the 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.”
A quick review of the facts of the Hyder case 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. A clause in the lease provided that Chesapeake pay an overriding royalty for off-lease wells that was 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.” The Hyders also included the following statement in their lease: “[Lessor] and [Lessee] agree that the holding in the Heritage Resources, Inc. case of shall have no application to the terms and provisions of this Lease.” This was done with the supposed intent of ensuring that common industry terms would not operate to make their “no deduct” language “surplusage”, which is what happened in the Heritage Resources, Inc. case when the lease used the phrase “market value at the well”. Here, Chesapeake deducted post-production costs from the overriding royalties, and Hyder brought suit. Chesapeake was unsuccessful at both the trial court and appellate court levels, and appealed to the Texas Supreme Court. The Supreme Court reached its decision on the matter recently. It acknowledged that “[g]enerally speaking, an overriding royalty on oil and gas production is free of production costs but must bear its share of post-production costs unless the parties agree otherwise.” The lease in question provided that the overriding royalty was “cost-free.” The question, then, was what that meant, and was it enough? The Hyders argued that this language could “only refer to post-production costs, since the royalty is by nature already free of production costs without saying so.” The Court, however, noted that “‘cost-free’ may simply emphasize that the overriding royalty is free of production costs.” Chesapeake claimed that “‘cost-free overriding royalty’ is merely a synonym for overriding royalty”. The Court, however, pointed to the exception for production taxes, which are post-production expenses, and noted that the inclusion of such an exception “cuts against Chesapeake’s argument. It would make no sense to state that the royalty is free of production costs, except for post-production taxes (no dogs allowed, except for cats).” The inclusion of the “Heritage language,” and what the Court says about it, is really the interesting part of the case. Many leases today have such language, similar to the Hyder’s lease, that say the holding in the Heritage Resources, Inc. case has no application to the terms and provisions of this lease. However, the Supreme Court has not, before this, had an opportunity to offer any guidance on the use of this language, and whether it could operate to prohibit deduction of post-production costs. The Hyders argued that the inclusion of such a disclaimer does, in fact, free the overriding royalty from post-production costs. The Court, however, found that “a disclaimer of that holding, like the one in this case, cannot free a royalty of post-production costs when the text of the lease itself does not do so.” Luckily for the Hyder’s, the Court found that “[h]ere, the lease text clearly frees the gas royalty of postproduction costs, and reasonably interpreted, we conclude, does the same for the overriding royalty.” The Court made it a point to specifically say that “[t]he disclaimer of Heritage Resources’ holding does not influence our conclusion.” Therefore, we learned that the inclusion of the Heritage Language does not, by itself, require that all royalties be free of post-production costs, and will never have that effect if other language in the lease suggests otherwise. With each new case that goes up, we are offered more and more clarity as to the language we should include in leases to ensure we have the effect we want, but we still need to draft these clauses with clarity, precision and an eye toward common, rather than industry, definitions.