Like the final season of ABC’s hit series Lost, the Texas Supreme Court’s opinion in Chesapeake Exploration, L.L.C. v. Hyder, No. 14-0302, was highly anticipated, but left many of us scratching our heads. The 5-4 decision, authored by Justice Hecht, is the latest in a series of cases from high courts across the country addressing the sharing of “post-production costs” between royalty owners and oil and gas lessees.
To appreciate the significance of Hyder, one needs a little background on a debate that has been raging in Texas oil and gas law since the Spice Girls had their first number one single and classics like Independence Day, Mission Impossible (the first one), and Eddie Murphy’s The Nutty Professor graced our silver screen. In states like Texas that follow the “at the well” rule, an oil and gas royalty owner usually takes his royalty share of production “at the well.” This means that the royalty owner’s share will be free of the costs necessary to actually bring oil or gas to the surface (“production costs”), but he will generally bear his proportionate share of any additional costs that the lessee incurs after the oil and gas has been produced (“post-production” costs). Courts in “at the well” states like Texas and Louisiana have generally recognized that these post-production activities (such as compression, transportation, and processing) add value to the raw oil or gas to the mutual benefit of both the lessee and royalty owners such that it is fair for the royalty owner to bear his proportionate share.
Post-production costs can be quite significant, however, depending on the location of the well and the particular costs at issue, and the savvy oil and gas lessors will almost inevitably attempt to contract out of these general rules. Modern royalty clauses frequently include a provision stating that the lessor’s royalty will be cost free or will not bear the costs of marketing. The effect of these clauses in Texas, has always been questionable in light of the Texas Supreme Court’s opinion in Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996). In Heritage Resources, the Supreme Court held that such “no deductions” clauses must be read in conjunction with the royalty provisions of the lease. So, when a no deductions clause states that there can be no deductions from “royalty,” Heritage Resources mandates that the court first determine where “royalty” is calculated. If calculated at the well, then the no deductions clause becomes mere surplusage because royalty at the well is already free of post-production costs. Increasingly, therefore, the extra savvy lessor will include a provision in their lease expressly stating that Heritage Resources will not apply or that the “no deductions” clause should not be regarded as surplusage despite the holding in Heritage Resources.
Enter Hyder. While the court construed other portions of the lease in passing, the core of the dispute in Hyder centered on an overriding royalty clause that provided for a “cost free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production.” A separate paragraph of the lease also stated that the parties to the lease “agree that the holding in the case of [Heritage Resources] shall have no application to the terms and provisions of this Lease.” Full discussion of the majority opinion’s analysis of these two lines far surpasses the few paragraphs’ traffic of our stage here. However, we note with particular interest the finding by the court on the effect of the so called Heritage disclaimer. The court found that such provisions had no effect and could not override the text of the lease. Therefore, the Heritage disclaimer had no effect and the court expressly stated that it had no influence on the court’s decision. Despite reaching this conclusion, the court, nevertheless, determined that the general statement that the overriding royalty was to be “cost free” referred to all costs both before and after production, and, therefore, Chesapeake had impermissibly taken deductions for post-production costs when calculating the overriding royalty.
Ironically, while denying parties to a contract the ability to disclaim it, the court appeared not to apply the Heritage Resources court’s analysis. Assuming that “cost free” referred to all costs, the next question under Heritage Resources should have been “cost free from where?” Instead of taking this next step under the Heritage Resources analysis, the majority opinion simply stated that the overriding royalty clause when “reasonably interpreted” freed the royalty from post-production costs as well as production costs. The court further stated that Heritage Resources “holds only that the effect of a lease is governed by a fair reading of its text.” So, while not disclaimed, it will be interesting to see how the Texas Supreme Court applies Heritage Resources in the future.