A Cost-Free Royalty Clause That Works – Part Two: The Override

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Explore:  Energy Oil & Gas Royalties

Welcome to part two of the hair-splitting decision in Chesapeake Exploration, L.L.C. v. Hyder. See our prior post about the basic facts.

More Facts

In addition to their cost-free royalty clause for wells on the leased premises, the Hyders also received an overriding royalty interest on wells drilled from pads located on the leased premises and completed on adjacent tracts. Chesapeake drilled seven of these “off-lease wells”.

The Royalty Clause

…within sixty (60) days from the date of the first production from each off-lease well, …convey a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5%) of gross production obtained from each such well payable….

Again, the parties disagreed over what “cost-free” means.

Chesapeake’s Position

“Cost free” merely reinforces current Texas law that an overriding royalty interest is free of production costs, but subject to its proportionate share of post-production costs.

The Hyder’s Position

“Cost free” refers to all costs (except the Hyder’s portion of production taxes), including post-production costs.

The Court’s Position (The one that matters)

Under Texas law, it is clear that an overriding royalty is normally free of production costs, but subject to post-production costs. However, the parties may modify this default rule by agreement. Chesapeake cited four cases for its position that post-production costs should be deducted, and the court addressed each (we briefly summarize the holdings):

  • XAE Corp. v. SMR Prop. Mgmt. Co., 968 P.2d 1201 (Okla. 1998) – the ORRI was an in-kind interest with delivery at the well head, and the lessee had no duty other than to deliver gas. Therefore, the lessee was not responsible for lessor’s share of post-production costs and expenses. Hyder is not about taking gas in-kind, and the Hyder lease contains a provision that expressly says the ORRI is “cost free.”
  • Heritage Resources Inc. v.  Nations Bank (see the prior post for a link) – the Hyder’s lease specifically says, that “Heritage Resources shall have no application to this lease.” As result, it has no applicability to this ORRI.
  • Martin v. Glass and Dancinger Oil Refineries v. Hamill Drilling Co. – In those Texas cases the ORRI was “free and clear of all costs of drilling, exploration or operation…” and ‘free and clear of operating expenses.” The court noted all of those costs are production costs. Under the Hyder facts, the lease language is not limited to production costs, it simply says “cost free”, meaning all costs – production and post production.

The court concluded by saying parties can modify the default rule that ORRIs “are normally subject to post production costs.” Here, as indicated by the four corners of the document, that is what the parties did. In short, the Hyders are responsible for their portion of production taxes only.

The Takeaway

In writing a lease, say what you mean. Sometimes, a “cost-free royalty” really is a cost free royalty.

In honor of the lawyers and their clients who dance a lot over the words in the lease, we end this offering with a dance contest. Feel ”free” to pick your favorite:

Candidite 1  

Candidate 2  

Candidate 3

 

Topics:  Energy, Oil & Gas, Royalties

Published In: General Business Updates, Energy & Utilities Updates

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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