post-production deductions

Co-author Chance Decker

 Burlington Resources Oil & Gas Company, LP. v. Texas Crude Energy, LLC et al is another chapter in the back-and-forth over deduction of post-production costs from royalty payments. In “clarifying” (royalty owners might say “retreating from”) Chesapeake Exploration & Production, LLC v. Hyder, the Texas Supreme Court held that a royalty delivered into the pipeline or tanks is akin to a royalty delivered “at the wellhead.” The lessee was entitled to deduct post-production costs from its royalty calculation, notwithstanding that the calculation was based on the “amount realized” from downstream sales.

Don’t read too much into it? Continue Reading Texas Supreme Court Clarifies Hyder

ceasarApparently unsatisfied with its analysis in Chesapeake Exploration v. Hyder, the Texas Supreme Court revisited its original opinion on an overriding royalty clause. The Hyders remain the winners. In effect, the court replaced its reliance on earlier decisions interpreting royalty clauses with its own analysis (which looks a lot like the original).

The Basics

Let’s start with the rules:

  • An override is free of production costs but bears its share of post-production costs.
  • The parties to a contract are free to agree otherwise.
  • A royalty paid on the market value of oil at the well bears post-production costs.  That value is the commercial value less processing and transportation expenses that must be paid before the gas reaches the commercial market.
  • A royalty based on the price a lessee actually receives for gas (a “proceeds lease”) does not bear post-production costs.  The price-received basis is sufficient in itself to excuse charges to lessors of post-production costs.

The analysis

The override at issue is: “cost-free (except only its portion of production taxes) … of five percent … of gross production obtained …”.

The exception for production taxes (which are post-production expenses) cuts against Chesapeake.  It would make no sense to say that the royalty is free of production costs except for post-production taxes (no dogs, except for cats, opined Justice Hecht).

The court doesn’t agree with Hyder that cost-free cannot refer to production costs.  Drafters frequently specify that an override does not bear production costs even though it is already free of costs because it is a royalty interest. I call it the “belt and suspenders” school of document drafting.

Chesapeake argued that because the override is paid “on gross production” the reference is to production at the wellhead, making the royalty based on the market value of production at the wellhead, which bears post-production costs.  The court concluded that gross production is a reference to volume only. Specifying that the volume is determined at the wellhead says nothing about result:  “Cost-free” includes post-production costs.

The dissent

Four justices dissented, essentially seeing the same language as did the majority and disagreeing on just about every point. A highlight is their analysis of so-called production taxes. They are really post-production costs, according to the majority.

 The dissent thinks not everyone understands that distinction, and parties can allocate taxes differently than other post-production costs.

The dissent believes a statute does not turn a production cost into a post-production cost.  It simply creates a statutory exception to the common law default rule that an override is free of production costs. Second, the pro rata nature of production taxes bolsters the reading that cost-free does not refer to post-production costs.  The dissent believes that “cost free” is indicated to emphasize the default rule, clarifying that Hyder was still obligated to pay its share of production taxes.

Takeaways

  • Some operators, Chesapeake chief among them, have been condemned for gangsterism in their treatment of lessors. Think Imperator Ceaser ravishing the Roman hinterlands. Will Chesapeake go the way of most of the Ceasers? Maybe, but losing five-to-four twice suggests a legitimate legal position this time.
  • Don’t look for a policy you an count on in this case or in Heritage, other than the court will read the lease and interpret the text.

Our musical interlude – dedicated to the dissenters.

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.

Co-author Travis Booher

Welcome to part two of the hair-splitting decision in Chesapeake Exploration, L.L.C. v. Hyder. See our prior post about the basic facts.

More Facts

In addition to their cost-free royalty clause for wells on the leased premises, the Hyders also received an overriding royalty interest on wells drilled from pads located on the leased premises and completed on adjacent tracts. Chesapeake drilled seven of these “off-lease wells”.

The Royalty Clause

…within sixty (60) days from the date of the first production from each off-lease well, …convey 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….

Again, the parties disagreed over what “cost-free” means.

Chesapeake’s Position

“Cost free” merely reinforces current Texas law that an overriding royalty interest is free of production costs, but subject to its proportionate share of post-production costs.

The Hyder’s Position

“Cost free” refers to all costs (except the Hyder’s portion of production taxes), including post-production costs.

The Court’s Position (The one that matters)

Under Texas law, it is clear that an overriding royalty is normally free of production costs, but subject to post-production costs. However, the parties may modify this default rule by agreement. Chesapeake cited four cases for its position that post-production costs should be deducted, and the court addressed each (we briefly summarize the holdings):

  • XAE Corp. v. SMR Prop. Mgmt. Co., 968 P.2d 1201 (Okla. 1998) – the ORRI was an in-kind interest with delivery at the well head, and the lessee had no duty other than to deliver gas. Therefore, the lessee was not responsible for lessor’s share of post-production costs and expenses. Hyder is not about taking gas in-kind, and the Hyder lease contains a provision that expressly says the ORRI is “cost free.”
  • Heritage Resources Inc. v.  Nations Bank (see the prior post for a link) – the Hyder’s lease specifically says, that “Heritage Resources shall have no application to this lease.” As result, it has no applicability to this ORRI.
  • Martin v. Glass and Dancinger Oil Refineries v. Hamill Drilling Co. – In those Texas cases the ORRI was “free and clear of all costs of drilling, exploration or operation…” and ‘free and clear of operating expenses.” The court noted all of those costs are production costs. Under the Hyder facts, the lease language is not limited to production costs, it simply says “cost free”, meaning all costs – production and post production.

The court concluded by saying parties can modify the default rule that ORRIs “are normally subject to post production costs.” Here, as indicated by the four corners of the document, that is what the parties did. In short, the Hyders are responsible for their portion of production taxes only.

The Takeaway

In writing a lease, say what you mean. Sometimes, a “cost-free royalty” really is a cost free royalty.

In honor of the lawyers and their clients who dance a lot over the words in the lease, we end this offering with a dance contest. Feel “free” to pick your favorite:

Candidite 1  

 Candidate 2 

 Candidate 3 

 

 

Co-author Travis Booher

Chesapeake Exploration, L.L.C. v. Hyder is another hair-splitting Texas decision about “cost-free royalties”

The Facts

The Hyder family executed a lease covering 1,037 acres. Chesapeake drilled 22 wells on the leased premises. The Hyders believed their lease provided for a “cost free” royalty; that is, no post-production deductions. Chesapeake deducted post-production costs, and the Hyders sued for breach of contract.

More Facts

A summary of how gas is moved downstream from the lease might be helpful (Hint: if it starts with a “C”, it’s a Chesapeake entity). COI produces the gas and sells to CEMI, who delivers the gas to several “points of delivery” for gathering by CMP. CMP transports to unaffiliated third-party interstate pipelines, who transfer the gas downstream to a “point of sale”, and then title passes from CEMI to the third-party purchaser. The Hyders were paid based on a weighted average sales price calculated on the sales to various third parties.

The Royalty Clause

The Hyders where to be paid:

…for natural gas … produced from the Leased Premises, twenty-five (25%) of the price actually received for such gas. The royalty … 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 lessee’s point of delivery or sale of such share to a third party. (underline ours)

The lease specifically said that, “ … Heritage Resources, Inc. v. NationsBank shall have no application to the terms and provisions of this lease.” (that was the 1996 Texas Supreme Court case holding that a “no deduct” provision was “surplusage as a matter of law.”)

Chesapeake’s Contention

They could deduct post-production costs incurred between the “point of delivery” and “point of sale.” Because of the disjunctive “or” between “delivery” and “sale”, they could choose either the point of delivery or the point of sale to determine whether the royalty clause permits the deduction of post-production costs after the point of delivery but before the point of sale. Therefore, they deducted costs such as third-party transportation costs.

Hyders’ Contention

Chesapeake’s distinction doesn’t matter. The royalty clause prohibits deduction of any post-production cost, regardless of where incurred, and provides for royalty “free and clear” of all costs. What about “free and clear” can’t be understood?

The Holding

The court agreed with the Hyders. The plain reading of the royalty clause, along with the parties’ agreement that Heritage did not apply, should be interpreted to mean no deductions. Therefore, in this case a “cost-free royalty” really meant a cost-free royalty.

The Takeaway

  • This is a common theme. It is necessary to carefully review the specific wording in the lease. Sometimes, “free” does mean “free”.  Sometimes it doesn’t. A court will construe a lease so that no provision will be rendered meaningless.
  • This post is about wells on the premises.  We will soon discuss the overriding royalty interest due the Hyders for seven Chesapeake off-premises wells.
  • As royalty clauses go, it looks like lessors have found a keeper.  (Or maybe you prefer the live version.)