A Cost-Free Royalty Clause That Works – Part One

by Gray Reed & McGraw
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Chesapeake Exploration, L.L.C. v. Hyder is another hair-splitting Texas decision about “cost-free royalties”

The Facts

The Hyder family executed a lease covering 1,037 acres. Chesapeake drilled 22 wells on the leased premises. The Hyders believed their lease provided for a “cost free” royalty; that is, no post-production deductions. Chesapeake deducted post-production costs, and the Hyders sued for breach of contract.

More Facts

A summary of how gas is moved downstream from the lease might be helpful (Hint: if it starts with a “C”, it’s a Chesapeake entity). COI produces the gas and sells to CEMI, who delivers the gas to several “points of delivery” for gathering by CMP. CMP transports to unaffiliated third-party interstate pipelines, who transfer the gas downstream to a “point of sale”, and then title passes from CEMI to the third-party purchaser. The Hyders were paid based on a weighted average sales price calculated on the sales to various third parties.

The Royalty Clause

The Hyders where to be paid:

…for natural gas … produced from the Leased Premises, twenty-five (25%) of the price actually received for such gas. The royalty … 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 lessee’s point of delivery or sale of such share to a third party. (underline ours)

The lease specifically said that, “ … Heritage Resources, Inc. v. NationsBank shall have no application to the terms and provisions of this lease.” (that was the 1996 Texas Supreme Court case holding that a “no deduct” provision was “surplusage as a matter of law.”)

Chesapeake’s Contention

They could deduct post-production costs incurred between the “point of delivery” and “point of sale.” Because of the disjunctive “or” between “delivery” and “sale”, they could choose either the point of delivery or the point of sale to determine whether the royalty clause permits the deduction of post-production costs after the point of delivery but before the point of sale. Therefore, they deducted costs such as third-party transportation costs.

Hyders’ Contention

Chesapeake’s distinction doesn’t matter. The royalty clause prohibits deduction of any post-production cost, regardless of where incurred, and provides for royalty “free and clear” of all costs. What about “free and clear” can’t be understood?

The Holding

The court agreed with the Hyders. The plain reading of the royalty clause, along with the parties’ agreement that Heritage did not apply, should be interpreted to mean no deductions. Therefore, in this case a “cost-free royalty” really meant a cost-free royalty.

The Takeaway

  • This is a common theme. It is necessary to carefully review the specific wording in the lease. Sometimes, “free” does mean “free”.  Sometimes it doesn’t. A court will construe a lease so that no provision will be rendered meaningless.
  • This post is about wells on the premises.  We will soon discuss the overriding royalty interest due the Hyders for seven Chesapeake off-premises wells.
  • As royalty clauses go, it looks like lessors have found a keeper.  (Or maybe you prefer the live version.)

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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