Chesapeake Loses on Rehearing Before the Texas Supreme Court, Subsequently Settles Thousands of Lawsuits in the Barnett Shale for Millions
Chesapeake Exploration v. Hyder:
The Texas Supreme Court Rejects Chesapeake’s Last-Ditch Rehearing Efforts
On January 29, 2016, the Texas Supreme Court crushed Chesapeake’s last-ditch effort to have the Chesapeake Exploration v. Hyder case resolved in its favor. In a split decision, the Texas Supreme Court denied Chesapeake’s Motion for Rehearing and affirmed the lower courts’ opinions in favor of the Hyders. Chesapeake described this ruling as a “sea change” in oil and gas law.
Justice Nathan Hecht issued the opinion for the majority, which was joined by Justices Green, Johnson, Boyd, and Devine, and added only three words—“we have said”—to the Court’s June 12, 2015 opinion against Chesapeake. Justice Brown issued a dissenting opinion, which was joined by Justices Willett, Guzman, and Lehrmann. The royalty language in dispute provided for “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production obtained” from wells that were drilled on the Hyders’ lease but bottomed on neighboring land (emphasis added). Chesapeake Exploration, L.L.C. v. Hyder, 483 S.W.3d 870, 873 (Tex. 2016). An overriding royalty interest is a share in the gross production and is carved out of the working interest. Typically, an overriding royalty is free of production costs, but subject to post-production costs, unless the parties agree otherwise. Here, the Hyders attempted to do that by adding the “cost free” language in the lease. Id.
The Court Says “Cost-Free” Means “Cost-Free” and Sides with the Mineral Owners
The Hyders argued that the “cost-free” language in the lease could only refer to post-production costs since an overriding royalty is, by nature, already free of production costs. Id. at 874. Chesapeake, however, argued that the “cost-free” language was merely restating that the overriding royalty was free of production costs, and argued the language was just a “surplusage”—a favorite argument of lessees seeking to ignore lease language following the much-maligned Heritage opinion (See our previous blog regarding Heritage here. The Court agreed with the Hyders that “cost-free” in an overriding royalty provision meant just that—the royalty provision was “free” of all costs, including to post-production costs. Hyder, 483 S.W.3d at 875. The Court explained that although an overriding royalty is, by nature, free of production costs, the plain “cost-free” language referred to both production and post-production costs. Id. at 874. Chesapeake was therefore required to present an argument to support the conclusion that the “cost-free” language in this lease did not also refer to post-production costs. Id. at 875.
“At the Wellhead” Language Is Not Indicative of Bearing Post-Production Costs
The Court further found in favor of the Hyders given that overriding royalty in the lease was expressed as a fraction of “gross production,” which the Court said refers to all gas, including gas used by the operator or lost in post-production operations, measured at the well when produced. Id. at 874. Chesapeake argued that because the overriding royalty was paid on “gross production,” the royalty provision was tantamount to a market value at the well provision, which Chesapeake argued would be subject to post-production costs, regardless of lease language. Id. The Court disagreed and explained that “[s]pecifying that the volume on which a royalty is due must be determined at the wellhead says nothing about whether the overriding royalty must bear postproduction costs.” Id.
Heritage Disclaimers May Not Work
The Hyders also attempted to justify that the overriding royalty was “cost-free” as to post-production costs by citing to the lease’s Heritage disclaimer. Id. The disclaimer provided 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.” Hyder, 483 S.W.3d at 872. Citing Justice Owen’s concurring opinion, the Court held that a Heritage disclaimer “cannot free a royalty of postproduction costs when the text of the lease itself does not do so.” Id. at 876. The Court reasoned that the Heritage disclaimer had no effect on the outcome of this case because the lease provided that the overriding royalty was already free from post-production costs. Id. at 875-76. As such, a Heritage disclaimer in a lease appears to have no effect on a lessor’s royalty statements.
Taking Royalty “In Cash” Does Not Mean Royalty Owners Bear Post-Production Costs
Chesapeake also argued that the Hyders’ royalty was subject to post-production costs because they chose to take the royalty “in cash” rather than “in kind” (via physical delivery of molecules). Id. at 875. If they Hyders were to take the royalty in kind, they would be required to market their gas and would incur post-production costs in doing so. Id. Chesapeake therefore argued that the Hyders should bear the post-production costs if they take the royalty in cash because they would have to do so anyway if they decided to take the royalty in kind. Id. The Court disagreed, stating that “[t]he fact that the Hyders might or might not be subject to postproduction costs by taking the gas in kind does not suggest that they must be subject to those costs when the royalty is paid in cash.” Id.
“Proceeds” Leases Mean No Deductions
The gas royalty provision in the Hyders’ lease guaranteed the Hyders 25% “of the price actually received by Lessee” for all gas produced and sold from the leased premises. Id. at 871. The provision added that the royalty was “free and clear of all production and post-production costs and expenses . . . .” Id. The Court explained that the price actually received by Chesapeake is the price its affiliate, Marketing, received from sales to third parties after post-production costs were paid. Id. at 873. However, the Court exempted the Hyders from paying post-production costs because the lease was a “proceeds” lease, which the Court stated “is sufficient itself to excuse the lessors from bearing postproduction costs.” Id. The Court further added that the no deductions provisions following the gas royalty “ha[d] no effect on the meaning of the meaning of the provision” and could be “regarded as emphasizing the cost-free nature of the gas royalty, or as surplusage.” Id.
The Overall Impact of Hyder in the Oil and Gas Community
The Hyder case is one of the few cases to reach the Texas Supreme Court since Heritage that examines “no deducts/cost free” lease language to determine the deductibility of post-production costs from royalties. This case suggests that oil and gas leases will finally be enforced as they are written. Moreover, this case suggests that adding the term “cost free” to any royalty provision in a lease now means that the royalty will be free from post-production costs. However, this case makes clear that adding a Heritage disclaimer and additional “no-deducts” language certainly will not hurt such an argument, but will merely be construed as “surplusage.”
Chesapeake Subsequently Settles Thousands of Lawsuits in the Barnett Shale for Millions
Shortly after the Chesapeake v. Hyder litigation ended, Chesapeake settled a majority of the royalty underpayment lawsuits in the Barnett Shale that were stuck in a Multidistrict Litigation proceedings (“MDL”). Specifically, Chesapeake settled MDL No. 1 (which consisted of royalty underpayment claims brought by the McDonald Law Firm and our law firm) and MDL No. 2 (which consisted of royalty underpayment claims brought by the City of Fort Worth and others).
Chesapeake MDL No. 1 Settlement
In regards to MDL No. 1, Chesapeake entered into a settlement agreement with The McDonald Law Firm and our law firm—who represented 13,000 plaintiffs in 400 lawsuits—for $52.5 million, pro-rated based on the number of plaintiffs who accepted the settlement. Pursuant to the terms of the settlement agreement, Chesapeake agreed to pay $29.4 million in cash and its joint venture partner, Total E&P USA, Inc., agreed to pay $13.1 million in cash. Chesapeake agreed to pay the remaining $10 million in a promissory note which is payable in installments over three years. The settlement was contingent upon the law firms receiving written approval by July 11, 2016 from 90% of their clients, representing 95% of those clients’ mcf production since May 1, 2011.
On July 13, 2016, Chesapeake and the law firms involved formally announced that 91% of the 13,000 landowners—representing 97.15% of natural gas production—agreed to accept the settlement with Chesapeake. The maximum payout of $52.5 million was prorated down to $51 million to equal the amount of production that matched the deal, which was agreed to in May. Chesapeake was therefore required to pay $28.5 million in cash, along with a $9.7-million-dollar promissory note payable in three years, and Total E&P USA, Inc. was required to pay $12.8 million in cash to landowners.
Chesapeake MDL No. 2 and Other Chesapeake Settlements in the Barnett Shale
In the sister MDL proceeding in Tarrant County, the City of Fort Worth reached a $15-million-dollar settlement agreement with Chesapeake over similar claims for underpayment of royalties in the Barnett Shale on May 24, 2016. Prior to the Chesapeake settlement, the City of Fort Worth reached a $6-million-dollar settlement agreement with Chesapeake’s joint venture partner, Total E&P USA, Inc.
This firm also has reason to believe that Chesapeake paid approximately $50 million in additional settlements to Fort Worth investor Ed Bass and twenty (20) other landowners on the eve of trial to resolve similar royalty underpayment claims. Moreover, Chesapeake paid an additional $6.7 million in royalty underpayment settlements to Dallas/Fort Worth Airport ($5 million settlement), the Fort Worth Independent School District ($1 million settlement), and the City of Arlington ($700,000 settlement).
Chesapeake Still Faces Royalty Underpayment Lawsuits Across Texas
Burns Charest Files Lawsuit on Behalf of Thirty Royalty Owners in the Barnett Shale
Despite the fact that thousands of lawsuits have already been settled against Chesapeake in the Barnett Shale, landowners are still filing suit against Chesapeake around the state. For example, the Burns Charest law firm just recently brought a lawsuit on behalf of thirty (30) business entities and individuals against Chesapeake for excessive fees and royalty underpayments. See North Texas Royalty Buyers and Investors Sue Chesapeake Energy Over Excessive Fees, Royalty Underpayments, Burns Charest, LLP (July 1, 2016). The plaintiffs in that lawsuit entered into a tolling agreement with Chesapeake effective as of September 28, 2016, which will toll the statute of limitations with respect to all claims by the plaintiffs related to their underpayment/non-payment of royalty claims.
This Firm Sues Chesapeake in Four Counties in the Eagle Ford Shale
Although royalty underpayment lawsuits against Chesapeake may coming to an end in the Barnett Shale, mineral owners from other Texas shale plays are bringing lawsuits against Chesapeake for similar claims. Just recently, our law firm filed four lawsuits on behalf of more than 100 clients against Chesapeake in the Eagle Ford Shale covering more than 60,000 acres of land. These lawsuits allege that Chesapeake breached its contractual agreements with the mineral owners, and violated specific provisions of the Texas Natural Resources Code in accounting for minerals. The breach of contract claims assert that Chesapeake violated lease terms by improperly deducting post-production costs that were not permitted by the lease terms, and based royalties on improper pricing and production volumes. The Texas Natural Resources claims assert that Chesapeake failed to provide the requisite information to royalty owners that would allow them to calculate the deductions made to their royalty payments. Unlike the lawsuits this firm filed in the Barnett Shale, these lawsuits stem from royalty underpayments on oil, gas and natural gas liquids, not just gas.
Upcoming Texas Supreme Court Oil and Gas Cases to Watch
In addition to the royalty underpayment cases against Chesapeake, two cases on “paying quantities”—BP America Prod. Co. v. Laddex Ltd. and BP America Prod. Co. v. Red Deer Res., LLC—have been appealed to the Texas Supreme Court. These cases have arisen due to capped wells and slow production in response to low energy prices.
Production is said to be in “paying quantities” if the company’s revenues exceed its operating costs over a reasonable period of time, no matter how small the profit. Clifton v. Koontz, 325 S.W.2d 684, 690-92 (Tex. 1959). If a well is not producing in paying quantities, then the operator may only continue producing if a reasonable prudent operator would continue to operate the well at a loss for more than mere speculation. Id.
In Laddex, both parties file petitions for review to the Texas Supreme Court after the appellate court ruled that the trial court erred in instructing the jury to only consider whether production ceased in paying quantities from August 1, 2005 to October 6, 2006. In Red Deer Resources, BP filed a petition for review, asking the Texas Supreme Court to review the appellate court’s finding that a well was incapable of producing in paying quantities at the same time it was shut in. Both cases are currently awaiting an opinion from the Texas Supreme Court.
This year has certainly been a historic time for royalty owners. With the recent decision in Hyder, oil and gas companies like Chesapeake that have been systematically underpaying royalties are more hesitant to take royalty underpayment cases to trial. This is good news for the Chesapeake royalty owners with current royalty underpayment claims. Hopefully 2017 will similarly start in a positive note for royalty owners as the Texas Supreme Court prepares to hear the upcoming “paying quantities” cases.