In June, the Texas Supreme Court issued a 5-4 opinion in a much-watched dispute between royalty owners and oil and gas producer, Chesapeake Exploration, LLC.   [Read full opinion here.]

This case is extremely important for all Texas royalty and overriding royalty owners to be aware of as it illustrates contractual language sufficient to prevent the production company from deducting post-production costs from royalty payments, and that which is not sufficient to prevent such deductions.  There is a fine line between sufficient and insufficient language, which can have a major impact on royalty payments.

Texas A&M Agrilife Extension Service Photo by Blair Fannin

Applicable Law

Under Texas law, neither royalty nor overriding royalties are subject to production costs, but both royalty and overriding royalty owners are typically subject to paying their share of post-production costs, including taxes, treatment, and transportation costs.  The parties may, however, modify this rule by contractual agreement.  At issue in this case is whether the contractual language included in the Hyder’s oil and gas lease sufficiently modified this general rule.

This issue was complicated by a 1996 Texas Supreme Court decision in Heritage Resources, Inc. v. NationsBank.  In Heritage, royalty clauses called for payment based upon a percentage of “market value at the well” and went on to provide “however, there shall be no deductions from the value of the Lessor’s royalty by reason of any required processing, cost of dehydration, compression, transportation, or other matter to market such gas.”  The royalty owners argued this language expressly modified the rule that they sould share in post-production costs.  The lessor argued that the language was mere surplusage and that any payment based on market value at the well, by definition, provided for the royalty owner to share in post-production costs.  The Court agreed with the oil and gas company that based on the common application of market value at the well, the additional language was surplusage and did not sufficiently modify the general rule that royalty owners share in post-production costs.  How to properly draft lease language sufficient to prevent deduction of post-production costs have vexed oil and gas attorneys and the courts since the Heritage opinion was issued.

Background

The Hyder family owns mineral rights in the Barnett Shale.  They leased these rights in 2004 and the lease was eventually acquired by Chesapeake.  The lease contained the following royalty language:

• Oil Royalty Clause.  This clause provides for payment of 25% royalty for “the market value at the well of all oil and other liquid hydrocarbons.”
• Gas Royalty Clause.  The lease provides for a royalty of 25% “of the price actually received by Lessee” for all gas produced from the lease premises and sold or used.  The lease adds that the royalty is to 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 Lessee’s point of deliver or sale of such share to a third party.  Lessor’s royalty share shall also be free and clear of all costs of construction, operation, or depreciation of any plant or other facilities or equipment used for processing or treating paid production.”
• Overriding Royalty Clause.  The lease calls for a “perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent of gross production obtained” from directional wells drilled on the lease but bottomed on nearby land.
• Heritage Disclaimer. The lease contains the following disclaimer:  “Lessors and Lessees 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.”
• In Kind Provision.  Finally, the lease provided that each Lessor “has the continuing right and option to take his royalty share in kind.”

No oil has been produced, so no payments have been made to the Hyders under the Oil Royalty Clause.

Under the Gas Royalty Clause, Chesapeake argued that it did have the right to deduct post-production costs from royalty payments, although it had not done so to date.  The Hyders argued that the contractual language prohibited deduction of any post-production costs. 

Under the Overriding Royalty Clause, there are seven directional wells producing gas.  Chesapeake sells the gas produced from these wells to its affiliate, “Marketing”, which gathers the gas and transports it through interstate pipelines for sale to third-party purchasers in distant markets.  Marketing pays Chesapeake a gas purchase price, calculated based on the weighted average of third-party sales prices, less post-production costs. Chesapeake, in turn, pays the Hyders 5% of that gas sales price.  The Hyders argue that the “cost-free” language of the Overriding Royalty Clause makes clear that they should be paid royalties based on the gas sales price without any deductions made for post-production costs.  Chesapeake argued that the “cost-free” language referred only to production costs, and that post-production costs were still allowable.

Lower Court Decisions

At trial, the jury found in favor of the royalty owners and awarded over $575,000 for post-production costs wrongfully deducted from the Overriding Royalty Clause.

On appeal, the San Antonio Court of Appeals affirmed that decision, finding that post-production costs were prohibited from being charged to the Hyders under both the Gas Royalty Clause and the Overriding Royalty Clause.  Specifically, the Court of Appeals reasoned that if post-production costs were deducted despite the Gas Royalty Clause’s “free and clear” language and the Overriding Royalty Clause’s “cost free” terms, this additional lease language would be rendered meaningless.  The court found that the parties to the lease successfully modified the general rule that post-production costs are shared by royalty and overriding royalty owners with this language, and, therefore, deductions from royalty payments for post-production expenses were improper.

Supreme Court Opinion

The Texas Supreme Court affirmed the decisions by the lower courts.

With regard to the Oil Royalty Clause, the court found the provision in the lease to be clear that the oil royalty bears post-production costs based on the “market value at the well” language.  Texas case law is clear that “market value at the well” means the commercial market value less the post-production costs such as processing and transporting that much be incurred before the gas reaches a commercial market.  This was made clear in the Heritage case discussed above.

The Court found that the Gas Royalty Clause did not bear post-production costs because it is based on the price that Chesapeake (through Marketing) actually receives for the gas when it is sold to third-party purchasers.  Royalty calculation, then is simply done by multiplying the Hyder’s 25% times the price actually received by Chespeake.  No deductions of post-production costs were permitted based upon the lease royalty language providing for payment on the “price actually received by the Lessee.”  The Court said: The “free and clear” language that follows “has no effect on the meaning of the provision” and “might be regarded as emphasizing the cost-free nature of the gas royalty, or as surplusage.”  Thus, even without the “free and clear” language, the Court indicated that the Gas Royalty Clause language prohibits post-production costs.

Next, on the key clause in the parties’ dispute, the Overriding Royalty Clause, the Court found that the contractual language modified the general rule and, therefore, the Hyders were due an overriding royalty payment free of any post-production costs.  With regard to the meaning of the “cost-free (except only its portion of production taxes)” language, the Court reasoned that the language must be referring to post-production costs.  Otherwise, it would make no sense for the “cost-free” term to apply only to production costs (which are excluded anyway) and then exclude production taxes, which are a post-production cost.  Thus, the Court reasoned that the “cost-free” term must apply to post-production costs.  Based on the contractual language and facts here, the Court found that the “cost-free” language in the Overriding Royalty Clause referred to post-production costs.  Thus, Chesapeake was not permitted to deduct post-production costs from the Hyders’ overriding royalty payments.

Finally, the Court also commented on the Heritage Disclaimer language in the lease.  The Hyders argued that the disclaimer language showed the parties’ intent for an overriding royalty to be free of post-production costs.  The Court rejected this argument, stating:  “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 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.”

Dissenting Opinion

Justice Brown issued a dissenting opinion, joined by Justices Willett, Guzman, and Lehrmann.  These justices do not believe that the Overriding Royalty Clause language is sufficient to modify the general rule that overriding royalties are subject to post-production costs.  Thus, they would have reversed the appellate court and found in favor of Chesapeake.

Justice Brown reasoned that the Overriding Royalty Clause does not call for value determination at the downstream point of sale, as does the Gas Royalty Clause.  He states that, had the parties so desired, they could have expressed the Overriding Royalty Clause in the same manner as the Gas Royalty Clause in order to allow the Hyders to avoid paying their share of post production costs.  But this, they did not do.  He explains that “although the overriding royalty may not have been expressed using the familiar market-value-at-the-well language, I read its value as being just that.”

The dissent also dismisses the “cost-free” royalty language, arguing that it refers only to the overriding royalty being free of production costs.  Although this language is not needed as the law already provides for freedom from production costs, the dissent notes that parties commonly include such language referring only to production costs.  He does not believe that the exception for production taxes changes this analysis.

With regard to the Heritage Disclaimer, the dissent seems to indicate that if a lease is dealing with language similar to that in Heritage and includes such a disclaimer, it could potentially have an impact.

Why Do We Care?

First, this case generally illustrates the complex nature of oil and gas leases.  Differences in a word or two can have an enormous impact on the royalty payments that will be received by the royalty holder.  Further, it shows that even using seemingly clear language can have no effect if not done properly under existing law.  It is critical that parties carefully review all portions of the oil and gas lease, but in particular the royalty provision.  I highly recommend seeking advice from an oil and gas attorney before signing any oil and gas lease.

Second, this case provides specific language that can successfully modify the general rule that royalties are subject to post production costs (the Overriding Royalty Clause) and an example of language that clearly does not modify the general rule (Oil Royalty Clause).  Understanding the difference between the language is critical when negotiating oil and gas royalty provisions.

Third, after the Heritage opinion, many mineral owners and attorneys began including something similar to the Heritage Disclaimer at issue in this case.  Here, the Texas Supreme Court makes clear that the disclaimer language will not modify contrary royalty language in a lease agreement.  It is important to realize that this type of disclaimer alone is not determinative of whether post-production costs may be deducted.