2015 Burleson LLP

Matthew W. Lichtenauer

Royalty Calculations: Deducting Post-Production Costs

04/17/2023 2

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Production vs. Post-Production Costs

• Production Costs– Exploring– Drilling– Producing

• Post-production costs– Transportation– Treating– Processing– Gathering– Compression– Marketing– Dehydration

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Diagram for Oil

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Diagram for Gas

**Source: Exhibit to Occidental Permian’s Oral Argument in French v. Occidental Permian Ltd., 440 S.W.3d 1 (Tex. 2014)

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Market Value vs. Proceeds

Market Value• “the market value at the well of

one-eighth of the gas so sold”• The price a willing buyer, not

forced to buy, would pay a willing seller, not forced to sell

Proceeds• “the royalty shall be one-

eighth of the amount realized from such sale”

Newer leases often use language that is a combination of both, becomes more difficult to determine which it falls under. (bifurcated)

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General Rule

• A lessee may deduct for post-production costs as long as they are reasonable– Or any costs incurred by a lessee after the wellhead, whether to improve

the quality of the production or to transport it to market, may be shared proportionately by the lessee and lessor

• Other jurisdictions– First Marketable Product Approach

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Market Value Background• Texas Oil & Gas Corp v. Vela

– This court rejected the idea that contract proceeds equaled market value as a matter of law

• Exxon Corp. v. Middleton– This court followed the reasoning held in Vela and held that for purposes

of determining the market value, gas would be considered sold at the time when it was delivered, and not as of the effective date of long term purchase contracts

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Heritage Resources, Inc. v. NationsBank

• In Heritage, a trustee for gas interest royalty owners brought suit against Heritage Resources to recover transportation costs which were deducted when calculating royalty payments

• The court held that Heritage Resources properly deducted transportation costs despite clauses in the lease prohibiting the deduction of post-production costs

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Heritage Resources, Inc. v. NationsBank• The court focused on the language of “the market value at the well”

of the gas produced• The court noted that there are two methods to determine market

value at the well:– Comparable sales which are sales comparable in time, quality, quantity,

and availability of marketing outlets (most desirable method)– Subtracting reasonable post-production costs from the market value at the

point of sale (note court used market value again here but seems the court meant actual market price)

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Heritage Resources, Inc. v. NationsBank

• Court held that the commonly accepted meaning of “royalty” and “market value at the well” renders the post-production clauses prohibiting their deductions to calculate royalty in each lease as surplusage

• In other words, when a lease prohibits deductions from royalty but royalty is valued at the wellhead, the lease still permits deductions of post-production costs to arrive at a wellhead price

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Warren v. Chesapeake Exploration, L.L.C.

• Three different leases:• Warrens’ Leases:

– Royalty: as royalty, Lessee covenants and agrees … (b) to pay Lessor for gas and casinghead gas produced from said land (1) when sold by Lessee, [22.5%] of the amount realized by Lessee, computed at the mouth of the well…. [emphasis added]

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Warren v. Chesapeake Exploration, L.L.C.

• Third Lease - Javeed’s Lease• Royalty: as royalty, Lessee covenants and agrees … (b) to pay Lessor

for gas and casinghead gas … 20% of the amount realized by Lessee, computed at the mouth of the well … [emphasis added]

• Addendum:– Notwithstanding any of the provisions contained in the oil and gas lease to

which this exhibit is attached, the following provisions shall apply:– The royalties to be paid by lessee are: … “the market value at the point of

sale of 20% of the gas so sold or used” [emphasis added]

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Warren v. Chesapeake Exploration, L.L.C.

• Why were these 3 leases treated differently?– Location of the valuation of the gas– Warren Leases – “computed at the mouth of the well” – The court stated

that the addendum does not change the point at which all royalty is computed (being the mouth of the well).

– Javeed Lease – “the market value at the point of sale of 20% of the gas so sold or used” – This moves the valuation away from the mouth of the well

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Potts v. Chesapeake Exploration, L.L.C.

• Lessors sued arguing that Chesapeake improperly calculated the royalty payments by deducting post-production costs

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Potts v. Chesapeake Exploration, L.L.C.

• The royalties to be paid by Lessee are … on gas … the market value at the point of sale of 1/4 of the gas sold or used … [emphasis added]

• The court permitted post-production cost deductions

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Potts v. Chesapeake Exploration, L.L.C.

• Why, when the valuation was set at the point of sale?– The court stated that when gas is sold at the wellhead, there are typically

no costs of compression, dehydration, treatment or transportation. And when there are no such costs at the wellhead, the market value is in fact “free of all costs and expenses”

• Did the plaintiffs argue the location of sale was not at the well because it was sold to affiliates?

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Chesapeake Exploration, L.L.C. v. Hyder

• This case is currently being decided by the Texas Supreme Court. Oral arguments were made in March of this year.

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Chesapeake Exploration, L.L.C. v. Hyder

• Again, Chesapeake uses a weighted average sales price to calculate the royalty and reduced the royalty amount by certain transportation costs paid by Chesapeake to unrelated pipeline companies

• District Court and the Court of Appeals held that the transportation costs could not be deducted under the provisions of the lease

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Hypo #1• Parties have not specified whether deductions may be made and

the point of valuation is at the wellhead– Yes, can deduct post-production costs

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Hypo #2

• Parties have stated no deductions may be made and the point of valuation is at the wellhead– Yes, can deduct post-production costs

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Hypo #3

• Parties have stated no deductions, valuation is at the point of sale, and sale is made at the well– Yes, according to Potts

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HYPO #4

• Parties have stated no deductions, valuation is at the point of sale, and sale is made downstream– No

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Checklist for interpreting Royalty Language

1. What does the lease say?a) Body vs. Addendumb) Proceeds vs. Market Valuec) Where is the valuation

point?

2. Where is the point of sale?a) At the well?b) Downstream?

3. Who is the gas sold to?a) Affiliate?b) Arms-length transaction to

non-affiliate?

Can I deduct that?

San AntonioWeston Centre112 East PecanSuite 700San Antonio, TX 78205T: 210.820.2625F: 210.820.2609

PittsburghSouthpointe Town Center1900 Main StreetSuite 201Canonsburg, PA 15317T: 724.746.6644F: 724.746.6645

MidlandMidland Tower223 W. Wall StreetSuite 400Midland, TX 79701T: 432.253.8600F: 432.253.8601

HoustonPennzoil Place700 Milam StreetSuite 1100Houston, TX 77002T: 713.358.1700   F: 713.358.1717

DenverWells Fargo Center1700 Lincoln StreetSuite 1300Denver, CO 80203T: 303.801.3200F: 303.801.3201

New OrleansPoydras Center650 PoydrasSuite 1400New Orleans, LA 70130T: 504.299.3427F: 504.299.3411

San AntonioWeston Centre112 East PecanSuite 700San Antonio, TX 78205T: 210.820.2625F: 210.820.2609

PittsburghSouthpointe Town Center1900 Main StreetSuite 201Canonsburg, PA 15317T: 724.746.6644F: 724.746.6645

MidlandMidland Tower223 W. Wall StreetSuite 400Midland, TX 79701T: 432.253.8600F: 432.253.8601

HoustonPennzoil Place700 Milam StreetSuite 1100Houston, TX 77002T: 713.358.1700   F: 713.358.1717

DenverWells Fargo Center1700 Lincoln StreetSuite 1300Denver, CO 80203T: 303.801.3200F: 303.801.3201

New OrleansPoydras Center650 PoydrasSuite 1400New Orleans, LA 70130T: 504.299.3427F: 504.299.3411

Thank You

Matt Lichtenauermlichtenauer@burlesonllp.com