Overriding Royalties: They are free of production costs, but are they free of post-production costs?

In Chesapeake v. Hyder, the Texas Supreme Court addressed the proper calculation of a “cost-free” overriding royalty interest (“ORRI”). The court has now asked the Hyders to respond to Chesapeake’s motion for rehearing of the decision in the Hyders’ favor.

The lawsuit arises out of a disputed, nonstandard ORRI clause that gives the Hyders a “cost-free [except only production taxes] overriding royalty of five percent (5.0%) of gross production obtained from each well.” The Hyders argued that the “cost-free overriding royalty” language meant that the royalty was free of both production and post-production costs. Chesapeake contended that the language at issue merely reinforced the nature of an overriding royalty, i.e., that it is not subject to production costs but it is subject to post-production costs.

The 5 to 4 majority decision in the Supreme Court sided with the royalty owners. The Court reasoned that while, generally speaking, an overriding royalty is free of production costs, the interest owner must bear post-production costs, i.e., costs incurred to make the gas marketable and to get the gas to the point of sale. The typical oil and gas lease provides a specified fraction of the “market value at the well” or the amount realized at the well and has been interpreted to mean that post-production costs are deducted from the amount paid the ORRI owner. The explicit “cost-free” language of the lease led the Court to the conclusion that the ORRI was to be cost free to all extents, including free of post-production costs. The key part of the decision, while somewhat opaque, follows:

The overriding royalty provision reads as though the royalty is in kind, but Chesapeake does not argue that it must be, and in fact the royalty has always been paid in cash. Were the Hyders to take their overriding royalty in kind, as they are entitled to do, they might use the gas on the property, transport it themselves to a buyer, or pay a third party to transport the gas to market as they might negotiate. In any event, the Hyders might or might not incur postproduction costs equal to those charged by Marketing.  The lease gives them that choice.  The same would be true of the gas royalty, which is to be paid in cash but can be taken in kind.  The fact that the Hyders might or might not be subject to postproduction costs by taking the gas in kind does not suggest that they must be subject to those costs when the royalty is paid in cash. The choice of how to take their royalty, and the consequences, are left to the Hyders.  Accordingly, we conclude that “cost-free” in the overriding royalty provision includes postproduction costs.

The Court did emphasize that the clarity of the text in the lease would be outcome determinative.

This decision has drawn a very large number of amicus briefs filed by both landowners and producers. (Amicus briefs are briefs filed with a court by someone not directly related to the litigation.)  Those briefs largely argue that where the royalty language of the lease is to be based on market value at the well, under Heritage Resources, Inc. v. NationsBank, 939 S.W.20 118 (Tex. 1986), language barring deductions of post-production costs is merely a restatement of the law and mere surplusage.  Even the majority opinion concurred that a disclaimer in the lease of the application of the holding Heritage Resources, by itself, would not have been enough to prohibit the deduction of post-production expenses, in this case.

The majority opinion frankly leaves it unclear what specific language in the lease at issue freed the ORRI from post-production costs, or would in the future, when that is the parties’ intent.  A decision on the motion for rehearing containing further clarification on what specific language would always suffice to bar the deduction of post-productions costs could prevent future confusion.

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