© 2015 The Texas Lawbook.
By Janet Elliott
AUSTIN (June 24) – Attorneys representing royalty owners in the explosion of litigation against energy companies are encouraged by a recent Texas Supreme Court ruling that interpreted a drilling lease as clearly excluding post-production costs from royalties.
David Drez, a partner in the Fort Worth office of Wick Phillips, won a ruling for the Hyder family of Fort Worth in a closely watched lease dispute. A sharply divided court agreed with the family that Chesapeake entities had improperly deducted post-production costs from royalties paid on gas wells located on 948 mineral acres in the Barnett Shale.
“One of the significant things about this case is the general perception – right or wrong – that a royalty owner doesn’t have a chance against an operator. Here you have a situation where the royalty owner actually does prevail,” said Drez.
Ken Slavin, who has been following the case on behalf of the Texas General Land Office and other royalty owners, said the ruling is significant because it narrowly construed a controversial 1996 Texas Supreme Court decision. In that case, Heritage Resources, Inc. v. NationsBank, the court found that transportation costs could be deducted from royalty payments despite a “non-deductions” provision in the lease.
“Some lawyers have been trying to use Heritage to expand the rights of oil and gas companies to the detriment of royalty owners. The court has reined that in a little bit,” said Slavin, a partner in El Paso’s Kemp Smith law firm.
Days after the June 12 ruling, Chesapeake filed a motion for an extension of time to file a motion for rehearing. Matt Stayton, a partner in Fort Worth’s Kelly Hart & Hallman, represents the Oklahoma City-based company.
Chesapeake is facing hundreds of lawsuits filed by a range of royalty interests, including small Texas landowners and large public entities. At the company’s urging, many of the lawsuits have been combined in multidistrict litigation pending in Tarrant County.
The Hyders were among the earliest litigants, having sued in 2010. In 2012, after a bench trial, the trial court awarded the Hyders $575,360 and the Fourth Court of Appeals in San Antonio affirmed. Drez said the amount in dispute is now more than $1 million.
Overriding Royalty Provision
Although the lease contained three royalty provisions, the language in dispute calls for “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production obtained” from directional wells drilled on the lease but bottomed on nearby land. The lease also included a disclaimer of any application of Heritage Resources.
The majority opinion discussed the relevance of its earlier ruling in a somewhat roundabout way.
“Heritage Resources does not suggest, much less hold, that a royalty cannot be made free of postproduction costs,” said Chief Justice Nathan Hecht for the five-member majority. “Heritage Resources holds only that the effect of a lease is governed by a fair reading of its text. A disclaimer of that holding, like the one in this case, cannot free a royalty of postproduction costs when the text of the lease itself does not do so.
“Here, the lease text clearly frees the gas royalty of postproduction costs, and reasonably interpreted, we conclude, does the same for the overriding royalty. The disclaimer of Heritage Resources does not influence our decision.”
The justices joining Hecht were Paul Green, Phil Johnson, Jeff Boyd and John Devine. The dissent was written by Justice Jeff Brown and joined in by Justices Don Willett, Eva Guzman and Debra Lehrmann.
Brown said he did not argue with the majority’s assessment of Heritage, but noted that the “free and clear” language in the lease is similar in specificity to the language held ineffective in Heritage. He said the Heritage disclaimer in the Hyders’ lease “could be interpreted as a belt-and-suspenders attempt to ensure the ‘free and clear’ language is given effect despite its conflict with the oil royalty’s market-value-at-the-well definition.
“Where the ‘no deductions’ language in Heritage was meaningless and ineffective, I read ‘cost-free’ as redundant but not meaningless,” said Brown. “And though the disclaimer expressly extends to ‘the terms and provisions of this Lease,’ its location in the oil-and-gas-royalty clause highlights that it is intended to support the ‘free and clear’ language, not to give the simple ‘cost-free’ designation any additional meaning.”
Brown said he read the overriding-royalty clause as granting the Hyders a percentage of production before post-production value is added and without allocating their share of post-production costs to Chesapeake.
Case Closely Followed
The case was closely watched and attracted several amicus briefs. The Texas Oil and Gas Association said in its brief that the court of appeals failed to understand settled Texas oil and gas law in several ways.
“Had the Court of Appeals correctly applied settled principles of Texas oil and gas law, that court would have concluded that the overriding royalty – which is based on gross production, cost-free – is not chargeable with production costs, but is chargeable with postproduction costs,” the brief states. “And because overriding royalty clauses are commonly used in the industry, it is important that this Court correct the legal errors in the Court of Appeals’ opinion.”
The Texas Land and Mineral Owners’ Association and the National Association of Royalty Owners-Texas, weighed in on behalf of the Hyders. The attorney who filed that brief, John McFarland, a shareholder in Austin’s Graves Dougherty Hearon & Moody, doesn’t think the court provided significant guidance on how much Heritage Resources should be relied on as precedent.
Writing in his Oil and Gas Lawyer Blog, McFarland noted the fact that four justices would allow Chesapeake to deduct post-production costs and said, “One lesson royalty owners and their lawyers should take away from Hyder: a ‘Heritage disclaimer’ clause in a lease, without more, will not insulate the royalty owner from post-production costs.”
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