Court Opinion

ID: 9378688
Source: CourtListenerOpinion
Date Created: 2023-03-12 14:05:50.221219+00
Date Added: 2024-06-11T17:15:38.813327
License: Public Domain

Supreme Court of Texas
                           ══════════
                            No. 20-0904
                           ══════════

  Devon Energy Production Company, L.P., f/k/a GeoSouthern
 DeWitt Properties, LLC, BPX Properties (NA) LP, GeoSouthern
     Energy Corporation, and BPX Production Company,
                             Petitioners,

                                   v.

                    Michael A. Sheppard, et al.,
                             Respondents

   ═══════════════════════════════════════
               On Petition for Review from the
     Court of Appeals for the Thirteenth District of Texas
   ═══════════════════════════════════════

      JUSTICE BLACKLOCK, dissenting.

      This Court recently observed that “allowing the holder of an ‘at
the well’ royalty to escape his responsibility for post-production costs
would improperly convert the royalty interest from a royalty on raw
products at the well to a royalty on refined, downstream products.”
BlueStone Nat. Res. II, LLC v. Randle, 620 S.W.3d 380, 392 (Tex. 2021)
(quoting Burlington Res. Oil & Gas Co. v. Tex. Crude Energy, LLC, 573
S.W.3d 198, 205 (Tex. 2019)). In my view, the Court’s decision today
commits a similar error. It allows the holder of a “gross proceeds”
royalty to convert his interest from a royalty on the products at the point
of initial sale into a royalty on more fully refined products sold by third
parties at a downstream market center. The parties’ agreement, as I
understand it, does not support this outcome. I therefore respectfully
dissent.
      The most relevant portions of the parties’ agreements are
Paragraph 3 of the Lease and Addendum L. There is no dispute that
Paragraphs 3(a) and 3(b) establish a conventional “gross proceeds”
royalty, under which “the royalty is to be based on the gross price
received by [the lessee].” Judice v. Mewbourne Oil Co., 939 S.W.2d 133,
136 (Tex. 1996). “When proceeds are valued in ‘gross,’ . . . the valuation
point is necessarily the point of sale because that is where the gross is
realized or received.” BlueStone, 620 S.W.3d at 391.
      There is also no dispute, at least in this Court, that Devon Energy
paid the royalties described by Paragraphs 3(a) and 3(b), which are
“gross proceeds” royalties calculated based on Devon’s proceeds from its
initial sale of products to a third party. The royalty holders nevertheless
claim that Paragraph 3(c) of the Lease, combined with Addendum L,
overrides the “gross proceeds” royalty and obligates Devon to pay
royalties based on downstream prices at market centers rather than
based on Devon’s gross proceeds. The Court agrees, relying heavily on
Paragraph 3(c), which provides:
      If any disposition, contract or sale of oil or gas shall include
      any reduction or charge for the expenses or costs of
      production, treatment, transportation, manufacturing,
      process or marketing of the oil or gas, then such deduction,
      expense or cost shall be added to the market value or gross
      proceeds so that Lessor’s royalty shall never be chargeable

                                     2
       directly or indirectly with any costs or expenses other than
       its pro rata share of severance or production taxes.
       Paragraph 3(c) cannot bear the weight the Court puts on it.
Rather than read Paragraph 3(c) to altogether change the nature of the
“gross proceeds” royalty created by the previous two paragraphs, I
understand Paragraph 3(c) (and Addendum L) as an attempt to ensure
that neither a clever lessee nor a wayward court will deprive the royalty
holder of the full benefit of its cost-free “gross proceeds” royalty.
       Paragraphs 3(a) and 3(b) provide essential context for what
follows.   Under the applicable portions of Paragraph 3(a), the oil
royalties are calculated based on the “market value” of the oil produced,
“such value to be determined by . . . the gross proceeds of the sale
thereof.” The gas royalties are likewise calculated based on “the gross
proceeds realized from the sale of such gas.” In either case, the royalty
holder is entitled to a 1/5 share of whatever value the product has at the
point of its initial sale by Devon. That value is determined based on the
“gross proceeds” of Devon’s initial sale, 1/5 of which belongs to the
royalty holder.
       With such a royalty—on the value of the product at its point of
initial sale by Devon—already established, the agreement proceeds to
Paragraph 3(c).     That provision only applies “[i]f any disposition,
contract or sale of oil or gas shall include any reduction or charge for the
expenses or costs of production . . . .” So the first question is whether
the sales at issue in this appeal included any such “reduction or charge.”
They did not. The sales at issue are Devon’s initial sales to third parties,
and these sales contained no “reduction or charge for the expenses or
costs of production.” They were arms-length transactions, and the buyer

                                     3
paid a freely agreed price that reflected the value of the product at the
point of sale. Nothing was “reduced” or “charged” from that amount “for
the expenses or costs of production.” In determining the price for these
sales, Devon did not identify a market price for the products in their
current form and then subtract a “reduction” or a “charge” for
already-incurred production expenses. Instead, it sold the products in
their current form for a price the market would bear for such products,
and it paid the royalty holders 1/5 of that price.         This transaction
involved no “reduction” or “charge” for production costs that reduced
either the proceeds received by Devon or the royalty received by the
royalty holders.
       The confusion arises only because of how the price Devon charged
was calculated. To identify a fair price for products that were not yet
ready for market, Devon and its counterparty subtracted estimated
future production costs from the published “market-center” prices for
more refined products. The result of this formula yields the market
value of the products at their point of initial sale, or so the parties to the
sale agreed. The royalty holders are then entitled to 1/5 of that value,
with no reduction for production costs, which is what Devon paid.
       The royalty holders and the Court, however, seize on Devon’s
method of calculating the value of the products at their point of initial
sale. They view the subtraction of future costs from the market-center
price as the “reduction” or “charge” envisioned by Paragraph 3(c). This
misperceives what is happening. The royalty is on the value of the
production at the point it is first sold. The market-center price only
came into the picture as a mechanism for calculating the value in which

                                      4
the royalty holders share.    Nothing in the agreements entitles the
royalty holder to receive a royalty based on the market-center price just
because Devon happened to use that price as a way to calculate the
product’s value at its point of initial sale. It is only that value—at the
point of initial sale—in which the royalty holder shares under these
agreements.
      The strange result of the Court’s approach is that the royalty
owed depends not on the value of the products at their point of initial
sale, but on how Devon calculates that value.         Under the Court’s
decision, if Devon had charged $100 at its initial sale without explaining
how it got that number, the royalty holders would get $20. But if the
sale documents show that the $100 price was calculated by taking a $120
market-center price and subtracting $20 in estimated post-sale
production costs, then the royalty holders get $24 (1/5 of $120). In both
cases, the market value of the thing sold and the gross proceeds from
the initial sale are identical.   The only difference is the method of
calculating the sale price. Actually, as the Court sees it, the difference
in royalty depends not even on the method of calculating the sale price
but on whether that method is reflected in the sale documents.
      None of this confusing arrangement—where the royalty
fluctuates based on the happenstance of paperwork instead of based on
the market value of the product or the gross proceeds from its sale—is
required by the text of the parties’ agreement. The parties certainly
could have written Paragraph 3(c) to create a royalty based on
market-center prices or based on price-calculation paperwork. They did
not, and the best evidence that they did not intend Paragraph 3(c) to

                                    5
accomplish this result is the words they used in Paragraph 3(c), which
explicitly tell us what it is trying to accomplish.          The reason “any
reduction or charge” must be added to gross proceeds, according to
Paragraph 3(c), is “so that Lessor’s royalty shall never be chargeable
directly or indirectly with any costs or expenses . . . .”
       When the royalty is on unrefined or partially refined products at
the point of initial sale—as this one is—then simply paying 1/5 of the
gross proceeds, as Devon did, in no way renders the royalty “chargeable
directly or indirectly with any costs or expenses.” The royalty holder is
not paying for post-sale production costs.          Neither is the producer.
Someone else will pay those costs later. The royalty holder naturally
receives less payment because such costs are yet to be incurred, but that
is only because he has a royalty on the less valuable products at their
point of initial sale. He does not have a royalty on further refined
products at the market center, so he has not been “charged” anything by
Devon’s refusal to pay him such a royalty. Nor has his royalty suffered
a “reduction” just because Devon happened to price its initial sale with
reference to market-center prices.
       Addendum L1 likewise tells us what it means to accomplish. The
royalty holders sought to ensure that “this paragraph shall not be

       1   Addendum L states:
       Payments of royalty under the terms of this lease shall never
       bear or be charged with, either directly or indirectly, any part of
       the costs or expenses of production, gathering, dehydration,
       compression, transportation, manufacturing, processing,
       treating, post-production expenses, marketing or otherwise
       making the oil or gas ready for sale or use, nor any costs of
       construction, operation or depreciation of any plant or other

                                       6
treated as surplusage despite the holding in the cases styled ‘Heritage
Resources, Inc. v. NationsBank’, 939 S.W.2d 118 (Tex. 1996) and ‘Judice
v. Mewbourne Oil Co.’, 939 S.W.2d 135–36 (Tex. 1996)” (cleaned up). In
both of those cases, the Court required the holders of an “at the well”
royalty to bear post-production costs, despite potentially contrary
language in the agreement, because an “at the well” royalty is an
interest in unrefined products. Heritage Res., 939 S.W.2d at 122–23;
Judice, 939 S.W.2d at 135.
      Addendum L is an attempt to prevent courts from reaching a
similar result in this case by treating this royalty as an “at the well”
royalty that bears post-production costs. The Addendum emphasizes
the “gross proceeds,” production-cost-free nature of the royalty and
disclaims any similarity to agreements that prior courts had found
insufficient to create a cost-free royalty.      The Addendum does not
transform the royalty from a “gross proceeds” royalty on partially
refined products at their point of initial sale into a royalty on further
refined products at a market center. Again, simply paying the royalty
holder 1/5 of the gross proceeds from the initial sale—as the agreement
calls for and as Devon did—does not “charge” the royalty holder with
any future costs of production.

      facilities for processing or treating said oil or gas. Anything to
      the contrary herein notwithstanding, it is expressly provided
      that the terms of this paragraph shall be controlling over the
      provisions of Paragraph 3 of this lease to the contrary and this
      paragraph shall not be treated as surplusage despite the holding
      in the cases styled “Heritage Resources, Inc. v. NationsBank”,
      939 S.W. 2d 118 (Tex. 1996) and “Judice v. Mewbourne Oil Co.”,
      939 S.W. 2d 135-36 (Tex. 1996).

                                      7
      Neither Paragraph 3(c) nor Addendum L is purposeless under my
reading. Both prevent Devon from using accounting gimmicks—such as
shifting pre-sale production costs to an affiliated third party—to reduce
the gross proceeds it receives for its initial sale and thereby to reduce
the royalty payment. These provisions do not, however, authorize the
royalty holder to use accounting gimmicks against Devon, which is what
happens when Devon is required to pay an inflated royalty just because
it left behind a paper trail indicating that it calculated its initial sales
price with reference to downstream market-center prices.
      In its desire to vindicate the agreement’s prohibition on “indirect”
cost-shifting, the Court ends up fundamentally changing the nature of
this royalty based on tenuous textual cues that are themselves indirect
at best. The reading of the agreement proffered by Devon harmonizes
Paragraph 3(c) and Addendum L with the “gross proceeds” royalty
created by Paragraphs 3(a) and 3(b). The result is a rational “gross
proceeds” royalty arrangement that is firmly tethered to the value of the
products at their point of sale and does not fluctuate depending on
administrative vagaries that have nothing to do with the value of the
products themselves. This is, to my mind, the superior reading of an
admittedly difficult agreement. Because the Court concludes otherwise,
I respectfully dissent.

                                         James D. Blacklock
                                         Justice

OPINION FILED: March 10, 2023

                                     8