Face Challenges Confidently

131 Yzaguirre v. KCS Resources, Inc.

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.
In Yzaguirre v. KCS Resources, Inc., 53 S.W.3d 368 (Tex. 2001), a unanimous Texas Supreme Court (Justice O’Neill not participating) held that the lessee’s market value royalty payments may be based on the lower market value rather than on the above-market amount received by the lessee under the lessee’s gas contract.  The court stated:

When royalty payments are based on market value under an oil and gas lease in Texas, the lessee owes royalties based on the price of gas on the open market, even though the gas was actually sold for less than this price under a long-term sales contract. In this case, we must decide whether the open-market price is still the correct measure under such a lease when the lessee sells the gas for more than market value under a long-term sales contract. The royalty owners argue that the lessee breached express and implied duties by paying royalty on the open-market value rather than the greater amount actually realized.

Since the decision in Texas Oil & Gas Corp. v. Vela, 429 S.W.2d 866 (Tex. 1968), Texas has steadfastly held to the position that “market value” means “at the time of production,” and that the plain meaning of the lease royalty clause will be given its intended effect. The plain meaning of the lease in Yzaguirre would therefore be given effect just as the lease in Vela, where the court held:

[The parties] might have agreed that the royalty on gas produced from a gas well would be a fractional part of the amount realized by the lessee from its sale. Instead of doing so, however, they stipulated in plain terms that the lessee would pay one- eighth of the market price at the well of all gas sold or used off the premises. This clearly means the prevailing market price at the time of the sale or use.

The royalty owners argued that by not paying royalties based on the actual gas contract proceeds, KCS had breached the implied covenant to reasonably market the gas. The court acknowledged that among the implied covenants read into the terms of oil and gas leases is a covenant to manage and administer the lease, which includes a duty to market the oil and gas reasonably. The court rejected the breach of implied covenant argument because “there is no implied covenant when the oil and gas lease expressly covers the subject matter of an implied covenant.”
The court also limited its earlier implied covenant decisions referring to the lessee’s duty to obtain the “best price available” under a proceeds royalty clause. The lessee could be liable for breaching the implied covenant to market if the lessee acted in bad faith in selling the gas at a rate substantially below market value. However, there is no absolute duty to sell gas at market value under a proceeds royalty clause. A failure to sell at market value may be relevant evidence of a breach of the covenant to market in good faith, but such failure is merely probative and is not conclusive. Similarly, the court clarified an earlier decision where it said that the lessee under a market value clause has a duty to “obtain the best current price reasonably available,” as meaning the best current market price reasonably available. The court refused to accept the royalty owners’ contention that the implied marketing covenant could effectively transform the “market value” royalty into a “higher of market value or proceeds” royalty.
The royalty owners contended that the price payable under KCS’s 1979 gas purchase contract should be admissible as relevant to the determination of market value. However, the court stated: “Market value is the prevailing market price at the time of delivery and is not affected by a price set at the time the lessee enters into a long-term sales contract with the buyer.”
In what is literally a footnote to the opinion, the court leaves open the question as to how the result might be affected by the Texas division order statute. In 1991, the Legislature statutorily defined “market value” and similar terms in oil and gas leases to mean “the amount realized at the mouth of the well by the seller of such production in an arm’s-length transaction.” The lease in Yzaguirre was a 1973 lease and the royalty owners did not argue that the statute was controlling. Perhaps in another case it will be argued that the statute is controlling, or at least as to a post-1991 lease, the statute is controlling.
The significance of the case is the holding that under a market value royalty clause the value of the royalty will be determined at the time of production without regard to the lessee’s contract or lessee’s proceeds of production. The contract is not evidence of market value. Under a proceeds lease royalty clause, the failure of the lessee to sell gas at market value may be some evidence of a breach of the covenant to market in good faith, but the evidence of market value is not conclusive on the issue of good faith.