560 Chesapeake Exploration, L.L.C. v. Hyder

Richard F. Brown

The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.

Chesapeake Exploration, L.L.C. v. Hyder held that an overriding royalty was free of all post-production costs. The Hyder family leased 948 mineral acres in the Barnett Shale under a lease that included an overriding royalty as part of the royalty payable to lessor. The relevant parts of the lease in dispute 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”; an optional right to take royalty in-kind; and a disclaimer that “‘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.’” The parties aligned as “Lessor” and “Lessee.” They agreed that the overriding royalty was free of production costs; they disputed whether it was also free of post-production costs.

The Court noted in an aside as to the general royalty provision that “the gas royalty is ‘free and clear of all production and post-production costs and expenses,’ and then goes further by listing [numerous examples]. 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 court of appeals reasoned otherwise, relying on the ‘free and clear’ language to conclude that both the oil and gas royalties are free of post-production costs. 427 S.W.3d at 477-78. [Lessee] has not challenged that ruling in this Court.” Apparently, the Court did not want to suggest by its holding in this case that it was abandoning its view that adding examples of post-production costs to a market value at the well royalty clause is mere surplusage as analyzed in Heritage Resources.

Turning to the overriding royalty provision, the Court first noted the general rule that an overriding royalty is free of production costs, but must bear its share of post-production costs unless the parties agree otherwise. Lessor argued that the express requirement in this lease that the overriding royalty be “cost-free” can only refer to post-production costs, because a royalty is by its nature already free of production costs without saying so. Lessee argued that “cost-free overriding royalty” is merely a synonym for overriding royalty, and a number of lease provisions analyzed in other cases support that view. The court noted that the express exception for production taxes, which are post-production expenses, cuts against Lessee’s argument because it would make no sense to state that the royalty is free of production costs, except for post-production taxes. Furthermore, the exception for taxes might be taken to indicate that “cost-free” refers only to post-production costs. However, an illogical taxes “exception” to freedom from production costs is common in Texas leases. Nevertheless, Lessee here must show that “cost-free” cannot refer to post-production costs in this lease.

Lessee argued that because the overriding royalty is paid on “gross production”, the reference is to production at the wellhead, making the royalty tantamount to one based on the market value of production at the wellhead, which bears post-production costs. The Court reasoned that “gross production” established the volume on which the overriding royalty was due, but says nothing about whether the overriding royalty must bear post-production costs. The Court concluded that “cost-free” as used in this lease as applied to the overriding royalty included post-production costs.

The Court did not rely upon the Heritage Resources disclaimer in the lease, and the Court’s explanation of that holding is the most significant part of the case:

Heritage Resources does not suggest, much less hold, that a royalty cannot be made free of postproduction costs. Heritage Resources holds only that the effect of a lease is governed by a fair reading of its text. A disclaimer of that holding, like the one in this case, cannot free a royalty of postproduction costs when the text of the lease itself does not do so. Here, the lease text clearly frees the gas royalty of postproduction costs, and reasonably interpreted we conclude, does the same for the overriding royalty. The disclaimer of Heritage Resources’ holding does not influence our conclusion.

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