Can Production Payments Really Outlive Their Oil & Gas Leases? The Supreme Court Will Answer

The Supreme Court of Texas has taken up an appeal that could ultimately change the landscape of oil and gas law and spur a new generation of production payment litigation. Depending on the Supreme Court’s decision, Texas law may in the future hold that production payments can survive the termination of their associated oil and gas leases.

That is exactly what the El Paso Court of Appeals held in a decision from March 2014—that production payments can outlive oil and gas leases. However, the El Paso court’s decision seems to go against a century of legal and academic authority in Texas, and likely this is why the Supreme Court has taken an interest in the case. The case is Apache Deepwater, LLC v. McDaniel Partners (click here for a link to the Supreme Court’s case file; and here for the underlying appeal).

Production payments are a share of minerals produced from the land (of course, produced under an oil and gas lease), which payments typically terminate when a certain volume of production has been paid over or when a certain dollar amount is reached from the sale of such oil. Historically, production payments have been used as vehicles to finance exploration and production, whereby the operator takes on the production payment debt up front, in exchange for a promise to deliver a set amount of the oil—or cash derived from the sale of that oil—in the future. Thus, production payments have long been an important component of E&P financing.

For context, production payments are very similar to overriding royalty interests in that they are created from the lessee’s interest—and therefore have been historically considered expressly dependent on the lessee’s ability to develop the mineral estate. Without a valid oil and gas lease, there can be no development by a lessee. It follows, then, that there can be no production payments or overriding royalty payments absent a valid oil and gas lease held by the lessee (absent express language to the contrary in the instrument creating those interests).

And therein lies the rub. Contrary to this conventional wisdom—and despite the fact that there was no express language to the contrary in the instrument creating the production payment—the El Paso court determined that McDaniel Partners’ right to production payments outlived the underlying leases.

McDaniel Partners’ rights to production payments in the Cowden, Broudy, and Peterman Leases were created in 1953 by their predecessor in interest, who assigned the leases to Apache’s predecessor, and reserved therefrom a significant production payment from those leases. The Cowden Leases were held by production until 1994, when they finally terminated for lack of production. So, when Apache acquired the Cowden Leases in its merger with Mariner Energy Resources in 2009, the Cowden Leases had already been expired for 15 years. The Broudy and Peterman Leases, however, continued to be active.

The El Paso court held that the because some of the leases remained active, the entirety of the production payments for all of the assigned leases remained active. Apache’s appeal, bolstered by noted academic and lawyer Bruce Kramer, calls this a “backwards” interpretation of the law, and most involved in the oil patch would likely agree. After all, without the original Cowden Leases, there would never have existed a production payment on those lands, and so it seems illogical to find a production payment could outlive those leases once they’ve expired (regardless of the survival of any of the ostensibly “related” Broudy and Peterman Leases).

E&P companies who have purchased, or intend to purchase, leasehold interests in Texas should be on the lookout for the Supreme Court’s decision, because affirming the El Paso court decision could alter the value of these deals and the obligations of assignees with respect to production payments on expired leases.

Oral argument in the Supreme Court is set for October 14, 2015. We will update this post when the Supreme Court’s decision is handed down.