Big victory for big oil . . . and big gas

Shutterstock_157298618The Fifth Circuit handed a large win today to oil and gas lessees in the Lone Star State.

The dispute that the court addressed concerned computation of royalties, which an oil and gas producer pays to landowners and others in return for the right to explore for minerals that underlie the property. 

The key part of the lease in question provided (with our emphasis) as follows:

Notwithstanding anything to the contrary herein contained, all royalty paid to Lessor shall be free of all costs and expenses related to the exploration, production and marketing of oil and gas production from the lease including, but not limited to, costs of compression, dehydration, treatment and transportation.

The lessee — Chesapeake Exploration, L.L.C. — produced natural gas from the lessors' land in Johnson County, Texas, south of Fort Worth. Chesapeake affiliates then compressed, dehydrated, and treated the gas before transporting it far away and selling it to independent buyers.

Computing royalties

But the company computed the royalties it had agreed to pay the lessors — one-fourth of the gas's "market value" at the "point of sale" — in a peculiar way. Although it purported to sell the gas at the "wellhead", Chesapeake based the royalty calculation on the sales prices at locations far from the wellhead, minus the compression, dehydration, treatment, and transportation costs that Chesapeake's affiliates incurred after the gas left the wellhead. The result, Chesapeake contended, constituted the price at the "point of sale" (the wellhead) to a non-Chesapeake affiliate.

That upset the lessors. They thought that "free of all costs and expenses" meant that Chesapeake couldn't deduct expenses it incurred in getting the gas to the actual places at which it bona fide sold the gas, far downstream. As the lessors pointed out, the lease required that "[p]ayments of royalties shall be based on sales of leased substances to unrelated third parties at prices arrived at through arms length negotiations." Because the sales to "unrelated third parties" took place at distant locations, they urged, Chesapeake had to pay royalties on the prices that the third parties paid, "free of all costs and expenses" of getting the gas to market.

The lessors sued. But they lost in the district court in Dallas.

Fifth Circuit rules

They lost again today in the Fifth Circuit. The panel explained its affirmance thus:

The above-quoted language directs that “royalty” is to be “free of all costs and expenses related to the exploration, production and marketing of” gas “including, but not limited to, costs of compression, dehydration, treatment and transportation.” As discussed above, when gas is sold at the wellhead, there are typically no costs of compression, dehydration, treatment or transportation. When there are no such costs at the wellhead, the market value at the wellhead is “free of all costs and expenses,” as contemplated by the above-quoted paragraph, and there is nothing in the royalty clause “contrary” to the “[n]otwithstanding” sentence. If the gas is sold by the lessee downstream of the wellhead, then both the sentence providing for a 1/4 royalty and the “[n]otwithstanding” sentence contemplate that costs incurred by the lessee between the point of production and the point of sale are to be borne by the lessee. Since it is undisputed that gas sales by Chesapeake have occurred at the wellhead, and since the lessors do not contend that the sales to unaffiliated purchasers were at less than market value, Chesapeake could arrive at the market value at the wellhead by deducting reasonable post-production costs to deliver the gas from the wellhead to the point at which the gas was sold to unaffiliated purchasers.

Potts v. Chesapeake Exploration, L.L.C., No. 13-10601, slip op. at 6 (5th Cir. July 29, 2014) (emphasis ours) (applying Texas law).

"Free of costs" that don't exist

The court said that "when gas is sold at the wellhead, there are typically no costs of compression, dehydration, treatment or transportation." Id.

Typically? How about never?

The "[n]otwithstanding" sentence has no meaning in the context of a sale and delivery that in fact take place at the wellhead. It applies only if the sale occurs somewhere downstream; otherwise no relevant "costs" exist. But the lessee may avoid the "[n]otwithstanding" language by purporting to sell the gas at the "wellhead" — something that Chesapeake accomplished by selling at the wellhead to an affiliate. Magic.