Texas Court Clarifies Who is a “Payor” under the Texas Division Order Statute

In a case of first impression, The Eastland Court of Appeals recently held that Tex. Nat. Res. Code § 91.402 (the “Texas Division Order Statute”) does not require an operator to pay royalties directly to mineral interest owners who have leased their interest to a different working interest owner.  Devon Energy Prod. Co., L.P. v. Apache Corp., 550 S.W.3d 259 (Tex. App.–Eastland 2018, pet. denied).

The dispute arose relating to the payment of royalties in Glasscock County, Texas.  A mineral owner had leased her one-third interest in the subject land to Apache Corporation (“Apache”) and the remaining mineral owners leased their combined two-thirds interest to Devon Energy Production Company, L.P. (“Devon”).  However, Devon and Apache were unable to agree on the terms of a joint operating agreement.  Apache drilled seven producing wells.  After payout, Apache paid Devon its full two-thirds share of production, including the landowner royalty set forth in the leases.  Neither Devon nor Apache paid Devon’s royalty owners their share of production.

The Plaintiffs, Devon’s royalty owners, alleged that Devon and Apache owed them royalty payments from the lease.  Devon filed a cross-claim against Apache alleging it was Apache’s responsibility as operator to pay Devon’s royalty owners directly.  Apache responded that it had no obligation to pay Devon’s royalty owners because it did not lease the minerals directly from those royalty owners.  The trial court held that Apache was not obligated to pay royalties to Devon’s royalty owners because Apache was not a “payor” under Tex. Nat. Res. Code § 91.402(a).[1]  The key issue addressed by the Court of Appeal was whether Apache had statutory obligations to pay royalties directly to the lessor plaintiffs pursuant to their leases with Devon.

In Texas, pursuant to the rules of equitable accounting between cotenants (in this case Devon and Apache), a cotenant has the right to extract minerals from common property without first obtaining the consent of the other cotenants.  However, he must account to his cotenants on the basis of the value of any minerals taken, less the necessary and reasonable costs of production and marketing (thus, the nonparticipating cotenant is “carried until payout”).  Prior to the Court of Appeals decision, the question of whether an operator owes a royalty to the third-party lessor of a nonparticipating cotenant lessee had not been addressed by the Texas courts.  See Caleb A. Fielder, Blood and Oil: Exploring Possible Remedies to Mineral Cotenancy Disputes in Texas, 50 Tex. Tech L. Rev. 173, 199-202 (2017).  However, Tex. Nat. Res. Code § 91.402(a) requires that “proceeds from the sale of production be paid to each payee by the payor on or before 120 days after the end of the month of first sale from the well.  Thereafter, payments must be made timely according to the frequency of payment specified in the lease or other written agreement between the payee and payor.”

Here, the Court of Appeals focused on the words “payor” and “payee” and determined that Devon, not Apache, was obligated to pay the Devon’s royalty owners.  The Court of Appeals explained that the phrases “legally entitled to payment” and “undertakes” in the definitions of “payee” and “payor” were significant.  In looking at the plain dictionary definition of these words, the Court of Appeals reasoned that to qualify as a “payor” who owes a “payee,” the “payor” must have “undertaken” (obligated itself) to the “payee” in some way.  Based on these definitions, the court found that Apache and the plaintiffs did not have a payor-payee relationship under the statute because Apache did not “undertake” to pay Devon’s royalty owners by entering into leases with them.

 

Distinguishing Nonparticipating Royalty Interests

In this case, the Court of Appeals drew a distinction between a royalty owner and a nonparticipating royalty interest (“NPRI”) and distinguished the San Antonio Court of Appeals decision in Prize Energy Res., L.P. v. Cliff Hoskins, Inc., 345 S.W.3d 537 (Tex. App.—San Antonio 2011, no pet.).  Prize Energy dealt with a similar situation, but in the context of an unleased mineral interest subject to an NPRI.  The Devon court asserted that the Prize Energy case was different than the case at hand because the royalty interest in Prize Energy was an NPRI burdening an unleased interest, and was not a contractual royalty interest reserved in a lease.  The Court of Appeals explained that because the NPRI does not relate to a particular lease, unlike a lease royalty interest or an overriding royalty interest, it does not end when the lease ends, rather it is generally “tied to the land.”  Thus, in Prize Energy, it didn’t matter that the defendants did not have a lease with the plaintiffs; rather, the plaintiff was a payee as soon as someone drilled a producing well on the land.

 

Key Takeaways

In Devon Energy Prod. Co., L.P. v. Apache Corp., the Court of Appeals established that an operator has no statutory duty to pay royalties to a nonparticipating cotenant’s “third-party” lessor.  Instead, the third-party lessor must seek payment from its own lessee.  However, the court’s decision did not answer address the nonparticipating cotenant’s obligation to pay a landowner its cost-free royalty prior to payout.

Unless the lessees have specifically agreed in an operating agreement or otherwise that the operator will pay the landowner royalty prior to payout, the question of when a nonparticipating working interest owner must pay its lessor remains unanswered.  It is now clear that the operator is under no obligation to pay a third-party lessor under the Texas Division Order Statute, and the nonparticipating cotenant lessee is not entitled to any proceeds from production until payout.  Thus, a third-party “cost-free” royalty owner could effectively be forced to bear the cost of drilling and operating the well until such time as payout occurs.

On the other hand, to avoid dispute, the best practice may be for the nonparticipating cotenant to pay the lessor’s royalty both before and after the well pays out.  Otherwise, a number of additional issues, such as a breach of Tex. Nat. Res. Code § 91.402 and even maintenance of the non-operating party’s leases may come into question.  The Texas Supreme Court has declined to address the Court of Appeals decision and these questions will remain unanswered.

[1] Tex. Nat. Res. Code § 91.401(2) defines “Payor” as “the party who undertakes to distribute oil and gas proceeds to the payee, whether as the purchaser of the production of oil or gas generating such proceeds or as operator of the well from which such production was obtained or as lessee under the lease on which royalty is due.  The payor is the first purchaser of such production of oil or gas from an oil or gas well, unless the owner of the right to produce under an oil or gas lease or pooling order and the first purchaser have entered into arrangements providing that the proceeds derived from the sale of oil or gas are to be paid by the first purchaser to the owner of the right to produce who is thereby deemed to be the payor having the responsibility of paying those proceeds received from the first purchaser to the payee.”