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October 14, 2014 Articles

Allocating Royalties Between Separate Tracts

Lessees should be cognizant of the dangers and uncertainty accompanying allocation wells.

By Christopher L. Halgren – October 14, 2014

The proper manner of allocating production has received increased attention sinceBrowning Oil Co. v. Luecke, 38 S.W.3d 625 (Tex. App.—Austin 2000, pet. denied.) and the more recent challenge to the legality of allocation wells. Many wells have been drilled in Texas that traverse multiple tracts with different ownership, requiring an operator or lessee to determine the proper method of paying royalties to each royalty owner. Sometimes, allocating royalties can be determined by use of pooling authority by obtaining a production-allocation agreement from each royalty owner. But where no prior pooling or sharing agreement exists or can be reasonably obtained, the lessee will have no guidance as to how to properly allocate production between separate tracts.

On December 20, 2013, the San Antonio Court of Appeals delivered an opinion that allocated royalties under the terms of a 1993 royalty-sharing agreement based on the proportion that the length of the productive horizontal lateral underlying each separate tract bears to the entire productive length. See Springer Ranch, Ltd. v. Jones, 421 S.W.3d 273 (Tex. App.—San Antonio 2013, no pet.). Whether this case presents merely the interpretation of a particular contract or has potential industry-wide application depends on whetherSpringer Ranch can answer at least one question posed by the Austin Court of Appeals inBrowning Oil Co. v. Luecke—how is production to be allocated between separate tracts absent pooling or other sharing agreement? If so, then Springer Ranch can be used as a court-approved method of allocation. While some suggested this approach may be appropriate, Springer Ranch appears to be the first Texas case that expressly accepts this methodology.

Background on Springer Ranch
In Springer Ranch, the parties were successors-in-interest to Alice Burkholder, who leased 8,545 acres of land, which lease was still in effect at the time of the court’s opinion in 2013. The property was partitioned among Burkholder’s successors. In 1993, an agreement was reached between Burkholder’s successors as follows:

[The parties] contract and agree with each of the other parties, that all royalties payable under the above described Oil and Gas Lease from any well or wells on said 8,545.02 acre tract, shall be paid to the owner of the surface estate on which such well or wells are situated, without reference to any production unit on which such well or wells are located.

Essentially, the parties agreed that royalties would be apportioned, entitling each landowner to 100 percent of all royalties from minerals produced from a well on his land. See Japhat v. McRea, 276 S.W. 669 (Tex. Comm’n App. 1925, judgm’t adopted) (discussing non-apportionment rule).

The 1993 agreement worked well for many years, when all wells were conventional vertical wells and each landowner received 100 percent of royalties from the wellhead physically located on his property. But things became more complicated when horizontal wells were introduced because, while the wellhead may be situated on property owned by one landowner, the well bore would traverse under land owned by a separate landowner. In this case, Springer Ranch argued it was entitled to 100 percent of royalties produced from the wellhead on its property. The other landowners (collectively, the Sullivan parties) argued they were entitled to a proportionate share of the royalties because the wellbore traversed under their surface.

The court held that the term “well” meant “the shaft or hole bored or sunk in the earth through which the presence of minerals may be detected and their production obtained”; in other words, the entire productive length of the lateral. This conclusion was based not only on the language of the 1993 agreement, but also on the “physical facts of the mineral and surface estates, and the applicable case law. . . .” The court rejected Springer Ranch’s contention that the term “well” was synonymous with “wellhead.” The court construed the term “well” to include both the surface owned by Springer Ranch and the surface owned by the Sullivan parties.

The next step was to apportion royalties between the surface owners. The expert for the Sullivan parties “measured the total distance between . . . [the] well’s first and last takepoints within the correlative interval, the distance between its first takepoint and the property line between Sullivan and Springer Ranch’s properties, and the distance between the property line and the well’s last takepoint.” To allocate royalties, the expert then multiplied the lessor’s royalty interest “by the ratio of the total distance between the first and last takepoints.” Importantly, “Springer Ranch did not dispute the expert’s measurements or calculations, nor did it offer evidence of any other basis for determining how much production was obtained from the parts of the well on the parties’ respective surface estates.”

Allocation of Royalties with “Reasonable Certainty” after Luecke 
After Luecke, many wondered how to properly allocate production “with reasonable probability.” One method, accepted by the court in Springer Ranch, would be to base the calculation on the proportion of the length of the productive horizontal lateral underlying each separate tract compared to the entire productive length. The well in Springer Ranchwas not an allocation well (it was a lease well), but neither was the well in Luecke. But because the 1993 agreement required royalties to be paid based on surface ownership, production on the separately owned tracts had to be separately accounted for.

The exercise of production allocation appears to be the same in Springer Ranch as it was inLuecke where the well crossed separate leased premises. The Luecke court held that the “Lueckes are not entitled to royalties on production from lands they do not own” based on the language of the lease, absent pooling or some other sharing agreement. Reversing the jury’s damage award, which included royalty on 100 percent of production, the Luecke court stated that “[t]he better remedy is to allow the offended lessors to recover royalties as specified in the lease, compelling a determination of what production can be attributed to their tracts with reasonable probability.” See id. at 647 (citing Ortiz Oil Co. v. Luttes, 141 S.W.2d 1050, 1053 (Tex. Civ. App.—Texarkana 1940, writ dism'd by agr.) for the proposition that that exact amount of oil produced cannot be precisely determined is no reason for denying recovery based on jury’s approximation). To emphasize the point, the court reiterated that “[t]he Lueckes are entitled to the royalties for which they contracted, no more and no less.”

In both Springer Ranch and Luecke, the starting point for allocating royalties is determining how much of the production was from the lessor’s own land. Importantly, in both cases, this was a matter of contract, not an operation of law. In Springer Ranch, this result was required by the 1993 agreement, which stated that each landowner was entitled to all production from a well on his property, together with the Springer Ranch court’s interpretation of “well” to be the entire length of the lateral. In Luecke, this result was required by the language of the lease, which provided that the lessor was to be paid for production from the leased premises.

The result in Springer Ranch would likely have been the same if the tracts at issue had been covered by separate leases and an allocation well been drilled. Under the guidance ofLuecke, both Springer Ranch and the Sullivan Parties would have been entitled to royalties on all production from their respective leased premises, exactly what was required in the 1993 agreement. The next question (left unanswered in Luecke) would have been the method of allocating such payments to the differing leased premises absent pooling or some other sharing agreement. The Springer Ranch court appears to answer this question by permitting allocation based on the ratio of the productive length of the productive lateral under each separate leased premise compared to the entire producing lateral.

While Springer Ranch may be the first allocation method accepted by a Texas court, many critical questions remain unanswered. It cannot be overlooked that Springer Ranch did not challenge the method proposed by the Sullivan parties to determine the amount of production that was obtained from the parts of the well on the parties’ respective surface estates. Instead, Springer Ranch argued that the calculation should be based on the length of the well bore from the wellhead to the terminus point. This approach was rejected by the court. While the court accepted the method suggested by the Sullivan parties, it is unknown whether this method would succeed in the future if attacked or if an alternative method were proposed. Many factors such as geology, drilling techniques, and the manner in which the well is perforated could come into play. To what extent should expert testimony, if any, be required on these or other topics? With the amount of money involved, these issues are likely to be answered one day.

Another issue not raised in Luecke is the possible application of Humble Oil v. West and the confusion-of-goods doctrine. See Humble v. West, 508 S.W. 812, 818–19 (Tex. 1974). InHumble Oil, the Texas Supreme Court stated that

[a]s a general rule, the confusion of goods theory attaches only when the commingled goods of different parties are so confused that the property of each cannot be distinguished. Where the mixture is homogeneous, the goods being similar in nature and value, and if the portion of each may be properly shown, each party may claim his aliquot share of the mass.

See id. at 818. “However, if goods are so confused as to render the mixture incapable of proper division according to the pre-existing rights of the parties, the loss must fall on the one who occasioned the mixture.” See id. The party causing the comingling has the burden to prove “with reasonable certainty” the aliquot share of each owner.

A mineral owner could argue that when an allocation well is drilled, the various mineral owners’ respective minerals to be so comingled, it is impossible to state with reasonable certainty who owns what proportion of production. Assuming the mineral owner could present evidence that the allocation method in Springer Ranch fails to establish each party’s respective share within “reasonable certainty,” the lessee may be left to find another, more defensible way to allocate production or risk suffering huge losses if the jury finds that the lessee failed to satisfy its burden under confusion-of-goods doctrine.

While the Springer Ranch court is interpreting the language of something that amounts to a sharing agreement for a lease well, the manner in which production is “shared” does not appear to be materially different than the concept called for in Luecke. In both cases, the landowners were entitled to production only from their respective properties. The only material difference for purposes of allocating production appears to be that Springer Ranchanswered the question left unanswered by Luecke—how to accomplish that allocation? But because the methodology used was unchallenged, it is unclear how well such methodology would hold up to scrutiny or opposing methods.

Lessees should be cognizant of the dangers and uncertainty accompanying allocation wells, including current challenges to their legality and the effect of the confusion-of-goods doctrine. The Springer Ranch provides something for the industry to point to when questioned about the proper method of allocating royalties between separate tracts, absent pooling or other sharing agreement.

Keywords: energy litigation, royalties, allocation wells, allocation agreement, pooling, sharing agreement, production allocation, horizontal wells, confusion of goods

Christopher L. Halgren is an associate with McGinnis Lochridge & Kilgore LLP in Houston, Texas.

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