Post-Production Deductions Revisited

Originally published by Charles Sartain.

Posted by Charles Sartain

Apparently unsatisfied with its analysis in Chesapeake Exploration v. Hyder, the Texas Supreme Court revisited its original opinion on an overriding royalty clause. The Hyders remain the winners. In effect, the court replaced its reliance on earlier decisions interpreting royalty clauses with its own analysis (which looks a lot like the original).

The Basics

Let’s start with the rules:

• An override is free of production costs but bears its share of post-production costs.
• The parties to a contract are free to agree otherwise.
• A royalty paid on the market value of oil at the well bears post-production costs.  That value is the commercial value less processing and transportation expenses that must be paid before the gas reaches the commercial market.
• A royalty based on the price a lessee actually receives for gas (a “proceeds lease”) does not bear post-production costs.  The price-received basis is sufficient in itself to excuse charges to lessors of post-production costs.

The analysis

The override at issue is: “cost-free (except only its portion of production taxes) … of five percent … of gross production obtained …”.

The exception for production taxes (which are post-production expenses) cuts against Chesapeake.  It would make no sense to say that the royalty is free of production costs except for post-production taxes (no dogs, except for cats, opined Justice Hecht).

The court doesn’t agree with Hyder that cost-free cannot refer to production costs.  Drafters frequently specify that an override does not bear production costs even though it is already free of costs because it is a royalty interest. I call it the “belt and suspenders” school of document drafting.

Chesapeake argued that because the override is paid “on gross production” the reference is to production at the wellhead, making the royalty based on the market value of production at the wellhead, which bears post-production costs.  The court concluded that gross production is a reference to volume only. Specifying that the volume is determined at the wellhead says nothing about result:  “Cost-free” includes post-production costs.

The dissent

Four justices dissented, essentially seeing the same language as did the majority and disagreeing on just about every point. A highlight is their analysis of so-called production taxes. They are really post-production costs, according to the majority.

 The dissent thinks not everyone understands that distinction, and parties can allocate taxes differently than other post-production costs.

The dissent believes a statute does not turn a production cost into a post-production cost.  It simply creates a statutory exception to the common law default rule that an override is free of production costs. Second, the pro rata nature of production taxes bolsters the reading that cost-free does not refer to post-production costs.  The dissent believes that “cost free” is indicated to emphasize the default rule, clarifying that Hyder was still obligated to pay its share of production taxes.

Takeaways

• Some operators, Chesapeake chief among them, have been condemned for gangsterism in their treatment of lessors. Think Imperator Ceaser ravishing the Roman hinterlands. Will Chesapeake go the way of most of the Ceasers? Maybe, but losing five-to-four twice suggests a legitimate legal position this time.
• Don’t look for a policy you an count on in this case or in Heritage, other than the court will read the lease and interpret the text.

Our musical interlude – dedicated to the dissenters.

Curated by Texas Bar Today. Follow us on Twitter @texasbartoday.

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