Carl v. Hilcorp Energy
U.S. Court of Appeals for the Fifth Circuit
Carl v. Hilcorp Energy, 91 F.4th 311 (5th Cir. 2024)
Carl v. Hilcorp Energy
Opinion
Case: 22-20226 Document: 00517032056 Page: 1 Date Filed: 01/12/2024
United States Court of Appeals
for the Fifth Circuit United States Court of Appeals
Fifth Circuit
____________ FILED
January 12, 2024
No. 22-20226
Lyle W. Cayce
____________ Clerk
Anne Carl, as Co-Trustee of the CARL/WHITE TRUST, on behalf
of itself and a class of similarly situated persons; Anderson White, as Co-
Trustee of the CARL/WHITE TRUST, on behalf of itself and a class of
similarly situated persons,
Plaintiffs—Appellants,
versus
Hilcorp Energy Company,
Defendant—Appellee.
______________________________
Appeal from the United States District Court
for the Southern District of Texas
USDC No. 4:21-CV-2133
______________________________
Before Dennis, Elrod, and Ho, Circuit Judges.
Per Curiam:1
In this mineral royalty dispute, the lessors appeal the district court’s
dismissal of their claim that the lessee must pay royalties on gas used off-lease
for post-production services like transport and processing. Because we
_____________________
1
Judge Dennis concurs only in the decision to certify the questions to the Supreme
Court of Texas.
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No. 22-20226
cannot confidently make an Erie guess on this issue that is likely to recur, we
CERTIFY two questions to the Supreme Court of Texas.
I
Anne Carl and Anderson White, as trustees of the plaintiff
Carl/White Trust, and defendant Hilcorp Energy Company are successors
in interest to a mineral lease that governs at least two wells in Brazoria
County, Texas. Under this lease, Hilcorp must pay royalties to the Trust
“on gas . . . produced from said land and sold or used off the premises . . . the
market value at the well of one-eighth of the gas so sold or used.” Hilcorp
also “shall have free use of . . . gas . . . for all operations hereunder.”
The Trust filed a class action complaint on behalf of royalty owners
with similar leases alleging that Hilcorp failed to pay royalties on gas used in
off-lease post-extraction processing services, such as compression and
dehydration, necessary to make the gas saleable, commonly referred to as
“post-production costs.” See Burlington Res. Oil & Gas Co. LP v. Texas Crude
Energy, LLC, 573 S.W.3d 198, 203 (Tex. 2019). The Trust’s complaint
asserted that two provisions of the mineral lease entitle it to royalties on gas
used off-lease for post-production costs. The off-lease clause requires
Hilcorp to pay royalties for gas “sold or used off the premises,” and the free-
use clause provides for the free use of gas, but only when used for
“operations” on the lease premises. The Trust asserted in its complaint that
the off-lease clause expressly requires Hilcorp to pay royalties on gas “used
off the premises” and the free use clause, by providing for free use of gas on-
lease, impliedly excludes the possibility of free use of gas off-lease.
Hilcorp moved to dismiss the Trust’s complaint for failure to state a
claim, arguing that the lease calculates royalties based on the market value at
the well, a value which necessarily excludes any gas used in post-production
costs. The district court agreed, observing that the market value at the well
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clause was the “critical clause in interpreting the lease agreement at issue.”
Applying the “workback method” recognized under Texas law, the district
court found that post-production costs would be deducted from the Trust’s
royalty calculation. Because the complaint only alleged unpaid royalties on
these deductions, the district court reasoned that the Trust sought royalties
to which it was not entitled under the lease. The court granted the motion to
dismiss. It did so without prejudice, however, and granted the Trust leave to
amend its allegations of off-lease use for non-post-production purposes. The
Trust filed a Second Amended Complaint with the new assertion that: “Gas
that is not sold, but is used off the lease, can be and is used for many purposes
and locations and never reaches a point of sale.” The district court dismissed
this complaint as well, determining that the Trust’s vague amendment failed
to allege with specificity any off-lease gas used in non-post-production
activities, and that the complaint otherwise failed for the same reasons
provided in the court’s earlier order. The Trust’s complaint was dismissed
with prejudice. The Trust timely appealed.
II
“We review de novo a district court’s dismissal under Rule 12(b)(6),
accepting all well-pleaded facts as true and viewing those facts in the light
most favorable to the plaintiffs. To survive a Rule 12(b)(6) motion to dismiss,
plaintiffs must plead enough facts to state a claim for relief that is plausible
on its face.” Warren v. Chesapeake Expl., L.L.C., 759 F.3d 413, 415(5th Cir. 2014) (citations omitted). In this Class Action Fairness Act diversity case, see28 U.S.C. § 1332
(d), “Texas law governs the interpretation of the plaintiffs’ oil and gas leases, and this court reviews a district court’s interpretation of state law de novo.” Warren,759 F.3d at 415
(citations
omitted).
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III
We begin with some background. Gas production is the process of
bringing raw gas to the surface. BlueStone Nat. Res. II, LLC v. Randle, 620
S.W.3d 380, 386 (Tex. 2021) (citing 8 Williams & Meyers Oil and Gas Law, Manual of Oil & Gas Terms, at 833 (2020)). “A royalty payment, which represents a lessor’s fractional share of production from a lease, may be calculated at the wellhead or at any downstream point, depending on the lease terms. Gas royalties are generally free of the expenses incurred to extract raw gas from the land (production costs) but not expenses incurred to prepare raw gas for downstream sale (postproduction costs). Because mineral leases are contracts, these general rules may be modified as the parties see fit.”Id. at 387
(citations omitted).
Royalty clauses typically have three components: “(i) the royalty
fraction—e.g., 1/8th, 25%, 1/5th; (ii) the yardstick—e.g., market value,
proceeds, price; and (iii) the location for measuring the yardstick—e.g., at
the well, at the point of sale.” BlueStone Nat. Res. II, LLC v. Randle, 601
S.W.3d 848, 856 (Tex. App.—Forth Worth 2019) (citing Byron C. Keeling, In the New Era of Oil & Gas Royalty Accounting: Drafting a Royalty Clause That Actually Says What the Parties Intend It to Mean,69 Baylor L. Rev. 516
, 520 (2017)), aff’d in part, rev’d in part on other grounds,620 S.W.3d 380
(Tex.
2021). The royalty clause in the Trust’s lease provides the Trust with a
royalty of 1/8 of the market value at the well of all gas sold or used off the
premises. Following the taxonomy above, its components are (i) 1/8 (ii) of
the market value (iii) measured at the well.
The market value of gas is typically lower at the wellhead than it is at
a downstream point of sale. This is because “[a]n arm’s length purchaser
typically will pay more for oil and gas that the lessee has already transported
to a downstream market and compressed, processed, treated, and otherwise
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made ready for a downstream sale.” Keeling, supra, at 525; see also Devon
Energy Prod. Co., L.P. v. Sheppard, 668 S.W.3d 332, 336 (Tex. 2023) (“These investments generally make production more valuable.”). Thus, the standard interpretation of a market value at the well provision in a mineral lease is that it “means value at the well, net of any value added . . . after [the gas] leaves the wellhead.” Judice v. Mewbourne Oil Co.,939 S.W.2d 133, 135
(Tex. 1996); see also Chesapeake Expl., L.L.C. v. Hyder,483 S.W.3d 870, 873
(Tex. 2016) (“The market value at the well should equal the commercial
market value less the processing and transporting expenses that must be paid
before the gas reaches the commercial market.”).
In a royalty dispute, it is the royalty owner’s burden to prove the
market value at the well. Heritage Res., Inc. v. NationsBank, 939 S.W.2d 118,
122(Tex. 1996). In Texas there are two accepted methods to determining market value at the well.Id.
The preferred is the “comparable sales” method, which uses “actual sales that are ‘comparable in time, quality, quantity, and availability of marketing outlets.’” Randle, 620 S.W.3d at 388 (quoting Heritage Res.,939 S.W2d at 122
). The second is the “workback method,” which is used when comparable sales data is unavailable.Id.
at 388–89. This method estimates the wellhead value by deducting post- production costs from the proceeds of downstream sale.Id.
“Although parties to an agreement may define post-production costs any way they choose, the term generally applies to processing, compression, transportation, and other costs expended to prepare raw oil or gas for sale at a downstream location.” Burlington Res.,573 S.W.3d at 203
. Consistent
with the notion that a mineral’s value at the wellhead is less than its value
after being transported, processed, and prepared for market, the workback
method allows the lessee to subtract these value-enhancing, post-production
costs to estimate the worth of the mineral before those services were
rendered. Keeling, supra, at 532. “[W]hile the comparable sales method is
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the preferred way of calculating the wellhead value of oil and gas production,
the vast majority of lessees do not use—and have never used—the
comparable sales method to calculate their royalty payments. This is true, as
a practical matter, because wellhead sales of oil and gas have become
increasingly less common since the early 1990s.” Id. at 531.
Where comparable sales allegations are not pleaded or proven, Texas
courts have consistently applied the workback method to calculate royalties
based on market value at the well. See Heritage Resources, 939 S.W.2d at 123(“Because there is no evidence to support the comparable sales method of computing market value at the well, we use the [workback] method.”); Occidental Permian Ltd. v. French,391 S.W.3d 215, 222
(Tex. App.—Eastland 2012) (“Having concluded that no evidence exists to support the trial court’s [comparable sales] determination of market value at the well, we next must examine whether that value is supported by evidence under the [workback] method.”); see also Randle, 620 S.W.3d at 388 (“When comparable sales data is unavailable, an alternative methodology for determining ‘market value’ at a specified valuation point is the . . . ‘workback’ method.”); Potts v. Chesapeake Expl., L.L.C.,760 F.3d 470, 475
(5th Cir. 2014) (“The deduction
of post-production costs incurred between the wellhead and a downstream
point at which market value could be ascertained was nothing more than a
method of determining market value at the well in the absence of comparable
sales data at or near the wellhead.”). Thus, the workback method, while not
preferred when the comparable sales method is available, is nonetheless a
perfectly adequate “proxy” for the lease term “market value at the well”
when the comparable sales method is unavailable. Randle, 620 S.W.3d at 389.
IV
The parties dispute whether, under the workback method, the lessee
must pay royalties on gas used off-lease as part of the post-production
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process. The off-lease clause requires Hilcorp to pay royalties for gas “sold
or used off the premises,” and the free-use clause provides for the free use of
gas, but only when used for “operations” on the lease premises. The district
court held that these provisions did not preclude lessees from deducting gas
used as fuel during post-production or as in-kind payment for post-
production services from the amount of gas on which royalties were owed.
The Trust argues that, under the Supreme Court of Texas’s recent
decision in Randle, the lease’s market value at the well provision does not
limit or affect the off-lease and free-use clauses, which clearly entitle it to
royalties on gas used off-lease. The Trust further argues that even if such gas
can be deducted, the deduction can only be applied to the value per unit of
gas. It cannot reduce the number of units of gas on which royalties must be
paid. Hilcorp contends that, as the district court held, Randle is inapplicable
because it concerned a gross-value-received lease, rather than a value-at-the-
well lease. While Randle does concern a different type of lease, the section of
that opinion addressing the free-use clause can be read to address free-use
clauses generally. This raises the question of whether the free-use clause
here, when read in conjunction with the rest of the lease, permits deduction
of gas used off-lease for post-production purposes. The uncertainty about
Randle’s effect raises the question of whether the appropriate course is to
certify the issue for resolution by the state court of last resort. It also raises
the question of how a potential deduction should be applied.
The Texas Rules of Appellate Procedure authorize the Supreme
Court of Texas to “answer questions of law certified to it by any federal ap-
pellate court if the certifying court is presented with determinative questions
of Texas law having no controlling Supreme Court precedent.” Tex. R. App.
P. 58.1. The issues presented here satisfy that condition. The issues pre-
sented also satisfy the three factors we use in deciding whether to certify:
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1) [T]he closeness of the question and the existence of suffi-
cient sources of state law;
2) [T]he degree to which considerations of comity are relevant
in light of the particular issue and case to be decided; and
3) [P]ractical limitations on the certification process: signifi-
cant delay and possible inability to frame the issue so as to
produce a helpful response on the part of the state court.
In re Gabriel Inv. Grp., 24 F.4th 503, 507(5th Cir. 2022). The circumstances here strongly support certification. “[A]ny Erie guess would involve more divining than discerning.” McMillan v. Amazon.com, Inc.,983 F.3d 194, 202
(5th Cir. 2020). Randle is a recent case, and we are not aware
of any opportunity that Texas courts have had to address whether its free-use
analysis applies to value-at-the-well leases. The parties cite several cases in
support of their respective positions, but the Texas cases precede Randle and
the federal cases, while careful and thoughtful, are Erie guesses about what
the Supreme Court of Texas would do. Accordingly, the cited cases do not
provide sufficient guidance as to Texas law on these issues. Comity interests
also favor certification, as the interpretation of mineral leases are an
important and significant part of Texas state law. Finally, we are not aware
of any practical impediments to certification.
* * *
Accordingly, we CERTIFY the following determinative questions of
law to the Supreme Court of Texas:
1) After Randle, can a market-value-at-the well lease containing an off-
lease-use-of-gas clause and free-on-lease-use clause be interpreted to allow
for the deduction of gas used off lease in the post-production process?
2) If such gas can be deducted, does the deduction influence the value
per unit of gas, the units of gas on which royalties must be paid, or both?
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We disclaim any intention or desire that the Supreme Court of Texas
confine its reply to the precise form or scope of the questions certified. We
will resolve this case in accordance with any opinion provided on these
questions by the Supreme Court of Texas. The Clerk of this Court is directed
to transmit this certification and request to the Supreme Court of Texas in
conformity with the usual practice.
QUESTIONS CERTIFIED.
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