Face Challenges Confidently

596 Chesapeake Exploration, L.L.C. v. Hyder, No. 03-14-00257-CV, 2015 WL 9583873 (Tex. App.—Austin Dec. 29, 2015, pet. filed)

Monday, November 7th, 2016

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, No. 03-14-00257-CV, 2015 WL 9583873 (Tex. App.—Austin Dec. 29, 2015, pet. filed) (mem. op.) held that an overriding royalty was free of all post-production costs. The opinion also attempts to clarify the deductibility of post-production costs generally under market value at the well and proceeds lease royalty clauses. 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.’” Heritage Resources construed a market value at the well royalty clause and held that the royalty payable in that case was effectively subject to its proportionate part of post-production costs, because market value at the well meant at the well. The parties in Hyder aligned as “Lessor” and “Lessee.” They agreed that the overriding royalty payable to Lessor was free of production costs; they disputed whether it was also free of post-production costs.

Before focusing on the overriding royalty clause, the Court briefly addressed the gas royalty clause which was a “proceeds” provision. “[T]he price-received basis for payment in the lease is sufficient in itself to excuse the lessors from bearing post 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 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. . . . [Lessee] has not challenged that ruling in this Court.” Apparently, the Court wanted to be clear that, under both market value at the well and proceeds lease royalty provisions, the royalty provisions themselves excuse the lessors from directly bearing post-production costs. However, the calculation or determination of the royalty payable might have the same indirect effect as deducting post-production costs proportionately.

Turning to the overriding royalty clause, 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 simple “cost-free” requirement of the overriding royalty clause referenced all costs, including post-production costs.

The Court also noted that had Lessor taken Lessor’s overriding royalty in kind, as Lessor was entitled to do, Lessor might have used the gas on the property, might have transported it to a buyer, or might have paid a third party to transport the gas to market as Lessor might negotiate. The Court reasoned that the “fact that the Lessor might or might not be subject to post-production 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 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 may be 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.