The Texas Supreme Court has been asked to answer another variation on the oft-posed question – what post-production costs are properly deductible from royalty? This time, however, the royalty in question is an overriding royalty provided for in the lease.

The facts of the case, Chesapeake v. Hyder, are as follows: In 2004, the Hyders entered into an Oil and Gas Lease that covered approximately 948 mineral acres in Johnson and Tarrant counties. The royalty clause in the lease provided that Chesapeake pay 25% royalty that “shall be free and clear of all production and post-production costs and expenses, including but not limited to, production, gathering, separating, storing, dehydrating, compressing, transporting, processing, treating, marketing, delivering, or any other costs and expenses incurred between the wellhead and [appellant's] point of delivery or sale of such share to a third party.” In addition, the lease provided for an overriding royalty for off-lease wells that were to be a “cost-free (except only its portion of production taxes) overriding royalty of five percent (5%) of gross production obtained from each such well payable to [appellees] (which overriding royalty shall be carved out of the leasehold estate by virtue of which such production is obtained), same to be effective from first production from the well to which such overriding royalty pertains.”

In addition, the Lease had “Heritage Language”: “[Lessor] and [Lessee] 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 Court of Appeals summarized Heritage, providing that it:

involved the question of how to properly calculate the royalties owed a group of lessors under oil and gas leases. The relevant royalty provisions required the lessee to pay the lessors a certain percentage of the market value at the well for all gas produced from the leased premises. […] The leases also contained a “no deduct” provision, which provided that “there shall be no deductions from the value of the Lessor's royalty by reason of any required processing, cost of dehydration, compression, transportation, or other matter to market such gas.” [T]he Court looked first to the applicability of the “no deduct” provision, which prevented deductions only from the “value of the Lessor's royalty. According to the Court, the “value of the Lessor's royalty” was the market value of the gas at the well—a measure that required a deduction for post-production costs. The Court thus concluded that the leases' “no deduct” provision was “surplusage as a matter of law.”

Chesapeake did deduct costs from the royalty and overriding royalties, and Hyder brought suit. At the trial court, the Hyders prevailed. Chesapeake appealed the decision to the Court of Appeals of Texas, San Antonio. Chesapeake was unsuccessful in front of the Court of Appeals. Chesapeake has now asked the Supreme Court to review the Court of Appeal’s decision regarding overriding royalty payments.

In reaching their decision, the Court of Appeals acknowledged the following legal definitions:

• An “Overriding Royalty” is an interest in the oil and gas produced at the surface, free of the expense of production.
• “Production Costs” are the expenses incurred in exploring for mineral substances and in bringing them to the surface.
• Absent an express term to the contrary, Production Costs are not chargeable to the non-operating royalty interest.
• Whatever costs are incurred after production of the gas or mineral are normally proportionately borne by both the operator and the royalty interest owners.
• These post-production costs include taxes, treatment costs to render the gas marketable, compression costs to make it deliverable into a purchaser's pipeline, and transportation costs.
• Under Texas law, it is clear that an Overriding Royalty is normally free of production costs, but subject to post-production costs.

(citations removed). Despite this analysis, and Chesapeake arguing that the nature of an overriding royalty is that it is subject to post-production costs, both the trial court and Court of Appeals held that Chesapeake improperly deducted post-production costs from the overriding royalty. The Court of Appeals found that “the lease recites the parties agreed to a ‘cost free (except only its portion of production taxes) overriding royalty,’”, and that the effect of adopting Chesapeake’s “interpretation would render the term ‘cost free’ meaningless and require us to determine the parties' true intent was to provide a traditional “overriding royalty,” or a “cost free (except only to its portion of production taxes and post-production costs) overriding royalty.” The Court of Appeals chose not to rewrite the lease, and affirmed the trial courts final determination.

In its brief to the Texas Supreme Court, Chesapeake pointed to recent cases, and argues that the Court of Appeals ignored the holdings that set forth that “similar cost-free or no deduction language in royalty clauses [were held to be applicable] to production costs, but not post-production costs incurred after the wellhead.” Chesapeake complains that the Court of Appeals “disregarded core legal principles announced by this Court [previously], ignored the parties’ expressed intent in the Lease, and rejected the judicially defined meaning of settled industry terms.”

This is certainly a case to watch, simply for future lease interpretation. If the Supreme Court decides to review this case, we may be offered more guidance with respect to the effect of adding the so-called “Heritage language” to Oil and Gas Leases, something that we do truly need clarity on. Specifically, does the inclusion of the Heritage Language require that all royalties be free of post-production costs, even though other language in the lease may provide otherwise? The Supreme Court now has an excellent opportunity to provide bright-line guidance to the industry in this hotly contested area.