Force Majeure in the Time of COVID-19

By: Michael Miller Michael P. Miller, PLLC; affiliated with Sadler Law Group, PLLC

“The man who smiles when things go wrong has thought of someone else he can blame it on.”

- Robert Albert Bloch

While it is assumed that the reader is well acquainted with the concept of force majeure, the purpose of this article is to discuss the employment of a force majeure clause to excuse nonperformance due to executive orders issued by the federal and various state governments that prevented or encumbered workforce activity in an attempt to slow the progression of COVID-19. This article identifies operative components of a typical force majeure clause and the normal analysis of the same usually undertaken by courts. Although COVID-19 is the first worldwide pandemic in over 100 years1 and its global impact on all aspects of society has been monstrous, an analysis of its impact as to whether its effects could trigger an exercise of a force majeure clause is no different than that for any other event.

It may be interesting to note that the concept of Force Majeure dates back to Roman law under the names of “via major” or “vis divina,” used as an excuse for nonperformance due to unforeseeable and “irresistible” events. Subsequently, the French included this concept as a “force majeure” in the French Civil Code dating back to 1804.2 In common law, the concept began an adoption of an existing excuse for nonperformance due to impossibility, and the English embraced the concept to forgive nonperformance when there was an “Act of God or the existing King’s Enemies” that prevented total performance. 3 Unlike its common law cousins of impossibility, impracticability and frustration of purpose, force majeure is a purely contractual concept which otherwise does not exist in current common law. It should be noted that while there are remnants of Texas law that treat impossibility and impracticability differently, over time Texas courts have gradually blended these concepts and now recognize no functional distinction between impossibility, impracticability and frustration of purpose.4

The purpose of a force majeure clause is to allocate risks for nonperformance caused by events which are superior and cannot be overcome by a contracting obligor, by providing a defense for the nonperformer. Generally, the nonperformer bears the burden of proof to establish such defense.5 Typically, there are two operational components found in a force majeure clause: (1) catch-all language, and (2) identification of express events. Catch-all language exists in an attempt to excuse nonperformance of contract terms due to the occurrence of an unforeseeable event that has made performance impossible or impracticable. To be an effective agent of excused performance under the catch-all term of a force majeure clause, it is important that such event was unforeseeable at the time the parties entered into the contract.6 Catch-all events are usually caused by acts of God (flood, hurricane, fire, earthquake, etc.) or uncontrollable events caused by people (unanticipated legislation and changes in agency rules, riots, strikes, wars, terrorist acts, severe civil unrest). A typical catch-all force majeure term frequently found in an oil and gas lease effectively states that should the Lessee be prevented from complying with any express or implied condition or covenant of the lease, from conducting drilling or reworking operations thereon or from producing oil or gas therefrom by reason of a force majeure, then while so prevented, the Lessee’s obligation to comply with such covenant or condition shall be suspended, and Lessee shall not be liable in damages for

failure to comply therewith, and the lease shall be extended while and so long as the Lessee is so prevented by any such cause from conducting drilling or reworking operations or from producing oil or gas from the lease premises.

Although many events may halt compliance with a contractual condition or covenant by an obligor, a claim of force majeure under catch-all language to excuse a nonperforming party will be met with resistance if such an event was foreseeable. For this reason, a second component of most force majeure clauses describes express events, which if such was to occur and prevent performance, the parties agree in advance as to how, and to what extent, the risk and cost of such nonperformance shall be allocated. Not all oil and gas contracts, particularly older agreements, describe specific events in their force majeure clause.

When parties include the occurrence of express events to excuse performance, there is no need for such event to be unforeseeable. “[W]hen the promisor has anticipated a particular event by providing for it in a contract, he should be relieved of liability for the occurrence of such event regardless of whether it was foreseeable.”7 Foreseeable special events often found in a force majeure clause include weather-related incidents, Federal or state law rules and regulations, riots, insurrection, terrorist attacks, inability to procure materials or utilities, scarcity of materials or labor, union strikes, transportation shortages, and inadequate market price. Without a catch-all, the canon of construction expressio unius est exclusio would exclude any event not named. If the catchall merely says “or any other events or circumstances beyond the reasonable control of the parties affected,” the canon of construction ejusdem generis would limit the meaning of the catch-all to the same type of events as those listed.8

Terms found in typical force majeure clauses tend to evolve with the times, as events once not foreseeable become foreseeable. For example, impossibility of performance due to terrorism is a more common express term post 9/11. Limited egg production caused by disease is frequently an express excuse for nonperformance in contracts with egg producers after the outbreak of avian influenza in 2014-15. Impossibility due to shutdowns and impossibility due to government regulations, pandemics, epidemics, and contagion outbreaks are foreseeable today. Therefore, force majeure catch-all language in a post-COVID-19 contract should not be relied upon to excuse performance due to the results caused by a future (or current) pandemic or resulting government restrictions. Accordingly, such events should be included as an express event that will excuse performance.

Generally, courts view force majeure clauses as limited in scope, and their application is interpreted narrowly. Texas courts favor provisions that describe express events excusing nonperformance over broad, general provisions that often are vague.9 Language is very important, as further illustrated below in Rembrandt Enters. v. Dahmes Stainless, Inc.10 Force majeure clauses are a contractual term; accordingly, their definition and use depend upon how such is defined in the contract. 11 Parties to a contract themselves draw the silhouette of a force majeure clause, and those terms dictate its application. Lease terms are controlling regarding an assertion of a force majeure event, and common law rules merely fill in the gaps.12

When analyzing a force majeure event, always ask (1) what is the triggering event, and (2) what is the impact of that event? It is crucial that one show with particularity how an event frustrated performance or made it impossible.13 A party who seeks to excuse a contractual obligation due to a force majeure event must

methodically connect the dots between the event (cause) and the effect (frustration of its contractual obligation to perform).

Although the COVID-19 pandemic is a new phenomenon, its effects on the economy are not unique. Exercising a force majeure clause to excuse nonperformance due to an economic downturn has been the source of considerable litigation.14 An economic downturn in oil and gas prices is generally not an event that a court will allow to trigger catch-all terms in a force majeure clause. Economic downturns in the oil patch, as well as in most other businesses, is foreseeable regardless of the cause.15 Texas courts seem to be in agreement that contractual obligations cannot be avoided because one’s economic burden becomes significantly larger than anticipated. 16 While COVID-19 and resulting governmental regulations may be the event, if the significant effect to an oil and gas producer is a decline in production revenue due to dropping oil prices (planes are not flying, cruise ships are not sailing, people are not driving to work, restaurants and entertainment venues are closed or limited), then such would be an attempt to invoke the force majeure clause due to economic hardship. Of course, if economic hardship was defined and enumerated as an express event in a force majeure clause, then declining revenue due to market conditions may have merit. Additionally, if government regulations due to COVID-19 had the effect of preventing equipment from being delivered, production in tanks from being transported to market, and vital oil and gas well operations labor from going to work, thus making production impossible, such effect may be more meritorious. However, it should be noted that Texas courts have specifically allowed parties to escape contractual obligations where performance has been prevented by government regulations, even when a government regulation is subsequently ruled as being invalid.17

As stated previously, facts and terms matter! For example, it may be considerably more difficult to convince a court that the occurrence of nonperformance caused by a hurricane should be excused under the catch-all language in a force majeure clause, if destroyed production facilities are located in Lake Charles, as opposed to Boise. As Big Tech has well proven recently, many employees do not need to be physically present at one central location to do their job and effectively communicate with the rest of the world. A catchall provision in a force majeure clause would likely be an anemic claim as an excuse for nonperformance by an operator if the facts indicated the reason for such claim was because governmental rules preventing travel meant the division order department could not go to the office. However, a defense offered to excuse nonperformance would be more enthusiastically received by a court if the reason was that unforeseen governmental regulations prevented the ability of trucks to load and transport oil production. Regardless, government regulations which restrict travel due to a pandemic is now a foreseeable event. Nonperformance due to such an event would probably not now be excused under a catch-all provision in a force majeure clause contained in a lease made after recent events caused by COVID-19. Therefore, one would need to consider the excused performance provisions for express events, if any, in the contract.

Look at performance prior to the triggering event. It will be difficult to convince a court that terms of a force majeure clause excuse nonperformance if nonperformance began prior to such an event. A party asserting a force majeure event, regardless of whether it falls under catchall language or a listed express event, will need to be able to demonstrate that they took reasonable efforts to overcome a barrier to performance and mitigate damages or lack of performance. 18 As illustrated in Hitz below, courts generally look to

equity and usually inquire about remedial steps taken to minimize the impact of the triggering event. Courts must not and “will not enforce an illegal contract, ‘particularly where the contract involves the doing of an act prohibited by statutes intended for the protection of the public health and welfare’.”19 However, if a contract is entered into for a specific purpose and that purpose subsequently becomes illegal, a court will likely not void the contract if the possibility of a subsequent illegality should have been foreseen. “When a party voluntarily undertakes and by contract binds himself to do an act or thing, without qualification, and performance thereof becomes impossible by some contingency which should have been anticipated and provided against in the contract, the nonperformance will not be excused.” “…the party’s failure to exempt himself from the responsibility in the event of the happening of the contingency will be attributable to his own folly… .”20

Listed below are eight summary questions to examine when considering a claim of a force majeure defense:

1. What is the link between the triggering event and the impact of that event? 2. Was the triggering event foreseeable or unforeseeable? 3. Does the force majeure clause enumerate specific trigger events, or does it only contain general language of foreseeability? 4. What analysis is produced when examining language contained in the force majeure clause? 5. Is the assertion of a force majeure event more than just the result of economic hardship? 6. Were there mitigating steps taken to minimize the impact of a force majeure event? By both sides? 7. What was the contractual performance prior to the triggering event? 8. Was anything about the underlying contract for the performance of an illegal activity? Claim of economic downturn as a force majeure, and the importance of contractual terms:

1. TEC Olmos, LLC v. Conoco Philips Co.

21

Under a Farmout Agreement with Conoco, TEC agreed to test drill in search of oil and gas. The Agreement contained the following force majeure clause:

Should either Party be prevented or hindered from complying with any obligation created under this Agreement, other than the obligation to pay money, by reason of fire, flood, storm, act of God, governmental authority, labor disputes, war or any other cause not enumerated herein but which is beyond the reasonable control of the Party whose performance is affected, then the performance of any such obligation is suspended during the period of, and only to the extent of, such prevention or hindrance, provided the affected Party exercises all reasonable diligence to remove the cause of force majeure.

TEC invoked the force majeure clause after a change in the global oil market eliminated the financing expected by TEC, causing TEC to not perform. TEC argued that the economic downturn qualified as an excused nonperformance under the general catch-all contained in the force majeure clause. However, the court held that economic downturns in oil and gas markets were foreseeable conditions, not covered by the general force majeure clause. Because such condition was not specifically listed as a force majeure event, such changes could not be considered as a force majeure.

2. Rembrandt Enter. v. Dahmes Stainless, Inc.22

Rembrandt, a commercial producer of eggs, entered into a contract with Dahmes for the installation of an egg dryer. Subsequently, but prior to the installation of the dryer, an outbreak

of the Avian Flu necessitated Rembrandt to reduce his bird production by over 50% and to cancel construction of the facility in which the dryer was to be installed. Claiming a force majeure, frustration of purpose, and impracticability due to the drastic reduction in egg production, Rembrandt cancelled the installation of the egg dryer and Dahmes claimed breach of contract. The pertinent part of the force majeure clause stated the following:

Force Majeure. Neither party shall be liable to the other for failure or delay in performance of the Work caused by war, riots, insurrections, proclamations, floods, fires, explosions, acts of any governmental body, terrorism, or other similar events beyond the reasonable control and without the fault of such party…

The court held that the force majeure clause defined “work” to mean efforts by Dahmes to build and install the dryer and therefore only applied to a failure or delay in performance by Dahmes. Because Dahmes did not cancel the contract, rather it was Rembrandt who unilaterally initiated the cancellation, no force majeure event occurred per the express terms of the contract.

Claims of the effects of COVID-19 as a force majeure:

3. Palm Springs Mile Associates v. Kirkland’s

Stores, Inc.23

This recent decision illustrates how litigants often try to fit the facts of their case into a force majeure event without giving thoughtful attention to the specific language of the operative force majeure clause or carefully connecting the force majeure event with a purported inability to perform. (Always connect the dots!) Kirkland’s, a home décor retailer, ceased paying rent beginning in April 2020. Consequently, Palm Springs sued for breach of a commercial lease. The force majeure clause in the lease stated in pertinent part the following:

Whenever a period of time is prescribed in this Lease for action to be taken by either party, such party will not be liable or responsible for, and there will be excluded from the computation of any such period of time, any delays due to strikes, riots, acts of God, shortages of labor or materials, war, governmental laws, regulations or restrictions or any other causes of any kind whatsoever which are beyond the reasonable control of such party.

Kirkland’s filed a motion to dismiss, asserting that its rent obligation was relieved by the force majeure provision in the lease triggered by government edicts for restrictions on business operations and nonessential activities. The court found several failures of Kirkland’s argument. (1) Kirkland’s did not explain how the government action it describes as a force majeure event resulted in its inability to pay rent, and even if it had demonstrated this, (2) an analysis of the same would be a factual determination and therefore improper on a motion to dismiss.

4. In re Hitz Restaurant Group24

This COVID-19 case illustrates that a force majeure clause does not excuse a claimant from mitigating damages. The force majeure clause at issue provided that any obligations that are prevented or delayed due to governmental action or order would be excused. Tenant Hitz, a Northern Illinois area pizzeria focused on dine-in service, ceased paying rent and declared bankruptcy. Hitz argued that Illinois Governor J. B. Pritzker’s executive order prohibiting on-site consumption of food and beverages at Illinois restaurants should excuse its failure to pay rent from March through June 2020. However, the court noted that said order permitted carry-out, curbside pick-up, and delivery from restaurant premises, and therefore only partially excused the

failure of Hitz to pay rent. Finding that the kitchen could have continued operations and that it (the kitchen) occupied approximately 25% of the rented space square footage, the court held that Hitz remained responsible for 25% of the rental payments and other contractual obligations such as real estate taxes and common area maintenance charges. Additionally, Hitz was adjudged responsible for the March rental obligation because it was due March 1, 2020, prior to the Governor’s order.

1 History of 1918 Flu Pandemic, Centers for Disease Control and Prevention, National Center for Immunization and Respiratory Diseases (NCIRD), https://www.cdc.gov/flu/pandemic-Resources/1918commemoration/1918-pandemic-history.htm (last updated Mar. 21, 2018) 2Marel Katsivela, Contracts: Force Majeure Concept or Force Majeure Clauses?, 12 UNIF. L. REV. (UK) 101 (2007); Jennifer Sniffen, Symposium Note and Comment: In The Wake of the Storm: Nonperformance of Contract Obligations Resulting From Natural Disaster, 31 NOVA L. REV. 551 (2007). 3See Peter Declercq, Modern Analysis of the Legal Effect of Force Majeure Clauses in Situations of Commercial Impracticability, 15 JOURNAL OF LAW & COMMERCE 213, 214 (1995). 4See Tractebel Energy Mktg. v. E.I. du Pont de Nemours & Co., 118 S.W.3d 60, 69 (Tex. App.—Houston [14th Dist.] 2003, pet. denied). 5See Kodiak 1981 Drilling P’ship v. Delhi Gas Pipeline, Corp, 736 S.W.2d 715 (Tex. App.—San Antonio 1987, writ ref’d n.r.e.). 6See TEC Olmos, LLC v. ConocoPhilips Co., 555 S.W.3d 176 (Tex. App.—Houston [1st Dist.] 2018), citing Zurich Am. Ins. Co. v. Hunt Petrol., 157 S.W.3d 462, 466 (Tex. App.—Houston [14th Dist.] 2004, no pet.). 7See Kodiak, 736 S.W.2d at 721 (quoting E. Air Lines v. McDonnell Douglas Corp., 532 F.2d 957, 992 (5th Cir. 1976)). 8Natalie L. Arbaugh, Amy Sanders & Elyse Lyons, Best Practice for Key Contract Provisions, State Bar of Tex. Prof. Dev. Program, 19th Annual Advanced In-House Counsel Course, ch. 6, (2020). 9See Va. Power Energy Mktg., Inc. v. Apache Corp., 297 S.W.3d 397, 402 (Tex. App.—Houston [14th Dist.] 2009, pet. denied); Sun Operating P'ship v. Holt, 984 S.W.2d 277, 283 (Tex. App.—Amarillo 1998, pet. denied). 10 Rembrandt Enter. v. Dahmes Stainless, Inc., No. C154248-LTS, 2017 U.S. Dist. LEXIS 144636 (N.D. Iowa Sept. 7, 2017). 11See Zurich Am. Ins. Co. v. Hunt Petrol, 157 S.W.3d 462 (Tex. App.—Houston [14th Dist.] 2004, no pet.). 12See, e.g., Tex. City Ref., Inc. v. Conoco, Inc., 767 S.W.2d 183, 186 (Tex. App.—Houston [14th Dist.] 1989, writ denied).

13 Jamie Gottlieb Furia & Justin Corbalis, Mounting A Successful COVID-19 Force Majeure Argument, Law 360 (Sept. 25, 2020), https://www.lowenstein.com/newsinsights/publications/articles/mounting-a-successful-covid19-force-majeure-argument-gottlieb-furia-corbalis. 14See TEC Olmos, LLC v. Conoco Philips Co., 555 S.W.3d 176, 182 (Tex. App. — Houston [1st Dist.] 2018, pet. denied). 15 Id. 16See Grayson v. Grayson Armature Large Motor Div., Inc., No. 14-09-00748-CV, 2010 WL 2361432, at *5 (Tex. App. — Houston [14th Dist.] June 15, 2010, pet. denied (mem. op); Huffines v. Swor Sand & Gravel Co., Inc., 750 S.W.2d 38, 40 (Tex. App.—Fort Worth 1988, no writ). 17See Tractebel Energy Mktg. v. E.I du Pont de Nemours & Co., 118 S. W.3d 60, 65 (Tex. App. — Houston [14th Dist.] 2003, pet. denied). 18See id. (citing Restatement (Second) of Contracts §261, cmt. d (1981). 19 Peniche v. Aeroméxico, 580 S.W.2d 152, 155 (Tex. App.—Houston [1st Dist.] 1979, no writ). See Merry Homes, Inc. v. Chi Hung Luu, 312 S.W.3d 938, (Tex. App.—Houston [1st Dist.] 2010) (appellate court affirmed district court holding that a commercial lease for a nightclub, and for “‘no other’ purpose” was void for illegality because the tenant was unable to obtain a liquor license due to the premises’ proximity to a public school); See also McCreary v. Bay Area Bank & Trust, 68 S.W.3d 727, 733 (Tex. App.—Houston [14th Dist.] 2001, pet. dism’d) (“Where a contract is made in violation of a statute, it is illegal and void.”); Lewis v. Davis, 199 S.W.2d 146, 148-9 (1947) (if an illegality does not appear on the contract’s face, a court will not find it void unless facts showing the illegality are before the court). 20 Houston Ice Brewing Co. v. Keenan, 88 S.W. 197, 198 (Tex. 1905). 21 TEC Olmos, LLC v. Conoco Philips Co., 555 S.W.3d 176 (Tex. App.—Houston [1st Dist.] 2018, pet. denied). 22 Rembrandt Enter. v. Dahmes Stainless, Inc., No. C154248-LTS, 2017 U.S. Dist. LEXIS 144636, at *34,*32,*35-36 (N.D. Iowa Sept. 7, 2017). 23 Palm Springs Mile Associates v. Kirkland’s Stores, Inc., No.20-21724, 2020 WL 5411353, at *2 (S.D. Fla. Sept. 9, 2020). 24 In re Hitz Restaurant Group, No. 616 B.R. 374, 2020 WL 2924523, at *379-380 (Bankr. N.D. III. 2020).

Royalty Disputes Continue to Thrive: Two Recent Postproduction Cost Deduction Cases

By: Austin W. Brister Partner, McGinnis Lochridge

Royalty disputes continue to thrive across Texas, including disputes regarding whether a royalty interest must bear a proportionate share of postproduction costs such as transportation, compression, processing, and marketing. These disputes often turn on determining the proper “valuation point” for the royalties. For instance, if a royalty provision establishes a valuation point “at the well,” then that factor generally suggests the royalty is subject to postproduction costs. On the other hand, if the royalty provision establishes a valuation point “at the point of sale,” then that factor generally suggests the royalty is free of postproduction costs.

Other cases have focused on the meaning of phrases such as “gross production,” “cost-free,” and enforceability of no-deducts provisions. As one recent case shows, sometimes parties utilize unique language that requires the lessee to actually add amounts to its proceeds before calculating royalties.

This article discusses two recent Texas appellate court cases regarding deduction of postproduction costs. In both cases a petition for review has been filed with the Texas Supreme Court.

BlueStone v. Engler Energy

One recent case is BlueStone Natural Resources II, LLC v. Nettye Engler Energy, LP.

1 This case is of interest to trial lawyers and inhouse lawyers for its interpretation of two notable Texas Supreme Court cases on deduction of postproduction costs: the Burlington Resources Oil & Gas Co. LP v. Texas Crude Energy, LLC case from 2019, and the Chesapeake Exploration, L.L.C. v. Hyder case from 2016.2 In BlueStone, the owner of a nonparticipating royalty interest (NPRI) contended that a 1986 deed creating the NPRI interest contained language that prohibited the deduction of postproduction costs. The 1986 deed contained the following language:

“This Grantor … shall be entitled to receive … a free one-eighth (1/8) of gross production of any such oil, gas or other mineral said amount to be delivered to Grantor’s credit, free of cost in the pipe line, if any, otherwise free of cost at the mouth of the well or mine...”3

In 2004, BlueStone’s predecessors leased the tract and drilled numerous producing wells. BlueStone’s predecessors incurred a number of postproduction costs but did not pass those costs onto the NPRI owner. In 2016, BlueStone acquired these leasehold interests and began to deduct from the NPRI a share of BlueStone’s postproduction costs for transportation, gathering, and compression. The NPRI owner filed suit. The trial court granted the NPRI owner’s motion for summary judgment and then this appeal followed.

On appeal, BlueStone argued that the 1986 deed’s use of the phrase “in the pipe line” indicated that the royalty was to be valued at the pipeline and therefore was subject to postproduction costs. The Fort Worth Court of Appeals agreed with BlueStone and reversed the trial court’s decision, rendering judgment in favor of Bluestone.

The BlueStone case is of interest due to its analysis of two Texas Supreme Court decisions

regarding postproduction costs: Burlington Resources, 4 and Hyder.

5

In Burlington Resources, the Texas Supreme Court held that the phrase “into the pipelines…with which the wells may be connected” was tantamount to the phrase “at the well,” thereby establishing a valuation point that requires a royalty interest owner to bear postproduction costs.

The NPRI owner made several arguments in an attempt to distinguish Burlington Resources. The NPRI owner argued that Burlington Resources was based on the full phrase in that case and did not broadly hold that “into the pipeline” sets a valuation point at the wellhead. Instead, the NPRI owner argued that the holding in Burlington Resources was limited to instruments referencing pipelines “connected” to the well. The BlueStone court disagreed, stating Burlington Resources “did in fact focus heavily on the singular phrase ‘into the pipeline.’”6

The NPRI owner also argued that, because the 1986 deed did not include a “connected to the well” phrase like in Burlington Resources, that reflects that the parties to the 1986 deed were referring to a major pipeline downstream, and not merely a gathering system connected to the well.7 The BlueStone court rejected that argument as well, pointing to multiple resources indicating that a gathering system is a type of pipeline.8

The NPRI owner also argued that, because the two phrases “free of cost in the pipeline” and “free of cost at the mouth of the well” are separated by the word “otherwise,” that means they are mutually exclusive. 9 The NPRI owner argued that the second phrase refers to gas with a valuation point at the mouth of the well, and therefore the first phrase must refer to oil and a valuation point somewhere other than the wellhead. 10 The BlueStone court rejected that interpretation as well. 11 Instead, the court construed the word “otherwise” as simply meaning that the valuation point is at the pipeline if there is a pipeline, otherwise the valuation point is at the mouth of the well.12

The NPRI owner also attempted to draw several analogies between the 1986 deed and the Hyder case. The NPRI owner cited Hyder in arguing that the phrase “cost free” in the 1986 deed means free of postproduction costs.13 The appellate court rejected that comparison. The appellate court noted that the Hyder decision was not based solely on the phrase “cost free,” but was instead “focused specifically” on the parenthetical that followed, which read “cost-free (except only its portion of production taxes).”14 Even though the phrase “cost free” in a royalty provision typically means only that the royalty free of production costs, this parenthetical in Hyder reflected a different intention given that it made an exception for “production taxes” which is a type of postproduction cost. Therefore, based on that parenthetical, the Hyder Court held that the parties intended for the phrase “cost-free” to mean free of postproduction costs.15

The BlueStone court also rejected the argument that the 1986 deed’s use of the phrase “a free one-eighth (1/8) of gross production” brought the 1986 deed in line with Hyder. 16 The court explained that Hyder recognized the phrase “free” in a royalty provision typically refers only to production costs and not postproduction costs.17 The BlueStone court explained that the 1986 deed did not express a contrary intent, as the word “free” appeared in multiple other locations in the context of production costs.18 Moreover, in the phrase “free of cost at the mouth of the well,” the reference to the mouth of the well suggests the word “free” is used in its standard nature, in reference to production costs.19

Devon Energy v. Sheppard

Another recent postproduction costs royalty case is Devon Energy Production Co., L.P. v. Sheppard. 20 This case involves “highly unique royalty provisions” in lease forms prevalent during the shale boom in the Eagle Ford area. The leases at issue included the following “add to proceeds” provision:

“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 directly or indirectly with any costs or expenses other than its pro rata share of severance or production taxes.”21

Another provision in the addendum indicated that royalties “shall never bear or be charged with, either directly or indirectly, any part of the costs or expenses of” several enumerated categories of postproduction costs.22

The royalty owners argued that these lease provisions required the lessee to add any ‘reduction or charge’ included in any ‘disposition, contract or sale of oil or gas’ to the lessee’s gross proceeds before calculating royalties. The lessors argued that a wide variety of the lessee’s purchase agreements, purchase statements, processing arrangements, and other instruments reflected reductions or charges, and therefore they should have been added to the lessee’s gross proceeds prior to calculating the lessors’ royalties.

The lessees argued that the controlling language in the leases was the royalty provision indicating that royalties were to be paid on the basis of “gross proceeds . . . at the point of sale.”23 The lessees argued that this established a valuation point at the point of sale, whereas the lessees argued that the reductions or charges at issue in this case were incurred downstream of the point of sale.24

The lessors and lessees submitted a joint stipulation to the court, identifying twenty-three different scenarios for the court’s consideration.25 The trial court granted summary judgment in favor of the lessors, and this appeal followed.26

The appellate court emphasized that Texas courts construe oil and gas leases by seeking to enforce the intention of the parties, and that they seek to give effect to all parts and do not give any single provision controlling effect.27

The appellate court reviewed the “highly unique royalty provisions” in the underlying leases and concluded that it is “exceptionally broad, and there is nothing in the leases suggesting that [it] is limited to pre-point-of-sale expenses.”28 The court further explained that the initial royalty clause indicates that “royalty is to be initially based on the [lessees’] gross proceeds (before [this unique additional provision] is applied).”29 The court explained that, if it were to hold that royalties were due only on gross proceeds, then the court would be rendering this additional “add to . . . proceeds” provision meaningless.30

The court also explained that this unique provision differs “significantly” from a mere “no deducts” clause, as it does not concern deductions

made to the royalty; rather, it focuses on the dispositions and sales contracts, and applies if they contain a “reduction or charge” for such expenses. Moreover, the phrase indicating that the royalty shall never be “directly or indirectly” charged with such costs reflected an intent that the royalty should not be reduced where “a downstream sales price is reduced to account for costs incurred or anticipated by the purchaser.”31

Ultimately, the court concluded that this unique language reflected the parties’ intent to base the royalty on more than mere gross proceeds. The court coined this a “proceeds plus” royalty. 32 The court held that this language requires the lessee to add to its gross proceeds any reduction or charge that is included in a disposition, contract, or sale of oil and gas, so long as the charge is for one of categories enumerated within the lease addendum.33

The Devon case serves as a reminder that determining whether a royalty interest bears postproduction costs is not merely a matter of determining the valuation location. 34

1 BlueStone Nat. Res. II, LLC v. Nettye Engler Energy, LP, No. 02-19-00236-CV, 2020 Tex. App. LEXIS 5095 (Tex. App.—Fort Worth July 9, 2020). 2 Chesapeake Expl., L.L.C. v. Hyder, 483 S.W.3d 870, 872 (Tex. 2016). 3 BlueStone Nat. Res. II, LLC v. Nettye Engler Energy, LP, No. 02-19-00236-CV, 2020 Tex. App. LEXIS 5095, at *2-3 (Tex. App.—Fort Worth July 9, 2020). 4 See Burlington Resources Oil & Gas Co. LP v. Texas Crude Energy, LLC, 573 S.W.3d 198 (Tex. 2019). 5 See Chesapeake Expl., L.L.C. v. Hyder, 483 S.W.3d 870, 872 (Tex. 2016). 6 BlueStone, 2020 LEXIS 5095, at *13. 7 Id. 8 Id. 9 Id. at 12. 10 Id. 11 Id. at 13. 12 Id. 13 Id. at 16. 14 Id. 15 Id. 16 Id. at 17. 17 Id. 18 Id. 19 Id. at 18. 20 Devon Energy Prod. Co., L.P. v. Sheppard, No. 13-1900036- CV, 2020 Tex. App. LEXIS 8378 (Tex. App.— Corpus Christi Oct. 22, 2020). 21 Devon Energy Prod. Co., L.P. v. Sheppard, No. 13-1900036-CV, 2020 Tex. App. LEXIS 8378, at *4-5 (Tex. App.—Corpus Christi Oct. 22, 2020). 22 Id. at 5. 23 Id. at 30. 24 Id. at 32. 25 Id. at 2. 26 Id. 27 Id. at 14. 28 Id. at 2. 29 Id. at 35. 30 Id. at 30. 31 Id. at 35. 32 Id. at 43. 33 Id. at 4-5. 34 Id. at 21-22.