A “COST-FREE” ROYALTY MEANS COST FREE. REALLY.

Chesapeake Exploration L.L.C. v. Hyder
Supreme Court of Texas, No. 14-0302 (June 12, 2015)
Opinion by Chief Justice Hecht; Dissent by Justice Brown
The Texas Supreme Court held 5-4 that a lessor of mineral acreage in the Barnett Shale effectively excluded deduction of post-production costs from its overriding royalty. The royalty clause called for “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of 5% (5.0%) of gross production obtained” from certain directional wells drilled on the lease but terminating outside the leased acreage. In Heritage Resources, Inc. v. Nations Bank, the Court had held an oil and gas royalty is ordinarily free of production expenses, but subject to post-production costs. But the Court in Heritage also held that parties are free to modify this typical allocation of post-production expenses by agreement. The question in Hyder was whether the parties had modified the general rule. The majority held they had.

Chesapeake had been calculating royalty based on actual third-party sales, less post-production costs. The Hyders contended their overriding royalty should be calculated on the gas sales prices without deducting post-production costs. The trial court concluded Chesapeake had wrongly deducted post-production costs and rendered judgment for the Hyders, and the San Antonio Court of Appeals affirmed.

The focus of the Supreme Court’s analysis was what the term “cost-free” meant, and whether it was intended to modify the general rule. Chesapeake argued “cost-free” simply emphasized the traditional rule that royalties were free from production costs. The majority concluded, however, that the express parenthetical excepting taxes—a specie of post-production expenses—undermined Chesapeake’s argument. “It would make no sense to state that the royalty is free of production costs, except for post production taxes . . . .” The majority likened Chesapeake’s argument to a sign stating “No Dogs Allowed, Except for Cats.” In other words, the express exclusion of a post-production expense—taxes—from the universe of “costs” undermined Chesapeake’s argument that “cost-free” only referred to production costs.

Chesapeake mounted a second argument based on the Hyders’ right under the lease to take their overriding royalty in kind rather than in cash. Had the Hyders taken the royalty in kind, they likely would have incurred post-production expenses, depending on what they chose to do with the gas. Nevertheless, the Court held “the fact that the Hyders might or might not be subject to post-production costs by taking the gas in kind does not suggest that they must be subject to those costs when the royalty is paid in cash.”

The dissent would have held the “cost-free” language in the overriding royalty did not modify the general rule that such royalties are subject to post-production costs. First, the dissent noted, because the overriding royalty is calculated on “gross production obtained from each … well,” the measure of value for the gas had to be at the wellhead. By implication, this meant any post-production activities that enhanced the sale value of the gas (and hence the royalty calculated thereon) were not intended to inure to the Hyders’ benefit. Additionally, because accepting royalty in kind would have subjected the Hyders to post-production expenses, the dissent reasoned the Hyders’ election to take the royalty in cash should similarly be subject to such expenses.

In response to the majority’s reliance on the exception of “production taxes” from the costs exempted from the royalty, the dissent acknowledged courts generally treat such taxes as post-production costs, but noted that some lease drafters consider them production costs. And they were labeled “production taxes” in the Hyder lease.

A curious aspect of the Hyder lease was a provision disclaiming any application of Heritage Resources in interpreting the lease. Both the majority and dissent struggled with what the parties intended by this disclaimer. Both ultimately concluded the disclaimer provided no guidance on the questions before the Court.

Hyder is significant for several reasons. First, the majority recognizes certain language effectively modifies the general rule that royalties are normally subject to post-production expenses. Parties wishing to craft such royalties now have some guidance about how to accomplish that. Second, while many wondered whether the Court might use this case as an opportunity to revisit its holdings in Heritage Resources, neither the majority nor dissent suggested doing so. Both reaffirmed the general rule regarding post-production expenses, and both reaffirmed that parties are free to modify that general rule by agreement. Finally, the 5-4 decision likely means disputes presenting different facts and slight variations in lease language may produce different outcomes from that in Hyder.

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