On June 12 2015 the Texas Supreme Court delivered its five-to-four decision in Chesapeake Exploration LLC v Hyder – the first decision to discuss its key 1996 ruling in Heritage Resources Inc v NationsBank.(1) The majority sided with the plaintiff royalty owners, the Hyders, holding that Chesapeake was not entitled to deduct post-production costs in calculating overriding royalties on gas under the Hyder lease. The decision reaffirmed the underlying premise of Heritage – that the specific lease language used by the parties controls the royalty valuation and deductibility of post-production costs.
The Hyder lease contained three royalty provisions. The first clause provided for a 25% royalty on "the market value at the well of all oil and other liquid hydrocarbons". A second royalty was for 25% of the "price actually received" by Chesapeake for all gas produced from the leased premises and sold or used, "free and clear of all production and post-production costs and expenses".(2) The third provision – at issue in the case – called for a "perpetual, cost-free (except only its portion of production taxes) overriding royalty" of 5% of "gross production obtained from each such [directionally drilled] well".
The Hyder lease also contained the following disclaimer:
"Lessors and Lessee agree 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."
The crux of the Hyders' claim was that Chesapeake breached the lease by effectively deducting post-production costs in calculating overriding royalty payments. After a bench trial, the trial court rendered judgment for the Hyders, awarding them post-production costs that Chesapeake wrongfully deducted from the overriding royalty. The court of appeals affirmed the judgment.
The Texas Supreme Court affirmed and held that the language in the overriding royalty provision in the Hyder lease "clearly free[d]" the overriding royalty of post-production costs. Important to the court's decision was the 'cost-free' requirement, because it showed that the parties wanted an overriding royalty free of post-production costs. Significantly, the overriding royalty provision lacked any 'at the well' language.
The court found that the exception for production taxes, which are post-production expenses, cut against Chesapeake's argument.(3) According to the court: "It would make no sense to state that the royalty is free of production costs, except for postproduction taxes (no dogs allowed, except for cats)."
The 'gross production' language in the Hyder lease did not affect the deductibility analysis. The court found that while 'gross production' specified that the volume on which the overriding royalty was due must be determined at the wellhead, it "sa[id] nothing about whether the overriding royalty must bear postproduction costs".
The court's deductibility analysis was likewise unaffected by the lease's disclaimer of the application of the Heritage ruling. The court emphasised that Heritage held only that the effect of a lease is governed by a fair reading of its text. Thus, a disclaimer of the Heritage ruling "cannot free a royalty of postproduction costs when the text of the lease itself does not do so".
The court noted that deductibility of post-production costs under the other two royalty provisions in the Hyder lease was clear. The oil royalty bore post-production costs because it was "paid on the market value of the oil at the well". However, the gas royalty did not bear post-production costs because the price-received basis for payment was "sufficient in itself to excuse the lessors from bearing postproduction costs". In the court's view, the 'free and clear' language had no effect on the meaning of the gas royalty provision and could be regarded as merely emphasising the cost-free nature of the gas royalty or as surplusage.(4)
Justice Brown – joined by Justices Willett, Guzman and Lehrmann – dissented, writing: "Though the overriding royalty may not have been expressed using familiar market-value-at-the-well language, I read its value as being just that." Brown expressly disagreed with the majority's interpretation of the 'cost-free' designation in the overriding royalty provision, noting that "courts often read such language as simply stressing the production-cost-free nature of a royalty without struggling to ascertain any additional meaning". However, he noted that "[i]f the extensive, specific, and detailed 'free and clear' language [in the gas royalty provision] should be read as only emphatic or surplusage, so should the mere 'cost-free' designation" in the overriding royalty provision. 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", the exception from the 'cost-free' designation for production taxes did not support the inference that 'cost-free' refered to production costs.
The court's ruling that post-production costs were not deductible under the specific overriding royalty provision in the Hyder lease is far from groundbreaking. However, several important takeaways from the decision are broadly applicable in performing deductibility analyses under Texas oil and gas leases:
- Where a lease provides for valuation 'at the well', post-production costs are deductible, notwithstanding 'no deductions' or 'free of costs' language in the lease, as held in Heritage.
- Loose usage of language such as 'cost-free' could be misinterpreted, demonstrating the importance of industry-knowledgeable drafting.
- The particular lease language remains key to determining deductibility of post-production costs in calculating royalty; a disclaimer of the Heritage ruling will not change plain lease language identifying the point of and basis for royalty valuation.
In short, the law on deductibility of post-production costs in calculating royalties under Texas oil and gas leases remains unchanged by Hyder. The Heritage ruling is still intact and cannot be avoided by the disclaimers contained in many recent leases. Deductibility of post-production costs remains governed by a fair reading of the particular royalty lease language.
William D Wood
Daniel M McClure
Rebecca J Cole
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