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Texas Supreme Court Confirms Deductibility of Gas Used in Off-Lease Post-Production Activities from "Market Value at the Well" Royalties

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On May 17, 2024, the Texas Supreme Court issued its opinion in Carl v. Hilcorp Energy Co., No. 24-0036, and confirmed that lessees can deduct gas used off lease in post-production activities when calculating “market value at the well” royalties.  The Court’s decision likely spells the end of recent efforts to upend longstanding practices for calculating such royalties. Those efforts arose in the wake of the Texas Supreme Court’s 2021 decision in BlueStone Natural Resources II, LLC v. Randle, 620 S.W.3d 380 (Tex. 2021). There, the Court held in the context of a “gross proceeds” royalty (i.e., a royalty that does not allow for deduction of post-production costs) that the lease’s “free use” clause, which governs use of gas generated from the lease, did not allow the lessee to use that gas off lease for fueling post-production activities without paying a royalty on the gas. Id. at 387. The Court’s opinion on the “free use” clause said nothing about the method for calculating royalties, much less the appropriate method for doing so under an at-the-well royalty.

Nevertheless, some royalty owners read Randle to mean that lessees could no longer deduct post-production costs in the form of gas used for post-production activities or as an in-kind payment even where the lease at issue provided for an at-the-well royalty.  Relying on this theory, the plaintiffs in Hilcorp filed a putative class action on behalf of other royalty owners, claiming underpayments in royalties owed under their leases because gas from those leases was used off lease for post-production activities. Hilcorp moved to dismiss.

The district court granted Hilcorp’s motion, holding that gas used off lease for post-production activities is properly excluded in calculating an at-the-well royalty.  Carl v. Hilcorp Energy Co., No. 4:21-CV-02133, 2021 WL 5588036, at *3 (S.D. Tex. Nov. 30, 2021).  The Hilcorp plaintiffs appealed this ruling to the Fifth Circuit.  Following oral argument, the Fifth Circuit certified two questions to the Texas Supreme Court: “(1) After Randle, can a market-value-at-the-well lease containing an off-lease-use-of-gas clause and free-on-lease-use clause be interpreted to allow for the deduction of gas used off lease in the post-production process? (2) If such gas can be deducted, does the deduction influence the value per unit of gas, the units of gas on which royalties must be paid, or both?” Carl as Co-Tr. of Carl/White Tr. v. Hilcorp Energy Co., 91 F.4th 311, 317 (5th Cir. 2024).

In answering the first question, the Texas Supreme Court rejected the Hilcorp plaintiffs’ efforts to construe Randle as a sea change in the Court’s oil and gas jurisprudence and concluded that the free-use clause central to Randle was largely irrelevant to the royalty-calculation issues in Hilcorp. Carl v. Hilcorp Energy Co., No. 24-0036, slip op. at 6 (Tex. May 17, 2024) (“[T]he question of how to account for post-production costs was not before the Court at all in Randle.”). Far from changing the law, the Court emphasized that Randle in fact “reiterate[d] the longstanding rule that an ‘at-the-well’ royalty ‘bears its usual share of postproduction costs.’” Hilcorp, slip op. at 4 (quoting Randle, 620 S.W.3d at 389).  Under the facts in Hilcorp, that necessarily required accounting for the gas used in the post-production activities in determining the royalty amount.  And the Court found Hilcorp’s method of doing so—deducting the gas from the royalty calculation—to be an appropriate application of the workback method long recognized under Texas law.  Id. at 7.

Because the parties’ briefing did not address the Fifth Circuit’s second question, the Texas Supreme Court declined to answer it.  The Court emphasized that “nothing in this opinion should be understood to state a preference for any particular method of royalty accounting, so long as the accounting results in the royalty holder being paid what he is lawfully owed.”  Id. at 8.

The Texas Supreme Court’s holding in Hilcorp is consistent with the conclusions reached by the other courts to have addressed this issue, see EnerVest Operating, LLC v. Mayfield, 2022 WL 4492785 (Tex. App.—San Antonio Sept. 28, 2022, no pet.); Fitzgerald v. Apache Corp., No. 21-CV-1306, 2021 WL 5999262 (S.D. Tex. Dec. 20, 2021), and definitively resolves any confusion regarding Randle’s impact on at-the-well royalty calculations.

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