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August 25, 2015 Articles

Texas High Court Rules Overriding Royalty Not Subject to Postproduction Expenses

A synopsis of the case and an interview with counsel for the leaseholder.

By Jack Edwards – August 25, 2015

The Texas Supreme Court ruled in Chesapeake Exploration, LLC v. Hyder that an overriding royalty was not subject to postproduction expenses under the terms of the parties’ agreement. No. 14-0302, 2015 WL 3653446, 2015 Tex. LEXIS 554 (Tex. June 12, 2015). An overriding royalty under Texas law is “a given percentage of the gross production carved from the working interest but, by agreement, not chargeable with any of the expenses of operation.” While an overriding royalty is usually free of production expenses, it is usually subject to postproduction expenses. But, according to the 5–4 majority, the terms of the Hyder lease freed the overriding royalty from postproduction expenses.

The Hyder lease contained “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production obtained” from certain wells. The parties agreed that the overriding royalty was free of production costs, but they disputed whether it was free of postproduction costs (e.g., gathering, transportation, and marketing costs). Chesapeake argued that the phrase “cost-free overriding royalty” was just a synonym for “overriding royalty,” so that the phrase “cost-free” was merely redundant surplusage that emphasized that the overriding royalty was free of production costs. But the court disagreed and found that the phrase “cost-free” referred to both production and postproduction costs, the only noted exception being for “its portion of production taxes.”

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 Heritagecase concluded that a “no deductions” phrase in a lease did not free an overriding royalty of postproduction costs. So a disclaimer of that holding, according to the Hyders, showed the parties intended for the overriding royalty to be free of postproduction costs. But, according to the court, the Heritage case held “only that the effect of a lease is governed by a fair reading of its text. A disclaimer of that holding . . . cannot free a royalty of postproduction costs when the text of the lease itself does not do so.” So the Hyder court did not rely on theHeritage disclaimer in reaching its conclusion.

Hyder highlights the importance of carefully drafting contract terms in oil and gas leases. While Texas law provides default rules for certain industry terms, the parties may modify those rules by expressing an intent to do so. According to the majority, the Hyder lease did just that, so Chesapeake could not deduct postproduction expenses from the overriding royalty.

An Interview with the Hyders’ Counsel
The author interviewed David Drez, the attorney who represented the Hyders inChesapeake v. Hyder, to find out more about the case.

Could you provide some brief background about the case? 
The case involved a substantial block of acreage that was leased in the early days of the Barnett shale boom. The land was in an area of the Barnett shale that was predicted to be very productive. The lease was originally signed in 2004 and had substantial surface protections due to the development potential of the land. The provision at issue in the case provided that the Hyders would get an overriding royalty when drilling locations on their lands were used for horizontal exploration of adjacent acreage that was not covered by the lease. Of particular note is that the lease was heavily negotiated with lawyers on both sides.

What are postproduction costs, and why are there disputes over these costs? 
Postproduction costs relate to enhancing the value of the gas after the wellhead. There are a variety of things that are done to enhance the value of the gas, such as gathering, transportation, compression, processing, and treatment. These costs can be significant, but they depend on a number of factors, such as the type of gas (i.e., wet or dry) and the region where production occurs. Postproduction costs may also depend on the price of gas, and disputes may arise over whether the lease requires the landowners to pay a portion of these costs. There can also be disputes over the reasonableness of postproduction costs, but that was not an issue in Hyder.

Was this a rare win for royalty owners? 
I have not done an analysis of the overall success of royalty owners before the Texas Supreme Court. The perception by some, rightly or wrongly, is that royalty owners do not typically do well. However, there was a case earlier this year (Hooks v. Samson Lone Star, Ltd. P’ship, 457 S.W.3d 52 (Tex. 2015)) on a statute-of-limitations issue where the royalty owner prevailed.

What are some takeaways from this case? 
In all leases, it is important to clearly state what you intend. In lease disputes, there are choppy seas because many of the lease terms have defined meanings and traditional significance, like “market value at the well.” The ultimate implication of this case remains to be seen. There will be a rehearing battle that will likely involve amicus briefing on both sides. Additionally, there are more customized leases with nonstandard royalty provisions in this day and age, so it is unclear whether the final outcome in Hyder will extend beyond provisions similar to the one in Hyder. So the chapter has not been fully written.

Keywords: litigation, energy, lease, overriding royalty, postproduction expenses

Jack Edwards is an associate with Ajamie LLP in Houston, Texas, and an editor of the Energy Litigation Committee's website.

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