Written by John McFarland of the Oil and Gas Lawyer Blog.
Yet another suit alleging underpayment of royalties has been filed against Chesapeake in the Barnett Shale. The petition can be viewed here: Addax v. Chesapeake Among the long list of plaintiffs is Kimbell Art Foundation. The petition alleges that plaintiffs are lessors under more than 8,000 leases in 280 pooled units with more than 725 producing gas wells. Defendants are Chesapeake and its working interest partner in the Barnett, Total E&P USA, Inc. Plaintiffs’ counsel is Burns Charest LLP.
The suit focuses on two complaints against the defendants. The first is based on the gathering agreement between Chesapeake and Access Midstream. The second is based on how Chesapeake has calculated the plaintiffs’ royalty interests in the pooled units.
When Chesapeake was developing its Barnett Shale leases, it built out its own gathering system to take the gas from the field to central delivery points on third-party pipelines. It put those gathering system assets into a Chesapeake subsidiary called Chesapeake Midstream, later renamed Access Midstream. When gas prices dropped and Chesapeake got in a cash bind, it decided to sell off its midstream assets by spinning off Access Midstream into a separate publicly owned company. In Wall Street lingo, Chesapeake sought to “monetize” the value of its midstream assets. But those gathering system assets would have no value unless the new company had contracts to gather gas on terms that would result in a profit to the new company. So, at the time of the spin-off in 2009, Chesapeake entered into a gathering agreement with Access Midstream to guarantee Access a cash flow for use of the midstream assets. The Addax plaintiffs complain that this gathering agreement contains terms very favorable to Assess Midstream (thus increasing the value of the midstream assets and the price Chesapeake could get for those assets in the market), and that Chesapeake is wrongfully charging the royalty owners their royalty share of those gathering agreement costs. The plaintiffs allege that the charges Chesapeake and Total are required to pay under the gathering agreement are excessive and above-market.
As I have written before, Chesapeake’s affiliate relationships are complex. Chesapeake Energy (75%) and Total (25%) own the leases and wells, and Chesapeake Operating operates the wells. Chesapeake Operating sells the gas to another affiliate, Chesapeake Marketing. The price paid by Chesapeake Marketing is the weighted average price for all gas sold by Marketing from the wells, less the gathering fees that must be paid under the gathering agreement with Access Midstream, and less a marketing fee charged by Chesapeake Marketing. The gas sales contract between Chesapeake Operating and Chesapeake Marketing provides for delivery of the gas to Marketing at the wells, so Chesapeake takes the position that it pays royalty based on the net price it receives from Chesapeake Marketing, after the gathering and marketing fees; and Chesapeake does not disclose those post-production costs on its royalty check details, arguing that those costs need not be disclosed because they are incurred by Chesapeake Marketing, not Chesapeake Operating. The allegedly excess gathering costs paid to Access Midstream are part of the costs deducted from the price in calculating the royalties Chesapeake pays, so the royalty owners are being charged their share of those gathering costs.
The plaintiffs allege that Chesapeake’s, decision to enter into the Access gathering agreement, thus “monetizing” its midstream assets at a huge profit to Chesapeake, and its practice of passing along the high Access gathering charges to the royalty owners, is a breach of Chesapeake’s express and implied obligations to its royalty owners. In effect, Chesapeake has benefited twice from the spin-off of its midstream assets: first by the price it received from the sale, and second by passing along a portion of the resulting high gathering costs to its royalty owners.
The second complaint plaintiffs make concerns how Chesapeake calculates royalty shares of production from pooled units. Many of the pooled units Chesapeake formed are in urban environments and include thousands of oil and gas leases covering home lots and other small parcels. Chesapeake often did not obtain leases on all the tracts within the boundary of the unit before it formed the unit, so there were unleased tracts, or “holes”, in the units. But for purposes of calculating the royalty owners’ shares of production from the pooled unit, Chesapeake treated those unleased hole tracts as if they were included in the pooled unit, reducing the royalty owners’ fractional shares of unit production.