Texas Supreme Court Denies Motion for Rehearing in Chesapeake v. Hyder

Last week the Texas Supreme Court denied Chesapeake’s motion for rehearing in Chesapeake v. Hyder. The court originally affirmed the lower courts’ opinions in favor of the Hyders, with four justices dissenting. On rehearing, the court’s alignment did not change, but Justice Hecht issued a new opinion for the majority, and Justice Brown issued a new dissenting opinion, joined by Justices Willett, Guzman and Lehrmann.

These new opinions end a long fight between Chesapeake and the Hyders over the deductability of post-production costs from their gas royalties in the Barnett Shale area. Although the leases contain strong language against deduction of post-production costs, Chesapeake argued that, under the precedent of the prior Supreme Court decision of Heritage Resources v. NationsBank, 929 S.W.2d 118 (Tex. 1996), it could deduct post-production costs. Chesapeake lost in the trial court and the court of appeals. The Supreme Court granted Chesapeake’s petition for review but affirmed the decisions below, split 5 to 4. With the denial of Chesapeake’s motion for rehearing, that decision is now final.

The Hyders’ lease allows Chesapeake to drill horizontal wells from surface locations on the Hyders’ property which produce from adjacent lands — in other words, to use the Hyders’ land to produce oil and gas from adjacent properties. As consideration for that right, the Hyder lease grants the Hyders a royalty interest in production from those wells — an “overriding royalty,” carved out of Chesapeake’s working interest in the leases covering those adjacent lands. The Hyder lease provides that the Hyders are granted “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent of gross production obtained” from such wells. The argument was over the meaning of that language. Chesapeake argued that “cost-free” meant free of production costs; the Hyders argued that “cost-free” means fee of production and post-production costs.

Originally, Chesapeake also contended it had the right to deduct post-production costs from the royalty paid on production from wells producing from the Hyders’ property. The no-deduction language in the lease related to royalties on Hyder wells was more clear than the language related to the overriding royalty, and Chesapeake’s appeal to the Supreme Court did not dispute the lower courts’ opinions on the lease royalty clause. Nevertheless, the Supreme Court opinions address the lease language related to the royalty on Hyder wells, as relevant to its construction of the “no cost” language in the overriding royalty clause. The opinions’ discussion of this royalty clause gives clarity to how courts should construe other gas royalty clauses, and how lawyers should draft them to avoid disputes.

The Hyder lease provides that royalty on gas produced from the Hyders’ lands shall be 25% “of the price actually received by Lessee.” Because of other language in the lease, Chesapeake did not dispute that the “price actually received by Lessee” was the price received by Chesapeake’s affiliate, Chesapeake Energy Marketing, which bought the gas from Chesapeake and resold it to third parties. The lease also provided that the gas royalty would be paid “free and clear of all production and post-production costs and expenses.” Referring to this language, Justice Hecht said:

Often referred to as a “proceeds lease”, the price-received basis for payment in the lease is sufficient in itself to excuse the lessors from bearing postproduction costs. … But the royalty provision expressly adds that the gas royalty is “free of all production and post-production costs and expenses,” and then goes further by listing them. This addition has no effect on the meaning of the provision. It might be regarded as emphasizing the cost-free nature of the gas royalty, or as surplusage.

In other words, if a lease simply says that royalty shall be based on the price received by the Lessee (or, if the gas is sold to an affiliate of Lessee, the price received by the affiliate), then the Lessee may not deduct post-production costs from the royalty. It is not necessary to add language that the royalty is “free of all post-production costs,” and in fact such language is “surplusage.”

Notably, Justice Brown’s dissenting opinion agrees with the majority on this point:

… the Hyders’ gas royalty is “twenty-five percent (25%) of the price actually received” upon resale by Chesapeake. That price necessarily reflects any post-production value added, and the Court rightly observes it thus does not bear post-production costs.

Chesapeake v. Hyder is the first Supreme Court case since Heritage v. NationsBank to examine lease language regarding deductability of post-production costs from lease royalties. And it is the first Texas Supreme Court case in some time upholding a judgment in favor of royalty owners.