Devon v. Sheppard postproduction ruling

Takeaway Lessons from the Texas Supreme Court’s Ruling in Devon v. Sheppard Regarding Post-Sale Postproduction Costs

In a recent holding, the Texas Supreme Court has upheld a lower court ruling enforcing an oil and gas lease provision which made the landowners’ lease  royalty-free of any post-sale postproduction costs that add value after the point of sale but that are not part of the producers’ “gross proceeds.”

The Postproduction Deduction Provision in the Lease

In the case of Devon Energy Production Co. v. Sheppard, 668 S.W.3d 332 (Tex. 2023)  a dispute arose over royalty payments. The  Sheppard and Crain families contended that they had been underpaid on their lease royalties when Devon had calculated such royalty payments based upon the amount that  Devon had received from oil and gas purchasers, which Devon argued was the “gross proceeds” amount contemplated for in the leases to be used for royalty calculation. The leases at issue provided for the lessors’ royalty to be paid based on a specific fraction of gross proceeds from the sale of oil and gas without deduction for the costs of production or for certain postproduction costs. The leases additionally included the following provision in Paragraph 3(c):

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 all oil or gas, then such deduction, expense or cost shall be added to the market value or gross proceeds so that the 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.

Postproduction Costs Attributable to Devon’s Sales Contracts

While Devon did not deduct any additional postproduction costs from the lessors’ royalty for which it had directly incurred, Devon’s gas sales contracts did include deductions from a stated gross price of any of the purchaser’s post-sale downstream costs, as well as deductions for any gas used as fuel or lost during operations.

The court stated that this broad lease language provided for a royalty that,

“…may exceed gross proceeds and plainly requires the producers to pay royalties on the gross proceeds of the sale plus sums identified in the producers’ sales contracts…even if such expenses are incurred only by the buyer after or downstream from the point of sale.”

Devon unsuccessfully argued that the language in Paragraph 3(c) was mere surplusage meant to emphasize the cost-free nature of a “gross proceeds” royalty by requiring them to “add back” only pre-sale postproduction costs. The court disagreed, pointing out specific provisions in Devon’s sales contracts that involved downward adjustments specifically labeled as accounting for “production, treatment, transportation, manufacturing, processing or marketing” expenses.

Lessons Learned

Based upon this ruling, producers in Texas may well avoid similar conflicts and benefit from either (1) negotiating out-of-royalty calculation provisions similar to the one described in Paragraph 3(c) above; or (2) adjusting their production sales contracts so that purchaser’s downstream costs are not directly attributable to the contracted sale price.

Written by Kyle Williams, Attorney at KMD Law.