Chesapeake Exploration, L.L.C. v. Hyder

• Decision Date: 29 January 2016
• Docket Number: NO. 14–0302,14–0302
• Parties: Chesapeake Exploration, L.L.C. and Chesapeake Operating, Inc., Petitioners, v. Martha Rowan Hyder, Individually, and as Independent Executrix and Trustee Under the Will of Elton M. Hyder, Jr., Deceased, and as Trustee Under the Elton M. Hyder Jr. Residuary Trust, and as Trustee of the Elton M. Hyder Jr. Marital Trust; Brent Rowan Hyder, Individually and as Trustee of the Charles Hyder Trust and as Trustee of the Geoffrey Hyder Trust; Whitney Hyder More, Individually and as Trustee of the Elton Matthew Hyder IV Trust, as Trustee of the Peter Rowan More Trust, as Trustee of the Lili Lowdon Hyder Trust, and as Trustee of the Samuel Douglas More Trust; and Hyder Minerals, Ltd., Respondents
• Court: Texas Supreme Court

483 S.W.3d 870

Chesapeake Exploration, L.L.C. and Chesapeake Operating, Inc., Petitioners,

v.Martha Rowan Hyder, Individually, and as Independent Executrix and Trustee Under the Will of Elton M. Hyder, Jr., Deceased, and as Trustee Under the Elton M. Hyder Jr. Residuary Trust, and as Trustee of the Elton M. Hyder Jr. Marital Trust; Brent Rowan Hyder, Individually and as Trustee of the Charles Hyder Trust and as Trustee of the Geoffrey Hyder Trust; Whitney Hyder More, Individually and as Trustee of the Elton Matthew Hyder IV Trust, as Trustee of the Peter Rowan More Trust, as Trustee of the Lili Lowdon Hyder Trust, and as Trustee of the Samuel Douglas More Trust; and Hyder Minerals, Ltd., Respondents

NO. 14–0302

Supreme Court of Texas.

Argued March 24, 2015

Opinion delivered: January 29, 2016

Bart A. Rue, Matthew David Stayton, Kelly Hart & Hallman LLP, Fort Worth TX, for Chesapeake Exploration, L.L.C., Chesapeake Operating, Inc.

David Jacob Drez III, Jacob Fain, Wick Phillips Gould & Martin, LLP, Fort Worth TX, James Wills IV, Jeffrey Wallace Hellberg, Wick Phillips Gould & Martin, LLP, Dallas TX, for Martha Rowan Hyder, Individually, and as Independent Executrix and Trustee, et al.

Ken Slavin, Kemp Smith, LLP, El Paso TX, for Amicus Curiae, General Land Office of the State of Texas.

Roger D. Townsend, Alexander Dubose Jefferson & Townsend LLP, Houston TX, for Amicus Curiae Longfellow Ranch Partners, LP, and Wesley West Minerals, LTD.

John B. McFarland, Graves Dougherty Hearon & Moody, P.C., Austin TX, for Amicus Curiae National Association of Royalty Owners–Texas, Inc. (NARO-Texas), and Texas Land and Mineral Owners Association (TLMA).

Marie R. Yeates, Vinson & Elkins LLP, Houston TX, Michael A. Heidler, Vinson & Elkins LLP, Austin TX, for Amicus Curiae Texas Oil & Gas Association.

CHIEF JUSTICE HECHT delivered the opinion of the Court, in which JUSTICE GREEN

, JUSTICE JOHNSON, JUSTICE BOYD, and JUSTICE DEVINE joined.

We deny the motion for rehearing. We withdraw our opinion of June 12, 2015, and substitute the following in its place.

Generally speaking, an overriding royalty on oil and gas production is free of production costs but must bear its share of postproduction costs unless the parties agree otherwise. The only question in this case is whether the parties' lease expresses a different agreement. We conclude it does and therefore affirm the court of appeals' judgment.¹

The Hyder family leased 948 mineral acres in the Barnett Shale.² Chesapeake Exploration, L.L.C., acquired the lessee's interest.³ The lease was negotiated and drafted by counsel for the Hyders and the original lessee.

The lease contains three royalty provisions. One is for 25% of "the market value at the well of all oil and other liquid hydrocarbons". No oil is produced from the lease. Another royalty is for 25% "of the price actually received by Lessee" for all gas produced from the leased premises and sold or used.⁴ The lease adds that the royalty is expressly "free and clear of all production and post-production costs and expenses," and lists examples of various expenses.⁵ The third provision, the one here in dispute, calls for "a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production obtained" from directional wells drilled on the lease but bottomed on nearby land.⁶ The lease contains two other provisions relevant to our consideration. One is this disclaimer: "Lessors and Lessee agree that the holding in the case of Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex.1996)

shall have no application to the terms and provisions of this Lease." The other is that "each Lessor has the continuing right and option to take its royalty share in kind". No lessor has ever exercised that right. While the overriding royalty appears to be in kind, the parties do not disagree that it can be paid in money.

The Hyders and Chesapeake agree that the overriding royalty is free of production costs; they dispute whether it is also free of postproduction costs. There are twenty-nine producing gas wells on the leased or pooled land, seven of which are directional wells bottomed on and producing from lands not subject to the lease. Chesapeake sells all the gas produced to an affiliate, Chesapeake Energy Marketing, Inc. ("Marketing"), which then gathers and transports the gas through both affiliated and interstate pipelines for sale to third-party purchasers in distant markets. Marketing pays Chesapeake a "gas purchase price" for volumes determined at the wellhead or—during earlier periods—at the terminus of Marketing's gathering system. The gas purchase price is calculated based on a weighted average of the third-party sales prices received (the "gas sales price") less postproduction costs.⁷ The overriding royalty Chesapeake pays the Hyders is 5% of the gas purchase price. The Hyders contend that their overriding royalty should be based on the gas sales price.

After a bench trial, the trial court rendered judgment for the Hyders, awarding them $575,359.90 in postproduction costs that Chesapeake wrongfully deducted from their overriding royalty. The court of appeals affirmed.⁸ We granted Chesapeake's petition for review.⁹

In Heritage Resources, Inc. v. NationsBank,

we noted that a royalty is free of production expenses but "usually subject to post-production costs, including taxes ... and transportation costs."¹⁰ But we added that "the parties may modify this general rule by agreement."¹¹ We long ago defined an overriding royalty as "a given percentage of the gross production carved from the working interest but, by agreement, not chargeable with any of the expenses of operation."¹² That agreement is now understood to be part of an overriding royalty, and an overriding royalty is like a landowner's royalty in that it usually bears postproduction costs but not production costs,¹³ though the parties may agree to a different arrangement.¹⁴

Two of the royalty provisions in the Hyder–Chesapeake lease are clear. The oil royalty bears postproduction costs because it is paid on the market value of the oil at the well.¹⁵ The market value at the well should equal the commercial market value less the processing and transporting expenses that must be paid before the gas reaches the commercial market.¹⁶

The gas royalty in the lease does not bear postproduction costs because it is based on the price Chesapeake actually receives for the gas through its affiliate, Marketing, after postproduction costs have been paid.¹⁷ Often referred to as a "proceeds lease", the price-received basis for payment in the lease is sufficient in itself to excuse the lessors from bearing postproduction costs. And of course, like any other royalty, the gas royalty does not share in production costs. But the royalty provision expressly adds that the gas royalty is "free and clear of all production and post-production costs and expenses," and then goes further by listing them. This addition has no effect on the meaning of the provision.¹⁸ It might be regarded as emphasizing the cost-free nature of the gas royalty, or as surplusage.

The overriding royalty in the Hyder–Chesapeake lease is not as clear as either of the other two royalty provisions. The Hyders argue that the requirement that the overriding royalty be "cost-free" can only refer to postproduction costs, since the royalty is by nature already free of production costs without saying so. But as with the gas royalty, "cost-free" may simply emphasize that the overriding royalty is free of production costs. Chesapeake argues that "cost-free overriding royalty" is merely a synonym for overriding royalty, and a number of lease provisions discussed in other cases support that view.¹⁹

The exception for production taxes, which we have said are postproduction expenses,²⁰ cuts against Chesapeake's argument. It would make no sense to state that the royalty is free of production costs, except for postproduction taxes (no dogs allowed, except for cats). The exception for taxes might be taken to indicate that "cost-free" refers only to postproduction costs. But a taxes exception to freedom from production costs is not uncommon in leases,²¹ suggesting only that lease drafters are not always driven by logic.

We thus disagree with the Hyders that "cost-free" in the Hyder–Chesapeake overriding royalty provision cannot refer to production costs. As noted above, drafters frequently specify that an overriding royalty does not bear production costs even though an overriding royalty is already free of production costs simply because it is a royalty interest.²² But Chesapeake must show that while the general term "cost-free" does not distinguish between production and postproduction costs and thus literally refers to all costs, it nevertheless cannot refer to postproduction costs here.

Chesapeake argues that because the overriding royalty is paid on "gross production", the reference is to production at the wellhead, making the royalty tantamount to one based on the market value of production at the wellhead, which bears postproduction costs. "Gross" means "[u]ndiminished by deduction; entire".²³ We agree with Chesapeake, as do the Hyders, that "gross production" is the entire amount of gas produced, including gas used by Chesapeake or lost in postproduction operations. But the parties do not dispute that the overriding royalty may be paid in cash and not in kind, though the Hyders retained the right to take it in kind. Specifying that the volume on which a royalty is due must be determined at the wellhead says nothing about whether the overriding royalty must bear postproduction costs.

This is clear from the other royalty provisions. The oil royalty is paid on all oil produced and bears postproduction costs. The gas royalty is due on all gas produced and used or sold—that is, all gas produced except that lost before sale or use. The gas royalty does not bear postproduction costs, not because it...