Imagine you own a 135-acre farm in Tioga County, Pennsylvania, and after negotiating what you believed to be a cost-free royalty agreement with XYZ Drilling Company, you’re hit with deductions for gathering, dehydration, and processing costs. This scenario reflects a common dispute in oil and gas law: the distinction between “production costs” and “post-production costs.”
This debate recently reached the Fourth Court of Appeals in San Antonio, Texas, in the case of Fasken Oil and Ranch LTD v. Puig (No. 04-23-00106, October 30, 2024). The court’s decision offers significant insight into the scope of “free of cost” royalty clauses and their implications for landowners and operators alike.
The Dispute: Production Costs vs. Post-Production Costs
At the heart of the case was a 1960 deed concerning 11,973 acres in Webb County, Texas. The deed reserved a one-sixteenth (1/16th) royalty interest for the seller, specifying it was to be “free of cost forever.” Despite this language, Fasken Oil and Ranch LTD deducted post-production costs, arguing the clause only exempted royalties from production costs. The Puig family, the royalty owners, sued, asserting that “free of cost forever” should cover all costs, including post-production.
Production costs are those incurred to bring oil or gas to the surface—expenses related to drilling, seismic testing, and well completion. Post-production costs, by contrast, include dehydration, compression, transportation, and processing to prepare the product for market. While production costs are typically borne solely by the operator, post-production costs often fall into a gray area, leading to disputes over how royalties are calculated.
This distinction became increasingly significant following the Federal Energy Regulatory Commission’s 1992 Order No. 636, which deregulated gas transportation. This shifted many post-production responsibilities—and costs—from pipeline companies to drillers, moving the point of sale downstream and complicating royalty calculations.
Arguments and Rulings
The Puig family argued that the language in the 1960 deed was akin to the “perpetual cost-free” royalty clause upheld by the Texas Supreme Court in Chesapeake Exploration, LLC v. Hyder (483 S.W.3d 870, 2016). In Hyder, the court ruled that “perpetual cost-free” language exempted royalties from both production and post-production costs. The Puigs contended that the “free of cost forever” clause should be interpreted similarly, exempting all costs without limitation.
Fasken, however, argued that the clause only applied to production costs and that the deed’s language was insufficient to rebut the default rule under Texas law—that royalties must bear their share of post-production costs unless explicitly stated otherwise. Fasken also argued that the word “produced” in the deed implied a valuation point at the wellhead, allowing for the deduction of post-production costs using the “net-back” method.
The Fourth Court of Appeals rejected Fasken’s arguments, ruling in favor of the Puig family. The court found no meaningful distinction between the “free of cost forever” clause in the 1960 deed and the “perpetual cost-free” clause in Hyder. It concluded that the “free of cost forever” language covered all costs—production and post-production—because the deed did not expressly limit the clause to production costs.
The court also dismissed Fasken’s valuation argument. It noted that the term “produced” would apply regardless of whether the valuation point was at the wellhead or downstream. Using the term “produced” did not imply a wellhead valuation or authorize deductions for post-production costs.
Implications of the Decision
The Fasken ruling reinforces the importance of precise language in oil and gas contracts. For landowners, it underscores the value of clearly drafted “free of cost” clauses that explicitly exempt royalties from all costs. The court’s decision ensures that operators cannot impose post-production costs unless the agreement explicitly allows it.
For operators, the case highlights the risks of relying on ambiguous language to justify cost deductions. The court’s emphasis on applying deeds and contracts as written—without implying terms that alter the agreement’s original intent—sets a strong precedent. Operators must be diligent in negotiating and documenting royalty terms to avoid costly disputes.
Lessons for Landowners and Operators
This case offers key takeaways for both parties in royalty agreements:
- Draft Clear Royalty Clauses: Landowners should ensure royalty clauses explicitly state whether they are exempt from both production and post-production costs. Phrases like “free of cost” should be clarified to prevent misinterpretation.
- Understand Valuation Points: Operators should avoid relying on implied valuation points, as courts may reject such arguments unless clearly articulated in the agreement.
- Know Your Rights: Landowners should regularly review royalty payments and agreements to ensure compliance. Discrepancies should be addressed promptly to avoid prolonged disputes.
The Fasken decision is a win for landowners, affirming that contractual language matters and will be enforced as written. As debates over production and post-production costs continue, this case sets a critical benchmark for resolving disputes and ensuring fair treatment in oil and gas royalty agreements.
