Texas Supreme Court Update: The Court Decides Issue of First Impression Related to the Scope of an Oil and Gas Lease’s Free-Use Clause and Further Interprets Conflicting Royalty Clause Provisions

By Elizabeth Byrne on March 31, 2021 Posted in Appellate, Contracts, Energy & Natural Resources, Energy Litigation, Litigation, Oil & Gas, Oil & Gas Contracts, Royalty, Texas

The Texas Supreme Court recently issued its anticipated decision in BlueStone Natural Resources II, LLC v. Randle, affirming in part and reversing in part the lower court’s ruling.  No. 19-0459, 2021 WL 936175 (Tex. Mar. 12, 2021).  The Court (1) affirmed that the lower court correctly concluded the oil and gas lease at issue explicitly resolved conflicting royalty provisions in favor of a gross-proceeds calculation; and (2) affirmed the lower court’s interpretation regarding application of the lease’s free-use clause, but remanded the case to recalculate the amount awarded to the royalty owners.

1. Factual and Procedural Background

The Texas Supreme Court’s March 12, 2021 decision reviewed two main issues: (1) whether a lease addendum providing for royalties based on the “gross value received” nullifies a lease requirement for royalties to be paid on the “market value at the well;” and (2) whether production used as plant or compressor fuel qualifies as royalty-free volumes used in “operations which Lessee may conduct hereunder.” While the Court is no stranger to interpreting (and often muddling) the familiar royalty clause interpretation questions surrounding the first issue, in a case of first impression, the Court also analyzed the breadth of a lease’s free-use clause.

By way of background, the lessor royalty owners originally entered into a form lease agreement in 2003; the lease provided that royalty payments were based on “the market value at the well.”  Meanwhile, an associated addendum—which the lease clarified would supersede in situations of conflict—stated that royalty payments were based on “the gross value received.” For almost a decade, the original lessee to the agreements never subtracted post-production costs from the royalty owners’ royalty payments.  In 2006, however, BlueStone acquired the lease and became responsible for paying royalties on production thereunder. Instead of continuing to pay royalties without deducting post-production costs, BlueStone began to pay royalties based on the lease’s “at the well” language (i.e., after deductions), resulting in lower royalty payments for the royalty owners.

Following litigation by the royalty owners, the Court had to decide if the “at the well” clause from the lease was superseded by the “gross value received” language from the addendum. If not superseded, BlueStone would be permitted to deduct post-production costs. If, however, the Court decided that the “gross value received” clause was both a valuation method and a valuation point, the addendum would control and BlueStone would not be permitted to deduct post-production costs from royalty payments. BlueStone argued the lease provisions were not in conflict, and that the “at the well” language allowed it to pay the lower amounts. BlueStone’s argument largely relied on the Court’s prior holding in Burlington Resources, which held lessees had “the right to subtract post-production costs from the ‘amount realized’ in downstream sales prices in order to calculate the product’s value” at the wellhead (ultimately distinguishing between a “valuation point” at the wellhead and a “valuation method” based on the amount realized in a downstream sale). Burlington Resources Oil & Gas Co., LP v. Texas Crude Energy LLC, 573 S.W.3d 198, 211 (Tex. 2019).

As discussed in a previous blog post, the trial court and court of appeals both found that “gross value received” could not be harmonized with “market value at the well,” reasoning the gross value received is determined at the point of sale—downstream of the well—once the production was transported and treated and its value increased; as a result, the “gross value received” addendum superseded the “market value” language from the lease. BlueStone Nat. Res. II, LLC v. Randle, 02-18-00271-CV, 2019 WL 1716415, at *1 (Tex. App.—Fort Worth Apr. 18, 2019, pet. granted).  Notably, the court of appeals held that “gross value received” superseded “at the well” because the “at the well” language was not included in the “gross value received” paragraph (i.e., the result may have been different had the addendum required royalties paid on the gross value received at the well).  See id. at *13-14.

The royalty owners also argued BlueStone erroneously applied the lease’s free-use clause, which allowed “free from royalty . . . the use of gas . . . produced from said land in all operations which Lessee may conduct hereunder[.]” BlueStone sent produced gas to a third party, off-lease processor, where the gas was used as fuel by the processing plant. After, per agreement with the processor, processed gas was delivered back to the lease to fuel compressors on the leased premises. BlueStone did not attribute any of the aforementioned gas volumes as royalty-bearing production. BlueStone argued that both of these uses benefited the lease and were free from royalty, regardless of whether the uses occurred on or off the leased premises.

1. Holding and Analysis
2. The addendum language supersedes the form lease language.

After deciding that “the lease’s ‘gross value received’ term [could not] be melded with an ‘at the well’ valuation point to produce a net-proceeds calculation,” and that “‘gross’ and ‘net’ terms do not peaceably coexist,” the Court applied basic contractual principles to hold the addendum language, requiring royalties to be based on “gross value received,” superseded the short, form-lease language requiring payment based on the market value at the well. While BlueStone argued the Court’s holding in Burlington Resources required the “at the well” language be decisive, the Texas Supreme Court disagreed. Accordingly, the Court found the addendum language to supersede and diminish any other language from the lease that might allow for the deduction of post-production costs.

As a result, the Court clarified that “gross value received” and “at the well” are conflicting and cannot coexist; specifically, if found in separate agreements, the Court will not attempt to marry the distinct provisions and language.

1. The lease language providing for the free use of gas operations hereunder did not include gas used off-lease premises or for the benefit of third parties.

In a matter of first impression, the Texas Supreme Court relied on the “lease’s plain language” and found that the “language contemplates free use limited to the leased premises and does not, by express language or otherwise, make any use that ‘benefits’ or ‘furthers’ the lease operations royalty free.” Thus, the Court held that while BlueStone did not owe royalties for fuel that was used on-lease premises, BlueStone did owe royalties on any gas volumes that were used in operations conducted off-premises.  The Court clarified that “operations hereunder” language “does not authorize a royalty-free use of gas off-lease,” and any gas that benefited a third party or was used off premises was royalty bearing.  Importantly, the Court noted that “the absence of any discernable limiting principle to BlueStone’s favored construction further commends construing the free-use clause as restricted to on-lease uses.” Because the damages award was “not conclusively established as the amount awarded,” the Court reversed “that portion of the judgment and remand[ed] to the trial court to determine damages, if any, for off-lease Compressor Fuel use.”

BlueStone thus provides a warning to future lessees: if it is the intent of the parties to have free use of gas both on and off the leased premises, such intent must be made clear and memorialized in an oil and gas agreement, using clarifying phrases that emphasize such intent.

III. Key Takeaway

The Court’s holdings in BlueStone are particularly instructive for lessees and lessors entering into oil and gas agreements. Ultimately, based on general principles of contract law, the language in an agreement is crucially important, and the Court will, when possible, follow the plain language of the contract. Accordingly, to avoid uncertainties and costly litigation, it is important for the parties’ intentions to be expressed in writing as to all elements of the agreement. As seen in BlueStone, the Court gave special credence to the lease language that resolved any conflicts between the lease and addendum language in favor of the addendum (as required in the lease) to determine royalty requirements. Likewise, the Court focused on the true meaning of the word “hereunder” to resolve the free-use issue. In short, oil and gas agreements are still contracts, and parties must ensure that their intentions are properly memorialized to avoid future disputes.

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