Texas Supreme Court Holds That Add-Back Provision In Oil And Gas Lease Required Royalties To Be Paid On Prices In Excess Of The Producers' Gross Proceeds

• Published date: 23 March 2023
• Subject Matter: Corporate/Commercial Law, Real Estate and Construction, Energy and Natural Resources, Contracts and Commercial Law, Energy Law, Oil, Gas & Electricity, Landlord & Tenant - Leases
• Law Firm: Liskow & Lewis
• Author: Samuel Allen, Jana L. Grauberger, James T. Kittrell and Alma Shields

The Texas Supreme Court recently released its opinion in Devon Energy Production Company, L.P. v. Sheppard, ' S.W.3d ', No. 20-0904, 2023 WL 2438927 (Tex. 2023), in which it held that lessees owed royalties in excess of their gross proceeds, specifically "adding back" costs incurred by third-party buyers that were enumerated in the sales contract and subtracted from the sales price.

The lessees owned working interests in certain oil and gas leases that were executed in 2007. The leases contained the following royalty provisions:

3. The royalties to be paid by Lessee are:

(a) on oil, [1/5th of production for the Sheppard or 1/4th of production for the Crain leases] to be delivered, free of all costs and expenses to the Lessor into the pipeline, or other receptacle to which the Lessee may connect its wells or the market value thereof, at the option of the Lessor, such value to be determined by ... the gross proceeds of the sale thereof ...;

(b) on 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 arm's 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.

(c) 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.

...

L. ROYALTY FREE OF COSTS:

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...