Texas Supreme Court Addresses the Deduction of Post-Production Costs

The Texas Supreme Court addressed the deduction of post-production costs in Burlington Res. Oil & Gas Co. LP v. Tex Crude Energy, LLC, 573 S.W.3d 198 (Tex. 2019).  The Texas Supreme Court, reversing the Court of Appeals, explained that Burlington, the lessee and producer, could deduct post-production costs when calculating royalty payments on the amount realized when the royalty interest is to be delivered “into the pipeline, tank, or other receptacle to which any well or wells on such lands may be connected . . . .”

In 2005, Burlington and Texas Crude entered into a Prospect Development Agreement and a Joint Operating Agreement (JOA), which both applied to leases in an Area of Mutual Interest (AMI) in parts of Live Oak, Karnes, and Bee Counties.  Under those agreements, Texas Crude acquired an overriding royalty interest on the leases within the AMI, which interests it then assigned to its affiliate, Amber Harvest.  After several years of accepting royalty payments that reflected a deduction for the royalty holder’s share of post-production costs, Texas Crude, on behalf of itself and Amber Harvest, alleged that the agreements did not allow for Burlington to deduct post-production costs.  The trial court and Court of Appeals concluded that post-production costs could not be deducted.

The Texas Supreme Court explained that royalty interests share in the production, free of the cost of production.  However, the general rule in Texas is that royalty interests are “usually subject to post-production costs, including taxes . . . and transportation costs.”  Id. (quoting Chesapeake Exploration, L.L.C. v. Hyder, 483 S.W.3d 870, 872 (Tex. 2016)).  This charge of post-production costs is tied to the fact that a product which has been subject to post-production processing is more valuable than a product at the well.  The Texas Supreme Court noted that parties are free to change the general rule by drafting their agreements to define post-production costs and their applicability as they choose.  In this case, the agreements’ language provided that the royalty interests would be delivered to the assignee “into the pipelines, tanks or other receptacles with which the wells may be connected . . . .”  The agreements also provided that the value from which the royalty would be paid would be the amount realized from sale of production and any products thereof.  Texas Crude argued that the parties contracted to negate the principle that royalty interests bear post-production costs because “by specifying that the royalty would be paid after sale of the product based on the “amount realized from such sale,” not based on the product’s value at the well,” meant that post-production costs would not be deducted.  Burlington, 573 S.W.3d at 204.  The Texas Supreme Court agreed that the valuation language supported the argument that post-production costs should not be deducted.  However, the Texas Supreme Court explained that the method of valuation was only a component of the inquiry.

The second inquiry is where the valuation takes place.  The Texas Supreme Court interpreted the provision “into the pipelines, tanks, or other receptacles” as to where in the production process the valuation should occur.  The Texas Supreme Court explained that when an agreement specifies “at the well” as the valuation point, then the royalty interest holder must share in the post-production costs, regardless of how the royalty is calculated or the stated valuation method. 573 S.W.3d at 205.  The Texas Supreme Court concluded that the use of the “into the pipelines” language was the equivalent of using the “at the well.”  The Texas Supreme Court noted that commentators have recognized the equivalence between “at the well” and “into the pipeline” language.  Additionally, the Texas Supreme highlighted that the joint operating agreement executed by the parties contained a provision requiring Burlington to account to Texas Crude for the “actual net proceeds” received for production, permitting the deduction of post-production costs.  As a result, The Texas Supreme Court concluded that the provision allowed for the deduction of post-production costs.