Texas Supreme Court Clarifies Law on Allocation of Post-Production Costs

On June 12, 2015, the Texas Supreme Court revisited its seminal 1996 ruling in Heritage Resources Inc. v. NationsBank.¹ The court's five-to-four holding in Chesapeake Exploration, L.L.C. v. Hyder clarifies when and how oil and gas leases can exempt post-production costs from overriding royalty interests.² Most significantly, Hyder confirms-for the first time-that parties to an oil and gas lease may allocate all post-production costs by agreement.³ This clarification of the legal landscape highlights the importance of careful drafting, as the text of overriding royalty clauses will determine who pays what, including post-production costs. 

Before Hyder, the longstanding rule in Texas was that royalty interests were free of production costs, but were generally subject to post-production costs, including taxes, treatment, and transportation expenses.⁴ Although case law recognized-in theory-the parties' ability to allocate post-production costs by agreement,⁵ the Texas Supreme Court's Heritage Resources decision made it very difficult to do so (with any degree of confidence) in practice.⁶ 

In Heritage Resources, the court considered whether certain post-production costs were properly borne by the operator alone or shared proportionately with the royalty owner.⁷ In concluding that the costs must be shared with the royalty owner, the court focused on two provisions in the parties' lease: (1) the point of valuation of the royalty interest (at the well); and (2) the (apparently explicit) requirement that "there shall be no deductions from the value of the Lessor's royalty by reason of" post-production costs.⁸ "[A]pplying the trade meaning of royalty and market value at the well," the court held that the apparent restriction against charging post-production costs to the Lessor's royalty was mere surplusage. This result was compelled, according to the court, by the "well accepted meaning" of the phrase "market value at the well," which normally involves "subtracting reasonable post-production marketing costs from the market value at the point of sale."⁹ As a result, "the post-production clauses merely restate[d] existing law" and did not bar the operator from deducting post-production costs in calculating the royalty.

Although the precedential value of Heritage Resources was to some extent limited by its slim, five-justice majority,¹⁰ it was cited widely in Texas oil and gas cases for nearly 20 years, and greatly strengthened the "default rule" that post-production costs may be charged to royalty owners.

This "default rule" has now been significantly weakened. In Hyder, the Texas Supreme Court made clear that Heritage Resources does not require overriding royalty owners to bear their proportional share of post-production costs where the lease clearly manifests a contrary intent.¹¹ 

In Hyder, royalty owners sued Chesapeake Exploration L.L.C., alleging that the company breached an oil and gas lease by deducting post-production costs from their overriding royalty payments.¹² To support their claim that the royalty interest was to be free of post-production costs, the royalty owners pointed to the lease itself, which granted them a "perpetual, cost-free…overriding royalty of five percent."¹³ The royalty owners also pointed to explicit language in the lease disclaiming the application of Heritage Resources: "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."¹⁴ Chesapeake countered that "cost-free" merely reinforced existing Texas law providing that an overriding royalty interest is generally free of production costs.¹⁵ After a bench trial, the trial court rendered judgment for the Hyders, awarding them the post-production costs it concluded Chesapeake had wrongfully withheld.¹⁶ The San Antonio Court of Appeals affirmed.¹⁷

The Texas Supreme Court's take was more nuanced than those of the lower courts, but it, too, affirmed the trial court's ruling.¹⁸ Although the court agreed with Chesapeake that the term "cost-free" might merely reinforce existing law that overriding royalties do not bear production costs, it required Chesapeake to shoulder the burden of showing that the term "cost-free" could not also refer to post-production costs.¹⁹ Chesapeake put forward several arguments, all of which the Court rejected.²⁰ It did not matter, the Court held, that the overriding royalty was to be paid on "gross production," which is measured at the well, or that other provisions in the lease were more specific when providing for royalties free of post-production costs.²¹ Chesapeake, therefore, could not meet its burden of demonstrating that the "cost-free" phrase could not have encompassed post-production costs. 

Hyder provides new ammunition for royalty owners arguing that post-production costs may not be deducted from their royalties. Indeed, the potential impact of the court's ruling was clear long before the decision was announced. At oral argument in March, Chesapeake's attorneys argued that allowing the court of appeals' ruling to stand would work a "sea change in Texas oil and gas law," a position backed by amici including the powerful Texas Oil and Gas Association.²² Going forward, operators negotiating leases must be alert for the inclusion of "cost-free" language that could release royalty owners from sharing the burden of post-production costs. By the same token, lessors must remain mindful of the Texas Supreme Court's caution that inclusion of a Heritage Resources disclaimer will not free a royalty of post-production costs where the text of the lease itself does not do so.²³