By Michael S. Sankey

The drafters of an Assignment of Overriding Royalty Interest in Burlington Resources Oil & Gas Company, L. P. v. Texas Crude Energy, LLC did not “say what they meant to say” and received an admonition from the Texas Supreme Court. In Burlington, the Court determined a royalty interest owned by Texas Crude was subject to post-production costs. Burlington reinforces the holding in Heritage Resources, Inc. v. NationsBank, that a royalty is valued where the agreement states it will be valued.

First, what are post-production costs and what effect do they have on a royalty interest? Post-production costs are the costs of processing, compression, transportation, and other costs expended to prepare raw oil or gas for sale at a downstream location. Generally, royalty interests are subject to post-production costs, however, parties may modify this rule by agreement.

The point at which parties agree to value oil and gas production from a well is called the “valuation point.” The valuation point determines what costs are attributable to the royalty interest absent clear provisions stating otherwise. For example, if the royalty is valued at the well but the sale takes place after the product has been processed and transported, the product sold is generally of greater value than the product in which the royalty owner has an interest, and therefore, the sales price must be adjusted to properly calculate the royalty payment. A way to calculate the royalty payment of a valuation point at the well is to subtract the post-production costs from the market price.

Conversely, if the parties agree that the valuation point is at the point of sale, the royalty interest owner would generally not be responsible for post-production costs since those costs would have already been expended prior to the sale. Naturally, a royalty owner would want a valuation free of all costs and an operator would want to share as much of these costs as possible with a royalty owner.

In Burlington, the Court determined the royalty owner, Texas Crude, was subject to post-production costs because the Assignment stated the royalty interest was to be “delivered to Assignee into the pipelines,” which the Court decided created an “at the well” valuation point because, in theory, production from a well goes directly into a pipeline to be transported to a point for processing or sale.

The Assignment also contained a clause that stated the value of the royalty is “the amount realized from such sale of such production,” which Texas Crude argued created a royalty interest free of post-production costs. The Court agreed with Texas Crude that “in isolation,” an amount realized valuation creates a royalty interest free of post-production costs. However, that is not the case when accompanied by an “at the well” valuation point, as was determined in this case.  Therefore, the Court held that Texas Crude’s royalty interest was subject to post-production costs.

Pro-Tip from the Texas Supreme Court: If you find yourself drafting an oil and gas contract, agreement, or assignment in Texas, by this case, you have free reign and are encouraged to clearly state the agreement between the parties, especially the valuation point and which costs can be deducted from a royalty interest. Accordingly, in Burlington, the Court said what it meant to say about the Assignment:

But the parties could have saved considerable time, money, and heartache if their cryptic language had truly been “delivered … into the … receptacle [ ].” It could then have been re-written to say exactly what the parties intend, without resort to industry jargon, outdated legalese, or tenuous assumptions about how judges will interpret industry jargon or outdated legalese. If you can’t understand what your contract means without asking the lawyer who wrote it, you should not be surprised later if judges—who can’t just take your lawyer’s word for it—also have trouble understanding what it means.