In resolving a dispute over post-production cost deductions from oil and gas royalties (PPC’s), the court in Shirlaine West Properties Ltd et al v. Jamestown Resources, LLC and Total E&P USA, Inc. opined that the case ” … is yet another episode in the endless struggle in the oil and gas context between lessors and lessees in the allocation of [PPC’s] in the calculation of royalty payments.”

Takeaway

Was the lessor’s gas royalty burdened by PPC’s? Yes. The market value royalty clause unambiguously fixed the wellhead as the valuation point for royalty calculation.

The royalty clause

The lessor did its best to be free of PPCs:

• Royalty on gas was 25% of “ … market value at the point of sale, use or other disposition …
• … to be determined “ … at the specified location and by reference to the gross heating value …”.
• “The market value used in the calculation … shall never be less than the total proceeds received by Lessee in connection with a sale, use or other disposition … “.
• Royalty “ … shall be free and clear of all costs and expenses whatsoever, except ad valorem and production taxes.”
• … [N]otwithstanding any language herein to the contrary, all oil, gas or other proceeds accruing to Lessor … shall be without deduction for [PPC’s] … and costs resulting in enhancing the value could be deducted ” … but in no event would Lessor receive a price lower than or more than the price received by Lessee.”
• If Lessee realized proceeds after deduction for PPC’s “ … the proportionate part of such deductions shall be added to the total proceeds received by Lessee … . “.
• Heritage Resources v. NationsBank would have no application.

The lessees engaged in a complex marketing regime involving a series of transactions with related and unrelated entities and a weighted average sales price. There were no PPC activities at the wellhead and the gas required no special treatment to be sold and transported off the lease.

The analysis

The court referred the reader to Bluestone Resources v. Randle for the basic structure of royalty terminology and for the historical legal background of treatment of oil and gas lease royalty clauses.

The court cited two examples of parties contracting for a lessor’s royalty to be free of PPC’s: “Proceeds” leases (Hyder v. Chesapeake) and “amount realized” leases (Bowden v. Phillips Petroleum). Those cases were no help to the lessors.

The court considered the Supreme Court’s ruling in Burlington Resources that it had never construed a contractual amount-realized valuation method to trump a contractual at-the-well valuation point, thus neutering the effect of the language the lessor relied upon to avoid PPC’s.

Considering the entire writing in an effort to harmonize and give effect to all of its provisions so that none would be rendered meaningless, the court concluded that the first two sentences of the royalty clause set market value as the measure of value and set the location of the value at the point of sale. It was uncontroverted that the point of sale of the gas in question was at the wellhead. Potential sales at other points might appropriately fall within the ambit of Heritage Resources holding that provisions purporting to deduct or exempt PPC’s from the lessor’s royalty are considered surplusage. But the court was not presented with such facts and declined to prognosticate about them. Heritage was not applicable.

Lessor’s reliance on Hyder was misplaced: Overrides are generally subject to PPC’s. The court’s rationale for the holding in Hyder was never clearly explained. In any event, Hyder did not value the override on the market value at the well and thus did not control.

Your musical interlude.

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