Exploration v. Hyder

• Decision Date: 12 June 2015
• 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

CHESAPEAKE EXPLORATION, L.L.C.

AND CHESAPEAKE OPERATING, INC., PETITIONERS, v. MARTHA ROWAN HYDER, INDIVIDUALLY, AND AS INDEPENDENT EXECUTRIXAND 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

June 12, 2015

ON PETITION FOR REVIEW FROM THE COURT OF APPEALS FOR THE FOURTH DISTRICT OF TEXAS

JUSTICE BROWN, joined by JUSTICE WILLETT, JUSTICE GUZMAN, and JUSTICE LEHRMANN, dissenting.

I disagree with the Court that the overriding royalty clause expresses an intent to modify the default rule that such an interest bears post-production costs. I would reverse the court of appeals and hold that Chesapeake's deduction of post-production costs was proper. I respectfully dissent.

The disputed clause gives the Hyders a "cost-free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production obtained from each [directionally drilled] well." This Court has held that "[a]n overriding royalty is an interest in the oil and gas produced at the surface, free of the expense of production." Paradigm Oil, Inc. v. Retamco Operating, Inc., 372 S.W.3d 177, 180 n.1 (Tex. 2012) (quoting Stable Energy, L.P. v. Newberry, 999 S.W.2d 538, 542 (Tex. App.—Austin 1999, pet. denied)). Though it is free of production expenses, an overriding royalty generally bears its share of post-production costs. French v. Occidental Permian Ltd., 440 S.W.3d 1, 3 (Tex. 2014) (citing Heritage Res., Inc. v. NationsBank, 939 S.W.2d 118, 121-22, 123 (Tex. 1996)); Blackmon v. XTO Energy, Inc., 276 S.W.3d 600, 604 (Tex. App.—Waco 2008, no pet.) ("Whatever costs are incurred after production of the gas or minerals are normally proportionately borne by both the operator and the royalty interest owners." (emphasis in original) (quoting Cartwright v. Cologne Prod. Co., 182 S.W.3d 438, 444-45 (Tex. App.—Corpus Christi 2006, pet. denied))). Parties to a lease, however, are free to allocate those costs as they wish. French, 440 S.W.3d at 8 (citing Heritage, 939 S.W.2d at 121-22). As with any other contract, we construe an oil-and-gas lease to give effect to the intent it expresses. Tittizer v. Union Gas Corp., 171 S.W.3d 857, 860 (Tex. 2005) (per curiam).

I agree with the Court that the measure of the overriding royalty here—"gross production obtained from each such well"—refers to the total volume of minerals extracted from the ground before any are used to fuel production or transportation or are lost en route to market. Exxon Corp. v. Middleton, 613 S.W.2d 240, 244 (Tex. 1981) ("Production means actual physical extraction of the mineral from the land." (citing Monsanto Co. v. Tyrrell, 537 S.W.2d 135 (Tex. Civ. App.—Houston[14th Dist.] 1976, writ ref'd n.r.e.))); Blackmon, 276 S.W.3d at 604 ("Historically, 'production' ceases once the lessee extracts oil or gas from the ground at the wellhead." (quoting Byron C. Keeling & Karolyn King Gillespie, The First Marketable Product Doctrine: Just What Is the "Product"?, 37 St. Mary's L.J. 1, 88-89 (2005))). I disagree, however, that this measure allows valuation downstream at any point of sale. The clause does not refer to any point of resale downstream. It implicates only one location—the wellhead at which point each directional well produces.

By contrast, the Hyders' gas royalty is "twenty-five percent (25%) of the price actually received" upon resale by Chesapeake. That price necessarily reflects any post-production value added, and the Court rightly observes it thus does not bear post-production costs. See ante at ___; cf. Judice v. Mewbourne Oil Co., 939 S.W.2d 133, 137 (Tex. 1996) (holding royalty based on "gross proceeds" would not allow deductions but royalty based on "net proceeds" would). The parties could have expressed the overriding royalty similarly, but they did not do so. See Middleton, 613 S.W.2d at 245 ("If the parties intended royalties to be calculated on the amount[-]realized standard, they could and should have used only a 'proceeds-type' clause." (emphasis in original)).

Post-production activities will add value to the Hyders' overriding royalty—their share of minerals produced from the directional wells—but it has not yet done so at the time of production. Though the overriding royalty may not have been expressed using the familiar market-value-at-the-well language, I read its value as being just that. Cf. Heritage, 939 S.W.2d at 131 (Owen, J., concurring) ("There are any number of ways the parties could have provided that the lessee was to bear all costs of marketing the gas.").

I further disagree that whether the Hyders accept cash rather than their share of production in kind should affect that value. Had they taken the actual gas as it was produced, they certainly would incur post-production and transportation costs in marketing the gas. They could, of course, also use that gas on the property for whatever purpose they found useful. But the manner in which they accept their royalty should not determine the value they receive. That Chesapeake undertook to market the gas should not saddle Chesapeake with post-production costs or entitle the Hyders to more than the royalty for which they bargained.

Likewise, I think the "cost-free" designation should not operate to add value to the Hyders' overriding royalty, and I disagree with the Court that it expresses an intent to abrogate the default rule that the lessee bears post-production costs. Though it need not be further spelled out that a royalty interest is free of production costs, parties commonly do so anyway. See, e.g., Martin v. Glass, 571 F. Supp. 1406, 1410 (N.D. Tex. 1983), aff'd,736 F.2d 1524 (5th Cir. 1984) (interpreting overriding royalty that was "free and clear of all cost of drilling, exploration or operation"); Delta Drilling Co. v. Simmons, 338 S.W.2d 143, 147 (Tex. 1960) (interpreting "overriding royalty interest, free and clear of all cost of development"); McMahon v. Christmann, 303 S.W.2d 341, 343 (Tex. 1957) (considering overriding royalty that was "free of cost or expense"); Midas Oil Co. v. Whitaker, 123 S.W.2d 495, 495 (Tex. Civ. App.—Eastland 1938, no writ) (interpreting overriding royalty that was "free of cost"). As the Court recognizes, courts often read such language as simply stressing the production-cost-free nature of a royalty without struggling to ascertain any additional meaning. See ante at ___. I would do so here.

The Court points out that the disputed clause excepts from the "cost-free" designation the Hyders' share of production taxes, which it suggests cuts against Chesapeake's interpretation. Ante at ___. It may be true that we have, on occasion, generally categorized taxes as a post-production cost. See Heritage, 939 S.W.2d at 122. But, as the Court recognizes, parties often allocate tax liability on the royalty owner while at the same time specifically emphasizing that the royalty is free from production costs. See, e.g., Martin, 571 F. Supp. at 1410 (interpreting overriding royalty that was "free and clear of all cost of drilling, exploration or operation, SAVE AND EXCEPT said interest shall be subject to its proportionate part of all gross production, ad valorem and severance taxes"); Delta Drilling, 338 S.W.2d at 147 (interpreting overriding royalty that was "free and clear of all costs of development, except taxes"); R.R. Comm'n v. Am. Trading & Prod. Corp., 323 S.W.2d 474, 477 (Tex. Civ. App.—Austin 1959, writ ref'd n.r.e.) (interpreting overriding royalty that was "free of all costs, except taxes"). The drafting in those instances suggests some parties consider taxes production costs. The taxes at issue here are specifically referred to as "production taxes," aligning them with production, not post-production, costs. See TEX. TAX CODE §§ 201.001(6), .051, .052 (imposing production tax calculated on "market value of gas produced and saved" and defining production as "gross amount of gas taken from the earth"). I do not believe the reference to production taxes here supports an inference that "cost-free" refers to post-production costs.

As recognized in Heritage, royalty clauses that purport to modify a royalty valued at the well are inherently problematic. 939 S.W.2d at 130 (Owen, J., concurring) ("The concept of 'deductions' of marketing costs from the...