Royalty dollars
Royalty dollars

A tough record for royalty owners

The highest civil court in the Lone Star State has tended over the years to issue rulings that have made Big Oil even bigger and richer — often at the expense of the Texans who owned the oil and gas deposits in the first place.

Disputes over how to compute the royalties owing under Texas leases raised questions worth billions of dollars. Sadly for the royalty owners, the ExxonMobils, ConocoPhillipses, and Chesapeakes won far more of those fights than they lost.

Just last year, for example, an ex-member of the Texas Supreme Court relied on a decision she had participated in 18 years earlier while a justice to rule against royalty owners. The leases in the 2014 rulings stated that the lessee, Chesapeake, would pay the royalty “free of all costs related to the exploration, production and marketing of oil and gas production from the lease”. But Chesapeake calculated the royalties on the dollars it received for the lessors’ gas less all of those “costs”. Potts v. Chesapeake Expl., L.L.C., 760 F.3d 470 (5th Cir. 2014) (applying Heritage Resources v. NationsBank, 939 S.W.2d 118 (Tex. 1996), to declare no-deduct clause surplusage); Warren v. Chesapeake Expl., L.L.C., 759 F.3d 413 (5th Cir. 2014) (same). The Fifth Circuit, applying Texas law, said fine.

Along comes a Hyder

The trend that the Fifth Circuit thus extended hit a bit of a wall last month.

The turnabout came in another Chesapeake case — Chesapeake Expl., L.L.C. v. Hyder, No. 14-0302 (Tex. June 12, 2015). That lawsuit involved Hyder family members who had reserved in their lease to Chesapeake’s predecessor “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production” from wells on their 948 mineral acres in the Barnett Shale. Chesapeake paid the Hyders five percent of what it sold the gas to third-parties for in distant market less its post-production costs.

The trial court, after a bench trial, ruled that “cost-free” meant “cost-free” and ordered Chesapeake to pay the Hyders more than $500,000 for the post-production costs that it had deducted before computing the overriding royalty. The San Antonio court of appeals affirmed. And so did the Supreme Court of Texas, by a 5-4 vote.

Basis for decision

Chief Justice Nathan Hecht explained the background thus:

In Heritage Resources, Inc. v. NationsBank, we noted that a royalty is free of production expenses but “usually subject to post-production costs, including taxes . . . and transportation costs.” But we added that “the parties may modify this general rule by agreement.” We long ago defined an overriding royalty as “a given percentage of the gross production carved from the working interest but, by agreement, not chargeable with any of the expenses of operation.” That agreement is now understood to be part of an overriding royalty, and an overriding royalty is like a landowner’s royalty in that it usually bears postproduction costs but not production costs, though the parties may agree to a different arrangement.

Two of the royalty provisions in the Hyder–Chesapeake lease are clear. The oil royalty bears postproduction costs because it is paid on the market value of the oil at the well. The market value at the well should equal the commercial market value less the processing and transporting expenses that must be paid before the gas reaches the commercial market.

The gas royalty in the lease does not bear postproduction costs because it is based on the price Chesapeake actually receives for the gas through its affiliate, Marketing, after postproduction costs have been paid. Often referred to as a “proceeds lease”, the price-received basis for payment is sufficient in itself to excuse the lessors from bearing postproduction costs. And of course, like any other royalty, the gas royalty does not share in production costs. But the royalty provision expressly adds that the gas royalty is “free and clear of all production and post-production costs and expenses,” and then goes further by listing them. This addition has no effect on the meaning of the provision. It might be regarded as emphasizing the cost-free nature of the gas royalty, or as surplusage.

The overriding royalty in the Hyder–Chesapeake lease is not as clear as either of the other two royalty provisions. The Hyders argue that the requirement that the overriding royalty be “cost-free” can only refer to postproduction costs, since the royalty is by nature already free of production costs without saying so. But as with the gas royalty, “cost-free” may simply emphasize that the overriding royalty is free of production costs. Chesapeake argues that “cost-free overriding royalty” is merely a synonym for overriding royalty, and a number of lease provisions discussed in other cases support that view.

The exception for production taxes, which are postproduction expenses, cuts against Chesapeake’s argument. It would make no sense to state that the royalty is free of production costs, except for postproduction taxes (no dogs allowed, except for cats). The exception for taxes might be taken to indicate that “cost-free” refers only to postproduction costs. But a taxes exception to freedom from production costs is not uncommon in leases, suggesting only that lease drafters are not always driven by logic.

We thus disagree with the Hyders that “cost-free” in the Hyder–Chesapeake overriding royalty provision cannot refer to production costs. As noted above, drafters frequently specify that an overriding royalty does not bear production costs even though an overriding royalty is already free of production costs simply because it is a royalty interest. But Chesapeake must show that while 22 the general term “cost-free” does not distinguish between production and postproduction costs and thus literally refers to all costs, it nevertheless cannot refer to postproduction costs here.

Hyder, slip op. at 4-7 (footnotes omitted).

Upshot

Chesapeake could not, of course, persuade the majority that “cost-free” excluded the “postproduction costs” that Chesapeake had deducted before computing the Hyders’ five percent overriding royalty.

Hyder implies three guideposts for royalty computation disputes:

  • Basing a royalty “on the market value of the [hydrocarbons] at the well” allows the lessee to deduct postproduction costs from the price at which it sells the hydrocarbons at points distant from the well.  Id. at 5 (emphasis added; footnote omitted).
  • Basing a royalty “on the price actually received by the lessee, not the market value at the well” means that it “does not bear postproduction costs”. Id. at 8 (emphasis added).
  • The outcome of a dispute over computation of royalties under any lease will generally depend on “a fair reading of its text.”  Id. at 10.
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Clients and colleagues call Barry Barnett an “incredibly gifted lawyer” (Chambers and Partners) who is “magic in the courtroom” (Who’s Who Legal), “the top antitrust lawyer in Texas” (Chambers and Partners), and “a person of unquestioned integrity” (David J. Beck, founder of Beck…

Clients and colleagues call Barry Barnett an “incredibly gifted lawyer” (Chambers and Partners) who is “magic in the courtroom” (Who’s Who Legal), “the top antitrust lawyer in Texas” (Chambers and Partners), and “a person of unquestioned integrity” (David J. Beck, founder of Beck Redden).

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Yale won, 14-0.