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Chesapeake Energy Corporation's 50 acre campus is seen in Oklahoma City, Oklahoma in this file photo taken April 17, 2012. REUTERS/Steve Sisney/Files, via Newscred

Texas high court hears case on gas royalty payments

AUSTIN – Chesapeake Energy went to the Texas Supreme Court last week to defend how it deducted post-production costs from royalty checks in a case that is being widely watched by the oil and gas industry and property owners suing the company for millions of dollars.

Chesapeake is appealing a San Antonio appeals court ruling from 2014 upholding a state district court decision that awarded the prominent Hyder family of Fort Worth at least $1 million in royalties, interest and attorneys fees. Chesapeake is arguing that not overturning the appeals court decision would create a “sea change in Texas oil and gas law.”

The Oklahoma City energy giant has drawn the support of the powerful Texas Oil and Gas Association, which in an amicus brief states that if the appeals court decision goes “uncorrected,” it will “generate confusion and inefficiencies for the oil and gas industry.”

On the other side, attorneys for the Hyder family argue that their case involves a “specifically tailored, heavily negotiated” unique oil and gas lease that stated that the deal would be “cost free” and that Chesapeake “continually alters its interpretation of its obligations.”

Backing up the Hyders is the Texas Land and Mineral Owners Association along with the National Association of Royalty Owners-Texas, which point out in court documents that “this is one of a long line of cases which Chesapeake has sought to profit at the expense of royalty owners.”

Attorneys monitoring the case say the impact of the Hyder case will depend on whether the court tackles concerns about a previous Supreme Court ruling in Heritage Resources v. NationsBank that allows post-production costs to be deducted even when contracts don’t appear to allow it.

“I think it could be significant if there is some focus on Heritage and (the question of), is it considered good law?” said Ralph Duggins, a Fort Worth attorney who is suing Chesapeake on behalf of the city of Fort Worth over royalty payments. “Until a court tells them they can’t do it, they will do it.”

Related: In Texas oil town, early signs of economic strain as drilling slows.

Overriding royalty

The Hyder family thought they had a straightforward deal for getting paid for the gas beneath about 1,000 acres in Tarrant and Johnson counties.

In 2004, they entered into a lease with Four Sevens Oil Co. The nine-page, single-spaced document states that the family would receive royalties of 25 percent of the gas’ value at the well free of any costs from production and the inevitable processing later.

Sophisticated investors, the Hyders also negotiated five percent of Four Sevens’ take of any gas taken from a neighbor’s property through a well sitting on their land. Known as an overriding royalty interest, this lease was supposed to be cost-free except for any taxes owed.

Nearly a year after signing the lease, Four Sevens began producing gas and the Hyders didn’t encounter any problems. But in 2006, Four Sevens sold the lease to Chesapeake and the family contends problems ensued “almost immediately.”

Chesapeake, applying the same process it has used throughout the Barnett Shale, began selling the gas to various affiliates and then would pay the Hyders a “weighted average sales price” based on what it was paid by an unaffiliated third party less post-production costs incurred in moving the gas.

In 2010, the Hyders sued Chesapeake for improperly subtracting the post production costs from their royalty checks for gas taken from their own property and through the overriding royalty interest. In 2012, state District Judge Melody Wilkinson awarded the family nearly $1 million.

Last year, the 4th Circuit Court of Appeals in San Antonio agreed with Wilkinson, but it also rejected application of a Texas Supreme Court precedent in Heritage because the Hyder’s lease specifically included a provision saying that the findings in the Heritage case did not apply.

“The parties modified the general rule by agreement, and we interpret the parties’ agreement as the royalty clause excluding all costs and expenses,” the court wrote.

“Benefit of their bargain”

But appearing before the Supreme Court last week, Chesapeake’s attorney Matthew Stayton only argued against the appeals court ruling as it applied to the overriding royalty interest payment.

While the Hyder’s lease was specific about what costs could not be charged when considering the gas taken from their own property, it was not as defined regarding gas produced from elsewhere but the physical location of the wellhead on their property, Stayton said.

Stayton said the Hyders had to pay their share of post production costs after the wellhead. In court documents, Chesapeake said those costs at one point hit about $584,000 and that during that time, the Hyders were paid $17 million in total royalties and overriding royalties under the lease.

“The industry relies on this to negotiate and structure their leases,” Stayton told the justices. “We know how to do this, the parties knew how to do it. The clear intent was trying to be accomplished in the royalty clause and not the override.”

Stayton also pointed to recent decisions in two cases by the 5th U.S. Circuit Court of Appeals in New Orleans that said, under Heritage, Chesapeake can subtract post-production costs in cases.

David Drez, the attorney representing the Hyders, pointed out in court documents that the two federal cases did not include a disclaimer similar to the one negotiated by his clients. He also argued in court records that Chesapeake believes the phrase “cost-free” is meaningless, whether it is included or not, and that it can deduct the post-production costs from the overriding royalty.

During the hearing, Drez made it clear that his clients were not attacking the Heritage decision because they “could not have been clearer” in what they intended to do in the original contract — that they would not have to pay the post production costs on the override lease.

“Parties have a right to contract as they see fit so long as their agreement does not violate the law or public policy,” Drez told the justices. “This is about money. It is about who will bear the economic burden of this post production costs, plain and simple.

“The Hyders should get the benefit of their bargain,” he added.

Elephant in the room

For attorneys watching the Hyder case, the Heritage case is the elephant in the room.

Attorneys George Parker Young and Dan McDonald have recruited thousands of plaintiffs accusing Chesapeake of wrongly subtracting post-production costs from royalty checks. In those cases, however, they challenge if the costs are reasonable, not whether they can be charged.

McDonald and Young expect to have filed up to 400 lawsuits by the end of the year naming about 40,000 individual plaintiffs.

While the Hyder case does not directly impact their cases, Parker said it could a “preamble” for the court to take up the Heritage decision. It is the first time since Heritage was decided almost 20 years ago that a disclaimer question has been raised.

“If the court goes with David (Drez) and whittles down Heritage a little bit, put some dings in it, that helps us all,” Young said.

John McFarland, an Austin attorney who has watched the Hyder case closely and filed the amicus brief for the mineral owners along with former Justice Raul Gonzalez, said it is up to the court to decide how big they want to go.

Make no mistake, Chesapeake will continue to use Heritage until the court decides otherwise, he said. “They are going to ride that horse as far as they can ride it,” McFarland said.

This article was written by Max B. Baker from Fort Worth Star-Telegram and was legally licensed through the NewsCred publisher network.

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