Fuel Gas and Postproduction Costs after BlueStone
By Christopher M. Hogan, Trial Attorney & Founding Partner, Hogan Thompson LLP
10/13/22 – When the Texas Supreme Court issued its 9-0 decision in BlueStone Natural Resources II, LLC v. Randle, 620 S.W.3d 380 (Tex. 2021), I assumed that there would be an uptick in litigation related to operators’ use of produced gas as fuel. BlueStone examined whether an operator had to pay royalties on gas used as fuel to power operations off-lease based on a lease with a “free-use” clause. The Court rejected the more “pragmatic” approach to free-use clauses taken by courts in New Mexico and North Dakota and instead found that such a clause “does not authorize a royalty-free use of gas off-lease.” BlueStone, 620 S.W.3d at 399. Based on this holding, I assumed quite a few royalty owners would try to seek payment for fuel gas under their lease.
Since BlueStone, however, most of the decisions on fuel gas have gone in favor of the operators. In Carl v. Hilcorp Energy Co., 4:21-CV-02133, 2021 WL 5588036 (S.D. Tex. Nov. 30, 2021) and Fitzgerald v. Apache Corporation, CV H-21-1306, 2021 WL 5999262 (S.D. Tex. Dec. 20, 2021), two Southern District of Texas judges rejected class actions based on the off-lease use of fuel gas. And just last week the San Antonio Court of Appeals in EnerVest Operating, LLC v. Mayfield, No. 04-21-00337-CV, 2022 WL 4492785 (Tex. App.—San Antonio Sept. 28, 2022, no pet. h.) rejected lessors’ attempt to use a free-use clause to trump a provision in a lease that permitted the operator to take postproduction deductions.
In EnerVest, the lease at issue had a royalty provision that set the royalty as the market value of the gas sold at the mouth of the well:
The royalties to be paid by lessee are on gas, including casinghead gas and all gaseous substances, produced from said land and sold or used off the premises or in the manufacture of gasoline or other product therefrom, the market value at the mouth of the well of one-eighth of the gas so sold or used, provided that on gas sold at the wells the royalty shall be one-eighth of the amount realized from such sale.
Id. at *1 (cleaned up) (emphasis added). But the lease also had a free-use clause that read as follows:
Lessee shall have free use of oil, gas, and water from said land, except water from lessor's wells and tanks, for all drilling operations hereunder, and the royalty shall be computed after deducting any so used.
Id. at *2 (emphasis added). EnerVest was using fuel gas to power its compressors and dehydrators as part of processing the gas for eventual sale. Id. at *1. The lessors argued that because EnerVest was not using the gas to support drilling operations, it needed to pay a royalty on the gas. EnerVest argued that it did not have to pay royalties on fuel gas because the lessors “must bear their share of post-production costs, and fuel gas is a post-production cost.” Id. at *2. The trial court agreed with the lessors and granted them summary judgment. EnerVest appealed that decision.
The San Antonio Court of Appeals began its decision by correctly recognizing that a royalty based on market value at the mouth of the well “has a commonly accepted meaning in the oil and gas industry” that “require[s] the royalty holder to share in post-production costs.” Id. at *3. This market value is “determined by subtracting post-production costs from downstream sale proceeds, and as a result, the royalty holder shares in post-production costs.” Id.
With that in mind, the court turned to the question of whether fuel gas is a postproduction cost. Quoting the Fifth Circuit, the court noted that “fuel gas is a processing cost because ‘it is all used to facilitate the production of the gas that is sold,’ and it ‘contributes to the material enhancement of the value of the gas sold.’” Id. at *4 (quoting Piney Woods Country Life Sch. v. Shell Oil Co., 905 F.2d 840, 856–57 (5th Cir. 1990)). Thus, because the lease permitted the lessee to deduct postproduction costs, it did not need to pay a royalty on fuel gas. Id.
The court of appeals then looked at whether the free-use clause affected this analysis. The lessors argued that BlueStone was analogous to their case. In BlueStone, the Texas Supreme Court had required the lessee to pay royalties on off-lease fuel gas because the lease only permitted free use of gas on-lease. Using this framework, the lessors argued that the lessee had to pay royalties on fuel gas not used for drilling operations because the free-use provision only permitted free use of gas for drilling operations. Id. at *4. But the court of appeals rejected this reading, finding that “this construction amounts to an isolated reading of the free-use clause and ignores the plain language in the gas royalty provision, which requires the determination of gas royalty by market value at the mouth of the well.” Id. The key distinction for the Court was that the lease in BlueStone did not permit the lessee to deduct postproduction costs while the lease in EnerVest did permit such deductions. Id.
Finally, the lessors argued that the court of appeals needed to consider the acts of EnerVest’s predecessors as lessee. They argued that “EnerVest's predecessors-in-interest agreed with their interpretation of the gas royalty and free-use provisions and paid them royalty on fuel gas.” Id. at *5. But the Court rejected this argument because the lease was unambiguous and past conduct cannot be used to alter the plain meaning of an unambiguous lease. Id. This lines up with the Texas Supreme Court’s rejection of a similar argument in Burlington Resources Oil & Gas Co. LP v. Texas Crude Energy, LLC, 573 S.W.3d 198, 206 (Tex. 2019) (rejecting “the course of the parties’ performance of the agreements” when interpreting unambiguous assignment of overriding royalty).
EnerVest shows the importance of understanding whether a lease permits postproduction deductions before looking at whether a lessee needs to pay royalties for fuel gas. It also confirms that the Texas Supreme Court’s BlueStone decision when it comes to fuel gas is unlikely to apply to at-the-wellhead leases.
Christopher M. Hogan Trial Attorney & Founding Partner chogan@hoganthompson.com | 713.671.5642
Chris Hogan focuses his litigation practice on resolving complicated disputes for corporate and individual clients, particularly those in the energy industry. Chris has substantial first-chair experience in federal court, state court, and arbitration proceedings. is honored to represent as lead counsel major energy companies such as Apache, BPX, Chevron, ConocoPhillips, Devon, EOG, Marathon Oil, Mewbourne, and Ovintiv.