The Oil and Gas Royalty Issue in BlueStone
On September 17, 2020, the Texas Supreme Court heard oral arguments in Cause No.
19-0459, BlueStone Natural Resources II, LLC v. Randle. The key issue in the case, at least according to the appellant, is the effect of a “gross proceeds at the well” royalty clause in an oil and gas lease. To oil and gas practitioners, this would appear to be an intriguing issue.
The terms “gross proceeds” and “at the wellhead” are seemingly inconsistent. A “gross proceeds” royalty clause suggests that the royalty owner is entitled to its proportional share of the gross sales proceeds that the lessee receives for its oil or gas production at the point of sale, without any deductions for any part of the lessee’s costs and expenses. The term “at the well” suggests that the lessee may calculate the royalty owner’s royalty payments on the basis of the price or value of the lessee’s production at the wellhead, not on the basis of the increased price or value of the lessee’s production at the point of sale after the lessee has incurred significant post-production costs to transport the production to the point of sale and place the production in a marketable condition.
Some of the parties and amici in BlueStone have cited past law review articles I have written. However, I have not previously taken a position on the specific issue that the appellant raises in BlueStone. Indeed, in my 2005 article with Karolyn Gillespie, we noted: “In contrast with the term ‘net proceeds at the well,’ the terms ‘gross proceeds at the well’ and ‘proceeds at the well’ [have] caused confusion among the courts in oil and gas producing states.” Byron C. Keeling & Karolyn King Gillespie, The First Marketable Product Doctrine: Just What is the “Product?,” 37 St. Mary’s L.J. 1, 34 n.132 (2005).
Regardless, I am skeptical that the royalty clause in BlueStone is actually a “gross proceeds at the well” royalty clause. The parties in BlueStone entered into a lease addendum specifying that the royalty owners were entitled to receive royalty payments in the amount of their fractional share of the “gross value received.” Although the original lease contained a “market value at the well” royalty clause, the parties do not seem to dispute that the royalty clause in the lease addendum superseded the royalty clause in the parties’ original oil and lease. The “gross value received” language in the lease addendum would appear to create a “gross proceeds” royalty clause: it contemplates that the lessee will calculate its royalty payments on the basis of the gross value that the lessee actually receives for its oil and gas production — i.e., by selling it for proceeds. Stated differently, the “gross value received” language in the addendum is not tied to the commercial “market value” of the lessee’s oil or gas production; instead, it is tied to the actual value that the lessee receives for its production in a third-party sale.
The appellant in BlueStone argues that because the lease addendum did not specify a royalty “valuation point,” the Texas Supreme Court should infer from the “at the well” language in the original lease that the parties intended for the lessee to calculate its royalty payments on the basis of the value of its production “at the wellhead.” If that is indeed the appellant’s argument, the appellant’s argument would seem to be misguided on several levels:
1. Although most royalty clauses specify a royalty valuation point, some royalty clauses do not. See, e.g., Byron C. Keeling, In the New Era of Oil and Gas Royalty Accounting: Drafting a Royalty Clause that Actually Says What the Parties Intend It to Mean, 69 Baylor L. Rev. 516, 520 (2017). Some royalty clauses do not need to specify a valuation point — especially if they do not require the lessee to determine the commercial “market value” of its production as part of its royalty calculations. Id. There is no reason to presume that when parties to an oil and gas lease enter into a lease addendum which substitutes a “gross proceeds” royalty clause for a “market value at the well” royalty clause, the “gross proceeds” language in the new royalty clause supersedes only the “market value” part of the old royalty clause and not the “at the well” part.
2. When a “market value” or “market price” royalty clause does not specify a royalty valuation point, a court may reasonably infer, as a default rule, that the lessee may calculate the market value or market price of its production “at the wellhead” for royalty purposes. See Keeling & Gillespie, supra, at 30-31. A “gross proceeds” royalty clause, however, does not require a valuation point. Unlike a “market value” or “market price” royalty clause, a “gross proceeds” royalty clause does not depend on the market value or market price of the lessee’s production at a particular location. On its face, the term “gross proceeds” means what it says — that the royalty owner is entitled to a royalty in the amount of the royalty owner’s fractional share of the gross proceeds that the lessee ultimately receives on the sale of its oil and gas production, wherever the sales location may be. See, e.g., Yzaguirre v. KCS Res., Inc., 47 S.W.3d 532, 539 (Tex. App.—Dallas 2000), aff’d, 53 S.W.3d 368 (Tex. 2001).
3. Judicially adding “at the well” language to a “gross proceeds” royalty clause would needlessly confuse an otherwise unambiguous royalty clause. See Judice v. Mewbourne Oil Co., 939 S.W.2d 133, 136 (Tex. 1996) (noting that there is “inherent conflict” in a royalty clause that uses the term “gross proceeds at the well”). By definition, the term “gross” suggests that the lessee may not deduct any post-production costs or expenses from the gross sales price that it received for its oil and gas production. Id. If a royalty clause is unambiguous, it should be enforced as written. Sun Oil Co. (Delaware) v. Madelay, 626 S.W.2d 726, 732 (Tex. 1981).
4. A court may enforce a “gross proceeds” royalty clause without any need to rewrite the clause and add a valuation point. “[W]hen a contract is unambiguous yet silent as to an immaterial, non-essential term, it requires no further supplementation.” Barrow-Shaver Res. Co. v. Carrizo Oil & Gas, Inc., 590 S.W.3d 471, 486 (Tex. 2019); see Tenneco, Inc. v. Enterprise Prods. Co., 925 S.W.2d 640, 646 (Tex. 1996) (“[C]ourts will not rewrite agreements to insert provisions parties could have included or to imply restraints for which they have not bargained.”).
I am looking forward to seeing the Texas Supreme Court’s opinion in BlueStone. My firm and I are not involved in the case. Nonetheless, as my past writings illustrate, I continue to hope that courts across the United States will construe oil and gas royalty clauses in a way that properly reflects what the clauses actually say — and not in a way that instead reflects what courts wished the clauses might have said if the parties had drafted them differently.
By: Byron C. Keeling