Consider this while celebrating the resurrection of Big Tex: When a lease prohibits post-production cost deductions, can a lessee deduct those costs from a lessor’s royalty? Yes, says Potts v. Chesapeake Exploration, L.L.C. In a market value lease, where lessee sells the gas “at the well” and the court applies the netback approach to calculating market value, the lessee is entitled to deduct post-production costs incurred after the point of sale.
That might make more sense when you know the facts.
The lease had a “no deduct” provision:
Royalties on gas were ” … the market value at the point of sale of 1/4 of the gas so sold or used. … , [a]ll 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.”
Chesapeake sold the gas “at the well”, and deducted no expenses attributable to Potts’ royalty payments from the time the gas was produced at the well until its first sale. To arrive at the value of the gas at this point Chesapeake took the value of the downstream market-based sale and subtracted costs and expenses incurred between the point of sale and the downstream resale point.
Potts contended that Chesapeake breached the express provisions of the no-deduct clause.
The difference in the parties’ positions arose out of how post-production marketing costs are treated in the calculation. Potts contended that Chesapeake deducted post-production costs to calculate the royalty. Chesapeake, on the other hand, contended that when applying the netback approach, post-production costs may be used to determine the market value of the gas.
The “point of sale” is the point where there is a transfer of title in an arms-length transaction in exchange for compensation. Potts contended that “point of sale” must be read together with the no-deduct language to ascertain its meaning and when doing so, point of sale means the point where the gas is ultimately sold off of the premises. The court didn’t agree.
According to the court, ” … the netback method requires ascertaining the market value of the gas where available downstream and then subtracting reasonable post-production costs from that point to the point where it is agreed to calculate the market value for royalty purposes. In this case it was the point of sale.
The court distinguished Heritage Resources v. NationsBank, even though the royalty clauses were similar. The factual difference was that the sale in Heritage took place off-premises. Had the royalty in Heritage been calculated at the off-premises point of sale, the no-deduct clause would have prevented deducting post-production costs incurred from the point of production at the well to the point of the off-premises sale.
In this case, the sale was at the well. Therefore, the no deduct provision is consistent with Heritage.
Takeaways – the best-laid plans …
Potts said their argument had to be correct because they wrote the no-deduct provision to comply with Heritage. But what they didn’t, and perhaps couldn’t, count on was the way Chesapeake sold its gas. Did Chesapeake plan it this way?. That seems unlikely, because at one point prior to litigation it agreed that it couldn’t deduct post-production costs.
Chesapeake’s sale was to an affiliate, about which Potts didn’t complain. With 20-20 hindsight, maybe he should have.
The court told Potts to give it up or turn it loose (their claim, that is), but not quite in this way.