The Supreme Court of Texas recently reaffirmed well-established law for determining the value of royalties to be paid according to the terms of a Texas mineral lease. The main issue in Carl vs. Hilcorp Energy and for similar lease owners was the proper allocation of post-production costs when calculating the gas production on which to base the payment of royalties.
The Texas energy attorneys at MehaffyWeber describe the dismissal and its potential impact on businesses in the Lone Star State.
The Basis for Calculating Mineral Lease Royalty Payments
In exchange for granting the right to extract oil and gas, a mineral lease provides that royalty payments will be made to the lease owner based on gas production. The amount of the royalty payments is typically stated as a fraction or percentage of the amount of gas produced.
A mineral lease also states the valuation method to be used and at what point in the production process the valuation will occur. Disputes over the amount of royalty payments can occur when lease owners and gas companies disagree about the production totals used to calculate the royalties.
Texas Law and the Royalty Clause of the Mineral Lease
In attempting to determine the appropriate interpretation of the lease terms under Texas law, the Fifth Circuit Court of Appeals requested the assistance of the state’s highest court. The royalty clause in Carl vs. Hilcorp gave the lease owners the following royalties:
- “1/8 of the market value at the well of all gas sold or used off the premises”
When the term ‘market value at the well’ is used in a mineral lease in Texas, it has a standard interpretation under the law. It means the value of the raw gas produced before undergoing any post-production processing to make it commercially saleable.
There are two methods used in Texas to determine market value at the well.
- Comparable sales – The value is based on actual sales similar in time, quantity, quality, and available marketing outlets.
- Workback – The value is based on the proceeds of commercial gas sales, less a proportionate share of post-production costs.
While the comparable sales method may provide more accurate information, the data is not available in many cases and Texas courts routinely use the workback method to determine market value at the well. Hilcorp had used the workback method to arrive at the production amount upon which royalty payments to Carl were based.
Carl did not dispute the market value at the well provision or the use of the workback method. Carl argued that their royalty payments must be based on “all gas sold or used off premises,” and gas used off premises included gas used in post-production processing.
The Texas Supreme Court’s Legal Analysis and Decision Regarding Mineral Lease Royalty Payments
The Texas Supreme Court first addressed the value difference between gas taken from the well and gas processed for commercial sale. The valuation of gas production often begins with a commercial sale. Under such circumstances, it is well-established law in Texas that lease owners who receive royalty payments based on market value at the well are responsible for a proportionate share of the post-production costs.
The Court reiterated that deducting necessary and reasonable post-production costs from production totals is an accepted approximation of market value at the well. The Court then turned to Carl’s argument concerning the proper way to interpret the language of the mineral lease royalty clause. It said Carl’s entitlement to a share of ‘all gas sold or used off premises” did not absolve the lease owner’s responsibility to share in the post-production costs as per the market value at the well provision.
The right to share in all gas sold or used off-premises in this case means all gas after the amounts are appropriately valued. Thus, the Court held that the market value at the well clause entitled Hilcorp to deduct a proportionate share of the post-production costs including gas produced from the well and used off premises for post-production. The Court went on to say that parties to a mineral lease are free to negotiate the allocation of post-production costs any way they choose and noted the post-production costs themselves were not challenged as being unreasonable or unnecessary.
How the Recent Supreme Court Decision Could Affect Texas Mineral Lease Owners
Mineral lease owners need to make sure they understand the royalty payment provisions in their contracts and how and when the payments will be calculated. If payments are to be based on market value at the well or similar valuation, lease owners can expect to see a reduction in value for a proportionate share of post-production costs.
While market value at the well royalty owners can expect to share in post-production costs, they can still challenge those costs if they are unreasonable or unnecessary. Lease owners need to understand the types of costs that are normally associated with the post-production processes so they can evaluate whether the claimed costs are appropriate.
The parties to a mineral lease are free to negotiate the allocation of post-production costs. The more detail that is included regarding how the production amount is to be calculated, the less likely disputes will arise due to misinterpretations and misunderstandings.
Why You Want an Experienced Energy Attorney to Negotiate or Review Your Mineral Lease
The financial compensation provisions of a mineral lease are of utmost importance to mineral lease owners. Lease owners want to negotiate the most advantageous royalty rate and lease bonus combination for the leased property and have royalty payments calculated from the highest possible production figures.
The experienced Texas energy lawyers at MehaffyWeber handle all types of transactions involving oil and gas, including mineral lease negotiations, review, and litigation. We help clients make the best deals, protect their rights, and avoid costly litigation if possible. Our ethical and innovative approach to the practice of law allows us to establish long-term partnerships with our clients in the Houston, Beaumont, San Antonio, and Austin business communities.
Contact us to arrange a consultation at your convenience today.