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“Royalty-Valuation Disputes in Texas Oil and Gas Leases, and Post-Production Deductions Against Royalties: A Royalty Pirate Looks at 50.” First Installment:

On Behalf of | Mar 22, 2021 | Law, Oil and Gas Work

The following article by James Holmes is broken into three installments: first, James gives a background for the article and discusses the first four “pillars” for disputes over royalty valuations under Texas law, including the reasons for the deterioration of royalty-owner rights since the 1990s.  Second, James discusses the remaining pillars for these disputes.  Finally, James gives his perspective on how royalty owners can best protect their rights under Texas law and industry practices, as they exist today.

“Mother, mother [oil field], I have heard you call . . .

You’ve seen it all, you’ve seen it all”

Holmes on dead man
Holmes with his Lucchese on a “dead man” in the North Permian Basin

James Holmes is 50 and it’s time again for him to weigh in on Texas law for royalty-valuation disputes and post-production deductions that lessen royalty income.  Holmes has given more speeches about – and has written more legal briefs on – this aspect of Texas law that one attorney should have to do in a lifetime.  But, such was the fate of the most active Texas lawyer for royalty owners from 2000-2010, when precious few law firms practiced royalty law.

The analysis of royalty-valuation disputes and post-production deductions under Texas law quickly becomes an intellectually heady endeavor – analogous to debating how many angels can dance on the head of a pin, or playing chess against Gary Kasparov in his prime.  In the following discussion below, Holmes purposely avoids as much complexity as he can, while still presenting the key concepts for the reader’s consideration.  He wants not only specialized oil and gas lawyers, but also non-lawyers and lawyers without oil and gas training to benefit from his observations.

These pillars of Texas royalty law stand firm:

First Pillar: Texas law – whether applied by Texas state courts, federal courts, or other state courts – tends to disfavor royalty owners (lessors) in cases involving royalty-valuation disputes and post-production deductions.  The same law tends to favor producers (lessees).  The Texas Supreme Court and intermediate appellate courts have crafted this pro-lessee law, as it exists today, over the past 25 year period.  Thus, to the extent they can, lessors must protect their legal rights “on the front end” (at the time of lease negotiation and execution) rather than “on the back end” (in the courthouse, arguing Texas case law).  Unfortunately, many royalty owners in legacy fields must rely upon antiquated lease language and Texas common law (which does not favor their rights).

Second Pillar: There is a historical reason that Texas law, which used to favor lessors or, at least, struck a commendable balance between lessees’ rights and lessors’ rights, became grossly lopsided in favor of lessees’ rights.  Having witnessed when, why and how Texas appellate courts began turning Texas law decidedly pro-lessee, James Holmes doesn’t lament this turn.  He simply questions when, if ever, the law may become more protective of lessors.  He doesn’t want to see Texas law return to the foolishness of the 1980s and 1990s – that would hurt the oil and gas industry, which is sacrosanct in Texas and vital to its economy.  But he would like to see more favorable treatment for lessors under Texas law, especially when they have attempted to draft lease language to protect their rights.

Brief background: In the 1980s and 1990s, class action lawyers – who knew little about (and cared little for) Texas oil and gas law – began holding the oil and gas industry hostage with state and federal class-action lawsuits over royalty-valuation disputes and post-production deductions.  Representing people they’d never met (called “Classes of Plaintiffs”), the class action lawyers would force large oil and gas companies to pay millions in damages and attorneys’ fees over royalty-valuation disputes and post-production deductions, with a large share of those winnings going into the lawyers’ pockets.  These aggressive lawyers would drive a Mack Truck through any small avenue for relief that Texas law provided to lessors.  For good reason, the industry didn’t like this.  The industry got busy in expressing its displeasure for such class-action lawyering and for such excessive usage of Texas oil and gas law.  Texas legislators and judges listened to the industry; one consequence was that Texas appellate courts began applying tremendous scrutiny to royalty-underpayment cases, whether brought by lessors in class actions or in individual cases.  Texas appellate courts would err on the side of allowing lessees to prevail – and allowing lessors to lose.  The aggressive lawyers had neither (a) the foresight to anticipate the “legal reforms” against what they were doing with Texas oil and gas law nor (b) the political skills to stop/ameliorate such reforms.  (After whimsically damaging Texas oil and gas law, these lawyers moved on to other states or jurisdictions in order to drive Mack Trucks through other areas of law (patents and copyrights! toxic torts and marketable securities! or . . . whatever happens to be lucrative!)– in order to make more money for themselves.)  Texas lessors as well as unleased-mineral owners didn’t know this battle of “Industry vs. Aggressive Lawyers” was happening – and, consequently, were not prepared to stop/ameliorate the deterioration of their legal rights.

But I digress.  Let’s get back to the “pillars” of Texas royalty-valuation disputes and post-production deductions . . .

Third Pillar: Post-production deductions and the resulting valuation disputes happen because producers (lessees) force royalty owners (lessors) to pay a proportionate share of per-BBL oil transportation fees (for trucking services or pipeline costs), per-MMBTU and per-MCF gas processing and transportation fees (for gathering, compression, cryogenics, absorption, and fractionation), and per-gallon NGL fees (for pipelining NGLs to places like Mont Belvieu, Texas and for fractionation at destination).  All of these post-production fees lessen oil and gas revenues to the producers – and those producers pay royalties to lessors using prices net of these fees.  The “net of” prices – often and especially for gas royalties – can erode 50% or more of the value that the lessors should receive.  Virtually all royalty-underpayment cases arise from some variation of this activity.

Fourth Pillar: As a default rule, Texas law allows producers (lessees) to take post-production deductions against royalties and to create royalty values “net of” such deductions.  See, e.g., Heritage Res., Inc. v. Nationsbank, 939 S.W.2d 118, 122 (Tex. 1996) (acknowledging that “royalty is usually subject to post-production costs, including taxes, treatment costs to render it marketable, and transportation costs [but that] the parties may modify this general rule by agreement” (citations omitted)); Burlington Res. Oil & Gas Co. LP v. Tex. Crude Energy, LLC, 573 S.W.3d 198, 203 (Tex. 2019) (“In general, oil and gas royalty interests are free of production expenses but ‘usually subject to post-production costs, including taxes . . . and transportation costs.’” (citations omitted)).  These post-production deductions result from fees in marketing contracts that producers have with unaffiliated or affiliated oil and gas purchasers (e.g., Plains Marketing for oil, or Targa Midstream for gas).  Even though lessors are not parties to their producers’ marketing contracts, Texas law nonetheless forces lessors’ royalties (whether based on “market value” or “proceeds” discussed below) to bear a proportionate share of the post-production fees arising in such contracts.

In conclusion, the first four pillars establish Texas law as generally pro-lessee (pro-producer) – and do so for specific historical reasons.  Also, they reveal a pattern for virtually all royalty-valuation litigation: the producers’ royalty payments based upon net of pricing (that is, prices with post-production deductions baked into them).  In the next installment, Holmes will survey Texas law’s crucial distinction between “market value”-style leases or “proceeds”-style leases, including the “duty to market” present in the latter (but not the former).  He also reviews samples of “market value” and “proceeds” valuations, as well as supplemental lease language to deter/prevent a producer’s taking of post-production deductions.