to the ... gross proceeds.'"¹⁷

The Court held that none of these additional post-sale postproduction costs were "gross proceeds."¹⁸ Nor was there any legal precedent "requiring producers to pay royalty on postproduction costs incurred downstream from the point of sale."¹⁹ The case reaffirmed established law on payment of royalty in Texas, including that postproduction costs are generally deductible by the producer from royalties.²⁰ Further, the Court specifically held that "an unaffiliated buyer's postproduction costs" are not "gross proceeds" "under the leases or under the law."²¹ Rather, as the Court made explicit, the case "address[es] only the specific language of the provisions before [the Court] as applied to the disputed issues on appeal."²² The Court emphasized "there is nothing common, usual, or standard about the language" of this lease.²³

Justice Blacklock, in dissent, criticized the majority opinion for allowing "the holder of a 'gross proceeds' royalty to convert his interest from a royalty on the products at the point of initial sale into a royalty on more fully refined products sold by third parties at a downstream market center." The dissent contended that the majority "misperceives what is happening"²⁴ in the calculation of the sales price. The dissent explained that the alleged "costs" in the sales contract formulas were in reality a formula to determine the price for the product at the point of sale based on adjustments to the downstream market-center index price.²⁵ The majority was wrong, according to the dissent, because it viewed the formula components as a "reduction or charge" rather than as the method that the parties used to derive the value of the oil or gas at the point of sale.²⁶ As the dissent explains, the producer "did not identify a market price for the products in their current form and then subtract a 'reduction' or a 'charge' for already-incurred production expenses. Instead, it sold the products in their current form for a price the market would bear for such products, and it paid the royalty holders 1/5 of that price."²⁷

Rather, according to the dissent, the majority ignores that the value of a product at the sales location upstream of a market center (such as at the tailgate of a processing plant) is not the same as the downstream market-center price for a further refined product, and that parties to the sales contract arrived at an appropriate price in the contract for the product at the point of sale by using a differential from the market-center index price. Because nothing was being deducted from the price of the product when and where it was sold, the lease provision here should not have been interpreted as requiring an addition to the gross proceeds.²⁸

Because of the Court's narrow holding, Devon v. Sheppard will have limited precedential effect in other cases

The key takeaway from the majority's opinion is its narrow application to the unique "add-to-proceeds" or "proceeds plus" lease provision. The Court was at pains to make clear that its ruling was lease-specific and did not change the basic law on postproduction costs. Thus, leases containing ordinary "gross proceeds" royalty language would not require the addition of post-sale postproduction costs to the royalty calculation.

Even for leases containing the "add-to-proceeds" clause, the Court's opinion provides an indication of how a producer could contract to avoid application of the rule announced in the case based on the provisions in the sales contract valuing the product. If the contracts for sale of the oil and gas do not specify the cost components in the formula used at arriving at the sales price of the product, then there is no add-to-proceeds obligation (even under the lease in Devon). Thus, a sales contract that values oil and gas at an index price minus a set price (e.g., index minus US$8.00), as opposed to an index minus transportation and fractionation costs, would not require adding to royalties the amount of the adjustment from the market center index price because there were no "enumerated postproduction costs or expenses … deducted in setting the sales prices."²⁹