Face Challenges Confidently

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

Thursday, September 3rd, 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 at the point of sale.  The parties aligned as Lessor and Lessee under an oil and gas lease which provided:

The royalties to be paid by Lessee are: . . . on gas . . . the market value at the point of sale of 1/4 of the gas sold or used . . . .  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 . . . .  Payments of royalties to Lessor shall be made monthly and shall be based on sales of leased substances . . . arrived at through arms length negotiations.  Royalties to Lessor [for] leased substances not sold in an arms length transaction shall be determined based on prevailing values at the time in the area.

The Chesapeake entity acting as Lessee sold the gas at the well to its affiliate, Chesapeake Energy Marketing, Inc. (“CEMI”).  CEMI transported the gas far downstream to sell to unaffiliated purchasers.  To determine market value at the well, Lessee used a net back price from CEMI’s downstream sales to unaffiliated purchasers.
The court’s analysis relied principally on the Texas Supreme Court’s ruling in Heritage Resources, Inc. v. NationsBank,  the leading Texas case regarding deduction of post-production costs.  Heritage featured leases which similarly provided that royalties would be paid as a percentage of “market value at the well,” a “no deductions” clause, and a wellhead point of sale.   Heritage held that market value at the well could be based on a net-back calculation from points of sale downstream from the wellhead.   There are two methods which can be used to determine market value at the well.  The preferred method is the “comparable sales” method, which looks to similar sales in the vicinity of the wellhead.  If comparable sales are not readily available, the “net-back” method may be used.  This method begins with the first point downstream at which market value can be sufficiently identified, and then works backwards by subtracting post-production expenses back to the wellhead.  Although the net-back method deducts post-production costs, the court noted that such deductions are “nothing more than a method of determining market value at the well in the absence of comparable sales data at or near the wellhead.”
The court held here that the lease unambiguously provided lessors’ royalty would be a percentage of the market value of the gas at the point at which it was sold.  Consequently, “had [Lessee] sold the gas at a point downstream from the wellhead . . . [p]ost-production cost incurred between the wellhead and the point of sale could not be deducted.”   Because the point of sale occurred at the well, when Lessee sold to CEMI, the circumstances were indistinguishable from the circumstances in Heritage.   Accordingly, the court determined that these post-point of sale deductions were a means of ascertaining market value and not a “burden” on the value of the lessors’ royalty.
Lessor contended that under the lease language providing that “royalties . . . shall be based on sales . . . to unrelated third parties,” a wellhead sale to an affiliate could not be the point of sale for the purpose of determining whether to deduct post-production cost.   The court reasoned that the lease specifically contemplated sales to related parties and resolved that issue by providing that royalty would “be determined based on prevailing values at the time in the area,” not at the ultimate point of sale in the event of a distant downstream transaction.
The significance of this case is the reaffirmation of Heritage as the controlling law in Texas regarding deduction of post-production costs.