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On January 29, the Texas Supreme Court issued its opinion in Hysaw v. Dawkins, a unanimous decision with opinion by Justice Guzman. Our firm represents one group of the plaintiffs in the case, which concerns construction of Ethel Hysaw’s will.

Ethel Hysaw had three children: Dorothy, Howard and Inez. Her will, executed in 1947, divided her lands in Karnes County among her three children. She gave one tract to each child. But she divided the royalties on oil and gas differently, and the dispute in the case was over how the will disposed of her royalty interest in the three tracts. The descendants of Dorothy and Howard argued that Ethel’s will divided all oil and gas royalties equally among Dorothy, Howard and Inez. The descendants of Inez argued that Ethel’s will divided a 1/8th royalty equally among her children, but left all other royalties to the child who got the surface of the property.  Wells producing from the Eagle Ford shale were drilled on the lands willed to Inez, and the lease signed by Inez’s descendants provides for 22.5% royalty. Inez’s heirs argued that Dorothy and Howard’s descendants each should receive 1/3 of 1/8th royalty, or 4.1666%, from those wells, and that they should receive the rest, .141666%. Dorothy and Howard’s descendants argued that each family should receive 1/3 of the 22.5% royalty, or 7.5% each.

Ethel’s will provided that

each of my children shall have and hold an undivided one-third (1/3) of an undivided one-eighth (1/8) of all oil, gas or other minerals in or under or that may be produced from any of said lands, the same being a non-participating royalty interest.

Other language in the will provided that, if Ethel sold any of her royalty during her lifetime, then her children “shall each receive one-third of the remainder of the unsold royalty.”

The trial court sided with Howard and Dorothy’s descendants. The San Antonio Court of Appeals reversed, holding that Inez’s descendants’ construction of the will was the correct one. The Supreme Court held that the trial court was correct, ruling that Ethel intended to devise all of her royalty equally among her three children.

The issue addressed by the Supreme Court in construing Ethel’s will is known as the “double-fraction problem.” It appears more often in construction of deeds that convey or reserve a royalty interest. The problem arises when the royalty interest conveyed or reserved is described as a fraction of 1/8th — as, in Ethel’s will, she described the interest devised to each child as 1/3 of 1/8. As Justice Guzman says, “when viewed against a historical backdrop in which the standard royalty was 1/8 and many landowners erroneously believed the landowner’s royalty could be no greater than 1/8, the quantum of the interest conveyed or reserved by double-fraction language is subject to disagreement.” The Supreme Court decided to take the case because “the proper construction of instruments containing double-fraction language is a dilemma of increasing concern in the oil and gas industry, as uncertainty abounds, disputes proliferate, and courts have seemingly varied in their approaches to this complicated issue.”  After reviewing all of the language of Ethel’s will, the Court concluded that Ethel intended to treat her three children equally, giving each 1/3 of the royalty in all of her property.

Our firm has handled several disputes involving the double-fraction problem. Justice Guzman’s opinion is a valuable addition to the jurisprudence in this area and will provide guidance to lawyers construing instruments that contain double fractions.

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Last week the Texas Supreme Court denied Chesapeake’s motion for rehearing in Chesapeake v. Hyder. The court originally affirmed the lower courts’ opinions in favor of the Hyders, with four justices dissenting. On rehearing, the court’s alignment did not change, but Justice Hecht issued a new opinion for the majority, and Justice Brown issued a new dissenting opinion, joined by Justices Willett, Guzman and Lehrmann.

These new opinions end a long fight between Chesapeake and the Hyders over the deductability of post-production costs from their gas royalties in the Barnett Shale area. Although the leases contain strong language against deduction of post-production costs, Chesapeake argued that, under the precedent of the prior Supreme Court decision of Heritage Resources v. NationsBank, 929 S.W.2d 118 (Tex. 1996), it could deduct post-production costs. Chesapeake lost in the trial court and the court of appeals. The Supreme Court granted Chesapeake’s petition for review but affirmed the decisions below, split 5 to 4. With the denial of Chesapeake’s motion for rehearing, that decision is now final.

The Hyders’ lease allows Chesapeake to drill horizontal wells from surface locations on the Hyders’ property which produce from adjacent lands — in other words, to use the Hyders’ land to produce oil and gas from adjacent properties. As consideration for that right, the Hyder lease grants the Hyders a royalty interest in production from those wells — an “overriding royalty,” carved out of Chesapeake’s working interest in the leases covering those adjacent lands. The Hyder lease provides that the Hyders are granted “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent of gross production obtained” from such wells. The argument was over the meaning of that language. Chesapeake argued that “cost-free” meant free of production costs; the Hyders argued that “cost-free” means fee of production and post-production costs.

Originally, Chesapeake also contended it had the right to deduct post-production costs from the royalty paid on production from wells producing from the Hyders’ property. The no-deduction language in the lease related to royalties on Hyder wells was more clear than the language related to the overriding royalty, and Chesapeake’s appeal to the Supreme Court did not dispute the lower courts’ opinions on the lease royalty clause. Nevertheless, the Supreme Court opinions address the lease language related to the royalty on Hyder wells, as relevant to its construction of the “no cost” language in the overriding royalty clause. The opinions’ discussion of this royalty clause gives clarity to how courts should construe other gas royalty clauses, and how lawyers should draft them to avoid disputes.

The Hyder lease provides that royalty on gas produced from the Hyders’ lands shall be 25% “of the price actually received by Lessee.” Because of other language in the lease, Chesapeake did not dispute that the “price actually received by Lessee” was the price received by Chesapeake’s affiliate, Chesapeake Energy Marketing, which bought the gas from Chesapeake and resold it to third parties. The lease also provided that the gas royalty would be paid “free and clear of all production and post-production costs and expenses.” Referring to this language, Justice Hecht said:

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. … But the royalty provision expressly adds that the gas royalty is “free 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. It might be regarded as emphasizing the cost-free nature of the gas royalty, or as surplusage.

In other words, if a lease simply says that royalty shall be based on the price received by the Lessee (or, if the gas is sold to an affiliate of Lessee, the price received by the affiliate), then the Lessee may not deduct post-production costs from the royalty. It is not necessary to add language that the royalty is “free of all post-production costs,” and in fact such language is “surplusage.”

Notably, Justice Brown’s dissenting opinion agrees with the majority on this point:

… 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.

Chesapeake v. Hyder is the first Supreme Court case since Heritage v. NationsBank to examine lease language regarding deductability of post-production costs from lease royalties. And it is the first Texas Supreme Court case in some time upholding a judgment in favor of royalty owners.

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The Texas Railroad Commission website includes a tool it calls the Public GIS Viewer, that all mineral owners should become familiar with. It can be found at http://wwwgisp.rrc.state.tx.us/GISViewer2/, and it looks like this (click to enlarge):

GIS Viewer

The RRC website also has a page showing you how to use the viewer, found here.

You can locate wells and permits, and find permit plats, P-12’s, and other records in the permit file. Spend a little time playing around on the viewer to become familiar with its tools.

Other data at the RRC can be searched from this page:  http://www.rrc.texas.gov/about-us/resource-center/research/online-research-queries/ . From this page, you can find completion reports, field rules, organization reports, P-4’s and P-‘5’s, production data, and much more. An explanation of the data that can be located from this data queries page can be found here.

Use the viewer to locate the lands where you own interests. Look up your wells. Look for permitting activity in the vicinity of your properties. Have fun.

 

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Flint Hills Resources, LLC, a refiner owned by Charles and David Koch, offered to pay $1.50/bbl for North Dakota Sour crude, from the Bakken shale. Flint Hills originally posted a price of -$0.50/bbl (that’s right, minus fifty cents) for the sour crude, but later said that was a mistake and corrected the posting to $1.50. There is a lack of pipeline capacity for this ultra-low quality crude.

Plains All American, another oil buyer, offered $13.25/bbl for South Texas Sour and $13.50 for Oklahoma Sour.

West Texas Intermediate futures traded as low as $28.36/bbl in New York, and Brent Crude futures settled at $28.55/bbl in London.

WTI graph

 

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The Texas Supreme Court recently denied a petition for review filed by the Aycocks in their suit against Vantage Fort Worth Energy. The trial court and  court of appeals both ruled against the Aycocks’ claims. The holding in the case is not surprising, but dicta in the court of appeals’ opinion may raise some eyebrows among oil and gas lawyers.

Desdemona Cattle Company owned an undivided mineral interest in 1,409 acres in Erath County. In March 2008 Desdemona leased its undivided interest to Vantage Fort Worth Energy for $750 per net mineral acre, for a total of $394,574.60. The Aycocks also owned an undivided mineral interest in the 1,409 acres, and when they learned of Desdemona’s lease to Vantage, they contacted Vantage and sought to lease their interest. Vantage never replied. No well was ever drilled, and the Desdemona lease expired in March 2011.

In May 2012, the Aycocks sued Vantage. They claimed that they had ratified the Desdemona lease and were entitled to be paid a bonus of $750 per net mineral acre for their mineral interest. The trial court denied the Aycocks’ claim. The Eastland Court of Appeals affirmed, holding that the Aycocks had no basis to assert a claim for unpaid bonus against Vantage.

The interesting part of the court’s opinion is what it says the Aycocks could have done. The court says the Aycocks could have sued Desdemona and recovered a share of the lease bonus Vantage paid to Desdemona. The reasoning goes like this: Desdemona is a cotenant in the mineral estate with the Aycocks. The oil and gas lease signed by Desdemona purported to lease the entire mineral estate to Vantage. The Aycocks had the right to ratify Desdemona’s lease, thereby approving Desdemona’s unauthorized act of purporting to lease the Aycocks’ undivided mineral interest; and having ratified Desdemona’s unauthorized act, the Aycocks are entitled to their share of any bonus and royalties paid under or for the oil and gas lease.

Typically, an oil and gas lease does not specify the undivided interest owned by the lessor. The lease simply says that the lessor is leasing the oil and gas in the land. A proportionate reduction clause in the lease provides that, if the lessor owns less than all of the oil and gas in the property, then any royalties owed under the lease will be proportionately reduced to reflect the undivided interest owned by the lessor. The bonus paid for the lease is calculated based on the parties’ understanding of the mineral title owned by the lessor when the lease is signed. So, even though the lease does not specify the undivided interest owned by the lessor, the lessor is not attempting or purporting to lease any other cotenants’ undivided interest in the property.

Cases cited by the court of appeals do hold that a cotenant can ratify an oil and gas lease and thereby become subject to that lease. None of those cases has held that a ratifying cotenant can recover a share of the bonus paid to the signing cotenant for the lease. Unless it can be shown that the lessee erroneously paid the signing cotenant for a mineral interest owned by a non-signing cotenant, I don’t think a signing cotenant should be required to share his/her bonus with another cotenant to decides to ratify the lease. To that extent, it appears to me that the court of appeals’ dicta is not correct.

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An article by Jim Malewitz in The Texas Tribune, “As Oil Prices Plunge, Questions about Big Tax Credit,” sheds light on an arcane and technical issue not well understood even by most oil and gas lawyers – classification of wells as “oil wells” or “gas wells” by the Texas Railroad Commission. While most wells produce both oil and gas, under RRC rules a well must be either one or the other. Different rules apply depending on well classification. Why does it matter?

For one thing, oil and gas leases traditionally have allowed larger pooled units for gas wells than oil wells – allowing operators to hold more acreage with a single well. This distinction is based on the theory that gas wells drain a larger area than oil wells – probably true in most conventional reservoirs, where oil and gas migrate through the formation as wells withdraw production. Not so true for new unconventional shale formations, which have very low permeability and porosity, and where oil and gas don’t “flow” through the formation but are produced through artificially induced fractures.

But operators recently are rushing to “reclassify” wells as gas wells that were originally classified as oil wells. According to Malewitz, the RRC granted operator applications to reclassify 844 wells from oil to gas this year – nearly six times the number reclassified in 2013. And Devon Energy has asked the RRC to reclassify more than 200 of its wells from oil to gas. The reason? Tax credits. Continue reading →

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The Texas Land & Mineral Owners Association Newsletter recently published an article disclosing that the Zavala County Appraisal District has denied agricultural-use special appraisal value for land used for oil-pad sites and frac ponds. One owner who challenged the re-appraisal got the District to agree that, if a well pad is not fenced, it won’t deny the ag-use appraisal for pad sites. But fenced frac ponds, it said, don’t qualify.

When there is a “change of use” of land classified as ag-use or open-space use, the law provides that the change of use results in a “roll-back” of property taxes for five years. The owner is assessed tax based on market value for the five years, plus interest at 7% per annum. This can be a big hit for property owners. For one property owner in Zavala county, the assessed property value went from $73/acre to $2,000/acre. And, once a special use value is denied, it may take years after the oil company ceases its use of the property before the owner can re-gain the special use value.

Landowners should consider a lease provision shifting the risk of this re-appraisal to the lessee. Such a provision might read as follows:

If Lessee’s use of the Leased Premises results in loss of any exemption or discount allowing payment of ad valorem tax based on the property’s use (or non-use), Lessee agrees to reimburse Lessor for all excess ad valorem taxes assessed as a result of Lessee’s use, including roll-back taxes, interest and penalties. Such payment shall be due to Lessor within thirty (30) days after Lessor’s written notice to Lessee; such notice shall provide copies of the ad valorem tax statements received by Lessor and Lessor’s calculation of the additional ad valorem taxes for which Lessee is responsible. Such obligation shall be a continuing obligation for as long as such excess ad valorem taxes are owed by Lessor, even if such taxes continue to be owed after expiration or termination of this lease or Lessee’s cessation of use of the portion of the Leased Premises as to which such excess ad valorem taxes were assessed.

This would be a good issue for the next Texas Legislature to address. Thanks to Texas Land & Mineral Owners Association for alerting its members.

TLMA is an advocacy and educational association for Texas land and mineral owners. It holds an annual conference, issues a quarterly newsletter, lobbies for and against legislation, and files friend-of-the-court briefs on issues related to land and mineral rights. I recommend to all my landowner clients that they join the association.

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The filing deadline is now past, and eight Republicans, three Democrats and a Libertarian have said they will run for a seat on the Texas Railroad Commission to replace David Porter, who unexpectedly decided not to run for re-election. Here’s the lineup:

  • Gary Gates, Republican. Gates is a wealthy real estate developer and rancher from Rosenberg and a social conservative. He spent more than $1 million of his own money in an unsuccessful effort to take Comptroller Glenn Hegar’s former senate seat, losing to Lois Kolkhors in a special election – the fourth time he failed to win an election for the Texas legislature.
  • John Greytok, Republican. He’s a lawyer and registered lobbyist and an early supporter of Ted Cruz. He wants the RRC to lead the charge against the Obama administration’s environmental policies.
  • Wayne Christian, Republican. Former state representative from Center for 16 years, Christian ran for an open seat on the RRC in 2014 and was defeated by Ryan Sitton, who won the seat. Christian said that “Stakeholders within both the oil and gas industry and the conservative grassroots movement have flooded my phone with calls encouraging me to run.”
  • Ron Hale, Republican. Hale ran unsuccessfully last year for a Houston state Senate seat.
  • Gary Gates, Republican. Gates has run unsuccessfully for five legislative seats.
  • Weston Martinez, Republican, from San Antonio, describes himself as a political and media strategist. Has not run for office before.
  • Doug Jeffrey, Republican. Jeffrey is an Air Force veteran who manages his family’s farm and ranch business in Vernon. Has never run for office.
  • Lance Christian, Republican. Lance is a geoscientist on the staff of the RRC and previously worked for the Texas Water Development Board.
  • Lon Burnam, Democrat, who served 18 years in the Texas house before being defeated last year.
  • Cody Garrett, Democrat, who describes himself as a former print and television journalist.
  • Grady Yarbrough, Democrat. He ran in the Democratic primary for US Senate in 2012, losing in a runoff.
  • Mark Miller, Libertarian. Miller also ran for RRC in 2014, garnering 3.2 percent of the vote.

No Democrat has held a position on the RRC for twenty years. Former Land Commissioner Jerry Patterson thought about running for the RRC spot, but decided against it. In a statement, Patterson said he thought “any nominee of the Republican Party should be able to enthusiastically support all other Republican nominees,” and that he could not support Donald Trump if he gets the nomination.

The Texas Railroad Commission has nothing to do with railroads. It is the agency responsible for regulating oil, gas and mining in Texas, including enforcement of environmental regulations, permitting wells, ensuring the safety of groundwater, and supervising pipelines. Except for the Commissioner of the General Land Office, it is the only state agency whose members are elected.

It seems that the quality and experience of candidates for the RRC may be declining. Only two of the candidates have ever held public office. Candidates have been defeated in elections at least thirteen times. None of the candidates except Lance Christian has special expertise in oil and gas regulation and none has served on a state regulatory agency board.

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The price downturn has finally pushed exploration companies to resort to bankruptcy. According to The Dune, the following companies have filed for bankruptcy protection:

RAAM Global Energy
Endeavour International Corp.
Quicksilver Resources Inc.
Sabine Oil & Gas Corp.
Hercules Offshore Inc.
Cal Dive International Inc.
Dune Energy Inc.
BPZ Resources Inc.
ERG Intermediate Holdings LLC
American Eagle Energy Corp.
Saratoga Resources Inc.
Milagro Oil & Gas Inc.
Miller Energy Resources Inc.

The Dune says that the following companies may soon follow:

Vantage Drilling Co.
U.S. Shale Solutions Inc.
Paragon Offshore plc
Midstates Petroleum Co.
Swift Energy Co.
Venoco Inc.
Energy XXI Ltd.
Magnum Hunter Resources Corp.

Royalty owners should watch for bankruptcy notices and get legal counsel on whether claims for unpaid royalties should be filed.

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Lawyers have filed a new class action against Chesapeake in Pennsylvania. The suit is against Chesapeake Energy and Chesapeake Marketing, filed in the US District Court for the Middle District of Pennsylvania. The plaintiffs also filed a demand for arbitration with the American Arbitration Association against Chesapeake Appalachia, LLC. According to the arbitration demand, title to Chesapeake’s leases in Pennsylvania is held by Chesapeake Appalachia, and many of those leases contain arbitration clauses requiring the lessor to arbitrate its claims. The complainants make the arbitration demand on behalf of all royalty owners in Pennsylvania who have leases with arbitration clauses.

The suit and the arbitration demand make similar claims, that Chesapeake through its affiliated companies “(1) paid the royalties on less than the revenue paid by the buyer, (2) paid no royalty on the proceeds of derivative contracts, (3) deducted costs incurred after [Chesapeake] no longer held title to the gas, (4) deducted gathering costs that were inflated through collusion and self-dealing with Access Midstream Partners, L.P., (5) deducted transportation costs that were fraudulent in their amounts, (6) deducted marketing fees that were never incurred, and (7) calculated the royalties on some of the gas without determining either the price paid or the costs deducted.”

The plaintiffs are represented by Caroselli Beachler McTiernan & Coleman, LLC in Pittsburgh and Robert C. Sanders, of Upper Marlboro, Maryland.

The class action suit:  OSTROSKI CLASS ACTION – FINAL FILED VERSION

The arbitration complaint:  Class Arbitration Demand and Complaint

A class action against Chesapeake for underpayment of royalties was filed in 2013 in Pennsylvania, Demchak Partners Limited Partnership, et al., v. Chesapeake Appalachia, LLC, Case No. 3:13-CV-02289-EM (US Dist. Court M.D. Pa.). A proposed settlement of that case has been submitted to the court for approval. It appears that the settlement of that case only applies to certain royalty owners who have “market enhancement clauses” in their leases, defined by the settlement agreement as “clauses or provisions in an oil and gas lease that preclude the lessee from deducting Post-Production Costs
incurred to transform leasehold gas into marketable form or make such gas ready for sale or use but permit the lessee to deduct a pro rata share of Post-Production Costs incurred after the gas is marketable or ready for sale or use.”

Chesapeake’s stock has taken a beating. From a high of $29.22/share on June 14, 2014, the stock closed at $4.27/share on December 7.

CHK shares

 

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