Post-Production Cost Deductions and the Lease's Valuation Point

Nettye Engler Energy, LP v. BlueStone Natural Resources II, LLC, 639 S.W.3d 682 (Tex. 2022). Post-Production Costs.

In Nettye Engler Energy, LP v. BlueStone Natural Resources II, LLC, the Supreme Court of Texas affirmed the Second Court of Appeal’s decision that, based on the specific language used in creating the in-kind non-participating royalty interest (“NPRI”) at issue, the royalty interest was free of production costs but burdened by postproduction costs. The Supreme Court of Texas qualified the court of appeal’s decision by noting that the court of appeals had reached the correct result, but misconstrued the opinion in Burlington Resources Oil & Gas Co. v. Texas Crude Energy, LLC, as establishing a rule that delivery “into the pipeline,” or similar phrasing, is always equivalent to an “at the well” valuation point. The Supreme Court clarified that the Burlington Resources opinion merely emphasized that all contracts are construed as a whole to ascertain the parties’ intent from the language they used to express their agreement.

Key Takeaways

1. While most post-production cost cases are fought over language in vintage deeds, if drafting today, be granularly specific about where the valuation point is to occur.
2. Valuation point matters. When parties intend to value the royalty “at the well” – i.e., prior to incurring the various costs to refine and get the product to the point of sale – then postproduction costs can be deducted from the interest. Conversely, where the parties intend for the valuation point to be at the “point of sale,” then such royalty interests will be considered cost-free, in the sense that they are not liable for the various costs required to transport and make marketable products.
3. Burlington Resources did not establish a bright-line rule on valuation point. Valuation point “into the pipeline” does not automatically mean “at the well.” Here, the Texas Supreme Court clarified that it’s decision in Burlington v. Texas Crude did not create such a narrow rule.
4. Valuation point is set by the parties based on their intent, as expressed in the specific deed in question. When reviewing a ‘cost-free’ royalty provision, or any unambiguous deed provision, the court will use established principles of deed construction to determine the valuation point based on the language of the parties in the case at hand.
5. General rules only apply where the parties are silent. Parties are free to define their contractual relationship in any way that is not criminal or tortious – the parties’ written agreement will take precedence over general rules of construction.
6. The Texas Supreme Court reaffirms three principles:
   
   • Four Corners Rule Is Alive & Well - The court’s objective in any deed interpretation case is to determine the intent of the parties as expressed in the writing itself. The entire writing will be considered, with an attempt to harmonize all provisions so that none are rendered meaningless.
   • No Bright-Line Rules - While there are general guidelines for deed/instrument interpretation (e.g., “at the well,” etc.), courts must enforce agreements as the parties intended.
   • Intent - Intent is determined based on language actually used by the parties to the deed, as well as supporting contextual information where necessary.

Origin of the Dispute

The dispute originated from a 1986 conveyance of land in Tarrant County in which the predecessors of Nettye Engler Energy (“Engler”) reserved a 1/8 NPRI (“1986 Deed”). The 1986 Deed provided that the grantors reserved “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 … .”

In 2004, BlueStone’s predecessors leased the land and drilled numerous producing gas wells. The gas was collected from the wellhead by a network of onsite gathering system pipelines. From here, the gas was compressed, processed, transported, and sold to a third-party gas-purchaser’s pipeline system. Thus, from the time the gas was gathered into the gathering system, the operator incurred various post-production costs to treat, compress, and transport the gas to the point of sale. Severance taxes were also imposed.
Initially, Quicksilver credited the NPRI as free of all postproduction costs and paid accordingly. That is, Quicksilver placed the valuation point from a post-production cost perspective at the point of sale to the third-party pipeline system and did not charge the NPRI with its proportionate share of costs incurred before this point. Rather, Engler was paid a proportionate share of the gross proceeds from the downstream sales of processed gas to third-party purchasers. In 2016, BlueStone acquired the operating rights for the wells from Quicksilver. Unlike Quicksilver, BlueStone interpreted the valuation point under the deed in question as being at the point gas entered the gathering system. As such, BlueStone assessed the NPRI with its proportionate share of all costs incurring after the gas entered the gathering system. In sum, while Quicksilver treated the NPRI as a true cost-free royalty interest, BlueStone treated the NPRI more akin to a standard NPRI free from production costs but subject to virtually all post-production costs, or at the least, all costs after the gas entered the gathering system. [Recall the Texas general rule in Heritage Res., 939 S.W.2d at 121-22, providing that royalties are subject to post-production costs unless the contracting parties agree otherwise.]

Restated, BlueStone – pursuant to its different interpretation of the 1986 Deed – changed the gas valuation point, moving it from the mouth of the third-party distribution pipeline (i.e., at the point of actual sale), much further upstream to the mouth of the onsite gathering system pipelines. Under this new, more self-serving interpretation, BlueStone paid royalties to Engler based on the relatively lower value of raw gas as it entered the gathering system pipeline attached to the well, rather than as a percentage of the gross value of the more valuable treated, processed, compressed, and transported gas at the point of sale.

Specifically, Engler suffered a diminution in value because, as opposed to Quicksilver having paid Engler a percentage of the gross value of the treated and transported gas at the point of sale without consideration for the severance taxes, BlueStone now netted out Engler’s proportionate share of all postproduction costs incurred from the time the gas entered the gathering system to the time the gas arrived at the point of sale. That is, Engler now paid its proportionate share of costs related to delivering the gas to market, namely costs for transportation, gathering and compression, regulatory fees, and severance taxes. After learning that BlueStone was deducting these postproduction costs from their royalty interest, Engler sued.

Trial Court

On cross-motions for summary judgment, the trial court found in favor of Engler, ruling that BlueStone should not have deducted at least some of the postproduction costs. However, a few days after delivering the ruling, the Supreme Court of Texas issued its opinion in Burlington Resources which addressed language similar to that in the 1986 Deed. In Burlington Resources, the Supreme Court of Texas held that the deed language requiring delivery “into the pipeline, tanks or other receptacles to which any well or wells on such lands may be connected” was analogous to an “at the wellhead” valuation point (thus tracking with BlueStone’s argument). BlueStone moved that the trial court reconsider the case in light of Burlington Resources, but the court refused and an appeal followed.

Second Court of Appeals

On appeal, the Second Court of Appeals reversed and rendered judgment for BlueStone. The court viewed Burlington Resources as establishing a rule that the language “into the pipeline” is equivalent to and creates a valuation or delivery point “at the wellhead or nearby.” Based on this understanding of the Burlington Resources opinion, the court of appeals concluded that the 1986 Deed’s language – “free of cost in the pipeline, if any, otherwise free of cost at the mouth of the well or mine” – creates a delivery point at the well. The court of appeals rejected Engler’s argument that a gathering system is not a pipeline on the grounds that gathering pipelines are recognized and regulated as pipelines under Texas law. Engler then petitioned the Supreme Court of Texas to review the court of appeals’ decision.

Petition for Review

In its petition for review to the Supreme Court of Texas, Engler attacked the court of appeals’ construction of Burlington Resources, claiming that the court adopted a rule divorced from contractual context. Engler contended that the 1986 Deed, properly construed, sets the delivery point at the transportation pipelines.

BlueStone defended the court of appeals’ construction of Burlington Resources and the 1986 Deed, advancing the same arguments it asserted in the trial court.

Analysis

On review, the Texas Supreme Court essentially narrowed the question before the court as to where the parties intended the valuation point to be for a post-production cost analysis: did the parties intend to value the gas (i.e., set the valuation point) at the beginning of the value chain (gathering system) or the end of the line (at the point of sale. Specifically, whether under the language of the 1986 Deed a gathering system is a pipeline for purposes of assessing costs.

The court concluded that the gathering system is a pipeline into which delivery may be made under the 1986 Deed because (1) a gathering pipeline is a pipeline in the ordinary industry and regulatory meaning of the term; (2) case law confirms that it is not uncommon for delivery of a royalty interest to be made into a “pipeline … to which the well is connected,” rather than a downstream location; (3) the deed does not distinguish such a gathering system pipeline from the usual meaning of the term ‘pipeline’ or specify any particular type of pipeline; and (4) the inclusion of a default delivery location at or near the wellhead does not negate a wellsite delivery point but, instead, confirms it.

In reaching this holding, the Texas Supreme Court very plainly laid out its decision-making process (which, in HELG’s opinion, is the real value of this decision. If you are unsure of what conclusion to reach in any situation, it is always best to first start with principles and apply those rules to the facts at hand. Issue / Rule / Application / Conclusion. Here, the Texas Supreme Court make clear how it will decide an issue of first impression). Before visiting the specific issue, the court laid out the process of deed interpretation and the law on document ambiguity - just in case you haven’t read any case law, textbooks, or secondary resources in the past 467 years.

Deed Construction 101

Deeds are interpreted as contracts and thus, the standard rules of contract interpretation apply. The main purpose of deed construction is to determine the intent of the parties as contained in the writing itself, based on the express language used. The court will look at the entire writing and harmonize the provisions so that each part is given effect, as the court will presume that the parties intentionally included each provision. Words will be given their plain and ordinary meaning unless this would clearly defeat the parties’ intent or the instrument shows that the parties used the terms in a different or technical sense.

Deed Ambiguity – The Ambiguously Unclear Duo

Ambiguity is present when a deed is subject to two or more (get it, duo) reasonable interpretations, which gives rise to a fact issue as to the parties’ intent. Whether a deed is ambiguous is a question of law for the court, not a question of fact for the jury. If a deed is determined to be unambiguous, then the document will be construed as a matter of law and enforced as written.
When the court is construing an unambiguous deed, it is allowed to consult facts and circumstances surrounding its execution but is not free to consider such facts and circumstances that would change the plain meaning, or that would go to show that the parties probably meant or could have meant, something other than what they said.

Determining the Valuation Point

The court relied on ordinary industry definitions to determine that (1) a gathering pipeline is a pipeline in the ordinary industry and regulatory meaning of the term. The court noted that the Williams & Meyers dictionary of oil-and-gas terms defines “pipeline” as: “a tube or system of tubes used for the transportation of oil or gas.” The court further noted that types of oil pipelines include gathering lines extending from lease tanks to a central accumulation point. The court explained that a gathering system generally consists of “interconnected subterranean natural gas pipelines and related compression facilities that collect the raw gas from wells and deliver it to a central point, such as a processing plant.”

The court next analyzed a North Dakota Supreme Court decision to establish that (2) case law confirms it is common for delivery of a royalty interest to be made into a pipeline to which the well is connected. In Blasi v. Bruin E&P Partners, LLC, the royalty owner argued, much like Engler, that “pipeline” as contemplated by the lease, meant “a pipe used to transport oil to a refinery … not a pipe between the wellhead and the tank battery to move oil a few feet.” The North Dakota Supreme Court rejected the argument, concluding that the provision, by its language, did “not designate a specific type of pipe as the ‘pipeline.’”

Finally, the Supreme Court launched an inquiry into whether the language in the 1986 Deed prohibited the valuation point at or near the well. Here, the court flatly rejected Engler’s argument that the deed language negated a construction of “pipe line” as being a pipeline in close proximity to the well. The court explained that to construe the deed as referring to a particular pipeline located off the premises would require adding additional words to the deed. If the parties had intended to more narrowly define the valuation point this way, they could have; but they didn’t. Accordingly, the court determined that (3) the deed does not distinguish the term pipeline from the usual meaning of the term so as to specify any particular type of pipeline, and (4) the inclusion of a default delivery location at or near the well head does not negate a wellsite delivery point.

Notably, the court found it telling that transportation pipelines were in existence at the time the deed was executed but were not mentioned in the deed. Moreover, the nonexistence of a gathering pipeline suggested that the parties intended for delivery to occur into the pipelines on the wellsite, rather than an intent to establish a downstream delivery point that would result in a markedly different royalty calculation.

Implications of Royalty Valuation Point

The key fight in this case was over where the royalty interest was valued for royalty payment purposes. Put simply, when gas is valued “at the well,” it is worth less because it still must be transported to the point of sale, which involves a host of processes – e.g., dehydrating, physical transportation, etc. – which incur various costs. Think of gas at the well as a raw good. In contrast, when gas is valued at the point of sale, it has a higher value. Gas at the point of sale is worth more because the gas has been transported to the end-user and has undergone various value-enhancing processes. Gas at this point is more akin to a finished good. If gas is valued at the well (and thus, royalties are calculated based on the value at the well), then the royalty owner is subject to the proportionate share of the various costs that must be incurred to turn the raw good into a finished good. On the other hand, if the royalty owner’s share of royalty is calculated based on the amount received at the point of sale, then the royalty owner avoids these additional costs.

Holding

The Supreme Court of Texas ultimately affirmed the Second Court of Appeals, ruling that the particular NPRI “free of costs in the pipeline” as defined here was free of production costs but burdened by post-production costs. It is important to note that while the Court reaffirmed its holding in Burlington, it also made clear that the language in the deed/instrument at issue will be outcome determinative. No bright line rules created here, just the broader guidelines. In that sense, Nettye Engler Energy, LP is the latest chapter in a seemingly never-ending struggle between Lessors and Lessees over the allocation of post-production costs.

One of the most important points in this case is that while the Texas Supreme Court will look first to principles of deed construction, when necessary, the court continues to reiterate that parties are free to contract however they see fit and will seek to apply the rules as the parties have defined them based on the express language used in their deeds.  

For a more detailed insight into the 2022 Texas Oil & Gas Case Law Update, download the HELG paper.