Many oil and gas leases across Pennsylvania allow the driller to divert and use volumes of raw gas to power and fuel production operations both on and off the leasehold. Is a driller obligated to pay a royalty on that volume of “fuel gas” used for off-site operations? As we have written before, the answer often depends on the precise language on the underlying oil and gas lease. See, Tenth Circuit Rules that Obligation to Pay Royalty On Fuel Gas Depends on Lease Language (February 2018); Oklahoma Federal Court Rules That Driller Must Pay Royalty on Fuel Gas (April 2019). The Texas Supreme Court recently addressed this complex issue in the much anticipated Carl v. Hilcorp Energy Corporation decision. See, Texas Supreme Court to Address the Obligation to Calculate Royalty on Gas Used to Fuel Off-Lease Operations (April 2024). As detailed below, the Texas Supreme Court ruled in favor of the driller. See, Anne Carl and Anderson White, et al. v. Hilcorp Energy Company (Texas Supreme Court, No. 24-0036, May 17, 2024). This is troubling news for landowners.

At issue in Carl was the interplay between two common lease clauses: the royalty clause and the “free use” clause. A “free use” clause typically gives the lessee/driller the right to use gas produced from the leasehold to fuel and power drilling-related operations. When a lease authorizes the driller to use gas to power operations, it is generally recognized “that the gas used for these purposes should be excluded [from] the calculation of the lessor’s royalty.” See, 2 W.L. Summers, The Law of Oil and Gas §33-12 at 160. This authority is not unlimited. Many leases stipulate that the operations fueled by the diverted gas must be actually located on the leasehold itself or in close proximity. See, Tidewater Associated Oil Co. v. Clemens, 123 S.W.2d. 780 (Tex. App. 1938) (the clause “limits the lessee’s free use of the residue gas to that provided from the land and to that used for operations thereon”); Bluestone Natural Resources II LLC v. Randall, 620 S.W.3d 380 (Texas 2021) (“The right to freely use gas is often limited to the leased premises. . . “). The use of gas is “free” only in the sense that the driller is not obligated to pay any royalty on that volume of gas. Such clauses are common but often contain a geographic limit as to where such “free” gas can be used. Gas used on the leasehold is generally “royalty free” but gas used elsewhere is not. In other words, the driller can still theoretically use produced gas to power distant or off-lease operations but the driller remains obligated to calculate and pay a production royalty on those diverted volumes of gas.

In Carl, the driller, Hilcorp Energy Corporation (“Hilcorp”), was using produced gas to power off-lease operations and refused to pay a royalty on that volume of gas. As we have written before, the plaintiff, the Carl/White Trust (the “Trust), brought suit in Federal District Court in Texas alleging that Hilcorp had breached the parties’ oil and gas lease by failing to pay such royalties. See, Texas Federal Court Rules No Royalty Due on Gas Used to Fuel Off-Lease Operations (March 2022). The Trust’s argument was two-fold. First, the Trust argued that the royalty clause in the parties’ lease required a royalty to be paid on all gas “sold” or “used off the premises”. The Trust’s position correctly recognized that gas produced from a well is either “sold” or “used”. Under either scenario, a royalty should be owed. Since the purported fuel gas was being “used” off-premises, the Trust contended that Hilcorp’s refusal to pay a royalty on that volume of gas was a material breach. Second, the Trust argued that the “free use” clause in the parties’ lease was inapplicable because that clause had a geographic limitation: gas could only be used “free” (i.e. no royalty) if the raw gas powered operations on the actual leasehold. Since the processing facility was located miles away, a persuasive argument was made that the “free use” clause was simply inapplicable. As such, the Trust argued that the “used off the premises” language in the royalty clause should control. Hilcorp argued, conversely, that the “at the wellhead” language in the royalty clause superseded the “used off the premises” language in that same clause. According to Hilcorp, the analysis began and ended there and there was no need to consider the “used off the premises” language or the “free use” clause.

The District Court agreed with Hilcorp and dismissed the Trust’s complaint. The District Court’s opinion suggested that the mere presence of the “at the wellhead” language in the royalty clause gave Hilcorp blanket authority to treat post-production “use” as an imaginary post-production “cost.” The Trust appealed the District Court’s decision to the United States Court of Appeals for the Fifth Circuit (the “Fifth Circuit”).

After the parties filed their respective briefs in the appeal, the Fifth Circuit issued an opinion on January 12, 2024 essentially saying that the issue before the court (i.e. obligation to pay royalty on fuel gas used off-lease) was unclear under Texas law. When questions of state law are unclear or unsettled, federal courts can submit the questions to the Supreme Court of the applicable jurisdiction. See, Texas R.A.P. 58.1 (the Supreme Court of Texas is authorized to “answer questions of law certified to it by any federal appellate court if the certifying court is presented with determinative questions of Texas law having no controlling Supreme Court precedent”). The Fifth Circuit concluded that it was unclear under Texas law whether the “at the wellhead” language trumped the “used off the premises” language as well as the “free use” clause. The Texas Supreme Court accepted the certified question and oral argument was held on March 19, 2024. Less than two months later, on May 17, 2024, the Texas Supreme Court answered the certified question and issued a formal opinion.

The Texas Supreme Court agreed with the District Court and held that the “at the wellhead” language was controlling. The Supreme Court opined that “in order to calculate the at the wellhead value of all gas produced, Hilcorp was entitled to account for reasonable post-production costs, which include the value of the gas used off the premises. . .” While the Supreme Court acknowledged that a royalty is due on all gas “sold” or “used off the premises,” the value of such volumes of gas must still be calculated utilizing the so-called work-back method to arrive at the wellhead value.[1] Because the royalty clause identified the royalty valuation point as being at the wellhead, all “costs” incurred between the wellhead and the downstream point-of-sale could be lawfully deducted by Hilcorp. According to the Texas Supreme Court, Hilcorp’s “use” of the fuel gas was essentially the same thing as a post-production cost: “[t]he value of the gas used for post-production activities was a post-production cost of the kind normally chargeable to the royalty holder.” As such, Hilcorp did not breach the lease when it excluded the fuel gas volume from the royalty calculation.

Remarkably, the Supreme Court ignored the express geographic limitation set forth in the “free use” clause and characterized the Trust’s reliance on that clause as a “distraction.” The Supreme Court concluded that “the free use clause in this lease has no bearing on the outcome of the dispute over how to account for post-production costs.” Such a statement is troubling for several reasons. First, Hilcorp’s use of the raw gas was not an actual post-production cost. It was an activity – not a “cost” paid to a third-party. The logic of the Supreme Court’s opinion falsely equates post-production use with a post-production cost – the two are fundamentally and legally distinct.

Second, the Supreme Court’s opinion is entirely inconsistent with the most basic rule of contract interpretation: all provisions of a contract must be read together and given effect. The Supreme Court rendered the “free use” clause meaningless by applying the “at the wellhead” language in a rigid and inflexible manner. The “at the wellhead” language merely set the royalty valuation point. It does not decide or determine if a royalty is to be paid. Moreover, the geographic limitation set forth in the “free use” clause required that a royalty be paid on all volumes of gas used off-premises. Here, there was no question or dispute that the raw gas was, in fact, used off-premises. That language should have been given effect and a royalty should have been calculated on that volume. Instead, the Supreme Court concluded that no royalty was due by expanding the scope and reach of the work-back method. As noted, the work-back method is an accounting device employed to arrive at a wellhead value. It is not an affirmative defense that can be used to eliminate a contractual obligation to calculate and pay a royalty on a certain volume of gas. But, the strained and myopic logic employed by the Texas Supreme Court effectively re-wrote the parties lease by deleting the “free-use” clause entirely. Inexplicitly, no effort was made to harmonize these two clauses and give effect to the entire lease. As a result, the decision in Carl is deeply flawed and suspect.

[1] “[W]hen the location for measuring market value is at the well, the workback method permits an estimation of wellhead market value by using the proceeds of a downstream sale and subtracting costs incurred between the well and the point-of-sale.” See, Bluestone Nat. Resources LLC v. Randall, 620 S.W.3d 380, 389 (Tex. 2021).