hide the ballThe result was like others we’ve seen. Lessors Win. These wells are in Johnson and Tarrant County, Texas. Lessee Chesapeake Exploration sells to affiliate Chesapeake Marketing through affiliate-operator Chesapeake Operating. Plaintiffs sued Exploration and Operating for underpayments of royalty and overrides.

The Takeways

  • This decision demonstrates the reason for special royalty clauses addressing sales to an affiliate of the lessee: To prevent the lessee from monkeying around with the sales mechanism, and therefore the price, so that the affiliate makes money that would otherwise go to the lessor.
  • Courts more often than not believe it is their job to reject creative legal and factual arguments if the result would be to avoid the plain language of a written agreement.

Chesapeake Stung by a WASP

The leases in question are all similar. Two leases, Trinity Valley School and Bass, provide for alternative methods of determining market value. Plaintiffs argued there is an irreducible minimum starting point, the “weighted average sales price” (the “WASP”), which is the average of the two highest prices paid by purchasers in Tarrant County for gas of the same quality and quantity. This method does not allow for post-production cost deductions. Chesapeake claimed it used a net-back calculation, which was not really a deduction.

The Trinity Valley School leases allow deductions only if the point of first sale is located more than two miles from the leased premises. It was undisputed that the first point of sale was at the wellhead on the premises. The court ruled that no deductions were permitted.

The Bass leases allow for deduction of post-production costs only if the costs are:

  • charged at arms-length by an unaffiliated entity,
  • actually incurred by the lessee for the purpose of making the oil and gas production ready for sale or use or to move said production to market, and
  • incurred by the lessee at a location off of the leased premises.

Chesapeake asserted reasons why it complied with all three prongs of the test. The court enforced the plain language of the leases, rejecting those arguments.

The McKinney lease prohibits deduction of post-production cost in the event of a sale to an affiliate and also specifies that where gas is sold to an affiliate, the price paid for royalties should be determined by the WASP. The court construed the McKinney lease the same as the Bass leases.

The court enforced the contracts as written. Because Chesapeake sells to an affiliate, the market value is determined by the WASP.

For our musical interlude let’s imagine this post-settlement conversation, in which the lessors speak to the lessee.