The Effects of Burlington Resources Begin to Be Felt in Texas Royalty Jurisprudence

Last year, the Texas Supreme Court issued Burlington Resources Oil & Gas Co. LP v. Texas Crude Energy, LLC, 573 S.W.3d 198 (Tex. 2019), probably the Court’s most important oil and gas royalty decision since its landmark decision in Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996). One of the big takeaways I took from the case was that the Court seemed to equate “into the pipeline” with “at the wellhead,” at least when it comes to post-production costs. In my update on the case last year, here is the number one takeaway I thought operators should take from Burlington Resources:

We are finally starting to see cases percolate through the court system that look at Burlington Resources and its impact on Texas royalty cases. Two major cases have recently come out of the same court—the Fort Worth Court of Appeals—and involved the same operator—BlueStone Natural Resources II, LLC. The first case is BlueStone Natural Resources II, LLC v. Randle, 601 S.W.3d 848 (Tex. App.—Fort Worth 2019, pet. granted), a surprisingly thorough court of appeals decision on post-production costs. But the Texas Supreme Court recently heard oral argument on this issue, and I’ll wait until that Court issues its opinion before commenting in-depth on that case.

The second case, BlueStone Natural Resources II, LLC v. Nettye Engler Energy, LP, 02-19-00236-CV, 2020 WL 3865269 (Tex. App.—Fort Worth July 9, 2020, pet. filed), may not similarly make it before the Texas Supreme Court, but it could impact Texas royalty litigation too. Fortunately, the decision proves to be favorable to oil and gas operators.

Like most Texas royalty disputes, this case revolved around whether a lessee (Bluestone) could take deductions for post-production costs, namely transportation, gathering and compression, regulatory fees, and severance taxes. When the lessor (Engler) found out that Bluestone was taking deductions for these costs, it filed the lawsuit. The applicable royalty provision is below (emphasis mine):

Grantor hereby excepts and reserves unto itself, its heirs, successors and assigns, an undivided one-eighth nonparticipating (1/8th) royalty interest in and to all of the oil, gas and other minerals on, in and under the Subject Property. Grantee . . . shall have the exclusive right ... to drill for and produce oil, gas and other minerals from the Subject Property and the exclusive power and right to execute oil and gas and other mineral leases covering the interest hereby excepted and reserved and to receive and keep any bonus, delay rental or any other payment other than royalty paid by any such lessee, provided that . . . Grantor . . . shall be entitled to receive from Grantee . . . and from any one else producing any oil, gas or other mineral, a free one-eighth (1/8) of gross production of any such oil, gas or other mineral said amount to be delivered to Grantor's credit, free of cost in the pipe line, if any, otherwise free of cost at the mouth of the well or mine. . . .

On cross-motions for summary judgment, the trial court granted judgment in favor of Engler, finding that the lease did not permit post-production costs. But a few days after that decision, the Texas Supreme Court issued its Burlington Resources case. Bluestone asked the trial court to reconsider, but the trial court refused, and an appeal ensued.

The lease language at issue is interesting because it features phrases from the Texas Supreme Court’s two most-recent post-production cost decisions. Like in Burlington Resources, the lease noted that oil and gas would be delivered “in the pipeline,” which the Court said fixes the valuation point at the wellhead. See Burlington Resources, 573 S.W.3d at 211. This means the lessee can take post-production costs. Id. But the lease also stated that the oil and gas is to be delivered “free of cost” at that location. This “free of cost” language is similar to the language at issue in Chesapeake Expl., L.L.C. v. Hyder, 483 S.W.3d 870 (Tex. 2016). In Hyder, the Court looked at a lease that included a “cost-free” overriding royalty. In a 5-4 decision, the Court held that the lease did not permit the lessee to deduct post-production costs for that overriding royalty interest.

Not surprisingly, the parties disagreed about which case controlled: Bluestone said Burlington Resources while Engler said Hyder. The court of appeals agreed with Bluestone. The court correctly noted that Burlington Resources “did in fact focus heavily on the singular phrase ‘into the pipeline,’” which is quite similar to the lease language in question. The court also rejected Engler’s argument that the gathering system to which the well initially flowed was not a “pipeline,” noting that the Texas Supreme Court and numerous other courts or statutes referred to gathering systems as a pipeline.

 Finally, the court tackled the question of whether Hyder applied. Digging into the case, the Court noted that the holding in Hyder was based not only on the “cost-free” language but also what followed it: “(except only its portion of production taxes) . . . .” The court of appeals noted that the Hyder Court found this language to be key to its decision:

The court reasoned that although the use of the term “‘cost-free’ may simply emphasize that the overriding royalty is free of production costs,” in the case of the Hyder provision, that could not be the case because “cost-free” had the parenthetical expressing a postproduction cost. As the Hyder court stated, “The [parenthetical] exception for production taxes, which we have said are postproduction expenses, cuts against Chesapeake's argument. It would make no sense to state that the royalty is free of production costs, except for postproduction taxes (no dogs allowed, except for cats).”

The court of appeals noted that the lease in question did not contain any such language and thus did not “specifically exempt postproduction costs.” It also reviewed other portions of the lease and found that “free” was used in the lease to note that the override was free of production costs but not post-production costs.

I think the court of appeals reached the right decision. I’ve often felt that some read Hyder too broadly by saying that references to phrases like “free of cost” always mean lessees cannot deduct post-production costs. In reality, Hyder was a narrow decision from a split court that relied heavily on parenthetical language I have not encountered much when reviewing leases. Bluestone should give oil and gas lessees more support when they encounter broad Hyder readings in their future cases.