BlueStone Natural Resources II, LLC v. Randle, 620 S.W.3d 380 (Tex. 2021) held that (1) a lessee improperly deducted postproduction costs while calculating royalty payments because “gross value” and “at the well” language cannot be harmonized within a lease, and (2) an off-lease exchange of gas did not fall within the scope of the lease’s “free-use” clause which was limited to on-lease use. In 2016, BlueStone Natural Resources II, LLC (“BlueStone”) acquired various oil and gas leases. Each lease consists of a form lease (“Printed Lease”) with an attached addendum (“Addendum”). The Printed Lease requires the lessee to pay gas royalties based on “the market value at the well . . . of the gas so sold or used [off the premises].” The Addendum stated that its language supersedes any contrasting language in the Printed Lease, and requires the lessee to pay royalties based on “the gross value received, including any reimbursements for severance taxes and production related costs.” The Addendum additionally stated that royalties “shall be without deduction” of postproduction costs.
BlueStone’s predecessor, Quicksilver Resources, had been paying the gas royalties to the lessors on gross value received without deducting postproduction cost for over a decade. BlueStone changed this practice after it acquired the leases and instead interpreted the Printed Lease and the Addendum as allowing for deduction of postproduction costs, and calculated the gas royalties accordingly, resulting in dramatically lower gas royalty checks to the Lessors. Four groups of lessors (“Lessors”) sued BlueStone for improperly deducting postproduction costs. The Lessors brought additional claims against BlueStone concerning the Printed Lease’s “free-use” clause after discovering BlueStone was not paying royalties on commingled gas used as plant fuel by a third-party processor (“Plant Fuel”) or on commingled gas the processor returned to BlueStone to fuel compressors on and off the leasehold (“Compressor Fuel”). The lower courts ruled in favor of the Lessors, holding that BlueStone cannot deduct postproduction costs. They additionally held that the Lessors are entitled to royalties on Plant Fuel and Compressor Fuel, and the court of appeals awarded damages based on the parties’ stipulations as to the fractional values of commingled gas attributable to the leases. BlueStone appealed, and the Texas Supreme Court granted its petition.
The Court began its analysis by discussing production, which is the process of bringing minerals to the surface, and production of raw gas occurs at the wellhead. A royalty payment may be calculated at the wellhead or at any point downstream, as the parties contractually agree. Here, two royalty provisions are at issue, one specifying “market value at the well” as stated in the Printed Lease and the other as “gross value” received “without deduction” in the Addendum. The parties agreed, the Addendum controls. However, BlueStone argued that the Addendum lacked a “valuation point” so the Printed Lease’s “at the mount of the well” valuation point may be added to the Addendum’s gross value received” without conflict. The Lessors argued that the Addendum language controlled, and the gas royalties were not subject to postproduction costs.
The Court defined “market value” as “the price a willing buyer under no compulsion to buy will pay to a willing seller under no compulsion to sell” (Heritage Res., Inc). The preferred method of determining market value is by using actual sales that are comparable. When comparable market sales are unavailable, “market value” may be determined at a specified valuation by using the “net-back” or “workback” method whereby postproduction costs incurred between the valuation point and the point of sale are deducted from sales proceeds, such as at the wellhead. “Market value at the well” is thus estimated by subtracting postproduction costs between the well and the point of sale from sales proceeds. “Proceeds” or “amount realized” clauses may either refer to the gross amount received or the net amount remaining after deductions, depending on the contract language. Without any modifier, “proceeds” or “amount realized” clauses create a royalty calculation based on the gross amount received, free from postproduction costs, regardless of whether it is more or less than “market value” (Bowden). In Burlington, the Court held that “amount realized at the well” language creates a royalty calculated by subtracting postproduction costs from sales proceeds. “When used in conjunction with ‘amount realized’ or similar language, ‘at the well’ is as much a valuation method as it is a valuation point.”
BlueStone argued that “gross value received” can be melded with the Printed Lease’s “at the well” valuation point to produce a net-proceeds royalty, citing Burlington as support that “at the well” language is a “trump” card, superseding all other language. The Court here disagreed. The Court noted that the royalty provisions in Burlington did not inherently conflict, as “amount realized” clauses can be calculated on the gross amount received or the net amount remaining after deductions. On the other hand, proceeds valued in “gross” can only be evaluated at the point of sale “because that is where the gross is realized or received.” “Gross value” and “at the well” language therefore cannot coexist, which the Court had previously held in Judice. Because the Addendum’s language controls, the Court held postproduction cost deductions were improper.
The Court then turned to the “free-use” clause, which provides BlueStone the free use of gas “in all operations which Lessee may conduct hereunder.” The Court noted that it has never decided a “free-use” clause case before and looked to the Energen opinion for guidance. The Energen court analyzed two groups of leases governed by either New Mexico or Colorado law. The New Mexico leases gave lessors the free use of gas “found on said land for its operations thereon.” The Court held that under New Mexico law, the phrase “operations thereon” in the “free-use” clause is “not a geographical limitation on where the use of the gas may occur but rather a limitation on the purposes for which the gas may be used—furtherance of the lease operations.” The Colorado leases gave lessors the free use of gas “for all operations hereunder.” Under Colorado law, the leases were governed only by contract-construction principles. The Court held that “for all operations hereunder” meant that the use of gas must be for operations in accordance with the lease, and since the purpose of the lease was to produce oil and gas, and store and build infrastructure, on the leased premises, the “free-use” clause functioned as a limitation “to operations that occurred on the leased lands (a geographical boundary).” Because the “free-use” clause here uses similar language as, and has a similar purpose as, the Colorado leases in Energen, the Court held the “free-use” clause does not extend to off-lease uses. The Court held that BlueStone breached the leases by failing to pay royalties on the Plant Fuel, which is used off the leased premises. As to the Compressor Fuel, which is used on and off the leased premises, the Court held that the stipulated value of each lease’s entire fractional share was not a proper measure for damages, as at least some of the comingled gas is used for compressors on the leases which needed to be accounted for, and accordingly reversed and remanded.
Significance
The significance of the case is the Court’s novel ruling on “free-use” clauses and its treatment of such clauses in line with the Energen opinion. The holding additionally adds a new fact pattern and analysis to the existing caselaw concerning treatment of “gross value” and “at the well” royalty clauses when both are present within a lease.
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