Part II. Heritage and Its Progeny

In our last blog we discussed in overview fashion the Texas Supreme Court’s Heritage opinion, and a more recent court of appeals opinion (Hyder) beneficially limiting Heritage’s application to certain leases, but implying that Heritage might still apply to other lease language.  This edition of the firm’s blog will show why Heritage should be treated as an aberrational opinion out of the mainstream of contract interpretation, and wholly violative of numerous principles of Texas contract construction.  If anything, Hyder does not go far enough. Since the Texas Supreme Court granted petition in Hyder, and heard argument , last month, it should take that opportunity to not only affirm Hyder, but put distance between itself and the incongruous Heritage opinion.  

The next blog will discuss one of the best Amicus Curiae briefs ever filed, one submitted in connection with the pending  Hyder case.  Amicus Brief - Tex. Land and Mineral Owners Ass'n Heritageaddressed the issue of calculation of royalty in leases that required a percentage royalty based on the “market value at the well for all gas…produced from the leased premises.” Heritage Res., Inc. v.NationsBank, 939 S.W.2d 118, 120-21 (Tex. 1996).  Importantly, the leases also had a “no deduct” provision expressly prohibiting deduction of post-productions costs:  “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.”  Id.  Of course, the industry lessee ignored this language, and made those very deductions.

In a series of opinions led by Justice Baker’s opinion, with Justice Priscilla Owen’s concurrence most frequently cited later, the Texas Supreme Court in Heritage ultimately ignored both the “at the well” and “no deducts” provisions. Instead, the Court focused on the “market value” language to construct a proposition that to determine “market value” at the well, the Court actually had to look downstream to the point of sale to others,  theorizing that necessarily required incurring the expressly prohibited gathering and transportation costs (the record on the necessity of these downstream costs to get to a market price was thin, to be generous, and seemed more driven by some claimed expertise on the part of some of the Justices than on the record).  

This blog will not attempt to chronicle all of the gymnastics Justice Baker and Justice Owen wentthrough to reach a result that ignored more than one express provision of the Heritage leases.  In doing so, they also blithely disregarded two touchstones of Texas contract interpretation: the “plain meaning” of terms is not ignored, and no provision will be rendered meaningless.  But a couple of key features bear consideration here.

By re-constructing the lease to apply the “no deducts” language to the “net” value of the royalty, not to the phrase as written (“there shall be no deductions from the value of lessor’s royalty…”), the Court engrafted a term (“net”) nowhere found in the lease.  According to the Court, the “value of the Lessor’s royalty” was supposed to be the market value of the gas at the well, but—according to it—since there was no evidence of the “market” for gas at the well in those leases (a rarity in the Barnett Shale and other shale plays), the two authors chose to use the downstream sales price, minus those very same prohibited deductions!

Most in the industry, in justifying deduction of post-production expenses, completely ignore this key part of Heritage, the inexplicable admission of no “market” at the well for the lessor’s gas.  Even according to Justice Baker’s and Justice Owen’s opinions, if there is a “market” for gas at the wellhead in the field,Heritage is inapplicable, because “comparable sales” will instruct on the “market” price(s) available.  

In addition, most of the Barnett Shale leases are not worded in terms of “market value” at the wellhead/mouth of the well; many are “proceeds” leases.  By its express language, Heritage is inapplicable to a “proceeds” lease.  Yet Justice Owen would later ignore this distinction once she moved to the federal Fifth Circuit, as seen below.  

And in a scary and telling portion of Heritage, the the majority and concurrence candidly admit that the result in the case ignores the intent (“expectations”) of the parties, and the actual expectations of the parties are probably frustrated, or said another way, completely ignored.

The Alice In Wonderland results of Heritage, as interpreted by the natural gas operators and producers, are this:

-- An express “no post-production deducts” royalty clause actually means all post-production costs are deducted in calculating royalty;

-- An “at the wellhead” or “mouth of the well” point of sale actually means focusing on prices far downstream at a completely different point of sale;

--“Market value at the well” does not really mean “market value at the well” and actually means market value somewhere else;

-- Determining the “intent of the parties” means treating a lease’s explicit written “no deduct” provision as “surplusage as a matter of law,” so that mutually expressed intent is completely ignored.

-- When there is no evidence of the “market” for gas at the wellhead, the Court is free to construct its own “market” paradigm, even without evidence on same.

These problems make the dissent in Heritage compelling reading.  And that dissent becomes hugely important in Hyder, as we will see in our next blog.

In Hyder, Chesapeake’s legal position boils down to this: not only is Heritage the greatest opinion sinceMarbury vs. Madison, there is really no way for the parties to contract around Heritage, or to use language in a lease that actually stops Chesapeake from deducting post-production costs, even from an overriding royalty interest (“ORRI”).

As we will see, the absurd results of Heritage have been multiplied in a couple of recent Fifth Circuit opinions decided by former Justice Owen, who not surprisingly agreed with Chesapeake, and touted herHeritage opinion as binding precedent.  

And ofimportance to the thousands of cases this firm and the McDonald firm are undertaking against Chesapeake and Total, nothing in Heritage or its progeny allows Chesapeake and Total to deductunreasonable post production costs.