Zehentbauer Family Land, LP v. TotalEnergies E&P USA, Inc. is a story we’ve heard before: Royalty owners contend they are not getting a big enough slice of the hydrocarbon pie, which presents a question courts must answer: Where is the valuation point for royalty calculation?

Under the oil and gas leases at issue, royalties are to be paid:

“based upon the gross proceeds paid to Lessee for the gas marketed and used off the leased premises, including casinghead gas or other gaseous substance… computed at the wellhead from the sale of such gas substances so sold by Lessee.”

The midstream arrangements and the “netback method”

Chesapeake and Total sell their production at the wellhead to their respective midstream affiliates, CEMLLC and TGPNA, each of which sells the transported product to unaffiliated downstream companies. The affiliates account for the gas using the “netback” method, which “takes a weighted average of prices at which the midstream affiliates sell the oil and gas at various downstream locations and adjusts for the midstream company’s [various costs (including transportation)] to move the raw oil and gas from the wellhead to downstream resale locations.” The netback method accounts for these midstream (post-production) costs. The midstream affiliates pay this reduced amount to the producers, who use this netback price as the base for calculating the plaintiffs’ royalty payments.

The plaintiffs sued alleging that the defendants failed to pay the full royalties due under the leases. They argued that that their royalties should be based on the gross proceeds received by CEMLLC and TGPNA further downstream after the product is refined and moved to market.

The result

The plaintiffs argued that BlueStone Natural Resources II, LLC v. Randle should guide the Court’s reasoning. There, the Texas Supreme Court held that the phrases “gross proceeds” and “at the wellhead” in a gas lease conflicted because the latter term envisions a net-proceeds calculation. Chesapeake and Total distinguished Bluestone. There, the lessor did not actually sell gas until after paying to have it processed and then sold to a downstream third party. Thus, “gross value received” for the refined gas was at the point of sale, which was not “at the wellhead” where the gas was in a raw, less valuable state.

In this Ohio case, the gas was sold at the wellhead, so the “gross value received” by Chesapeake and Total was the wellhead price. The court concluded that the defendants’ royalty calculations were proper. After selling the oil and gas at the well to their respective affiliates, Chesapeake and Total calculated the landowners’ royalties based on the amount received from those sales. The Court concluded that the royalty calculation is based on:

• the “gross” (or total) proceeds,
• paid to Lessees (i.e., the defendants themselves),
• on gas marketed,
• at the wellhead,
• using the netback method.

Your musical interlude

[View source.]