Court of Appeals Decision Illustrates Importance of Royalty Language

**This article is not a substitute for the advice of an attorney.**

Chesapeake Exploration, L.L.C. v. Hyder, decided by the San Antonio Court of Appeals last week, highlights the importance of royalty language in an oil and gas lease.  [Read full opinion here.]

Background

The lawsuit was filed by a group of royalty and overriding royalty holders who were party to a mineral lease with Chesapeake.  These royalty and overriding royalty owners alleged that Chesapeake breached the lease terms by impermissibly charging certain costs to royalty owners. The lease at issue was signed in September 2004 between Four Sevens Oil Co. (who then assigned the lease to Chesapeake) and the royalty owners and covers 948 mineral acres of land in Johnson and Tarrant County, Texas.  As of December 2011, Chesapeake had drilled 22 wells on the premises.

The dispute arose with regard to whether Chesapeake was permitted to charge the royalty holders post-production costs incurred between the point of delivery and the point of sale (Chesapeake’s contention) or whether the royalty interests were to be free of any post-production costs, regardless of where incurred. The trial court found in favor of the royalty owners and awarded over $1,000,000 in damages.  Chesapeake appealed.

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General Texas Law on Post-Production Costs

Under Texas law, neither royalty nor overriding royalties are subject to production costs, but royalty and overriding royalty owners are normally subject to post-production costs, including taxes, treatment, and transportation costs.  The parties may, however, modify this rule by contractual agreement.

The Lease Provisions at Issue in This Case

The lease clause at issue provides as follows, with the key provisions in italics and underlined:

For the royalty holders–Chesapeake “covenant and agree  to pay [appellees] the following royalty: (a) twenty-five percent (25%) of the market value at the well of all oil and other liquid hydrocarbons produced and saved from the Leased Premises as of the day it is produced and stored; and (b) for natural gas, including casinghead gas and other gaseous substances produced from the Leased Premises and sold or used on or off the Leased Premises, twenty-five percent (25%) of the price actually received by [appellants] for such gas . . . .The royalty reserved herein by [appellees] shall be free and clear of all production and post-production costs and expenses, including but not limited to, production, gathering, separating, storing, dehydrating, compressing, transporting, processing, treating, marketing, delivering, or any other costs and expenses incurred between the wellhead and [appellant’s] point of delivery or sale of such share to a third party.”

For the overriding royalty holders–Chesapeake “shall, within sixty (60) days from the date of the first production from each off-lease well, convey to [appellees] a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5%) of gross production obtained from each such well payable to [appellees] (which overriding royalty shall be carved out of the leasehold estate by virtue of which such production is obtained), same to be effective from first production from the well to which such overriding royalty pertains.”

Court of Appeals Decision

The Court of Appeals affirmed the trial court’s finding.  Specifically, the Court of Appeals found that Chesapeake’s interpretation of the language allowing for post-production costs to be charged would render the “free and clear” provision in the royalty clause and the “cost free” provision in the overriding royalty clause meaningless.  The court held that the parties to the lease modified the general rule on post-production costs by agreeing to exclude all costs and production and post-production from being charged to the royalty owners.

Why does this matter?

First, in a general sense, this case illustrates the importance of language contained in the royalty provision of an oil and gas lease.  Even just two words like “cost free” can alter the rights of either party to the lease, as was the case here.  Without the “free and clear” provision or the “cost free language,” the outcome of this case would have been completely different.  It is critical that Texas mineral owners considering entering into an oil and gas lease carefully review the terms of the lease and I highly recommend that they have an attorney review the lease as well.

Second, in a more specific sense, this case shows how a royalty owner may be able to avoid sharing in any post-production costs, thereby increasing his or her royalty payments.  By using the “free and clear” language that was included in the royalty provision or the “cost free” term in the overriding royalty clause, royalty owners may be able to overcome the general rule in Texas that royalty owners share in post-production costs.  Again, mineral owners are encouraged to seek legal counsel in negotiating oil and gas leases as experienced attorneys are much better able to understand and negotiate for these types of provisions in a lease.

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