498 Warren v. Chesapeake Exploration, L.L.C.
Thursday, September 3rd, 2015
The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.
Warren v. Chesapeake Exploration, L.L.C. held that the royalty clause of an oil and gas lease permitted deduction of post-production costs incurred by lessee in delivering marketable natural gas from the mouth of the well to the actual point of sale. Charles Warren and Robert Warren (“Lessor”) sued various Chesapeake entities (“Lessee”) for deducting post-production costs from the royalty otherwise payable under an oil and gas lease. The relationship among the Chesapeake entities was not an issue in the case. The pre-printed lease royalty clause required that royalty be paid based on “. . . the amount realized by Lessee, computed at the mouth of the well . . . .” The lease also had an addendum that provided:
Notwithstanding anything to the contrary, herein contained, all royalty paid to Lessor shall be free of all costs and expenses related to the exploration, production and marketing of oil and gas production from the lease including, but not limited to, costs of compression, dehydration, treatment and transportation. Lessor will, however, bear a proportionate part of all those expenses imposed upon Lessee by its gas sale contract to the extent incurred subsequent to those that are obligations of Lessee.
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It is expressly agreed that the provisions of this Exhibit shall super[s]ede any portion of the printed form of this lease which is inconsistent herewith, and all other printed provisions of this Lease, to which this is attached, are in all other things subrogated to the express and implied terms and conditions of this Addendum.
“The phrase ‘amount realized by Lessee computed at the mouth of the well’ means that the royalty is based on net proceeds, and the physical point to be used as the basis for calculating net proceeds is the mouth of the well.” This applies “to all gas sold by the lessee, regardless of whether the gas is sold at the mouth of the well, off the leased premises, or at some point in between.” The issue in the case was the effect of the addendum.
The court held that the addendum was not inconsistent with the printed royalty provision. Although the addendum stated that the royalty payable would be free of post-production costs, it did not change the point at which all royalty is computed, which is the mouth of the well. If the parties intended for Lessor to receive the royalty fraction of the proceeds of sales, regardless of where the sales occurred, they could have deleted “computed at the mouth of the well” from the pre-printed lease or in the addendum said “regardless of the location of the sale.”
Lessor acknowledged that the first sentence of the addendum addressing post-production costs is functionally equivalent to the “no deductions” clause in Heritage Resources, Inc. v. NationsBank and that it does not accomplish the result they desired. Lessor contended that the second sentence of the addendum saying that “Lessor will, however, bear a proportionate part of all those expenses imposed upon Lessee by its gas sale contract to the extent incurred subsequent to those that are obligations of Lessee,” established that there are two sets of obligations: (1) those borne solely by Chesapeake, and (2) shared obligations.
Although, the court conceded the second sentence was confusing, it held that “[u]nder the royalty clause in the pre-printed lease, the lessee bears the expenses of producing and selling the gas at the mouth of the well. Its obligation with respect to royalty is to pay the amount of proceeds computed at the mouth of the well, which means proceeds net of reasonable post-production costs incurred beyond the mouth of the well.” The court concluded that “[t]o the extent that a gas sale contract requires the lessee to bear the cost of delivering marketable gas to a sales point other than the mouth of the well, the second sentence [of the addendum] expressly provides that the lessor will bear a proportionate part of all those expenses.”
This case is one of several that have construed post-production cost issues primarily under the precedent established in Heritage Resources, Inc. v. NationsBank. The lessor generally loses because the royalty clause fixes the point for computing the royalty at the well, which means net proceeds at the well, and thus there are effectively deductions for post-production costs incurred downstream.