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Important Texas Supreme Court Decision Regarding Deduction of Post Production Costs from Royalties and Free Use of Gas

As a Texas oil and gas attorney, I often find it necessary, when negotiating an oil and gas lease for a client, to add an addendum that modifies some of the terms in the printed lease. The printed lease form is often extremely operator oriented and does not give the mineral owner many rights. Very often, the printed lease will provide for deduction of post-production costs from royalties due to the mineral owner by providing that royalties shall be calculated “at the well”. In the addendum, we often add language that provides that royalty shall be calculated, not on the market value at the well, but instead on the gross proceeds received by the oil and gas operator. The result of that language in the addendum is that post-production costs cannot be deducted from the royalties.

In the recent Texas Supreme Court decision of BlueStone Natural Resources II LLC v. Walker Murray Randle et al, the printed oil and gas lease contained language that indicated that the royalties would be calculated on the market value at the mouth of the well. Prior decisions by the Texas Supreme Court determined that this language allows the well operator to deduct post-production costs. The operator and the mineral owner agreed to an addendum that stated that royalties would be based instead on the “gross value received” by the operator. The addendum also stated that if the addendum was in conflict with the printed lease provisions, then the addendum would control and prevail.

Once production was obtained on the well, the operator proceeded to deduct post-production costs. The mineral owner sued. The operator argued that the “at the well” language is the only lease language providing a valuation point, so nothing in the addendum can be considered contradictory to that portion of the printed lease’s royalty provision.

The Supreme Court disagreed and held that BlueStone’s deduction of post-production costs was improper because there was, in fact, a conflict and the mineral lease explicitly resolves the conflict in favor of the gross‑proceeds calculation.

The operator also claimed a contractual right to “free use” of gas without regard to whether gas is consumed on or off the leased premises so long as the use benefits or furthers the leasehold operations. Specifically, the operator argued that plant fuel and compressor fuel benefits and furthers lease operations and thus falls within the scope of each lease’s free‑use clause.

The Supreme Court disagreed and noted that the lease’s plain language contemplates free use of gas is limited to the leased premises and does not, by express language or otherwise, make any use that “benefits” or “furthers” the lease operations royalty free.

The operator’s arguments in this case were, in my view, pretty unreasonable and destined to fail. It is heartening to see the Supreme Court give effect to the plain language of the addendum in this case.