Face Challenges Confidently

011 Diamond Shamrock Exploration v. Hodel

Thursday, September 3rd, 2015

Richard F. Brown
The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.
Diamond Shamrock Exploration v. Hodel, 853 F.2d 1159 (5th Cir. 1988), holds that no royalty is due on take-or-pay payments unless and until gas is actually produced and taken. Gas purchase contracts executed prior to 1983 commonly contained minimum-take provisions which obligated the gas purchaser to take certain minimum quantities of gas. These provisions were frequently linked with a “take-or-pay” clause that obligated the pipeline-purchaser to pay the producer certain funds if the minimum quantity of gas specified was not taken. The funds payable were often measured by the value of the minimum quantity of gas the purchaser was obligated to take. Thus, the purchaser had to take a certain minimum quantity of gas, or, even if not taken, pay for it. Some contracts provided that the purchaser would have a “make-up” right out of future production, and some contracts had no make-up right. The take-or-pay clause served two primary purposes: (1) it was a powerful incentive for the pipeline-purchaser to take the gas because the gas must be paid for whether taken or not, and (2) it preserved cash flow for the producer, who often had an enormous investment and whose future operations were often dependent upon the anticipated cash flow.
When gas deliverabilities began to markedly exceed market demand in the early 1980’s, these provisions became significant. Some purchasers made take-or-pay (or deficiency) payments, some refused to pay, and there has been a great deal of litigation between producers and pipeline- purchasers resulting in numerous judgments and settlements. Producers have generally taken the position that no royalty is payable until gas is actually produced, so that no royalty is due on take-or- pay payments and settlements. Royalty will eventually be paid when the gas is actually produced.
The federal government has sought royalty on take-or-pay payments for leases on federal lands–offshore, onshore and Indian lands. The United States District Court for the Fifth Circuit (which includes Texas) has now held that royalty payments are due only on minerals actually produced, i.e. physically severed from the ground. The court focused on the lease language which provided that royalty was payable on the “value of production saved, removed, or sold . . .” and concluded that “production” could refer to the products of an oil and gas well, which was the logical meaning of the word as used in the lease. Therefore, no royalty is dues unless and until gas is actually produced and taken. The court noted that take-or-pay payments are generally intended solely to benefit the producer, who has taken all of the economic risk and who has made a substantial economic investment. The result in this case is consistent with the only other decided case, which involves a state lease in Wyoming. State of Wyoming v. Pennzoil Company, 752 P.2d 975 (Wyo. 1988).
The Diamond Shamrock case is significant because there is no decided case in Texas, and because the reasoning used in the case could be very persuasive under Texas law in construing leases on private lands. Texas lease forms commonly provide that royalty is payable on “production,” and production in Texas is usually defined to require actual production or physical severance from the earth. The case has strongly reinforced the producer’s position that royalty is not payable on take-or- pay payments. However, several commentators have suggested that in the proper case the producer may nevertheless be liable for breach of the implied covenant to market or because the fundamental consideration for the leasing transaction itself is “royalty” and not mere “production.”