The Texas Supreme Court recently discussed the impact of Heritage Resources v. NationsBank on an overriding royalty clause in Chesapeake Exploration, L.L.C. v. Hyder.[1]   According to an article published by Law 360, “[l]awyers say th[is] decision pricks a hole in the armor oil and gas well operators have held up . . . as a means to avoid bearing the entire burden of post-production expenses.”  See Jess Davis, Well Operators’ Costs May Rise After Chesapeake Ruling, Law 360 (last visited June 22, 2015).[2]  The Hyder opinion suggests that a lease’s language can free a royalty owner from the burden of post-production costs, even though the Court’s prior Heritage opinion suggests that, in practice, avoiding post-production cost is almost never possible.      

            The Hyder opinion was decided by the Texas Supreme Court on June 12, 2015.  The Court examined the nature of the overriding royalty expressed in the Hyder’s oil and gas lease with Chesapeake.  An overriding royalty interest is a share in the proceeds from gross production. Chesapeake argued that an overriding royalty is carved out of the working interest.  Typically, an overriding royalty is free of production costs. However, Chesapeake argued that such a royalty is subject to post-production costs unless the parties agree otherwise.  Chief Justice Hecht delivered the opinion of the Court and concluded that the nature of the override as expressed in the lease was completely “cost-free”—it was subject to neither production nor post-production costs.  The result of the Hyder opinion together with the Heritage opinion creates a conundrum in the oil and gas industry: whether “cost-free” means “cost-free” with reference solely to an overriding royalty (as discussed in Hyder), or whether “cost-free” means “cost-free” if applied to a far more common “royalty” clause; Heritage suggests not, though this bifurcation makes absolutely no sense, and shows the deep flaws in the Heritage opinion.

            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 Hyder’s lease but bottomed on neighboring land.[3]  The Hyders argued that “cost-free” can only refer to post-production costs since an overriding royalty is, by nature, already free of production costs.  Chesapeake, however, argued that the “cost-free” language was merely restating that the overriding royalty was free of production costs.  The Court agreed with the Hyders that “cost-free” in an overriding royalty provision refers to, and therefore prohibits the deduction of post-production costs.  The Court reasoned that although an overriding royalty is, by nature, free of production costs (of course, so is a royalty), the “cost-free” language referred to both production and post-production costs.  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.  

            The overriding royalty in the Hyder lease was expressed as a fraction of “gross production,” which refers to all gas, including gas used by the operator or lost in post-production operations, measured at the well when produced.  Employing Heritage­-like reasoning, Chesapeake argued that because the overriding royalty was paid on “gross production,” a reference to production at the wellhead, the royalty provision was tantamount to a market value at the well provision, which is subject to post-production costs.  The Court disagreed, and effectively nullified the concurring opinion’s conclusion in Heritage that a reference to production “at the well” includes deductions for post-production costs from a lessor’s royalty.  The Court 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” (emphasis added).  Therefore, Hyder correctly holds that a reference to production “at the wellhead” does not determine who bears the burden of certain post-production costs; wellhead simply refers to where volume is measured.   

            Chesapeake’s subsequent argument dealt with the manner in which the Hyders take their oil and gas royalty.  The Hyders elected to receive their royalty payments “in cash” rather than “in kind” (physical delivery of molecules).  If the 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.  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.  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.”

            The Court in Hyder also discussed the validity of the Heritage disclaimer in the lease.  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.”  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.”  The Court reasoned that the Heritage disclaimer had no effect on the outcome of the case because the lease provided that the overriding royalty was already free from post-production costs.  As such, a Heritage disclaimer in a lease appears to have no effect on a lessor’s royalty statements.  But elsewhere, Chief Justice Hecht’s reliance on Owen’s concurrence rather than Baker’s majority opinion does seem to suggest that he would overrule the Heritage majority opinion, reject Justice Gonzalez’ dissenting opinion, and call Justice Owen’s concurrence the main opinion.     

            The Texas Supreme Court further stated that a “proceeds” lease, in addition to a “cost-free” overriding royalty provision, is free of post-production costs.  The Hyders’ gas royalty provided for 25% “of the price actually received by Lessee” for all gas produced and sold from the leased premises and expressly added that the royalty was “free and clear of all production and post-production costs and expenses” and listed examples of such expenses.  The Court found that this royalty provision was tantamount to a “proceeds” royalty provision.  Under a “proceeds” lease, the lessor’s royalty is based on the price the lessee actually receives for the gas it produces and sells after post-production costs are paid.  Because Chesapeake sold gas through its affiliate, Chesapeake Energy Marketing, Inc., pursuant to a “proceeds” lease, the Hyders were able to receive their royalty free of post-production costs.  However, the Court added that the no deductions provisions following the gas royalty “ha[d] no effect on the meaning of the provision” and could be “regarded as emphasizing the cost-free nature of the gas royalty, or as surplusage.” 

            The dissenting opinion disagreed with the majority on the royalty’s point of valuation.  While the majority opinion concluded that the overriding royalty required valuation downstream at the point of sale rather than at the wellhead, the dissenting opinion concluded that the overriding royalty clause did not refer to any point of resale downstream and thus implicated that the royalty was to be valued at the wellhead.  The dissent therefore viewed this royalty provision as a “market value at the well” provision, which puts the burden on the royalty owner to pay the post-production costs.  Although the majority concluded that the exception for production taxes inferred that post-production taxes were “cost-free,” Justice Brown stated in his dissent that he did not believe the reference in the lease to production taxes supported an inference that “cost-free” referred to post-production costs because “parties often allocate tax liability on the royalty owner while at the same time specifically emphasizing that the royalty is free from production costs.”[4]   

            The Kachina opinion was also decided by the Texas Supreme Court on June 12, 2015.[5]  At issue was the trial court’s construction of an agreement’s compression-cost provision and the construction of its option provision.  The trial court concluded that Kachina had the right to deduct compression costs from Lillis’ monthly net proceeds and that Kachina duly exercised its option rights under the agreement.  The Court of Appeals reversed and held that the agreement unambiguously did not allow Kachina to charge Lillis for compression.  Chief Justice Brown delivered the opinion of the Court and affirmed the decision of the Court of Appeals, finding the agreement to be unambiguous, and the deductions were not allowed. 

            Unlike Heritage where the Court rendered contractually negotiated language as mere “surplusage,” the Court in Kachina examined the agreement in its entirety, giving effect to each provision so that none was rendered meaningless.  Based on an analysis of the plain text, the Court concluded that “the provision unambiguously allow[ed] Kachina to deduct only the costs of compression installed during the term of the Agreement if required to overcome the working pressure in Kachina’s system.”  If a well failed to overcome Kachina’s working pressure, then Kachina was given two options: (i) do nothing; or (ii) elect to install compression so that the well can overcome the working pressure.  If Kachina elected to do the later, then Kachina could properly deduct compression pursuant to the agreement.  The Court stated that allowing the compression-cost provision to apply to all compression rather than just the added compression would ignore the plain language of the lease because Kachina would then be deducting compression from Lillis’ payment when that compression was not even used to bring about delivery.  

            The Kachina opinion suggests that Heritage should either be withdrawn or severely limited.  Heritage cuts against the opinion in Kachina because Heritage ignored the plain text of the agreement—the no deductions language—and also ignored the parties’ intent—that no deductions would be made from royalty payments.  Rather than examining the entire agreement and giving effect to each provision so that none was rendered meaningless, Heritage found specifically negotiated language to be “surplusage,” thereby ignoring the parties’ intentions.  Although the Court in Hyder stated that the no deductions provisions following the gas royalty could be regarded as surplusage, this was dicta and had no controlling effect on the outcome of the case.  Therefore, the Kachina opinion does not contradict the Hyder opinion like it does the Heritage opinion.

            Both Hyder and Kachina stand for the proposition that the specifically negotiated language in an oil and gas contract—including cost-free/no deducts language—can and should be given its true meaning despite the existence of the dreaded Heritage opinion.  Therefore, both opinions are “. . . a victory for property owners to have the court read the contract fairly, as the provision was considered by the parties.”  See Jess Davis, Texas Justices Say Chesapeake Must Pay Cost-Free Royalties, Law 360 (last visited June 22, 2015).[6]            

[1] Chesapeake Exploration, L.L.C. v. Hyder, No. 14–0302, 2015 WL 3653446 at *1 (Tex. 2015).

[2] http://www.law360.com/articles/667411/

[3] Hyder, 2015 WL 3653446 at *1 (emphasis added).

[4] Hyder, 2015 WL 3653446 at *7.

[5] Kachina Pipeline Co. v. Lillis, No. 13–0596, 2015 WL 3653272 at *1 (Tex. 2015). 

[6] http://www.law360.com/articles/667175/.