A recent case that was decided by the Texas Court of Appeals in San Antonio illustrates the problems when mineral owners sign a "standard" form for their oil and gas lease and why they should consider getting the opinion of an experienced Texas oil and gas attorney before they sign. Failing to do so could end up costing you money every month.
The decision is Chesapeake Exploration, LLC v. Hyder. The Court, in a unanimous decision written by Justice Sandee Bryan Marion, ruled that, despite the claims of the well operator, post-production costs could not be deducted from the mineral owner's royalties, based on the specific language of the lease before the Court. This particular lease was most definitely not a standard form and appeared to have been carefully drafted by the Hyder's attorney.
The Hyder lease was executed on September 1, 2004 with another oil company, and then the lease was assigned to Chesapeake Exploration LLC. The leased premises consisted of two tracts of 1,037 acres and 948 mineral acres in Johnson County and Tarrant County. The lease allowed Chesapeake to drill from existing well sites adjacent to the leased premises, as well as within the leased premises itself. For the wells on the leased premises, the Hyders were paid a precentage royalty. For wells outside the leased premises, the Hyders were to be paid a specified percentage as overriding royalties.
As of December 2011, Chesapeake had 22 wells on the leased premises and seven wells on the adjacent land. Chesapeake deducted certain costs from both kinds of royalty. The Hyders alleged that the deduction of costs from either royalties or overriding royalties was a violation of the lease. Chesapeake counterclaimed to recover royalty overpayments. In spite of a pretty clear and specific clause in the Hyder lease that prohibited deduction of any costs, Chesapeake argued that, as to the regular royalties, the lease authorized the deduction of the Hyders' share of post-production costs and expenses between the point of delivery of the oil and gas and point of sale, and that the overriding royalty clause for the wells adjacent to the leased premises also allowed them to deduct the Hyders’ share of post-production costs and expenses from the overriding royalties.
The trial court awarded the Hyders a $1 million judgment against Chesapeake for breach of the royalty and overriding royalty clauses, attorney’s fees and interest. The Court of Appeals affirmed. Justice Marion wrote in the decision, "[w]hile we acknowledge an overriding royalty is normally subject to post-production costs, we also acknowledge Texas law allows the parties to modify this default rule." The opinion noted that in the Hyder lease, the following language appears: “[Royalty owners] and [Chesapeake] agree that the holding in the case of Heritage Resources, Inc. v. Nationsbank, 939 S.W.2d 188 (Tex. 1996) shall have no application to the terms and provisions of this Lease.” (The Heritage case described a rule for cost deduction based on the language in that particular lease). The Court also pointed out the specific phrases "no deduction of costs" and "cost-free" in the Hyder lease.
The Court of Appeals confirmed the ruling of the trial court on a second issue involving damages. The Hyders wanted reimbursement for a quantity of gas that was apparently lost and thus unaccounted for. The Court held that since the unaccounted-for gas was neither sold by Chesapeake nor used at the leased premises (the two situations where the lease said that royalty was due), the Hyders could not be reimbursed for it.
The kind of hairsplitting that was the basis of Chesapeake's arguments made me embarrassed for them. Chesapeake's financial woes of have been reported on in the media for many months. I can only guess that Chesapeake ordered its accounting department and attorneys to seek out recovery of costs wherever they could, even if it meant advancing somewhat specious arguments in court.
This case illustrates that the language of the lease is critical, and since post-production costs can be quite substantial, the language of the lease can have a large impact on the amount of royalties that a mineral owner gets. Elimination of post-production costs clauses in an oil and gas lease is something that the oil company almost never offers; it really has to be negotiated. It generally requires an experienced oil and gas attorney to get the most favorable cost provisions given the mineral owner's particular circumstances.
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