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Texas Court Holds Participating Oil and Gas Lessee Co-Tenant Owes No Royalties to the Nonparticipating Co-Tenant’s Lessors

The recent case of Devon Energy Production Co. v. Apache Corporation, Case No. 11-16-00105-CV (Tex.Civ.App.- Eastland 2018, pet. filed) addressed a novel question under Texas law about whether an oil company cotenant owed royalty payments to the other co-tenant oil company’s lessors. The trial court said no and the Court of Appeals affirmed.

In Devon Energy, a part-owner — Norma Jean Hester — of a certain mineral interest under lands located in Glasscock County leased her interest to Apache Corporation. The other part-owners (having the remaining two thirds of the ownership) leased their interest to Devon Energy Production Company. Hestor and the other lessors reserved royalty payments of 25% under the two separate leases.

The legal effect of two leases covering the entirety of a mineral estate was to create a co-tenancy relationship between Apache and Devon. This is because, under Texas law, a typical oil and gas lease conveys the mineral estate (less those portions expressly reserved, such as royalty) as a determinable fee. When two production companies share ownership over the same mineral estate, they become co-tenants.

Texas law imposes on mineral estate co-tenants both rights and obligations. Among the most important right is the right to extract any oil, gas, and minerals from the common property without first obtaining the consent or permission from the co-tenant(s). But a corollary obligation is imposed which is that the extracting/producing co-tenant must account for and pay to the other nonparticipating co-tenant(s) the value of any minerals taken, less the necessary and reasonable costs of production and marketing.

In this case, Devon and Apache tried to jointly develop the mineral estate, but were unable to come to agreement. Thereafter, Apache — Hester’s lessee — drilled several producing oil and gas wells and eventually paid Devon its two-thirds share of the net revenue. Devon, however, did not pay royalties to its lessors.

Devon’s lessors brought suit against Devon and Apache. The claim against Apache was that Apache should have paid royalties to Devon’s lessors. Apache defended by saying that it did not owe royalties to the Devon lessors because Apache did not have a lease with them. The Devon lessors argument was based on subsection (1) of section 91.401, et seq., of the Texas Natural Resources Code which defines “payee” as “any person or persons legally entitled to payment from the proceeds derived from the sale of oil or gas from an oil or gas well located in this state.” The Devon lessors argued that they were “payees” under the statute. Section 91.402(a)also states that: “The proceeds derived from the sale of oil or gas production from an oil or gas well located in this state must be paid to each payee by payor on or before 120 days after the end of the month of first sale of production from the well.”

At the trial level, various cross-summary judgment motions were filed. In all respects, the trial court ruled in favor of Apache holding that Apache was not a “payor” with respect to the Devon lessors as “payees” and that § 91.402 did not impose on Apache any obligation to pay royalties to Devon’s lessors. In other words, the payor-payee relationship was between Apache and Devon (and between Apache and Hester). According to the trial court, the payor-payee relationship was created by the leases. For Apache, the Devon lessors are not “payees” with respect to Apache because Apache never entered into a legally binding relationship with them.

The Court of Appeals affirmed the trial court’s summary judgment rulings. In affirming the trial court, the Court of Appeals rejected the reasoning of Prize Energy Res., L.P. v. Cliff Hoskins, Inc., 345 S.W.3d 537 (Tex.Civ.App.-San Antonio 2011, no pet.). In Prize Energy, among the many plaintiffs was (i) Cliff Hoskins, Inc., a 25% owner of the relevant mineral estate and (2) BP American Production Co. (“BP”) who deeded to Hoskins its 25% ownership of the mineral interest holding back a 6.75% NPRI. In Prize Energy, there was only one well operator — a partnership combination of sorts between Prize Energy Group and Rutherford Oil Production Company (“Prize/Rutherford”). A dispute arose and both Hoskins and BP sued Prize/Rutherford under many legal theories including alleged violation of the Natural Resources Code for failure to pay certain royalties. After a jury trial, both Hoskins and BP were awarded damages under Section 91.402. On appeal, Prize/Rutherford argued that it did not owe royalties to BP because they did not have a lease or other contractual relationship with BP (only with Hoskins). This was rejected. The Prize Energy court held that BP was a “payee” under § 91.401 and that § 91.402 obligated Prize/Rutherford to pay BP its royalties.

In the Devon case, the Court of Appeals distinguished Prize Energy because BP’s royalty was a NPRI whereas the Devon lessor’s royalty was a royalty interest reserved by a lease. The Court explained that an NPRI is “tied to the land” and as such, the court stated that “… BP was a payee as soon as someone drilled a producing well on the land.” By contrast, if the royalty right flows from a lease, the “payor/payee” relationship is based on the lease.

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