Royalty Litigation:

An Overview of Current Trends

AUGUST 31, 2016

29TH ANNUAL ENERGY LAW INSTITUTE

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Part One: Introduction to Royalty

Clauses

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Two Primary Components to

Royalty Clause Disputes

HOW is the production valued?

WHERE is the production valued?

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Three Types of

Royalty Clauses

Sales Based

Market Based

Hybrids

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Ok, there are also

“in kind” Royalty Clauses,

but let’s move on …

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“Sales Based” Royalty Clauses

The royalty owner’s payment is based on a “sale,” but not always a sale by the lessee.

The “sale” may be one by a non-affiliate.

The “sale” may occur at a location, regardless of the parties to the transaction.

Examples include, but are not limited to:

Gross proceeds received

Sometimes, just “proceeds”

Net proceeds received

Amount realized

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“Market Based” Royalty Clauses

The royalty owner’s payment is based on market conditions, not an actual transaction.

In theory, the price received by the lessee is not determinative.

Examples include, but are not limited to:

Market value

Highest posted price

Average price received in the field

Best price received in the field

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“Hybrid” Royalty Clauses

The royalty owner’s payment can be based on the “higher

of” a market valuation and sales valuation.

Examples include, but are not limited to:

The higher of market value and the net proceeds received by

the lessee.

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The Valuation Point Can Vary

Common valuation points include, but are not limited to:

Valued “at the well” or the “mouth of the well”

Valued at the “point of sale” or the “first sale to an

unaffiliated third-party”

Valued at the “delivery point”

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Remember to Look For Defined Terms

Leases are “contracts” and courts will construe them as

such.

“Industry custom” will only take you so far …

It is not uncommon for leases to have defined terms

which dictate what will constitute things such as a “sale”

or “market value.”

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Part Two: Common Royalty

Disputes

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Typical Types of Royalty Disputes

Failure to pay royalties

Underpayment of royalties

Overpayment of royalties

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Complete Failure to Pay Royalty

Royalty owners can assert a claim as a “breach of contract” (ie, the

lease) and/or under the Texas Natural Resources Code.

The Texas Natural Resources Code provides for certain safe harbors, if:

The royalty owner has refused to sign a division order that complies

with the statute;

Royalty is being withheld because of a bona fide title dispute;

But, make sure that the lease does not override a safe harbor.

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T.S . Reed v. Samson 14

Underpayment of Royalty

These cases are usually determined after an audit.

Common reasons for underpayment of royalty cases

include, but are not limited to:

Disputes over “no-deduct” clauses.

Disputes over lease interpretation of “how” production is

valued and/or “where” it is valued.

Disputes over the impact of pooling and/or PSA wells.

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Heritage Resources v. Nationsbank

939 S.W.2d 118 (Tex. 1996) Royalty on gas was to be calculated by the “market

value at the well.”

The lease contained a “no-deducts” clause (ie, royalty

not chargeable with post-production costs).

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Heritage Resources v. Nationsbank

939 S.W.2d 118 (Tex. 1996) A split court (5-2-2) held that the “no deducts” clause

was mere surplusage (it was meaningless) because

royalty calculated “at the well” prior to any post-

production costs being incurred.

Decision permits a lessee to use the “netback method”

or the “comparable sales method” of determining

royalty.

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Hyder v. Chesapeake

The overriding royalty provision provided for a “perpetual, cost-free

(except only its portion of production taxes) overriding royalty of five

percent (5.0%) of gross production obtained.”

A clause provided that “each Lessor has the continuing right and

option to take its royalty share in kind.”

A so-called anti-Heritage clause which provided that “Lessors and

Lessee agree that the holding in the case of Heritage Resources,

Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996) shall have noapplication to the terms and provisions of this lease.”

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Unusual Issues with Hyder

The royalty was paid as a surface use payment, but was incorrectly

referred to as an “override.”

There was no valuation point. There was a reference to receiving a

portion of the “gross production,” but this is a metric of volume, not

valuation.

The opinion reveals no contention (from any party) that the

provision described an “in-kind” royalty, which it arguably is.

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Overpayment of Royalty

Generally arise when the lessee is confronted with a

demand for royalty which reveals an error in the way the

lessee has been paying royalty.

Suit is brought by the lessee against the royalty owner to

recover overpayments.

These cases can turn on the reason for the overpayment.

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Amoco Production v. Smith

Amoco owed royalty to H.W. Smith, but paid the wrong H.W. Smith.

Once the issue was raised by the correct H.W. Smith, Amoco sued the

party that was paid in order to recoup the improperly paid royalties.

This was a mistake of fact because Amoco intended to pay the

correct person, but erroneously paid the wrong person with the same

name. The result could be different if Amoco made a mistake of law.

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Part Three: Damages

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Common Remedies Sought

by Royalty Owners

Money (unpaid royalties)

Interest

Can be recovered by contract and/or by statute

Rates can vary

Watch for issues of compounding vs. simple interest

Attorneys’ Fess

Can be recovered by contract and/or by statute

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Some Leases Provide For Lease

Termination Be aware of the remedies provided in a lease.

Some leases provide that the lease will terminate if the

royalties are not timely and properly paid.

Courts consider these types of clauses “forfeiture” clauses,

which are disfavored.

But be cautious anyway!

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Escondido Resources II, LLC v. Justapor

Ranch Company, LC

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Part Four: Current Trends in Royalty

Litigation

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Current Trends

“Post-Production Cost” Litigation

PSA Well Litigation

Bad Faith Pooling

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Post-Production Cost Litigation

Numerous cases over the past five years.

Typically involve a variation of the dispute in the Heritage

case.

Can be complicated:

Midstream agreements

Affiliate sales

Evolving technologies: production costs or post-production?

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Heritage Resources v. Nationsbank

One of the most cited cases on this topic.

Describe the “netback method” and “comparable sales”

method to determining market value.

“Anti-Heritage” clauses have arisen in oil and gas leases.

Their effect, if any, is debatable.

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French v. Oxy Although having different royalty provisions, the French court found that both leases

provided that the royalty owner would not bear any production expenses but

would bear at least some post-production costs.

One lease valued production “at the well” and the other lease valued

production prior to the first sale.

Oxy performed a CO2 flood in a field with 106 wells. Producing casinghead gas

contained 85% CO2.

Oxy paid royalty based on 70% of the NGLs produced, but not on the other 30%which was paid to Kinder Morgan in kind as part of Kinder Morgan’s compensation

for constructing a plant to remove most of the CO2 and H2S. Oxy did not pay any

royalty on any residual gas, 100% of which was given in kind to Kinder Morgan. Oxy

considered a monetary fee paid to Kinder Morgan to be a production expense..

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French v. Oxy 31

KM plant removes Most

of the CO2 and H2S

Torch Energy removes the

remaining CO2 and H2S

Field

Oil and Gas produced from

the field with CO2

Chesapeake v. Hyder

French v. Oxy was not cited in the Court’s opinion.

Seems that the Court could have held that the royalty

provision was an “in kind” royalty and the Hyders must bear

post production costs if they permit their gas to be sold with

Chesapeake’s gas.

The Supreme Court noted that no party argued that the

royalty should be construed to be an in kind royalty.

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PSA Well Litigation

Disputes of “PSA Wells” generally come in two forms:

Contractual authority for the lessee to drill a PSA well

Some believe this to be a form of “pooling”

The Texas Railroad Commission does not consider this to be

pooling

Issues on allocation of royalty

This is a topic which will likely be addressed by the courts

and/or the Legislature

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Authority for Lessee to Drill

The Texas Railroad Commission seems to have concluded

that lessees do not need pooling authority to drill a

production sharing well.

The issue was disputed in the “Klotzman” well protest

The subject of debate

Rival articles have been published within the past few months

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Allocation of Royalty

Royalty payment issues can arise when a PSA well is drilled

without agreement on apportionment of production to

various tracts.

Litigation on this issue is risky for both parties.

The industry and others are working to obtain action from

the Legislature.

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Browning Oil Company v. Luecke

Lessee create a unit which did not comply with pooling

restrictions.

Lessors sought to nullify the unit and claimed entitlement to

royalty based on 100% of production, regardless of whether

the production came for the Lessors’ property.

Court held that the Lessors were only entitled to royalty from

their specific property.

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Bad Faith Pooling

This is an area that is seeing a slight resurgence, but we

could see more.

New issues are implicated when pooling horizontal wells.

The downturn in the industry could result in a spike in

pooling litigation.

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Part Five: One More Thing

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Be Careful and Know Your Landscape

Be aware of the lease terms.

Be aware of your royalty owners.

Be aware of what you put in your files.

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CHRISTOPHER L. HALGRENMcGinnis Lochridge

711 Louisiana St., Ste 1600

Houston, TX 77002

Direct: 713-615-8539

713-615-8585 FAX

Email: chalgren@mcginnislaw.com

Website: www.mcginnislaw.com

Blog: www.oilandgaslawdigest.com

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