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Royalty Litigation:
An Overview of Current Trends
AUGUST 31, 2016
29TH ANNUAL ENERGY LAW INSTITUTE
1
Part One: Introduction to Royalty
Clauses
2
Two Primary Components to
Royalty Clause Disputes
 HOW is the production valued?
 WHERE is the production valued?
3
Three Types of
Royalty Clauses
 Sales Based
 Market Based
 Hybrids
4
Ok, there are also
“in kind” Royalty Clauses,
but let’s move on …
5
“Sales Based” Royalty Clauses
 The royalty owner’s payment is based on a “sale,”
but not always a sale by the lessee.
 T...
“Market Based” Royalty Clauses
 The royalty owner’s payment is based on market conditions, not an
actual transaction.
 I...
“Hybrid” Royalty Clauses
 The royalty owner’s payment can be based on the “higher
of” a market valuation and sales valuat...
The Valuation Point Can Vary
 Common valuation points include, but are not limited to:
 Valued “at the well” or the “mou...
Remember to Look For Defined Terms
 Leases are “contracts” and courts will construe them as
such.
 “Industry custom” wil...
Part Two: Common Royalty
Disputes
11
Typical Types of Royalty Disputes
 Failure to pay royalties
 Underpayment of royalties
 Overpayment of royalties
12
Complete Failure to Pay Royalty
 Royalty owners can assert a claim as a “breach of contract” (ie, the
lease) and/or under...
T.S . Reed v. Samson 14
Underpayment of Royalty
 These cases are usually determined after an audit.
 Common reasons for underpayment of royalty ...
Heritage Resources v. Nationsbank
939 S.W.2d 118 (Tex. 1996)
 Royalty on gas was to be calculated by the “market
value at...
Heritage Resources v. Nationsbank
939 S.W.2d 118 (Tex. 1996)
 A split court (5-2-2) held that the “no deducts” clause
was...
Hyder v. Chesapeake
 The overriding royalty provision provided for a “perpetual, cost-free
(except only its portion of pr...
Unusual Issues with Hyder
 The royalty was paid as a surface use payment, but was incorrectly
referred to as an “override...
Overpayment of Royalty
 Generally arise when the lessee is confronted with a
demand for royalty which reveals an error in...
Amoco Production v. Smith
 Amoco owed royalty to H.W. Smith, but paid the wrong H.W. Smith.
 Once the issue was raised b...
Part Three: Damages
22
Common Remedies Sought
by Royalty Owners
 Money (unpaid royalties)
 Interest
 Can be recovered by contract and/or by st...
Some Leases Provide For Lease
Termination
 Be aware of the remedies provided in a lease.
 Some leases provide that the l...
Escondido Resources II, LLC v. Justapor
Ranch Company, LC
25
Part Four: Current Trends in Royalty
Litigation
26
Current Trends
 “Post-Production Cost” Litigation
 PSA Well Litigation
 Bad Faith Pooling
27
Post-Production Cost Litigation
 Numerous cases over the past five years.
 Typically involve a variation of the dispute ...
Heritage Resources v. Nationsbank
 One of the most cited cases on this topic.
 Describe the “netback method” and “compar...
French v. Oxy
 Although having different royalty provisions, the French court found that both leases
provided that the ro...
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...
Chesapeake v. Hyder
 French v. Oxy was not cited in the Court’s opinion.
 Seems that the Court could have held that the ...
PSA Well Litigation
 Disputes of “PSA Wells” generally come in two forms:
 Contractual authority for the lessee to drill...
Authority for Lessee to Drill
 The Texas Railroad Commission seems to have concluded
that lessees do not need pooling aut...
Allocation of Royalty
 Royalty payment issues can arise when a PSA well is drilled
without agreement on apportionment of ...
Browning Oil Company v. Luecke
 Lessee create a unit which did not comply with pooling
restrictions.
 Lessors sought to ...
Bad Faith Pooling
 This is an area that is seeing a slight resurgence, but we
could see more.
 New issues are implicated...
Part Five: One More Thing
38
Be Careful and Know Your Landscape
 Be aware of the lease terms.
 Be aware of your royalty owners.
 Be aware of what yo...
CHRISTOPHER L. HALGREN
McGinnis Lochridge
711 Louisiana St., Ste 1600
Houston, TX 77002
Direct: 713-615-8539
713-615-8585 ...
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Royalty litigation - Chris Halgren

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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.

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Royalty litigation - Chris Halgren

  1. 1. Royalty Litigation: An Overview of Current Trends AUGUST 31, 2016 29TH ANNUAL ENERGY LAW INSTITUTE 1
  2. 2. Part One: Introduction to Royalty Clauses 2
  3. 3. Two Primary Components to Royalty Clause Disputes  HOW is the production valued?  WHERE is the production valued? 3
  4. 4. Three Types of Royalty Clauses  Sales Based  Market Based  Hybrids 4
  5. 5. Ok, there are also “in kind” Royalty Clauses, but let’s move on … 5
  6. 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 6
  7. 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 7
  8. 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. 8
  9. 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” 9
  10. 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.” 10
  11. 11. Part Two: Common Royalty Disputes 11
  12. 12. Typical Types of Royalty Disputes  Failure to pay royalties  Underpayment of royalties  Overpayment of royalties 12
  13. 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. 13
  14. 14. T.S . Reed v. Samson 14
  15. 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. 15
  16. 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). 16
  17. 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. 17
  18. 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.” 18
  19. 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. 19
  20. 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. 20
  21. 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. 21
  22. 22. Part Three: Damages 22
  23. 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 23
  24. 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! 24
  25. 25. Escondido Resources II, LLC v. Justapor Ranch Company, LC 25
  26. 26. Part Four: Current Trends in Royalty Litigation 26
  27. 27. Current Trends  “Post-Production Cost” Litigation  PSA Well Litigation  Bad Faith Pooling 27
  28. 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? 28
  29. 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. 29
  30. 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.. 30
  31. 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. 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. 32
  33. 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 33
  34. 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 34
  35. 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. 35
  36. 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. 36
  37. 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. 37
  38. 38. Part Five: One More Thing 38
  39. 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. 39
  40. 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 40

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