TX Supreme Court: Chesapeake May Not Deduct Postproduction Costs from Overriding Royalty Posted by: Austin W. Brister -&- Chris Halgren 9 hours ago in News and Caselaw Update 0 Comments In a 5-4 decision, the Texas Supreme Court issued its opinion in Chesapeake Exploration, L.L.C. v. Hyder, 14-0302, 2015 WL 3653446 (Tex. June 12, 2015), holding that Chesapeake is prohibited from deducting postproduction costs from an “overriding royalty interest” described in a lease. The Majority noted that while overriding royalty interests are generally subject to post production costs, the language used in the lease creating the Hyder overriding royalty shifted the burden of paying these postproduction costs to Chesapeake, alone. Background: Heritage v. NationsBank In reaching its holding, the Majority noted that unless otherwise modified by agreement, royalty interests generally are not subject to the costs of production, but are usually subject to postproduction costs. In the 1996 Heritage Res., Inc. v. NationsBank 1) case, a lease provided that gas sold off the leased premises would be valued by “market value at the well,” and contained a clause prohibiting deductions of certain postproduction costs. The Court in Heritage held that because the lease called for royalty to be “market value at the well,” the postproduction clauses “merely restate existing law,” and “renders the post-production clauses surplusage.” Following this decision, landowners began negotiating “anti-Heritage clauses,” and otherwise drafting their leases to avoid postproduction burdens. 2) The Dispute and the Lease Provisions Chesapeake Exploration was selling all the gas produced to its affiliate, Chesapeake Energy Marketing, Inc., who was paying Chesapeake Exploration for volumes determined at the wellhead, calculated based on a weighted average of the third-party sales prices received less postproduction costs. As a result, the Hyders’ royalty was being reduced by a proportionate share of the postproduction costs. 3) Hyder argued that its overriding royalty 4) should not be subject to such postproduction costs. This case primarily involved three provisions: the overriding royalty clause, which provided for a “perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production obtained” from directional wells drilled on the lease but bottomed on nearby land, a clause stating that “each Lessor has the continuing right and option to take its royalty share in kind,” and a clause disclaiming the Heritage case, stating “Lessors and Lessee agree that the holding in the case of Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996) shall have no application to the terms and provisions of this lease.” Cost-Free Clause The Majority first reviewed the “cost-free” clause. The Hyders argued that this can only refer to postproduction costs, since royalty is already free of production costs. Chesapeake argued that “cost-free overriding royalty” is merely a synonym for overriding royalty. The Court concluded that the “cost-free” phrase was not dispositive of the issue, and therefore examined other provisions of the lease. The second portion of the lease analyzed by the Majority was the overriding royalty clause’s exclusion of “production taxes” from permissible deductions. The Hyders argued that, because the “cost-free” clause contained an exception allowing deductions for “production taxes,” which is a form of postproduction cost, this “cost-free” clause could only refer to postproduction costs. Again, the Majority concluded that the language was not dispositive because the taxes exception could refer to both production costs and postproduction costs, as drafters commonly provide for a “taxes exception to freedom from production costs… suggesting only that lease drafters are not always driven by logic.” However, the Majority did note that it would make no sense to state that the royalty is free of production costs, except for postproduction taxes. As the Court stated, this would be akin to “no dogs allowed, except for cats.” The Court placed the burden on Chesapeake to “show that while the general term ‘cost-free’ does not distinguish between production and postproduction costs and thus literally refers to all costs, it nevertheless refers to postproduction costs here.” Chesapeake argued that because the overriding royalty is paid on “gross production,” this referenced production at the wellhead, requiring royalty based on market value at the wellhead. However, the Court disagreed, noting that the term “gross” means “undiminished by deduction; entire” and stating that specifying the volume on which royalty is due says nothing about postproduction costs. Taking In Kind Chesapeake argued that the lease allows the overriding royalty to be taken in kind, in which case the Hyders would incur some form of postproduction costs. However, the Majority noted that the lessors were not required to take in kind, and concluded that “[t]he fact that the Hyders might or might not be subject to postproduction costs by taking the gas in kind does not suggest that they must be subject to those costs when the royalty is paid in cash.” The Majority concluded that the specific “cost-free” language barred Chesapeake from deducting post-production costs from the overriding royalty. Anti-Heritage Clause As a final note, the Majority clarified that Heritage does not suggest that a royalty cannot be made free of postproduction costs, but that a lease must be construed based on all its terms. Further, a disclaimer of that holding, like the one in the Hyder lease, “cannot free a royalty of postproduction costs when the test of the lease itself does not do so.” This makes it clear that lessors wishing to ensure that the lessee may not deduct postproduction costs must do more than simply disclaim the holding in the Heritage case. Conclusion As a result, the Majority concluded that Chesapeake was barred from deducting post-production costs from the overriding royalty. Dissenting Opinion The Dissent argued that the overriding royalty owners should have borne postproduction costs, contending that “gross production obtained from each such well” does not provide any mechanism to calculate a cash royalty, does not allow valuation downstream, and does not refer to any point of resale downstream. The Dissent reasoned that had the lessors taken the gas in kind, they would have necessarily incurred their own postproduction costs, As such, the manner in which the owners accept their royalty should not determine the value they receive, and the Hyders should not receive more than the royalty for which they bargained. Similarly, the Dissent argued that Chesapeake’s undertaking to increase the value of the gas should not cause it to bear the costs alone. Additionally, the Dissent stated that, while taxes are generally a post-production cost, the phrase in the Hyder lease referred to “production taxes” which is more in line with production costs rather than post-production costs. Image courtesy Bilfinger SE, some rights reserved.
Unfortunately, Robert, this doesn't resolve all of the post production costs issues people are having with Chesacheat...
To me, the most important aspect of this case is that the Supreme Court of Texas is telling royalty owners - you can draft proper language to prohibit post-production expenses - but it is not as simple as stating "the holding in Heritage v Nationsbank is not applicable to this lease". The court ruled properly, which gives me some faith, but people still need to draft proper leases to prevent these issues. The vast majority of people cannot afford to fight this issue in court like the Hyder's have done.
It also gives warning to using the term "Gross Production" and "Gross Proceeds". Without further clarification, these terms could be used to indicate "market value at the well", which is obviously what everyone wants to avoid (emphasis added). If someone here disagrees with my interpretation of what the court said, I highly suggest reading the Court's opinion. It is full of valuable information, whether anyone agrees with my interpretation or not.
It would be interesting to put in your lease an item that bypasses deductions, namely, you must be paid exactly what the operator receives. If it is not done, the lease is automatically cancelled. When I think about it, most operators would not sign.