Washout of Production Payments Upon Expiration of the Underlying Leasehold

The Texas Supreme Court, in Apache Deepwater, LLC v. McDaniel Partners, Ltd., No. 14-0546, 2016 Tex. LEXIS 179 (February 26, 2016), addressed the issue of the calculation of production payments reserved in the assignment of four oil and gas leaseholds, and whether, after two of the leases terminated, the production payment should be adjusted to reflect the loss of the two leaseholds.

The dispute in Apache Deepwater centered on the interpretation of a production payment reserved in the assignment of four oil and gas leases. Id., at *1-2. In 1953, Hugh W. Ferguson, Jr. ("Ferguson") assigned to L.H. Tyson ("Tyson") four oil and gas leases that Ferguson owned in Upton County, Texas. Id., at *2. The assignment reserved to Ferguson a one-sixteenth (1/16) production payment, which it described as "1/16th of 35/64ths of 7/8ths, being one-sixteenth of the entire interest in the production from said lands to which Assignor claims to be entitled under the terms of the said respective oil and gas leases." Id., at *3-4 (emphasis added). At the time of the assignment, Ferguson owned a one-half (1/2) mineral interest in two of the leases, a one sixty-fourth (1/64) mineral interest in one lease, and a two sixty-fourth (2/64) mineral interest in the last lease, for a total mineral interest of thirty-five sixty-fourths (35/64) in the four leases. Id., at *3. Each of the four leases also reserved a one-eighth (1/8) royalty to the lessors, leaving the lessee with a seven-eighths (7/8) working interest in the lands covered by the four oil and gas leases. Id. Therefore, the production payment reserved in the Ferguson assignment included the interest in production from the conveyance (1/16); the fraction of the mineral interest under the four leases (35/64); and the fraction representing the leasehold estate after subtracting the lessors' royalty interest (7/8). Id., at *3-4.

Twenty years after Ferguson assigned the four oil and gas leases, two of the leases expired for lack of production, being the leases covering 32/64 of the mineral interest. Id., at 5. Then, in 2009, Apache, as Tyson's successor-in-interest, acquired its interest under the Ferguson assignment. Id. Apache, soon thereafter, acquired additional leases that were not assigned by the Ferguson assignment, completed additional wells and began production of oil and gas from all of the land now covered by the two remaining oil and gas leases. Id. After obtaining production, Apache sent a division order to McDaniels Partners, Ltd. ("McDaniels"), Ferguson's successor in interest, stating that the production payment reserved in the Ferguson assignment should now be 1/16 of 3/64 of 7/8, reflecting the expiration of the two expired leases. Id. (emphasis added). McDaniels disagreed and later sued arguing that the production payment should be calculated under the assignment's original equation, being 1/16 of 35/64 of 7/8. Id. (emphasis added).

To determine which percentage should be used to calculate the production payment, the Supreme Court examined whether the intent of the assignment was to convey a fixed production payment or whether the assignment intended for the production payment to be proportionately adjusted based an individual lease's expiration. Id., at *7-8. McDaniels argued that because the equation stated the production payment as a percentage of the cumulative working interest conveyed and it is used throughout the agreement, it was indicative of the parties' intent to burden the individual leases jointly with a production payment based upon the original, cumulative working interest conveyed (35/64). Id. On the other hand, Apache contends that the production payment was to be a fraction of the working interest owned in each of the leases.

The Supreme Court analyzed the production payment as though it were an overriding royalty interest and explained that "[w]hen . . . the production payment is carved from the lessee's working interest, it is like an overriding-royalty interest, except for its more limited duration." Id., at *12. In the case of a single lease, a production payment would not survive the expiration of the underlying lease and the Supreme Court applied the same rationale when analyzing the assignment of multiple leases. Id. Thus, the Supreme Court concluded that the production payment as to the expired leases owned by McDaniels terminated upon the expiration of the underlying leases. The Supreme Court noted that Ferguson Assignment did not include any savings clause or other language to allocate the burden of the production payment to the surviving leases. Accordingly, under the Texas Supreme Court's decision in Apache Deepwater, a production payment terminates upon expiration of the underlying lease. However, Apache Deepwater implied that a production payment may survive expiration of the underlying lease with an appropriate savings clause.