Heritage Resources, Inc. v. NationsBank

939 S.W.2d 118, 1996 WL 200362

Opinions

Justice BAKER

delivered the opinion of the Court,

in which Chief Justice PHILLIPS, Justice CORNYN, Justice ENOCH, and Justice SPECTOR join.

This case involves construction of royalty clauses in several oil and gas leases. Nati-onsBank sued Heritage contending that Heritage deducted transportation costs from the value of NationsBank’s royalty in violation of the leases.

The trial court rendered a partial summary judgment against Heritage deciding liability and damages through 1991. Nati-onsBank amended its pleading to include Heritage’s deductions through 1993. After a bench trial, the trial court awarded Nati-onsBank and other royalty owners the transportation costs Heritage deducted plus interest and attorney’s fees.

The court of appeals affirmed the trial court’s judgment. 895 S.W.2d 833. It held that the royalty clauses showed the parties’ intent not to deduct the post-production transportation costs when determining market value at the well. 895 S.W.2d at 836-37. The court of appeals also held that the division orders Heritage and the royalty owners executed did not bind the royalty owners and that Heritage was liable for the full amount deducted. 895 S.W.2d at 839.

We conclude the trial court and the court of appeals incorrectly interpreted the royalty clauses. We reverse the court of appeals’ judgment. We render judgment that Nati-onsBank take nothing. Further, we disapprove of the court of appeals’ language about the liability of an operator who underpays royalty interest owners.

Facts

NationsBank is the trustee for owners of interests in gas, oil, and other minerals inherited under David B. Trammel’s will. Heritage is the lessee and operator under a number of leases. Heritage also owns an undivided working interest in some of the leases. Heritage sold gas off the leased premises. Heritage deducted the cost to transport the gas from the wellhead to the point of sale as a post-production cost from the sales price before calculating royalties.

In January 1989, NationsBank noticed that Heritage was deducting severance taxes and transportation charges from the purchase price. NationsBank objected to the transportation charge deduction. NationsBank contended that the leases specifically prohibited the deduction. Three different leases are in issue. The relevant parts are:

3. The royalties to be paid Lessor are ...

(b) on gas, including casinghead gas or other gaseous substances produced from the land, or land consolidated therewith, and sold or used off the premises or in the manufacture of gasoline or other products therefrom, the market value at the well of ⅜ of the gas so sold or used, provided that on gas sold at the well the royalty shall be ⅜ of the amount realized from such sale provided, however, that there shall be no deductions from the value of the Lessor’s royalty by reason of any required processing, cost of dehydration, compression, transportation or other matter to market such gas.

or:

3. In consideration of the premises, Lessee covenants and agrees ...

(b) To pay the Lessor ⅛ of the market value at the well for all gas (including substances contained in such gas) produced from the leased premises; provided, however, that there shall be no deductions from the value of Lessor’s royalty by reason of any required processing, cost of dehydration, compres sion, transportation, or other matter to market such gas.

or

3. Lessee shah pay the following royalties subject to the following provisions: ...

(b) Lessee shall pay the Lessor ⅜ of the market value at the weh for all gas (including ah substances contained in such gas) produced from the leased premises and sold by Lessee or used off the leased premises, including sulphur produced in conjunction therewith; provided, however, that there shall be no deductions from the value of Lessor’s royalty by reason of any required processing, cost of dehydration, compression, transportation, or other matter to market such gas.

Although the court of appeals states that the leases are virtually identical, the first lease is distinctly different from the others. In the first lease, for gas sold on the lease, royalty is on proceeds, with no deduction for marketing costs, but if sold at a point off the lease, the royalty is the market value at the well. However, this difference is irrelevant for purposes of this opinion. All three leases require us to determine if Heritage improperly deducted transportation costs from the royalty payments. The critical clause in all three leases is the requirement that Heritage pay the royalty interest owners their fractional interest of “the market value at the well” of the gas produced.

Royalty Clause Construction

Heritage contends that the royalty clauses define the lessor’s royalty as a fraction of the market value at the well. Therefore, the clauses limiting deduction from the value of the lessor’s royalty simply means that Heritage cannot deduct an amount from the sales price that would make the royalty paid less than the required fraction of market value at the well. Because NationsBank concedes Heritage only deducted reasonable transportation costs from the market value at the point of sale, Heritage did not make a deduction from the “value of the Lessor’s royalty.”

The court of appeals rejected Heritage’s interpretation of the royalty clause. 895 S.W.2d at 836. The court of appeals reasoned that because royalty interests are normally subject to post-production costs, Heritage’s interpretation renders the post-production clause meaningless. 895 S.W.2d at 837. Although we do not disagree with the court of appeals’ reasoning in this respect, we find that applying the trade meaning of royalty and market value at the well renders the post-production clauses surplus-age as a matter of law.

(a) Applicable Law

Oil and Gas Lease Construction

The question of whether a contract is ambiguous is one of law for the court. R & P Enters. v. LaGuarta, Gavrel & Kirk, Inc., 596 S.W.2d 517, 518 (Tex.1980). A contract is ambiguous when its meaning is uncertain and doubtful or is reasonably susceptible to more than one interpretation. Coker v. Coker, 650 S.W.2d 391, 393 (Tex.1983). In construing an unambiguous oil and gas lease our task is to ascertain the parties’ intentions as expressed in the lease. Sun Oil Co. v. Madeley, 626 S.W.2d 726, 727-28 (Tex.1981); McMahon v. Christmann, 157 Tex. 403, 303 S.W.2d 341, 344 (1957). To achieve this goal, we examine the entire document and consider each part with every other paid so that the effect and meaning of one part on any other part may be determined. Steeger v. Beard Drilling, 371 S.W.2d 684, 688 (Tex.1963). We presume that the parties to a contract intend every clause to have some effect. Ogden v. Dickinson State Bank, 662 S.W.2d 330, 331 (Tex.1983). We give terms their plain, ordinary, and generally accepted meaning -unless the instrument shows that the parties used them in a technical or different sense. Western Reserve Life Ins. Co. v. Meadows, 152 Tex. 559, 261 S.W.2d 554, 557 (1953), cert. denied, 347 U.S. 928, 74 S.Ct. 531, 98 L.Ed. 1081 (1954). This Court will enforce the unambiguous document as written. Sun Oil Co., 626 S.W.2d at 728. Both the trial court and the court of appeals determined that the leases in question were unambiguous. We agree.

Royalty

Royalty is commonly defined as the landowner’s share of production, free of expenses of production. See Delta Drilling Co. v. Simmons, 161 Tex. 122, 338 S.W.2d 143, 147 (1960); Alamo Nat’l Bank v. Hurd, 486 S.W.2d 335, 338 (Tex.Civ.App.—San Antonio 1972, writ ref'd n.r.e.); 8 Williams & Meyers, Oil & Gas Law, 856-57 (1987); 3 Kuntz, Oil & Gas Law, § 42.2 (1989). Although it is not subject to the costs of production, royalty is usually subject to post-production costs, including taxes, treatment costs to render it marketable, and transportation costs. Martin v. Glass, 571 F.Supp. 1406, 1410 (N.D.Tex.1983), aff'd, 736 F.2d 1524 (5th Cir.1984); Williams & Meyers, supra, p. 857. However, the parties may modify this general rule by agreement. Martin, 571 F.Supp. at 1410.

Market Value at the Well

Market value at the well has a commonly accepted meaning in the oil and gas industry. See generally Wakefield, Annotation, Meaning of, and Proper Method for Determining, Market Value or Market Price in Oil and Gas Lease Requiring Royalty to be Paid on Standard Measured by Such Terms, 10 ALR 4th 732 (1981). Market value is the price a willing seller obtains from a willing buyer. See Exxon Corp. v. Middleton, 613 S.W.2d 240, 246 (Tex.1981). There are two methods to determine market value at the well.

The most desirable method is to use comparable sales. Middleton, 613 S.W.2d at 246; Texas Oil & Gas Corp. v. Vela, 429 S.W.2d 866, 872 (Tex.1968). A comparable sale is one that is comparable in time, quality, quantity, and availability of marketing outlets. Middleton, 613 S.W.2d at 246; Vela, 429 S.W.2d at 872.

Courts use the second method when information about comparable sales is not readily available. See, e.g., Le Cuno Oil Co. v. Smith, 306 S.W.2d 190, 193 (Tex.Civ.App.—Texarkana 1957, writ ref'd n.r.e.), cert. denied, 356 U.S. 974, 78 S.Ct. 1137, 2 L.Ed.2d 1147 (1958); Clear Creek Oil & Gas Co. v. Bushmiaer, 165 Ark. 303, 264 S.W. 830, 832 (1924); see also Pierce, Royalty Valuation Principles in a Changing Gas Market, in State Bae of Texas PROF. Dev. PROGRAM, 11th Annual Advanced Oil, Gas and Mineral Law Course E, E-9 (1993). This method involves subtracting reasonable post-production marketing costs from the market value at the point of sale. Texas Oil & Gas Corp. v. Hagen, 683 S.W.2d 24, 28 (Tex.App.—Texarkana 1984), dism’d as moot, 760 S.W.2d 960 (Tex.1988). Post-production marketing costs include transporting the gas to the market and processing the gas to make it marketable. Hagen, 683 S.W.2d at 29. With either method, the plaintiff has the burden to prove market value at the well. Hagen, 683 S.W.2d at 29.

(b) Application of Law to the Facts

The court of appeals disregarded the generally accepted meanings of “market value at the well” and “royalty” to determine that Heritage wrongfully deducted post-production costs. The court of appeals’ construction results in a royalty clause that specifies royalty payable as a fraction of the market value at the well, to mean the royalty is payable as a fraction of the market value at the point of sale with no deductions for post-production costs.

The terms “royalty” and “market value at the well” have well accepted meanings in the oil and gas industry. The post-production clauses in issue here plainly state that there “shall be no deduction from the value of the Lessor’s Royalty.” The leases clearly set the lessor’s royalty as a fraction (⅛ or ½) “of the market value at the well.” Under the leases, the lessee must determine the value of the lessor’s royalty. The lessee accomplishes this by determining market value at the well and multiplying it by the fraction specified in the royalty clause (⅝ or ⅜). This result is the value of the lessor’s royalty. The post-production clauses then specify that there can be no deduction from this value (the value of the lessor’s royalty) by reason of any post-production costs.

Here, the only conclusion we can draw is that the post-production clauses merely restate existing law. The post-production clauses illustrate that the lessee cannot pay the lessor less than his fractional value of the comparable sales price (market value). This could occur if the amount realized from the sale of the gas less the post production costs was less than the comparable sales price and the lessee calculated the lessor’s royalty by subtracting post production costs from amount realized. At times the amount realized from the sale of gas has varied greatly from the market value of the gas. See Vela, 429 S.W.2d at 875-76 (evidence sustained trial court’s finding that market value was 13.047 cents per mcf even though amount realized by lessee under long term gas sales contract was 2.3 cents per mcf). Even though the Vela scenario may be unlikely to reoccur in the future due to changes in the market place, see, e.g. Pierce, supra, E-l— E-3, the market value may differ from the amount realized.

We recognize that our construction of the royalty clauses in two of the three leases arguably renders the post-productions clause unnecessary where gas sales occur off the lease. However, the commonly accepted meaning of the “royalty” and “market value at the well” terms renders the post-production clause in each lease surplusage as a matter of law.

To determine if Heritage correctly paid royalties under the leases, we must first determine the market value of the gas at the well. NationsBank offered no evidence of comparable sales. However, Heritage conceded in its response to NationsBank’s motion for partial summary judgment that the price Heritage received for the gas was the market price at the point of sale. Nations-Bank conceded at oral argument that the transportation costs Heritage deducted were reasonable.

Because there is no evidence to support the comparable sales method of computing market value at the well, we use the alternate method. Under that method, Heritage must pay a royalty based on the market value at the point of sale less the reasonable post-production marketing costs. Hagen, 683 S.W.2d at 28. Based on the parties’ concessions, the amount Heritage paid is the correct amount in royalties to NationsBank under the leases.

Division Orders

Heritage entered into division orders with the royalty owners. The division orders contained the following language:

All proceeds from the sale of gas shall be paid to the undersigned or their assigns in the proportions as herein set out less taxes and any costs incurred in the handling and transportation to the point of sale, treating, compressing boosting, dehydrating or any other conditioning necessary, subject to the terms of any contract of purchase and sale which affects the above described property ...

The court of appeals held that the division orders were of no effect and that Heritage was liable for reimbursement to the royalty owners for transportation costs improperly withheld in payment to Urantia. The court of appeals’ discussion about the effect of a division order that contradicts the lease terms conflicts with our earlier opinion in Gavenda v. Strata Energy, Inc., 705 S.W.2d 690 (Tex.1986).

The general rule is that division orders are binding until revoked. Gavenda, 705 S.W.2d at 691; Middleton, 613 S.W.2d at 250. When an operator prepares a division order that allocates payments among the interest owners in a manner that differs from the lease provisions and the operator retains the benefits, the division order is not binding. Gavenda, 705 S.W.2d at 692. The basis of this rule is unjust enrichment. Gavenda, 705 S.W.2d at 692. The operator then becomes liable for the part of the interest owner’s payments the operator retained. See Gavenda, 705 S.W.2d at 693. The operator is not liable for the amounts it paid out to other interest owners. Gavenda, 705 S.W.2d at 693.

The court of appeals decision incorrectly states that “Heritage was liable for reimbursement to the royalty owners for transportation costs improperly withheld in payment to Urantia.” 895 S.W.2d at 839. Under Gavenda, Heritage would be liable, if at all, only for the amount of the unpaid royalty it retained. In this case, there were other working interest owners who were not parties to the suit. Absent an agreement otherwise, all the working interest owners would benefit from an improper deduction of transportation charges from the royalties paid to NationsBank. Therefore the trial court could only hold Heritage liable for an amount of unpaid royalties that Heritage retained.

Summary

In conclusion, we hold that the court of appeals erred in holding that the lease required Heritage to pay royalties based on the market value at the point of sale. Further, we specifically disapprove of the court of appeals discussion about an erroneous division order’s effects. We reverse the court of appeals’ judgment and render judgment that NationsBank take nothing from Heritage.