Face Challenges Confidently

443 Potts v. Chesapeake Exploration, L.L.C.

Tuesday, September 1st, 2015

Richard F. Brown

The following is not a legal opinion.  You should consult your attorney if the case may be of significance to you.
Potts v. Chesapeake Exploration, L.L.C. held that the net-back method should be used to determine market value at the point of sale when there are no comparable sales made at the point of sale, notwithstanding that the lease prohibited any deductions for post-production costs.  Potts and West (“Potts”) had an oil and gas lease with Chesapeake Exploration, L.L.C. (“Chesapeake”).  The royalty clause expressly prohibited deductions for post-production costs (“no-deduction clause”).  The facts of the case were undisputed.  Chesapeake operated the lease and sold its production to its affiliate, Chesapeake Energy, Inc. (“CEMI”), at the well.  There were no comparable sales to CEMI at that point that could be used to establish market value.  Chesapeake used the next downstream sale by CEMI less the costs and expenses incurred between the point of sale to CEMI and the downstream resale point to calculate the market value at Chesapeake’s point of sale to CEMI (at the well).
Most of the analysis in this case centered around construing the leading Texas case on deduction of post-production costs.  In Heritage Res. Inc. v. NationsBank, the lease provided for a royalty payable on market value at the well, there was a no-deduction clause, and the point of sale was off the lease.  Ultimately, the Texas Supreme Court, in Heritage, approved royalty payments based on a net-back from the off-lease point of sale to the wellhead to arrive at market value at the well.  Many oil and gas leases provide for payment of royalty based on the “market value at the well.”  “Market value at the well” is defined as “the value of gas at the well, before it is transported, treated, compressed or otherwise prepared for market.”  There are two methods which can be used to determine the market value at the well.  The preferred method is the “comparable sales” method.  This method determines value by sales that are “comparable in time, quality, quantity, and availability of marketing outlets.”  If no comparable sales are available, the “net-back” method may be used.  This method begins by identifying the first point in the downstream process where market value can be established, and working backwards by subtracting post-production expenses, which have been incurred from that point, back to the well.  Although the net-back method subtracts post-production costs, the court noted that these costs “are not actually taxed to the royalty owner, they are simply used to determine the value of the gas at the point in time the parties agreed to determine the royalty payments.”  Accordingly, even a lease with a no‑deduction clause does not preclude all deductions, and whether or not a deduction is proper depends on “how and where the Lease establishes the point at which the value is determined.”
The court noted that the Chesapeake lease did not otherwise define “point of sale.”  Accordingly, the court gave the term its generally understood ordinary meaning, namely, “the point where the gas is sold in an arm’s length transaction.”  Here, this occurred on the premises, at the well, when Chesapeake sold the production to its affiliate CEMI.  Thus, the circumstances were actually indistinguishable from the circumstances in Heritage.
There was language in the Heritage opinion that suggested that the royalty owner who wanted to avoid the result in Heritage could draft the royalty clause so that it was tied to market value at the point of sale.  That is what Potts did in Potts’ lease.  However, the suggestion in Heritage assumed the wellhead and the point of sale would not be at the same location.  In an effort to avoid the Heritage result, Potts argued that “at the well” means “anywhere on the premises described in the lease agreement.”  Accordingly, to avoid “point of sale” from becoming synonymous with “at the well,” “point of sale” must be construed to refer to a sale occurring off the leased premises.  The court declined to adopt this interpretation because it would require the court to reject the term’s ordinary meaning.
The significance of the case is the reaffirmation of Heritage as the controlling law in Texas on the deduction of post-production costs and the application of the ordinary meaning of “point of sale” when the point of sale is at the well.