Texas Supreme Court Determines That Off-Lease Fuel is Deductible from Royalties Valued at the Well

On May 17, 2024, the Texas Supreme Court held that when a lease requires royalties to be paid on all gas sold or used off the premises, but the valuation point for said royalties is “at the well,” gas used off premises as fuel is deductible as a matter of law. Carl v. Hilcorp Energy Company, — S.W.3d —-, No. 24-0036, 2024 WL 2226931 (Tex. May 17, 2024).

This decision was brought to the Court as a certified question from the United States Court of Appeals for the Fifth Circuit in Carl v. Hilcorp Energy Company, —F.4th—, No. 22-20226, 2024 WL 137038 (5th Cir. Jan. 12, 2024) asking whether gas used off the premises could be deducted from the royalties and, if so, whether such deductions should influence the value per unit of gas, the total number of units of gas on which royalties must be paid, or both. A blog post concerning this certified question, and a more detailed discussion of the background, can be found here.

The issue before the Court centered around a lease that required royalties to be paid on all gas “sold or used off the premises,” valued royalties “at the well,” and contained a “free-use” clause. The lessee, Hilcorp, used gas off the premises to prepare other gas produced from the premises for sale, and it did not pay royalties on that gas to the lessor (the Trust) because Hilcorp considered the gas to be a post-production cost.  The Trust claimed that deducting the gas used off the premises from its royalties was improper because the lease at issue required royalties to be paid on all gas “sold or used off the premises.” The United States District Court for the Southern District of Texas held in favor of Hilcorp, but on appeal, the Fifth Circuit certified the two questions noted above to the Texas Supreme Court.

The Court’s analysis began with a recognition that when royalties are valued “at the well,” a proportionate share of post-production costs generally may be deducted from the value of royalties. At the same time, when leases require that royalties be paid on all gas “sold or used off the premises,” royalties are owed on all gas produced, including any gas used off the premises. But the dispute at issue was whether gas used off the premises as fuel for operations on the premises were deductible as a post-production cost. After all, if royalties were not paid on gas used off the premises, then royalties would not be paid on all gas “sold or used off the premises.” Both parties agreed that the gas used off the premises was a post-production cost.

The Court resolved this conflict by holding that royalties being owed on all gas “sold or used off the premises” does not alter that post-production costs are deductible under an “at the well” royalty provision. While the Trust was correct that royalties were owed on all gas that was produced, including gas used off the premises, post-production costs were nonetheless deductible, even on gas used off the premises.

According to the Court, Hilcorp’s accounting may have given the appearance that royalties were not being paid on all gas produced, but that was not the case. Hilcorp’s accounting was simply one way to convert the downstream sales price of the gas to an “at-the-well” value.

The Lease also contained a “free-use” clause, and the Trust, relying on the Supreme Court’s previous opinion in BlueStone Nat. Res. II, LLC v. Randle, 620 S.W.3d 380 (Tex. 2021), argued that the “free-use” clause only permitted the free use of gas on the premises—not off the premises. While it was true that the “free-use” clause only applied to gas used on the premises, the Lease nonetheless valued royalties at the well, and the gas used off the premises was a genuine post-production cost. As such, the “free-use” clause had no bearing on whether gas used of the premises was deductible.

The Court ultimately answered the Fifth Circuit’s first question—whether an “at the well” lease containing an “free-use” clause allowed for gas used off the premises to be deducted—with a “Yes.” And it declined to answer the Fifth Circuit’s second question—whether such deduction influences the value per unit of gas, the units of gas on which royalties must be paid, or both—because the parties’ briefing did not address the question and, according to the Court’s “rough mathematical calculations,” either accounting method would yield the same result.

For further information regarding this topic, contact Liskow attorneys Sam Allen, J.T. Kittrell, and Jana Grauberger and visit our Energy Litigation practice page.

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