Whether or not the operator of an oil and gas well can deduct post-production costs (“PPC”) can significantly impact the economics of a well for both an operator and a royalty owner.  In BlueStone Natural Resources II, LLC v. Randle, — S.W.3d —-, 2020 WL 936175, 64 Tex. Sup. Ct. J. 450 (Tex. 2021), the Texas Supreme Court was called upon to determine whether or not an oil and gas lease permitted the deduction of PPC from sales proceeds before royalties are computed.

How to calculate the payment of royalty is a matter of contract.  The value of royalty can be computed at the wellhead or at any downstream point, depending on the terms of the particular oil and gas lease.  It is common for lease forms to provide that royalty is based on the market value at the wellhead.  Since oil and gas is typically not sold at the wellhead, but rather at a point further downstream, a common method to compute royalties payable based on market value at the wellhead is the “net-back” or “workback” method.  Using this method, a lessee estimates market value at the wellhead by starting with the proceeds of a downstream sale and subtracting PPC incurred between the wellhead and the point of sale.  This method is based on the premise that production is less valuable at the wellhead because a purchaser at the wellhead would be required to incur costs for things such as processing, compression, and transportation in order to prepare it for sale to a downstream market.  Therefore, with a lease that requires royalty to be computed at the well, the royalty will bear its share of PPC.

In contrast, a lease can provide for royalty computed on “proceeds” or “amount realized” by the lessee.  A “proceeds” or “amount realized” clause, standing alone, creates a royalty that is free from PPC.  In such a case, the lessee bears all costs downstream from the wellhead to the point of sale.

The oil and gas lease in BlueStone provides in paragraph 3 of the body that royalty on gas is based on the “market value at the well” of the gas sold or used off the premises.  The lease contains an addendum that provides in paragraph 26 that the lessee “agrees to compute and pay royalties on the gross value received.”  The addendum also contains language stating that it “supersedes any provisions to the contrary in the printed lease.”  Thus, the dispute was whether the phrase “gross value received” in the addendum conflicts with the phrase “at the mouth of the well” in the body of the lease, and, therefore, would supersede the language in the body of the lease.

BlueStone argued that there was no conflict between the “at the well” language in the body and the “gross value received” language in the addendum, because the terms can be read together to produce a net-proceeds calculation, permitting the deduction of PPC.  However, the Court disagreed, citing its prior decision in Judice v. Mewbourne Oil Co., 939 S.W.2d 133 (Tex. 1996), which found that the phrase “gross value received at the well” gave rise to an inherent conflict.  That language rendered the royalty clause ambiguous because “at the well” is a net-proceeds equivalent that contemplated the deduction of PPC, whereas “gross proceeds” indicates just the opposite.

BlueStone argued that the Court’s decision in Burlington Resources Oil & Gas Company, LP v. Texas Crude Energy, LLC, et al., 573 S.W.3d 198 (Tex. 2019) stood for the proposition that “at the well” language will always mean that a royalty clause allows for deduction of PPC.  Although there is language in Burlington stating that prior decisions held that when parties specify an “at the well” valuation point, the royalty owner must share in PPC, the Court said that it is a misreading of Burlington to suggest that “at the well” language supersedes all other language in the contract.  Rather, the Court said that the oil and gas lease in question should be read and interpreted in its entirety, and construed according to all of its terms.

Based on the foregoing, the Court found that the “at the well” language in the body of the lease was in conflict with the “gross value received” language in the addendum, so the language in the addendum controlled.  Since “gross value received” language clearly does not allow the deduction of PPC when calculating the royalty, the Court held that the lease did not allow BlueStone to deduct PPC when computing the royalty owed to its lessor.