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Energy Law Exchange

August 4, 2015

Texas Supreme Court Clarifies When Parties to an Oil and Gas Lease May Allocate Post-Production Costs by Agreement

The Texas Supreme Court recently decided Chesapeake Exploration, L.L.C. v. Hyder, providing a notable win for royalty interest holders. In a close 5-4 decision, the Texas Supreme Court held that Chesapeake had improperly deducted postproduction costs from the overriding royalty interest. Chesapeake Exploration, L.L.C. v. Hyder, 14-0302, 2015 WL 3653446 (Tex. June 12, 2015). The general rule in oil and gas lease interpretation is that an overriding royalty is free of production costs, but not postproduction costssuch as transferring and delivering oil or gas produced under the lease. In Chesapeake, however, the Court found that the lessee failed to establish that certain lease language provided that the overriding royalty holder should bear postproduction costs. This finding was based on several separate provisions in the lease.

First, the lease included a provision establishing a a perpetual, cost-free (except only its portion of production taxes) overriding royalty. . . Id. at 3. The Court disagreed with Chesapeakes argument that cost-free overriding royalty was simply a synonym for overriding royalty. Id. at 6. The Court ultimately concluded that the provision cost-free meant to exclude postproduction costs from the overriding royalty; however, the Court also held that this clause was not dispositive of the issue. Id. at 7.

The Court next looked at the lease provision allowing the overriding royalty interest to take in kind. If the royalty holders elected to take in kind, by taking their share of the produced oil or gas at the well, they would therefore be responsible for postproduction costs. But even though the royalty holders might be subject to postproduction costs, this did not suggest that they must be subject to those costs when the royalty is paid in cash. Id. at 8.

Finally, the Court reviewed the lease provision disclaiming the application of Heritage Resources, Inc. v. NationsBank, a Texas Supreme Court decision from 1996. In Heritage Resources, the Court had noted that a royalty is usually subject to post-production costs, including taxes . . . and transportation costs. 939 S.W.2d 118, 122 (Tex. 1996) (emphasis added). But the Court explained that Heritage Resources does not suggest, much less hold, that a royalty cannot be made free of postproduction costs. It holds only that the effect of a lease is governed by a fair reading of its text. Id. at 10. The Court further noted that [a] disclaimer of that holding, like the one in this case, cannot free a royalty of postproduction costs when the text of the lease itself does not do so. Id. The disclaimer of Heritage Resources thus did not influence the Courts decision.

The holding in Chesapeakehas repercussions for the oil and gas industry in Texas. Operators negotiating leases should be cautious consenting to cost-free language that could unintendedly release royalty owners from sharing the burden of post-production costs. Parties should also be aware that disclaiming Heritage Resources, by itself, is not sufficient to free a royalty of post-production costs if the lease language does not otherwise do so.