Are Postproduction Expenses Borne by an Overriding Royalty Interest in Texas?
The Texas Supreme Court (“TXSC”) recently made a significant ruling with regard to whether oil and gas production companies may deduct certain expenses from payments to the owners of overriding royalty interests (“ORRI”). An ORRI may arise out of an oil, gas and mineral lease (“OGML”) in a number of ways, but the most common is a 25% ORRI reserved by the mineral interest owner(s) that first leased the mineral interests to either a lease-flipping entity (who would, in turn, typically bundle several leaseholds and sublease those mineral interests to either an exploration company or a exploration & production company, often reserving a small ORRI for themselves in addition to receiving a cash payment and/or a working interest in future wells), an exploration company (seeking to prove up the hydrocarbons in the fields and then sell them to a production company, once again often reserving a small ORRI for themselves in addition to receiving a cash payment and/or a working interest in future wells), or an exploration & production company (which drills its own wells and then operates the wells long-term).
This recent TXSC ruling altered the way ORRI owners have been negotiating payment clauses, which was previously controlled by a 1996 TXSC case, Heritage v. NationsBank. Heritage held that leases containing payment clauses that ORRI interest were to be calculated based off the “market value at the well” and further prohibited the deduction of postproduction (e.g., transportation, processing, dehydration, storage, marketing) expenses from the ORRI payments were not effective in barring the deduction of such postproduction payments. The Task’s reasoning in 1996 was that the language disallowing postroduction costs was duplicative of existing Texas law and duplicative of the “market value at the well” provision, in legal terms “surplusage.” Surplusage language clauses are routinely stricken by courts and given no effect.
Under Heritage, the general rule was that ORRI payments were subject to deduction of postproduction costs. As a result, ORRI payment clauses because to specifically “contract around” the Heritage case, or in other words contain express disclaimers of the ruling in Heritage, such that the ORRI was calculated on the gross vase of the minerals produced at the well, and not after postproduction expenses were deducted. This can be significantly important when, as is common with most larger production companies, the postproduction expenses are paid to an affiliated entity, or “sister company.” By deducting postproduction expenses that the company was paying to it’s wholly-owned related company, the production company was able to reduce the ORRI payment while increasing its reimbursements to itself. As a result of Heritage, most savvy ORRI payment clauses after 1996 were negotiated to expressly negate the ruling in Heritage, and to mandate that the ORRI be paid its proportionate percentage based on the gross value of the production without deduction for any of the expenses incurred after the hydrocarbons were produced.
In June of 2015, the TXSC decided Chesapeake Exploration, O.K. v. Hyder, which modified the current law and lease negotiation practices substantially. Chesapeake was a narrowly-decided (5 justices agreeing on the holding, and 4 justices dissenting) that prohibited the deduction of postproduction costs from ORRI payments. In short, the TXSC ruled that, when a lease specifically contracts around the majority rule from Heritage, then the production company must bear all postproduction expenses form its share and may not change any portion or percentage of those expenses to the ORRI owner(s).
As a result of this significant decision, ORRI owners throughout Texas may be due significant payments for past deductions of postproduction costs.
Written By:
Edward Allred
Watts Guerra LLP
4 Dominion Drive, Bldg 3, Suite 100
San Antonio, Texas 78527
Office (210) 447-0500
Mobile (210) 685-1845
eallred@guerrallp.com
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