On July 16, 2014, the United States Court of Appeals for the Fifth Circuit issued an opinion that deals with a topic that many in this industry should be paying attention to: the proper deduction of post-production costs from royalty. In the lawsuit, Warren v. Chesapeake Exploration, LLC, the Warrens (and others) sued Chesapeake for an alleged breach of the royalty provisions in oil and gas leases. The breach occurred, according to Warren, by the improper deduction of post-production costs from the sales proceeds of natural gas.
One of the royalty provision in the leases at issue provides the following:
As royalty, Lessee covenants and agrees . . . (b) to pay Lessor for gas and casinghead gas produced from said land (1) when sold by Lessee, [22.5%] of the amount realized by Lessee, computed at the mouth of the well . . . .
An addendum to the Leases, also at issue, provided as follows:
Notwithstanding anything to the contrary, herein contained, all royalty paid to Lessor shall be free of all costs and expenses related to the exploration, production and marketing of oil and gas production from the lease including, but not limited to, costs of compression, dehydration, treatment and transportation. Lessor will, however, bear a proportionate part of all those expenses imposed upon Lessee by its gas sale contract to the extent incurred subsequent to those that are obligations of Lessee.
It is expressly agreed that the provisions of this Exhibit shall super[s]ede any portion of the printed form of this Lease which is inconsistent herewith, and all other printed provisions of this Lease, to which this is attached, are in all other things subrogated to the express and implied terms and conditions of this Addendum.
Chesapeake argued that they sold the gas at the well to an affiliated company and that they “paid royalty based on the full amount it realized at the well from its affiliated purchaser.” The Court determined that the Warrens argument was “that sales occurred downstream from the mouth of the well and that post-production costs incurred delivering the gas to that point of sale have been deducted in calculating royalty payments.”
The Court stated that the phrase “’amount realized by Lessee, computed at the mouth of the well’ means that the royalty is based on net proceeds, and the physical point to be used as the basis for calculating net proceeds is the mouth of the well.” As such, since Chesapeake calculated royalty on the full amount realized at the mouth of the well, it was clear that Chesapeake complied with the first royalty provision, even though they deducted post-production costs that occurred downstream.
The Court then examined the addendum to determine if it was inconsistent with either the royalty provision or the method used by Chesapeake to calculate royalty payments. The Court found that “[b]ased on the method of calculating royalty specified in the pre-printed lease form, all royalty, regardless of where the gas sales occur, is free of post-production costs such as compression, dehydration, treatment, and transportation. That is because ‘the amount realized by Lessee, computed at the mouth of the well’ necessarily excludes such costs.” This is because when royalty is calculated at the mouth of the well, there are no post-production costs incurred. Therefore, the Court found that the addendum was not inconsistent with the first royalty provisions. “The addendum does not change the point at which all royalty is computed, which is the mouth of the well. If the parties intended for the lessor to receive 22.5% of the proceeds of sales, regardless of where the sales occurred, they could have accomplished that end by any number of ways.”
Despite the Warren’s claim “[i]t has become too easy for courts to avoid considering explicitly negotiated lease language and simply stamp it as ‘See Heritage, Return to Sender,’ without opening the envelope,” their leases were, in fact, leases that set forth that royalty was to be calculated at the wellhead. Therefore, like the leases in Heritage Res., Inc. v. NationsBank, a case that allowed the deduction of post-production costs even though the lease stated royalty was to be free of costs because it also provided that royalty was to be calculated “at the well”, costs incurred after this calculation are properly deducted. As a result, the Court determined that Chesapeake properly deducted the post-production costs. Unlike Heritage, however, where the Texas Supreme Court determined that the provision prohibiting the deduction of post-production costs in a lease was ‘surplusage’ when used after the lease provides that royalty shall be calculated at the mouth of the well, this Court found that in these leases, there was no surplusage. All of the terms harmonized because the royalty received was computed at the well, as provided for in the lease, and the costs of transportation, etc., were deducted after that computation. Therefore, Chesapeake’s deduction of post-production costs was perfectly acceptable.
Mineral owners and operators alike will need to pay particular attention to these provisions in their leases to ensure the effect intended is accomplished, and to ensure that there is no breach of lease occurring. Although some may deny the truth of the following statement, it appears that if the lease provides that royalty shall be calculated at the well, then no matter what provisions are inserted later, prost-production costs are properly deductible. Many operators may not want to test that, but we should keep an eye on those that are willing, as their actions (and any repercussions from same) can guide us all.