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 (( 939 S.W.2d 118, 121 (Tex. 1996) )) 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. (( See, e.g., 6 West's Tex. Forms, Minerals, Oil & Gas § 3:25 (4th ed.) ))

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. ((As the court stated, “[t]he gas purchase price is calculated based on a weighted average of the third-party sales prices received (the “gas sales price”) less postproduction costs.” Cf. Warren v. Chesapeake Exploration, L.L.C., 759 F.3d 413, 415 (5th Cir. 2014) (holding costs can be deducted) with Potts v. Chesapeake Exploration, L.L.C., 760 F.3d 470, 472 (5th Cir. 2014) (holding costs cannot be deducted). ))

Hyder argued that its overriding royalty ((Notably, the interest described in the lease as an “overriding royalty interest” was not a traditional ORRI because it was not carved out of any lease, but was rather a surface use payment made by the lessee to the lessor for permitting the lessee to use the surface to drill wells which would produce off lease where the lessor would not share in production. For purpose of this article, the term “overriding royalty interest” is used because it is the term utilized by the lease, the parties, and the Court.)) 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 text 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.