Beware of the Use of “Proceeds,” “Gross Proceeds,” “Gross Sales Price,” or “Amount Realized” in Conjunction with “At The Wellhead” Language in Crafting a Gross Royalty Clause in an Oil And Gas Lease
Should “proceeds,” “gross proceeds,” “gross sales price,” “amount realized,” or similar language be used in conjunction with “at the wellhead” language in crafting a royalty clause where the intent is to create a gross royalty?
Use of the words “proceeds,” “gross proceeds,” “gross sales price,” “amount realized” or similar language in conjunction with “at the wellhead” language is problematic when the intent is to craft a gross royalty. If “at the wellhead” is used with any of the aforesaid language or similar language, the result may be quite different than what was intended. The use of “proceeds,” “gross proceeds,” “gross sales price,” “amount realized” or similar language in conjunction with “at the wellhead” could very well result in a royalty that is calculated using the “net-back method,” meaning that post-production costs would be deducted from the sale price before the lessor’s royalty is calculated, thereby not resulting in the intended gross royalty.
In Kilmer v. Elexco Land Servs., Inc., 990 A.2d 1147 (Pa. 2010), the Supreme Court of Pennsylvania held that Pennsylvania’s Guaranteed Minimum Royalty Act, 58 P.S. § 33, should be read to permit the calculation of a royalty at the wellhead, as provided by the net-back method. The goal of the net-back method is to determine the value of the gas when it leaves the ground by deducting from the sales price the cost of getting the natural gas from the wellhead to market.
In Coastal Forest Res. Co. v. Chevron U.S.A., No. 2:20-cv-1119, 2021 U.S. Dist. LEXIS 89675 (W.D. Pa. May 11, 2021), the United States District Court for the Western District of Pennsylvania addressed the question of whether Kilmer should be given broad construction, covering all instances where the term “at the wellhead,” is used or whether Kilmer was narrowly focused on whether leases using the term run afoul of Pennsylvania’s Guaranteed Minimum Royalty Act.
The royalty clause in Coastal Forest used both “gross sales price” and “at the wellhead” language in the lease’s royalty clause. Specifically, the clause stated:
Gas: To pay lessor as royalty for all gas and its constituents thereof, including all liquid, solid or gaseous substances produced and saved from any sand or sands on the leases [sic] premises, an amount equal to five-thirty-seconds (5/32) or 15.625% of the gross sales price received by Lessee from the sale of such gas and constituents thereof at the wellhead.
Coastal Forest alleged that Chevron took unauthorized deductions for post-production costs from the gross sale price using the net-back method. Coastal Forest alleged that the deductions were inconsistent with the plain language of the lease, i.e., 15.625% of the gross sales price received by lessee. The district court disagreed. Kilmer should be read broadly. As such, and despite the wording in the lease of a gas royalty of 15.625% of the gross sales price received by lessee, the lease, because it used the term “at the wellhead,” called for the calculation of royalties using the net-back method.
In Warren v. Chesapeake Exploration, L.L.C., 759 F.3d 413 (5th Cir. 2014), the Fifth Circuit Court of Appeals reviewed leases that provided in a pre-printed royalty clause that the lessors were entitled to 22.5% of the amount realized by the lessee, computed at the mouth of the well. The court noted that “amount realized” required the measurement of the royalty based on the amount that the lessee in fact received under its sales contract for the gas. Warren, 759 F.3d at 417 (citing Bowdon v. Phillips Petroleum Co., 247 S.W. 3d 690, 699 (Tex. 2008)). Had the leases provided only that the lessor was to receive 22.5% of the amount realized by the lessee, there would be little question that the lessors would be entitled to 22.5% of the sales contract price the lessee received, with no deduction of post-production costs; however, this is not what the leases provided. There was a further proviso, i.e., the amount realized was to be “computed at the mouth of the well.” This quantification of what the royalty was, was to be applied to all gas sold by the lessee, regardless of whether the gas was sold at the mouth of the well, off of the leased premises, or at some point in between. The phrase “amount realized by lessee computed at the mouth of the well” meant that the royalty was to be based on net proceeds, and the physical point to be used as the basis for calculating net proceeds is the mouth of the well. If the parties intended for the lessor to receive 22.5% of the proceeds of sales, regardless of where the sales occurred, they could have accomplished that end by any number of ways. They could have deleted the phrase “computed at the mouth of the well.” They could have said in the addendum that the lessor was entitled to 22.5% of the actual proceeds of sale, regardless of the location of the sale. They did not.
Even when term “at the wellhead” is used with language that indicates that the royalty is to be a gross royalty, e.g., the calculation of the royalty is based on the gross proceeds received, the result can still be a royalty that is not the gross royalty that the lessor intended when the lessor signed the lease.
In Zehentbauer Family Land, LP v. TotalEnergies E&P USA, Inc., No. 20-3469, 2022 U.S. App. LEXIS 3151 (6th Cir. February 1, 2022), the Sixth Circuit Court of Appeals dealt with a royalty clause that contained “gross proceeds” and “at the wellhead” Language.
In Zehentbauer, a class of landowners in Ohio’s Utica Shale Formation claimed that the defendants, oil and gas exploration companies, miscalculated their royalty payments by basing them on the “at the wellhead” price rather than on the downstream higher value of the refined oil and gas products.
Plaintiffs entered into oil and gas lease agreements with the predecessors of the defendants between 2010 and 2012.These agreements allowed the defendant production companies to extract oil and gas from the landowners’ properties. In exchange the landowners were to receive royalty payments “based upon the gross proceeds paid to Lessee for the gas marketed and used off of the leased premises, including casinghead gas or other gaseous substance . . . computed at the wellhead from the sale of such gas substances so sold by Lessee.” (emphasis added). “Gross Proceeds” were defined as “the total consideration paid for oil, gas, associated hydrocarbons and marketable by-products produced from the leased premises.” Gross proceeds were derived from sales either to (1) an unaffiliated bona fide purchaser in an “arms-length transaction,” or (2) an “affiliate of Lessee,” for a comparable sale price “and without any deductions or expenses.”
The defendant producers sold their oil and gas at the wellhead to midstream affiliates. The midstream affiliates processed the raw products and transported them for sale to other unaffiliated downstream companies. The midstream affiliates paid for the gas using the net-back method. The midstream affiliates paid this reduced amount to the defendant producers, who used this net-back price as the basis for calculating the plaintiffs’ royalty payments.
Plaintiffs felt that their royalty should be based on a different set of gross proceeds; not the gross proceeds that were received for the purchase at the wellhead but rather the gross proceeds received by the affiliates further downstream after the product was refined and moved to market, thereby resulting in a higher price. In 2015, Plaintiffs sued the defendant lessees on behalf of themselves and other lessors complaining that Defendants had breached their lease obligations by “failing to pay the royalties due under the leases” to the class members.
Defendants filed a motion for summary judgment, which was granted by the district court with the district court holding that the plain and unambiguous language of the contract required that royalties were to be valued based on the wellhead value of the oil, gas and natural gas liquids and therefore, the deduction of post-production costs were authorized. Zehentbauer Fam. Land LP v. Chesapeake Expl., LLC, 450 F.Supp. 3d 790, 811 (N.D. Ohio 2020). Plaintiffs appealed.
The Sixth Circuit Court of Appeals held that defendants’ royalty calculations followed the lease language. Defendants sold the oil and gas at the well to their affiliates and calculated the landowners’ royalty payments based upon the amount received from those sales.
In drawing this conclusion, the Sixth Circuit obtained its conclusion from a textual analysis. In looking at the leases, the leases provided that gas royalties are calculated “based upon the gross proceeds paid to Lessee for the gas marketed and used off the leased premises . . . computed at the wellhead from the sale of such gas substance so sold by Lessee.” Thus, the royalty calculation was based on the “gross” (or total) proceeds; paid to Lessee[s], i.e., defendants themselves; on gas marketed, i.e., sold; at the wellhead (citing Henceroth v. Chesapeake Expl. LLC ,814 F. App’x 67, 69 (6th Cir. 2020) (noting that the key language is produced and marketed from the leasehold, and it showed that the first sale price is the proper royalty base); using the net-back method, id. (stating that “[i]t is standard practice in the industry to calculate the wellhead sales price using the net-back method and to use the net-back price to calculate landowners’ royalties”). Thus, plaintiffs’ royalties were based on the wellhead value of the gas sold. There was no deduction at all. Stated differently, though the lessees were receiving an amount that is “net” as to the downstream affiliate, it was not “net” from the lessees’ perspective, but simply the actual cost of the raw product produced by the lessee production company without any deductions (production or post-production) by the lessee for its production costs. Plaintiffs’ royalties were based on those gross proceeds paid to the lessee.
Should “proceeds,” “gross proceeds,” “gross sales price,” “amount realized” or similar language be used in conjunction with “at the wellhead” language in crafting a royalty clause where the intent is to create a gross royalty? No. If the intent is to craft a royalty clause providing for a gross royalty, using “at the well head” language with “proceeds,” “gross proceeds,” “gross sales price,” “amount realized” or similar language may very well result in a net royalty or a royalty that is calculated after all of the post-production costs have been deducted from the “proceeds,” “gross sales price,” “amount realized” or anything similar. If the intention is to receive a gross royalty, do not use “at the wellhead” language.
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