Part I.  Heritage and Hyder:  An Overview

This firm is deeply involved in representing thousands of royalty owners in claims against Chesapeake, its joint venture partner Total, and other operators, for the underpayment of royalties due royalty owners.  Our firm has teamed with The McDonald Law Firm, also based here in Fort Worth, to represent these royalty owners.   

We have asserted several grounds in the Tarrant County and Johnson County cases filed so far, but a core allegation in almost all is that even in cases where the deduction of post-production costs (gathering, compression and transportation/transmission) is arguably permitted in calculating the royalty owed, the post-production costs that Chesapeake and Total deducted were “unreasonable,” and in fact “grossly excessive.”

How does this compare with many of the other lawsuits filed against Chesapeake over the underpayment of Barnett Shale royalties in the last several years?  Simply put, most of the previous cases against Chesapeake involved royalty owners who had insisted on lease language that prohibited the deduction of any post-production costs from the royalty payment, often because someone somewhat knowledgeable about the natural gas business counseled that such a clause could be beneficial to the royalty owner.  Almost all of the other lawsuits against Chesapeake to date assert that a “no deducts” clause is effective. Until very recently, none have asserted that even if deductions are allowed, they must be reasonable--Chesapeake’s and Total’s deductions were not.  Our lawsuits do.

But even in the “no deducts” leases, there was a trap for all but the most sophisticated (and expensive) oil and gas lawyer, one best called the “Heritage Trap.”  

An almost-twenty-year-old Texas Supreme Court opinion has been [mis-]read by the oil and gas industry (and some courts—more anon) to negate even the plainest lease language either (1) calling for sale at the wellhead/mouth of the well (before any post-production gathering, compression and transportation costs are incurred), or (2) otherwise expressly prohibiting deduction of post-production costs.  SeeHeritage Res., Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996).  Heritage opinion.

This cringe-worthy opinion is discussed in more detail below and in this firm’s next two blogs.   More recently, a court of appeals has found that Heritage does not apply, and “no deducts” language is effective, where a very well-drafted lease provided: “[Lessee] and [Lessor] agree that the holding in the case ofHeritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996) shall have no application to the terms and provisions of this lease.”  Chesapeake Exploration, L.L.C. v. Hyder, 427 S.W.3d 472 (Tex. App.—San Antonio 2014, pet. granted). Hyder opinion.

Chesapeake has appealed to the Texas Supreme Court, and that Court has granted the petition for review.  Some heavyweights have filed amicus on both sides of the issue, and one of the Amicus Curiae (“friend of the court”) briefs, perhaps the best we’ve ever seen, will be discussed in a later blog.    Oral argument is set for March 24, 2015. Petitioner's Brief on the Merits; Respondent's Brief on the Merits.

But for now, as will be seen from the discussion below, the natural gas producers argue that the state of the law in Texas is this:  Even if a lease expressly prohibits the deduction of post-production costs, that provision is ignored and producers like Chesapeake are free to deduct almost any post-production costs they want to, UNLESS the lease contains the exact same no deducts language, but also explicitly provides, simply, that the Heritage case is inapplicable. 

Indeed, the Basses, the Hyders, the City of Fort Worth, DFW Airport, and other very-well-off royalty owners have asserted that Heritage doesn’t apply to their leases, all drafted with the counsel and assistance of some of the best oil and gas lawyers in the state.

Of course, the Barnett Shale urban drilling boom was mainly a “rooftop” boom, with tens of thousands of small less-than-an-acre leases signed by relatively unsophisticated landowners.  No doubt Chesapeake and other lessees took advantage of this lack of sophistication, with the promise of an up-front bonus and future royalties based on projections when gas prices were $8 or $9 an mcf, never disclosing that with the deduction of the post-production costs, and even a modest drop in natural gas prices, future royalties could be all but wiped out.  Never mind that Chesapeake’s post-production costs were part of sham sale arrangements to affiliates designed to disguise the deduction of excessive post-production costs.  

Heritage (even as modified by Hyder), as interpreted by the industry, results in a sort of “rich man’s justice” that must give pause to even the most jaded of oil and gas practitioners.

Coming Up:  Further discussion of Heritage, and thoughts on its deep flaws.