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Case Study: Chesapeake Exploration, L.L.C. v. Hyder – Royalty Clauses: Free and Clear or Cost Free

Posted 6:30 AM, January, 6th 2015 by Manning Wolfe & filed under Blog, Case Studies, Legal

Background:  The appeal arose out of a dispute involving the construction of the royalty and overriding royalty clauses in the Hyder oil and gas lease, between Appellants - Chesapeake Exploration, L.L.C. and Chesapeake Operating, Inc., and the Appellees - the royalty interest holders.  Royalty owners filed suit against Chesapeake alleging a breach of the lease. Chesapeake counterclaimed to recover overpaid royalties.

Facts:  Chesapeake, as lessee, produced gas and sold it at the well to a Chesapeake affiliate, which took title. The affiliate gathered and transported the gas to a delivery point, where a third party took possession and transported it downstream to a point of sale. Another unaffiliated third party purchased the gas and took title. Chesapeake accounted to the royalty owners on the sales price at the point of sale.

Issue:  The dispute between the parties arose from each party's interpretation of the royalty and overriding royalty clauses of the lease. Chesapeake contended the royalty clause isapplicable to the wells on the leased premises, and overriding royalty clauses on off-lease wells, allowed them to deduct appellees' share of post-production costs and expenses incurred between the "point of delivery" and the "point of sale". Appellees countered that their royalty interest is not subject to any post-production costs, regardless of where the costs are incurred.

At issue in the case was the $1,750,000 in third party transportation costs that Chesapeake incurred between the point of delivery and the point of sale.

Chesapeake pointed to the “or” language in the royalty clause, arguing that it was disjunctive and allowed deduction of post-production costs incurred after the point of delivery, but before the point of sale.The lease also provided that Chesapeake would pay a “perpetual, cost- free … overriding royalty” on production obtained from certain off-lease wells.The royalty owners contended that this “cost-free overriding royalty” meant that it was free of both production and post-production costs.Chesapeake contended that the language simply reinforces the nature of an overriding royalty, which is that an overriding royalty is not subject to production costs but is subject to post-production costs.  The royalty clause provided that Chesapeake would pay royalty as a percentage of the price “actually received by (Chesapeake) for such gas” and that the royalty would be “free and clear of all production and post-production costs and expenses . . . incurred between the wellhead and point of delivery or sale . . . to a third party.”

Trial Court Ruling:  The trial court held for the royalty owners, asserting that post-production costs are not deductible if the royalty clause contains the words “free and clear” or “cost free.”

Rationale on Appeal:  The Appellant court acknowledged the general rule that post-production costs are deductible from royalty, but the parties may modify the general rule by agreement.The court reasoned that it would be contrary to the plain reading of the royalty clause to interpret the lease language to exclude post-production costs from the wellhead to the point of delivery, but include post-production costs from the point of delivery to the point of sale.

Bottom Line:  By express provisions, parties may agree to effectively exclude post-production costs, notwithstanding industry custom that royalties are subject to these costs.

Final Judgment:  The appellate court affirmed the trial court and entered a final judgment in favor of appellees (the royalty interest holders); awarding them damages for breach of the royalty and overriding royalty clauses, attorney's fees, and pre-judgment and post-judgment interest.

Judgment affirmed.

Reference:  Chesapeake Exploration, L.L.C. v. Hyder, 427 S.W .3d 472 (Tex. App.—San Antonio 2014, pet. filed).

 

Drafting Note:  The case referenced Heritage Res., Inc. v. NationsBank, 939 S.W.2d 118, 121 (Tex. 1996).  In Hyder, the royalty clause specifically stated that “Heritage Resources, Inc. v. NationsBank . . . shall have no application to the terms and provisions of this Lease.”  The royalty owners contended that this language indicated that their royalty interest was not subject to any post-production costs and expenses, regardless of where such costs were incurred.  In Heritage, the court held that the parties modified the general rule in their agreement by expressly excluding all post-production costs.

The issue in Heritagebetween market value at the well and “no deduction” from market value at the well, did not exist in Hyder. However, the Hyder court determined that as in Heritage, it must give contractual terms their plain and ordinary meaning unless the instrument shows the parties' intent to use the terms in a different sense. The opinion construed Heritagevery narrowly, so that at least as to a proceeds lease, language to avoid deduction of post-production costs should be easy to draft.

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