Royalty Free of Post-Production Costs

The Texas Supreme Court, in Chesapeake Exploration, L.L.C. v. Hyder, No. 14-0302, 2015 Tex. LEXIS 554 (June 12, 2015), addressed the issue of allocation of post-production costs and whether, based on a certain lease royalty provision, an overriding royalty must bear its share of post-production costs.

The dispute in Hyder centered on the interpretation of a lease royalty provision. Chesapeake Exploration, L.L.C. ("Chesapeake"), as lessee, acquired an interest in 948 mineral acres in the Barnett Shale previously leased by the Hyder family. Id., at *2-3. The Hyder family had previously executed a lease with the original lessee containing three royalty provisions. Id., at *3. The royalty provision in dispute provided "a perpetual, cost-free (except only its portion of the production taxes) overriding royalty of five percent (5.0%) of gross production obtained." Id., at *3-4. Additionally, the lease contained a disclaimer, which provided: "Lessors and Lessee agree that the holding in the case of Heritage Resources, Inc. v. Nations Bank, 939 S.W.2d 118 (Tex. 1996) shall have no application to the terms and provisions of this Lease." Id., at *5.

Although the Hyder family and Chesapeake agree that the overriding royalty is free of production costs, the dispute is whether it is also free of post-production costs. Id. The long-held definition of an overriding royalty in Texas 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." Id., at *7. Therefore, absent an agreement, an overriding royalty, by definition, is to bear its share of post-production costs, but not production costs. Id.

To determine if the Hyder family and Chesapeake entered an agreement where the overriding royalty was not to bear its share of post-productions costs, the Court examined the use of the phrase "cost-free overriding royalty" in the royalty provision. Id., at *9. The Hyder family argued that because an overriding royalty, by definition, is free of production costs; the phrase can only refer to post-production costs. Id. On the other hand, Chesapeake, relying on similar leas provisions, argued that "cost-free overriding royalty" is just a way of saying that an overriding royalty bears no production costs. Id., at *9-10 (citingMcMahon v. Christmann, 157 Tex. 403 (Tex. 1957); R.R. Comm'n v. Am. Trading & Prod. Corp., 323 S.W.2d 474 (Tex. Civ. App. - Austin 1959, writ ref'd n.r.e.); Midas Oil Co. v. Whitaker, 123 S.W.2d 495 (Tex. Civ. App. - Eastland 1938, no writ). However, the Court noted that the use of the phrase "except only as to its portion of the production taxes" ran counter to Chesapeake's argument. Id., at *10. Production taxes are a post-production expense, and therefore, the use the phrase would make no sense if "cost-free" referred to production costs. Id. Nevertheless, the Court also disagreed with the Hyder family that "cost-free" could not refer to production costs, noting that instruments frequently include a phrase stating that an overriding royalty does not bear production costs even though an overriding royalty is by definition free of production costs. Id., at *11. Despite the disagreement with the Hyder family's interpretation of "cost-free," the Court placed the burden on Chesapeake to prove that "cost-free" did not refer to post-production costs. Id.

Chesapeake made several arguments to attempt to explain why the use of "cost-free" in the royalty provision does not refer to post-production costs. Id., at *11-12. First, Chesapeake argued that because the overriding royalty was to be paid on "gross production," which is measured at the well, the royalty was one based on the market value of production at the wellhead, which bears post-production costs. Id., at *11. Next, it argued that other provisions in the lease were more specific when providing for royalties free of post-production costs. Id., at *12. Nevertheless, the Court determined that Chesapeake was unable to meet its burden to establish that "cost-free" does not refer to post-production costs. Id., at 13. Therefore, the Court concluded that "cost-free" in the overriding royalty provision includes post-production costs. Id.

Finally, the Court addressed the use of the Heritage Resources disclaimer in the lease and its effect on the holding in the case. Id., at *13-16. The Hyder family argued that by the inclusion of the disclaimer, the parties intended an overriding royalty free of post-production costs. Id., *13. The Court held that the use of a Heritage Resources disclaimer, like the one in this case, cannot free a royalty of post-production costs when the text of the lease itself does not do so. Id., at *16. Consequently, the Court held that the Heritage Resources disclaimer did not influence their conclusion on the holding in this case. Id.

Hyder is significant because it provides that a Heritage Resources disclaimer alone is not effective to permit deduction post-production costs from a royalty owner's share. It is important for operators negotiating leases to be alert for the inclusion of "cost-free" or similar language that may potentially release royalty owners from incurring the burden of post-production costs.