On June 4, 2024, the United States Court of Appeals for the Fifth Circuit affirmed the dismissal of an "at the well" royalty holder's class action lawsuit after the Texas Supreme Court held that Hilcorp Energy Co. properly deducted from its royalty calculation the value of gas used off-lease in post-production activities.

In June 2021, two royalty holders, on behalf of a proposed state-wide class of plaintiffs, sued Hilcorp Energy Co. in the Southern District of Texas alleging that Hilcorp had systematically underpaid royalties.  The mineral lease provided that royalties were to be paid "on gas…produced from said land and sold or used off the premises" and were to be calculated based on the "market value at the well."  The plaintiffs alleged that Hilcorp used a portion of the produced gas as fuel for certain post-production activities necessary to market and sell the gas, such as compression and treating, but that Hilcorp wrongfully did not pay royalties on the "fuel gas."  In a motion to dismiss, Hilcorp argued that it was entitled to deduct the value of any produced gas used off-lease for post-production costs under long-standing Texas law applicable to mineral leases providing for a "market value at the well" royalty.  The Texas Supreme Court has previously held that because processing costs increase the value of gas and are not incurred until after gas leaves the wellhead, backing out these reasonable and necessary post-production costs from the gross sales proceeds is an appropriate way to approximate market value at the well.  BlueStone Nat. Res. II, LLC v. Randle, 620 S.W.3d 380, 389 (Tex. 2021).

The district court granted Hilcorp's motion to dismiss, explaining that because the lease provides that royalties are to be paid based on the "market value at the well," post-production costs, including gas used to power gas processing, must be deducted from the royalty calculation.  Carl, et al. v. Hilcorp Energy, Co., No. 4:21-cv-02133, at *5-6 (S.D. Tex. Nov. 20, 2021).  Plaintiffs appealed the eventual dismissal with prejudice of their complaint to the Fifth Circuit.

After oral argument, the Fifth Circuit certified two questions to the Texas Supreme Court, one of which was whether the lease could be interpreted to allow for the deduction of gas used off-lease in post-production activities.  The Texas Supreme Court answered the first question in the affirmative and in accordance with the district court's opinion.  Justice Blacklock's opinion explained that the lease provision requiring royalties for gas "sold or used off the premises" did not alter a producer's ability to deduct post-production costs—even where such costs are in the form of fuel gas—when calculating royalties.  After the Texas Supreme Court issued its opinion, the Fifth Circuit quickly affirmed the district court's judgment.

This case reinforces the rule in Texas that for leases calculating royalties based on the market value at the well, produced gas used in the processing of royalty-bearing gas is an expense that can be deducted from the royalty calculation.

Hilcorp is represented by Bracewell LLP and White & Case LLP