Limits to “Add-Back” Claims on Post-Production Costs

By Christopher Hogan, Trial Attorney & Founding Partner, Hogan Thompson LLP

When it comes to litigation over post-production costs for oil and gas, one of the most discussed aspects is the “add-back” claim. After a recent North Dakota Supreme Court decision and a Texas Court of Appeals decision on the issue, I assumed that lessors and other royalty owners would be taking more aggressive positions on add-back claims. But the Fort Worth Court of Appeals’ decision in Shirlaine West Properties Ltd. v. Jamestown Resources, L.L.C., 02-18-00424-CV, 2021 WL 5367849, at *1 (Tex. App.—Fort Worth Nov. 18, 2021, no pet. h.) shows the limit of these claims.

Add-Back Claims

If you are not familiar with an add-back claim, picture a gross-proceeds lease where the lessor gets paid based on money that an operator receives for gas. The operator might have paid a pipeline company—Pipeline Inc.—to transport the gas from the lease to a pipeline and then paid for Pipeline Inc. to process the gas for sale to a third party. In a typical gross-proceeds situation the operator would not have been able to deduct those post-production costs from the lessor’s royalty. 

So instead, the operator sells the gas to Pipeline Inc. at the well, and Pipeline Inc. processes and transports the gas to the point of sale to the third party. Pipeline Inc. then pays the operator based on the eventual sales price of the gas to the third party, minus a fixed percentage or cost based on the expense of transportation and processing. Now when the operator pays the lessor its share of the proceeds it will get from Pipeline Inc., those proceeds will be less than they would have been had the operator paid Pipeline Inc. to transport and process the gas outside of this arrangement.

An add-back claim is a demand that the operator, when calculating royalty payments to the lessor, adjust the payment upward to account for these third-party expenses. Essentially, the lessor demands a higher royalty than one based solely on the operator’s gross proceeds. 

The example above is a simple one. But add-back claims get more suspect the more you think about them. In our example above, what if Pipeline Inc. sells the gas to a trading house, which then sells it to an LNG exporter, which then transports the gas to Japan and sells it to a utility, which then sells it to its customers. Does the lessor get a royalty based on the (much higher) sales price in Japan? Such a scenario shows some of the conceptual problems with add-back claims.

Recent Add-Back Cases

In the last two years, courts have handed down two important decisions on this issue.[1] First, in Newfield Exploration Co. v. State, 931 N.W.2d 478 (N.D. 2019), the North Dakota Supreme Court examined an add-back claim related to a gross-proceeds leases. The lessee, Newfield, sold its gas to Oneok for processing and transportation. While Oneok took title to the gas before processing, it did not pay Newfield for the gas until after the processing was complete and Oneok had sold the gas to a third party. When Oneok did pay Newfield, it paid about 70-80% of the price Oneok received from the third party, with the 20-30% reduction used to cover processing costs. 

Newfield paid the lessor (the State) based on the money that it received from Oneok and argued that this payment was the “gross proceeds” that it had received. But the state said that it should be paid on the price that Oneok received. Both sides agreed that had Newfield processed the gas itself, or paid Oneok directly to process the gas for it, those costs would not have been deductible. And the language in the lease said that the state was to be paid based on “all consideration” in any form. Newfield, 931 N.W.2d at 481. The Court found that Newfield benefitted from Oneok’s expenditures incurred in processing of the gas and this benefit had to be considered in the royalty payments. Thus, Newfield had to account for this benefit under the leases. Id. Accordingly, “[g]ross proceeds from which the royalty payments under the leases are calculated may not be reduced by an amount that either directly or indirectly accounts for post-production costs incurred to make the gas marketable.” Id.

The second case is Devon Energy Production Co. L.P. v. Sheppard, 13-19-00036-CV, 2020 WL 6164467 (Tex. App.—Corpus Christi Oct. 22, 2020, pet. filed). The leases at issue in the case had a detailed provision—paragraph 3(c)—that the lessor-plaintiffs argued covered add-back claims:

If any disposition, contract or sale of oil or gas shall include any reduction or charge for the expenses or costs of production, treatment, transportation, manufacturing, process or marketing of the oil or gas, then such deduction, expense or cost shall be added to the market value or gross proceeds so that Lessor’s royalty shall never be chargeable directly or indirectly with any costs or expenses other than its pro rata share of severance or production taxes.

Devon, 2020 WL 6164467, at *2. The case started when the lessor noted that oil and gas sold under the lease had an $18/barrel “reduction” that was attributed to “gathering and handling, including rail car transportation.” Id. Ultimately, twenty-three issues were identified for the court as possibly falling under paragraph 3(c).

The appellant-lessees hewed quite closely to the argument that the lease was “an ordinary gross proceeds clause” and that because the lessors received their gross proceeds from sales of oil and gas that was the end of the story. They noted that they took no deductions from the gross-proceeds price, per the lease. The lessors argued that the lease was a gross-proceeds lease with the royalty calculation needing another adjustment based on any reduction or charges from the royalty, even if those reductions or charges were incurred by a third party and then passed through to the lessee. 

The court agreed with the lessors, noting that the lease was a gross-proceeds lease but that paragraph 3(c) “expressly contemplates the addition of certain sums to gross proceeds in order to arrive at the proper royalty base.” Id. at *11. It also noted that the lessees’ reading would render 3(c) superfluous, as earlier paragraphs had already established that the lease was a gross-proceeds lease and thus paragraph 3(c) was unnecessary for that. The court then went through different costs that the lessee incurred and grouped them into costs that needed to be added-back versus those that did not.

Newfield and Devon likely have limited precedential impact—at least in Texas. Newfield is, of course, not under Texas law and has been critiqued as essentially importing the first-marketable-product rule into North Dakota. I do not think Texas courts will find this out-of-jurisdiction case with thin legal reasoning to be very persuasive. No court outside of North Dakota has cited the case in the more-than-two years since it was decided. And Devon is dependent on what the court called “highly unique royalty provisions.” I have not run across language like paragraph 3(c) very often in Texas, and I do not think lessors’ efforts to use Devon to claim add-back damages under garden-variety no-deduction leases will work.

Shirlaine West Properties Ltd. v. Jamestown Resources, L.L.C.

With cases like Newfield and Devon making waves, it was only a matter of time before more lessors tried to incorporate add-back claims where they do not really fit. Shirlaine West Properties Ltd. v. Jamestown Resources, L.L.C., 02-18-00424-CV, 2021 WL 5367849, at *1 (Tex. App.—Fort Worth Nov. 18, 2021, no pet. h.) appears to be a good example of such a situation. 

The case stems from a 2010 lease between Shirlaine and Chesapeake Exploration (“Chesapeake”). The lease at issue provided for a royalty that was “25% of the market value at the point of sale, use or other disposition of all such gas” and noted that “[t]he market value of all gas shall be determined at the specified location and by reference to the gross heating value (measured in British thermal units) and quality of the gas.” Id. at *1. The lease also contained no-deductions language and a Heritage disclaimer. Id. Finally, the lease had a provision (the “Add-Back Provision”) about the possible add-back of deductions:

If Lessee realizes proceeds of production after deduction for any expenses of production, gathering, dehydration, separation, compression, transportation, treatment, processing, storage or marketing, then the proportionate part of such deductions shall be added to the total proceeds received by Lessee for purposes of this paragraph.

After execution of the lease, Chesapeake assigned some of its interest to Total E&P USA, Inc. (“Total”). Both Chesapeake and Total sold their gas at the wellhead to affiliates. While the mechanics of how those affiliates then sold the gas differed, the result was that both lessees received sales proceeds reduced based on post-production costs that the affiliates incurred in processing and/or marketing the gas. 

The lessors sued claiming that post-production costs were not permitted under the lease. The court first examined the key questions of the measure of value and the location of that valuation. Based on the lease language, the court held that the lease “fix[es] market value as the measure of value and set[s] the location of the value at the point of sale.” Id. at *6. Because the point of sale was the wellhead, the lessees had a right to take post-production deductions even though that sale was to an affiliate. Citing Justice Owen’s concurrence in Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996), the court also rejected the no-deductions language as “surplusage, or restatements of existing law.” Id. And the court rejected the Heritage disclaimer based on the Texas Supreme Court’s rejection of similar language in Chesapeake Exploration, L.L.C. v. Hyder, 483 S.W.3d 870 (Tex. 2016). Each of these holdings by the court was a rather straightforward application of Texas caselaw on post-production costs. 

But the lessors claimed that the Add-Back Provision presented the court with a new twist: 

Lessors contend that by Lessees selling the gas to [their affiliates] with postproduction costs deducted from the purchase price, Lessees realize proceeds after deduction for expenses identified in Sentence 7, and Lessors are therefore entitled to have these expenses added back into the “total proceeds” to be used for calculating royal.

Id. at *7. The court, however, rejected this argument. It found that such a reading would “create an internal conflict [with] the market-value-at-the-well provisions” and “effectively convert a market-value-at-the-well lease into a ‘total proceeds’ lease.” Id. While the court left open the possibility that the Add-Back Provision might apply if sales had not occurred at the wellhead, the court determined that the lessors’ attempt to use the provision to eliminate post-production cost deductions conflicted with the rest of the lease. 

I hope that Shirlaine West Properties Ltd. will be the first in a line of cases that reject an expansive use of add-back provisions. While some leases—like those in Devon—use bespoke language to cover add-back claims, most do not. Attempts to use generic lease language to back-door in the results from Devon or Newfield are unlikely to succeed if Shirlaine West Properties Ltd. is any guide.