Overview of current trends in oil and gas royalty litigation. Covers post-production cost deductions, royalty calculation, lease royalty clauses, and some applicable statutory provisions.

1. Royalty Litigation:
An Overview of Current Trends
AUGUST 31, 2016
29TH ANNUAL ENERGY LAW INSTITUTE
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2. Part One: Introduction to Royalty
Clauses
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3. Two Primary Components to
Royalty Clause Disputes
 HOW is the production valued?
 WHERE is the production valued?
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4. Three Types of
Royalty Clauses
 Sales Based
 Market Based
 Hybrids
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5. Ok, there are also
“in kind” Royalty Clauses,
but let’s move on …
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6. “Sales Based” Royalty Clauses
 The royalty owner’s payment is based on a “sale,”
but not always a sale by the lessee.
 The “sale” may be one by a non-affiliate.
 The “sale” may occur at a location, regardless of
the parties to the transaction.
 Examples include, but are not limited to:
 Gross proceeds received
 Sometimes, just “proceeds”
 Net proceeds received
 Amount realized
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7. “Market Based” Royalty Clauses
 The royalty owner’s payment is based on market conditions, not an
actual transaction.
 In theory, the price received by the lessee is not determinative.
 Examples include, but are not limited to:
 Market value
 Highest posted price
 Average price received in the field
 Best price received in the field
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8. “Hybrid” Royalty Clauses
 The royalty owner’s payment can be based on the “higher
of” a market valuation and sales valuation.
 Examples include, but are not limited to:
 The higher of market value and the net proceeds received by
the lessee.
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9. The Valuation Point Can Vary
 Common valuation points include, but are not limited to:
 Valued “at the well” or the “mouth of the well”
 Valued at the “point of sale” or the “first sale to an
unaffiliated third-party”
 Valued at the “delivery point”
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10. Remember to Look For Defined Terms
 Leases are “contracts” and courts will construe them as
such.
 “Industry custom” will only take you so far …
 It is not uncommon for leases to have defined terms
which dictate what will constitute things such as a “sale”
or “market value.”
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11. Part Two: Common Royalty
Disputes
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12. Typical Types of Royalty Disputes
 Failure to pay royalties
 Underpayment of royalties
 Overpayment of royalties
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13. Complete Failure to Pay Royalty
 Royalty owners can assert a claim as a “breach of contract” (ie, the
lease) and/or under the Texas Natural Resources Code.
 The Texas Natural Resources Code provides for certain safe harbors, if:
 The royalty owner has refused to sign a division order that complies
with the statute;
 Royalty is being withheld because of a bona fide title dispute;
 But, make sure that the lease does not override a safe harbor.
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14. T.S . Reed v. Samson 14

15. Underpayment of Royalty
 These cases are usually determined after an audit.
 Common reasons for underpayment of royalty cases
include, but are not limited to:
 Disputes over “no-deduct” clauses.
 Disputes over lease interpretation of “how” production is
valued and/or “where” it is valued.
 Disputes over the impact of pooling and/or PSA wells.
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16. Heritage Resources v. Nationsbank
939 S.W.2d 118 (Tex. 1996)
 Royalty on gas was to be calculated by the “market
value at the well.”
 The lease contained a “no-deducts” clause (ie, royalty
not chargeable with post-production costs).
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17. Heritage Resources v. Nationsbank
939 S.W.2d 118 (Tex. 1996)
 A split court (5-2-2) held that the “no deducts” clause
was mere surplusage (it was meaningless) because
royalty calculated “at the well” prior to any post-
production costs being incurred.
 Decision permits a lessee to use the “netback method”
or the “comparable sales method” of determining
royalty.
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18. Hyder v. Chesapeake
 The overriding royalty provision provided for a “perpetual, cost-free
(except only its portion of production taxes) overriding royalty of five
percent (5.0%) of gross production obtained.”
 A clause provided that “each Lessor has the continuing right and
option to take its royalty share in kind.”
 A so-called anti-Heritage clause which provided that “Lessors and
Lessee agree that the holding in the case of Heritage Resources,
Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996) shall have no
application to the terms and provisions of this lease.”
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19. Unusual Issues with Hyder
 The royalty was paid as a surface use payment, but was incorrectly
referred to as an “override.”
 There was no valuation point. There was a reference to receiving a
portion of the “gross production,” but this is a metric of volume, not
valuation.
 The opinion reveals no contention (from any party) that the
provision described an “in-kind” royalty, which it arguably is.
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20. Overpayment of Royalty
 Generally arise when the lessee is confronted with a
demand for royalty which reveals an error in the way the
lessee has been paying royalty.
 Suit is brought by the lessee against the royalty owner to
recover overpayments.
 These cases can turn on the reason for the overpayment.
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21. Amoco Production v. Smith
 Amoco owed royalty to H.W. Smith, but paid the wrong H.W. Smith.
 Once the issue was raised by the correct H.W. Smith, Amoco sued the
party that was paid in order to recoup the improperly paid royalties.
 This was a mistake of fact because Amoco intended to pay the
correct person, but erroneously paid the wrong person with the same
name. The result could be different if Amoco made a mistake of law.
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22. Part Three: Damages
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23. Common Remedies Sought
by Royalty Owners
 Money (unpaid royalties)
 Interest
 Can be recovered by contract and/or by statute
 Rates can vary
 Watch for issues of compounding vs. simple interest
 Attorneys’ Fess
 Can be recovered by contract and/or by statute
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24. Some Leases Provide For Lease
Termination
 Be aware of the remedies provided in a lease.
 Some leases provide that the lease will terminate if the
royalties are not timely and properly paid.
 Courts consider these types of clauses “forfeiture” clauses,
which are disfavored.
 But be cautious anyway!
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25. Escondido Resources II, LLC v. Justapor
Ranch Company, LC
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26. Part Four: Current Trends in Royalty
Litigation
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27. Current Trends
 “Post-Production Cost” Litigation
 PSA Well Litigation
 Bad Faith Pooling
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28. Post-Production Cost Litigation
 Numerous cases over the past five years.
 Typically involve a variation of the dispute in the Heritage
case.
 Can be complicated:
 Midstream agreements
 Affiliate sales
 Evolving technologies: production costs or post-production?
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29. Heritage Resources v. Nationsbank
 One of the most cited cases on this topic.
 Describe the “netback method” and “comparable sales”
method to determining market value.
 “Anti-Heritage” clauses have arisen in oil and gas leases.
 Their effect, if any, is debatable.
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30. French v. Oxy
 Although having different royalty provisions, the French court found that both leases
provided that the royalty owner would not bear any production expenses but
would bear at least some post-production costs.
 One lease valued production “at the well” and the other lease valued
production prior to the first sale.
 Oxy performed a CO2 flood in a field with 106 wells. Producing casinghead gas
contained 85% CO2.
 Oxy paid royalty based on 70% of the NGLs produced, but not on the other 30%
which was paid to Kinder Morgan in kind as part of Kinder Morgan’s compensation
for constructing a plant to remove most of the CO2 and H2S. Oxy did not pay any
royalty on any residual gas, 100% of which was given in kind to Kinder Morgan. Oxy
considered a monetary fee paid to Kinder Morgan to be a production expense..
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31. French v. Oxy 31
KM plant
removes Most
of the CO2 and
H2S
Torch Energy
removes the
remaining CO2
and H2S
Field
Oil and Gas
produced from
the field with
CO2

32. Chesapeake v. Hyder
 French v. Oxy was not cited in the Court’s opinion.
 Seems that the Court could have held that the royalty
provision was an “in kind” royalty and the Hyders must bear
post production costs if they permit their gas to be sold with
Chesapeake’s gas.
 The Supreme Court noted that no party argued that the
royalty should be construed to be an in kind royalty.
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33. PSA Well Litigation
 Disputes of “PSA Wells” generally come in two forms:
 Contractual authority for the lessee to drill a PSA well
Some believe this to be a form of “pooling”
The Texas Railroad Commission does not consider this to be
pooling
 Issues on allocation of royalty
 This is a topic which will likely be addressed by the courts
and/or the Legislature
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34. Authority for Lessee to Drill
 The Texas Railroad Commission seems to have concluded
that lessees do not need pooling authority to drill a
production sharing well.
 The issue was disputed in the “Klotzman” well protest
 The subject of debate
 Rival articles have been published within the past few months
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35. Allocation of Royalty
 Royalty payment issues can arise when a PSA well is drilled
without agreement on apportionment of production to
various tracts.
 Litigation on this issue is risky for both parties.
 The industry and others are working to obtain action from
the Legislature.
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36. Browning Oil Company v. Luecke
 Lessee create a unit which did not comply with pooling
restrictions.
 Lessors sought to nullify the unit and claimed entitlement to
royalty based on 100% of production, regardless of whether
the production came for the Lessors’ property.
 Court held that the Lessors were only entitled to royalty from
their specific property.
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37. Bad Faith Pooling
 This is an area that is seeing a slight resurgence, but we
could see more.
 New issues are implicated when pooling horizontal wells.
 The downturn in the industry could result in a spike in
pooling litigation.
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38. Part Five: One More Thing
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39. Be Careful and Know Your Landscape
 Be aware of the lease terms.
 Be aware of your royalty owners.
 Be aware of what you put in your files.
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40. CHRISTOPHER L. HALGREN
McGinnis Lochridge
711 Louisiana St., Ste 1600
Houston, TX 77002
Direct: 713-615-8539
713-615-8585 FAX
Email: chalgren@mcginnislaw.com
Website: www.mcginnislaw.com
Blog: www.oilandgaslawdigest.com
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