Articles Posted in Post-Production Costs

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Three amicus briefs have been filed in support of the Hyders, opposing Chesapeake’s motion for rehearing of the Texas Supreme Court’s decision in Chesapeake v. Hyder.

An amicus brief was filed by the City of Fort Worth and others who have filed suits against Chesapeake and Total to recover additional royalties on production in the Barnett Shale area:  City of Fort Worth Amicus Brief

An amicus brief was filed by a group of royalty owners represented by Dan McDonald, a Fort Worth attorney who has filed 430 separate suits against Chesapeake, representing more than 20,900 royalty owners in Johnson and Tarrant Counties: Barnett Shale Royalty Owners Amicus Brief

Our firm, on behalf of Texas Land & Mineral Owners’ Association and the National Association of Royalty Owners-Texas, filed an amicus brief supporting the Hyders: TLMA and NARO Texas Amicus Brief

Chesapeake lost its appeal to the Texas Supreme Court in a 5-4 decision and has asked the Texas Supreme Court to reconsider its decision. Amicus briefs supporting Chesapeake’s motion for rehearing have been filed by the Texas Independent Producers and Royalty Owners’ Association (TIPRO), the Texas Oil & Gas Association (TXOGA), Sandridge Exploration & Production, BP America, Devon Energy, EOG Resources, EXCO Resources, Shell Western E&P, Trinity River Energy, Unit Corp. and XTO Energy.

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The Texas Supreme Court asked the Hyders to respond to Chesapeake’s motion for rehearing in Chesapeake v. Hyder, after the court’s recent 5-4 decision in favor of the Hyders. Several amicus briefs (“friend of the court” briefs by entities not parties to the case) were filed in support of Chesapeake’s motion for rehearing. Exploration companies are clearly unhappy with language in Chief Justice Hecht’s majority opinion and asking the court to modify its language. The amicus briefs made the San Antonio Business Journal’s “Eagle Ford Shale Insight” feature.

I’ve written about this case before, and our firm filed an amicus brief in the case before the court issued its opinions, on behalf of Texas Land & Mineral Owners’ Association and the National Association of Royalty Owners-Texas.

So far, on rehearing, the following parties have joined in amicus briefs criticizing the court’s majority opinion:

  • Texas Oil & Gas Association
  • Texas Independent Producers and Royalty Owners Association
  • BP America Production Co.
  • Devon Energy Production Co. LP
  • EOG Resources Inc
  • EXCO Resources Inc
  • Shell Western E&P Inc
  • Trinity River Energy LLC
  • Unit Corp.
  • XTO Energy Inc
  • SandRidge Exploration and Production LLC

The Texas General Land Office, joined by Longfellow Ranch LP and Wesley Ranch Minerals, LP have filed an amicus brief supporting the court’s opinion. The GLO and SandRidge are engaged in a separate suit that concerns a lease provision in the Texas Relinquishment Act lease form and Sandridge is concerned that the court’s opinion could impact its case, prompting its interest in Hyder.

The issue in Hyder is the meaning of a clause that grants the Hyders an overriding royalty on horizontal wells drilled on adjacent leases from locations located on the Hyder property. The lease provision granting the overriding royalty calls for “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5%) of gross production obtained” from wells bottomed under neighbors’ land.” The parties dispute whether, in paying the Hyders this overriding royalty, Chesapeake can deduct post-production costs. The court held that it cannot. “Cost-free” includes post-production costs, according to the majority opinion.

One might think it curious that Texas Independent Producers and Royalty Owners Association (TIPRO) would file an amicus brief supporting Chesapeake’s reading of the lease. How can an organization purporting to represent royalty owners advocate a position detrimental to their interests? The San Antonio Business Journal quotes TIPRO’s President Ed Longanecker’s press release on its support of Chesapeake:

TIPRO believes the Court’s erroneous interpretation of the overriding royalty interest (“ORRI”) at issue will affect thousands of ORRIs in the state of Texas, many of which have been in existence for decades. If allowed to stand, the ruling that the ORRI prohibits the deduction of post-production costs will result in substantial unintended windfalls for ORRI owners. It may also call into question the commercial viability of marginal wells, leading to the possible plugging of wells across the state and thus less production and royalty revenue.

One might think that, if an oil company agreed to pay a “cost-free” overriding royalty, that payment – free of post-production costs – would not constitute an “unintended windfall” to the royalty owner. Perhaps TIPRO should reconsider its name.

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A federal judge in Dallas has ruled that Chesapeake cannot deduct post-production costs on the Plaintiffs’ leases covering lands in Tarrant and Johnson Counties, in the Barnett shale.  The order can be viewed here: Winscott – Order on MSJs 

The case is Trinity Valley School, et al. vs. Chesapeake Operating, Inc., et al., No. 3:13-CV-08082-K, in the US District Court for the Northern District of Texas, Judge Ed Winscott presiding. The order, although a partial summary judgment, appears to resolve Chesapeake’s claim of right to deduct post-production costs. Plaintiffs include Ed Bass, the Harris Methodist Southwest Hospital and Texas Health Presbyterian Hospital Dallas. The language construed in the leases varies, but all of the leases contain language dealing with sales to an affiliate.

As I have discussed before, Chesapeake sells its gas at the well to its affiliate Chesapeake Energy Marketing (CEMI). The price on which Chesapeake pays royalties is based on the weighted average price CEMI receives for the gas less gathering and transportation costs incurred by CEMI and a CEMI marketing fee.

The Bass leases at issue allowed deduction of post-production costs only if

(i) charged at arms-length by an entity unafilliated with Lessee; (ii) actually incurred by Lessee for the purpose of making the oil and gas produced hereunder ready for sale or use or to move such production to market; and (iii) incurred by Lessee at a location off of the Leased Premises …

The Court agreed with the Basses that, under Chesapeake’s marketing scheme, its sales of gas failed to meet any of these three requirements. The costs were charged by CEMI, an affiliate by an entity unafilliated with Chesapeake; the costs were not “actually incurred by Lessee,” because Chesapeake sold the gas at the well to CEMI, which incurred the charges; and the costs were not incurred “at a location off of the Leased Premises” because Chesapeake sold the gas at the well, where the charges were incurred.

Chesapeake found itself in the awkward position of arguing that the costs that were actual third-party transportation costs, as opposed to CEMI’s fees, were really “incurred” by Chesapeake, even though it created the scheme of selling at the well to its affiliate and its affiliated incurred the costs. It argued that the meaning of the lease “turns on the meaning of ‘incur’.” (Reminds me of Bill Clinton.)

The leases provide that, if Chesapeake sells to an affiliate, the royalties shall be based on the average of the two highest prices for gas being paid by purchasers in Tarrant County. The Plaintiffs said that this should, at least, be the weighted average price (WASP) for which CEMI sold their gas, without deductions for post-production costs. Chesapeake cried unfair; that price was for sales at locations remote from the wells, after post-production costs had been incurred. The price, Chesapeake argued, should be based on the value of the gas at the well.  The Court disagreed. “Because the market value is determined by a reference price, rather than a value at a geographical point, and WASP qualifies as a reference price, the Court finds that the WASP establishes a minimum price for the market value inquiry.”

In this case, Chesapeake’s sales to its own affiliate have come back to haunt it. Had Chesapeake sold its gas in the normal manner rather than through its affiliate, it would have been entitled to deduct legitimate third-party costs from the Plaintiffs’ royalty.


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Chesapeake is spending a lot of money on lawyers.

Dan McDonald, a Fort Worth attorney, has filed some 250 cases against Chesapeake contending that it is underpaying its royalty owners. Companies affiliated with former House of Representatives Speaker Tom Craddick have now been added to McDonald’s client list. So many cases have been filed against it in Texas that Chesapeake asked the cases to be granted multidistrict litigation status, so that one judge could control pretrial discovery and motions and settings. Two judges have been appointed for that purpose, one for McDonald’s cases and another for cases brought by other attorneys. Chesapeake is settling cases as fast as it can.

Most of the claims against Chesapeake arise from its structure for selling gas. Chesapeake sells its gas at the wellhead to its wholly owned subsidiary Chesapeake Energy Marketing. Chesapeake Energy Marketing arranges for the gathering of the gas and delivery to central sales points, and pays Chesapeake for the gas based on a weighted average price of all sales at those central gathering points, less costs of compression, gathering, treating and transportation, and less a “marketing fee” charged by Chesapeake Energy Marketing. The costs incurred between the wellhead and the point of delivery to the purchaser were formerly incurred by another Chesapeake affiliate, Access Midstream. Chesapeake spun off its gathering systems into a separate company a few years ago, and as part of that deal it guaranteed a minimum rate of return on those gathering systems to the new spin-off company, thereby receiving a premium price in the market for the new company’s shares. Chesapeake pays royalties based on the new price it receives from Chesapeake Energy Marketing, after deduction of post-production costs and marketing fees. McDonald says that these “costs” are “sham sales” and “fraudulent transactions.”

McDonald’s first ten cases against Chesapeake are set for trial early next year. McDonald’s cases are mainly for wells in the Barnett Shale, where Chesapeake has sold a share in its wells to Total, the French energy company. Total is also named as a defendant, and it markets its share of gas in a manner similar to Chesapeake.

Chesapeake recently reported a $4 billion loss and has eliminated its dividend. It recently sued its founder and former CEO Aubrey McClendon for allegedly stealing trade secrets when he was fired by the company.

Chesapeake recently lost an important case in the Texas Supreme Court, Chesapeake v. Hyder, and the opinion in that case has other companies concerned about their ability to deduct post-production costs from royalties. Chesapeake recently filed a motion for rehearing in that case, and amicus briefs urging the court to reconsider its opinion have been filed by Texas Oil & Gas Association, BP, Devon, EOG, Exco, Shell, XTO and others. With low gas prices, the ability to force royalty owners to share in post-production costs can mean the difference between profit and loss for some companies.


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The Texas Supreme Court has ruled 5 to 4 that Chesapeake cannot deduct post-production costs from the Hyder family’s gas royalties.

The case in the Supreme Court actually addresses only the Hyders’ overriding royalty. As part of the Hyders’ oil and gas lease, the Hyders agreed that Chesapeake could use their land to drill horizontal wells producing from their neighbors’ land — the surface location on the Hyders’ land, but all of the productive lateral of the well under the neighbor’s property. In exchange, Chesapeake agreed to pay the Hyders a 5% royalty on production from such wells. Because the Hyders have no mineral interest in the lands from which these wells produce, the parties referred to this royalty as an overriding royalty.

The Hyders’ lease contains very specific provisions prohibiting Chesapeake from deducting post-production costs from the Hyders’ royalty on production from their lands. But the lease provision granting the overriding royalty on production from wells bottomed under their neighbors’ property is not so clear. Although Chesapeake originally fought to deduct post-production costs from both the royalties and the overriding royalties, the trial court and court of appeals ruled for the Hyders on all claims, and Chesapeake elected to appeal to the Texas Supreme Court only on the issue of deductibility of post-production costs from the Hyders’ overriding royalty.

The lease provision granting the overriding royalty calls for “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5%) of gross production obtained” from wells bottomed under neighbors’ land.” The lease also provided that “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.”

Justice Hecht wrote the majority opinion, joined by Justices Green, Johnson, Boyd and Devine. The parties’ arguments in their briefs and at oral argument focused on what was meant by “cost-free (except only its portion of production taxes).” Chesapeake argued that “cost-free” refers only to production costs. The Hyders argued that an overriding royalty is by definition free of production costs, so “cost-free” must refer to post-production costs. Justice Hecht said that “We disagree with the Hyders that ‘cost-free’ … cannot refer to production costs. … But Chesapeake must show that while the general term ‘cost-free’ does not distinguish between production and post-production costs and thus literally refers to all costs, it nevertheless cannot refer to post-production costs.”

Chesapeake made another argument, based on the requirement that the overriding royalty be based on “gross production.” It reasoned that “gross production” meant all gas, measured at the well when produced, so the value of that production must be measured at the wellhead, and any costs incurred thereafter must be shared by the royalty owner. The overriding royalty is expressed as a fraction of “gross production,” a royalty payable in-kind. Chesapeake argued that, if the Hyders elected to separately market their share of the gas, they would have to incur those post-production costs to get the gas to market, so the parties intended that the Hyders should bear those costs if Chesapeake sold the gas and paid the Hyders their 5% share of proceeds.  Hecht disagreed. “The fact that the Hyders might or might not be subject to post-production costs by taking the gas in kind does not suggest that they must be subject to those costs when the royalty is paid in cash.” Hecht concluded that “‘cost-free’ in the overriding royalty provision includes post-production costs.”

Four justices dissented. Justice Brown wrote the dissenting opinion, joined by Justices Willett, Guzman and Lehrmann. The dissenters agreed with Chesapeake that, because the overriding royalty was on “gross production,” the Hyders had to bear post-production costs. They concluded that “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).” Further discussing Heritage, Justice Brown said:

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 value of the gas is meaningless when gas is valued at the well.”). Here, no post-production costs have been incurred at the time of production, and it means nothing to say that the overriding royalty is free of those yet-to-be incurred costs.

In short, Justice Brown gave controlling effect to the “gross production” language, while Justice Hecht gave controlling effect to the “cost-free” language.

Justice Hecht’s opinion is interesting in its discussion of two other lease provisions. Although the case before the court did not encompass whether Chesapeake could deduct post-production costs from the Hyders’ royalty, Justice Hecht discussed the royalty clause. One of the provisions in the royalty clause states that the Hyders’ royalty shall be

free and clear of all production and post-production costs and expenses, including but not limited to, production, gathering, separating, storing, dehydrating, compression, transporting, processing, treating, marketing, delivering, or any other costs and expenses incurred between the wellhead and Lessee’s point of delivery or sale of such share to a third party.

Remarkably, Justice Hecht considered this language “surplusage”:

The gas royalty in the lease does not bear post-production costs because it is based on the price Chesapeake actually receives for the gas through its affiliate … after post-production costs have been paid. Often referred to as a ‘proceeds lease’, the price-received basis for payment is sufficient in itself to excuse the lessors from bearing post-production 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. It might be regarded as emphasizing the cost-free nature of the gas royalty, or as surplusage.

Another provision in the Hyders’ lease disclaimed the holding in Heritage v. NationsBank:

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 royalty clause in Heritage  provided that Lessor’s royalty is

1/5 of the market value at the well of the gas so sold or used, provided, however, that there shall be no deductions from the value of the Lessor’s royalty by reason of any required processing, cost of dehydration, compression, transportation or other matter to market such gas.

The court in Heritage held that the lessee could deduct transportation costs from the royalty, and that the “no-deductions” proviso was “mere surplusage.”

The Hyders argued that the “Heritage disclaimer” clause in their lease showed the parties’ intent that their overriding royalty should be free of post-production costs. Justice Hecht disagreed:

Heritage Resources does not suggest, much less hold, that a royalty cannot be made free of post-production costs. Heritage Resources holds only that the effect of a lease is governed by a fair reading of its text. A disclaimer of that holding, like the one in this case, cannot free a royalty of post-production costs when the text of the lease itself does not do so. Here, the lease text clearly frees the gas royalty of post-production costs, and reasonably interpreted, we conclude, does the same for the overriding royalty. The disclaimer of Heritage Resources’ holding does not influence our conclusion.

The dissent also discussed Heritage.  Justice Brown notes that, unlike the gas royalty clause, the oil royalty clause in the Hyder lease provides for payment based on the “market value at the well” of the oil, just as in Heritage.  Justice Brown questions Justice Hecht’s conclusion that the “Heritage disclaimer” in the Hyders’ lease should have no effect even as applied to the oil royalty clause: “The disclaimer could be interpreted as a belt-and-suspenders attempt to ensure the ‘free and clear’ language is given effect despite its conflict with the oil royalty’s market-value-at-the-well definition.” In other words, the Heritage disclaimer might not be “surplusage.” But the four dissenting justices would nevertheless in effect follow Heritage. They would give effect to the “gross production” language in the overriding royalty clause, and would hold that this term is equivalent to the “at the well” clause in the Heritage royalty provision; and they would then hold that, because the overriding royalty is to be valued “at the well,” the language making the overriding royalty “cost-free” is, under Heritage, surplusage.

So, what should royalty owners and their counsel take from these opinions?

This firm filed an amicus brief in Hyder on behalf of the Texas Land and Mineral Owners’ Association and the National Association of Royalty Owners-Texas, in which we urged the court to clarify how royalty clauses should be construed in relation to post-production costs, and how much, if at all, the court’s prior decision in Heritage v. NationsBank should be relied on as precedent. Unfortunately, this case does not provide much guidance. Justice Hecht does note in a footnote that, on rehearing in Heritage, the court re-aligned itself, and one justice recused himself. The result, not mentioned in the footnote, is that the court was evenly divided on whether the Court’s original opinion was correct. And Justice Hecht’s opinion does say that “Heritage Resources holds only that the effect of a lease is governed by a fair reading of its text.” Perhaps this is Justice Hecht’s way of saying that Heritage has little precedential value where the text of the royalty clause differs from that in Heritage. But the continued power of Heritage is reflected in the fact that four justices dissented and would hold that Heritage requires a reading of the Hyder overriding royalty clause that would allow Chesapeake to deduct post-production costs, despite its “cost-free” language.

One lesson royalty owners and their lawyers should take away from Hyder: a “Heritage disclaimer” clause in a lease, without more, will not insulate the royalty owner from post-production costs.

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Last November, the Texas General Land Office lost its appeal in Commissioner v. SandRidge Energy, Inc., in the El Paso Court of Appeals. For the first time, a court has ruled that a lessee can deduct post-production costs under the Texas General Land Office’s Relinquishment Act lease form, citing Heritage Resources v. NationsBank, 939 S.W.2d 118 (Tex. 1996).

The case actually involves several oil and gas leases owned by SandRidge in Pecos County, some covering lands owned by private parties, some covering Relinquishment Act lands. (The State owns the minerals under Relinquishment Act land; the surface owner is agent for the state in granting oil and gas leases, for which the surface owner receives ½ of bonuses and royalties. The lease must be approved by the GLO and be on the approved GLO lease form.) The most interesting part of the case is the court’s interpretation of the GLO’s Relinquishment Act lease form. There are somewhere between 6.4 million and 7.4 million acres of Relinquishment Act lands in Texas, principally in West Texas, in and around the Permian Basin.

SandRidge’s wells on the leases in dispute produce mostly carbon dioxide, mixed with some natural gas. Originally, SandRidge paid the GLO royalties on its sales of natural gas and carbon dioxide. More recently, SandRidge made an agreement with Oxy USA; SandRidge built a plant, the Century Plant, to extract the CO2 from SandRidge’s gas. Oxy owns and operates the plant and gets the CO2 extracted; SandRidge gets the natural gas. Oxy doesn’t charge SandRidge for separating the gas from the CO2. Oxy uses the CO2 in secondary recovery projects. The plant reportedly cost a billion dollars.

When the Century Plant was up and running, SandRidge stopped paying royalties on CO2 under its Relinquishment Act leases. The State sued, and the parties filed motions for partial summary judgment. The trial court ruled in favor of SandRidge.

The GLO relied on the following provisions of the Relinquishment Act leases:

4(B).  NON PROCESSED GAS. Royalty on any gas (including flared gas), which is defined as all hydrocarbons and gaseous substances not defined as oil in subparagraph (A) above, produced from any well on said land (except as provided herein with respect to gas processed in a plant for the extraction of gasoline, liquid hydrocarbons or other products) shall be 25% part of the gross production or the market value thereof, at the option of the owner of the soil or the Commissioner of the General Land Office, such value to be based on the highest market price paid or offered for gas of comparable quality in the general area where produced and when run, or the gross price paid or offered to the producer, whichever is the greater ….

 7.  NO DEDUCTIONS. Lessee agrees that all royalties accruing under this lease (including those paid in kind) shall be without deduction for the cost of producing, gathering, storing, separating, treating, dehydrating, compressing, processing, transporting, and otherwise making the oil, gas and other products hereunder ready for sale or use. Lessee agrees to compute and pay royalties on the gross value received, including any reimbursements for severance taxes and production related costs.

 The State argued that SandRidge was paying for the cost of treating the natural gas by giving the CO2 to Oxy, and that this cost is not deductible under the Relinquishment Act lease form. SandRidge argued that the cost of treating the gas is deductible, based on Heritage v. NationsBank.  In Heritage, the Texas Supreme Court held that, where a lease provides for royalties based on “market value at the well,” a lessee may deduct post-production costs even if the lease prohibits such deductions. According to the Court, “from SandRidge’s perspective, Heritage stands for the principle that a market value at the well clause trumps any other provision that conflicts with it.” SandRidge argued that the paragraph 4(B) of the Relinquishment Act lease is in effect a market-value-at-the-well royalty provision. The El Paso Court of Appeals agreed. It said that the clause provides for royalties based on the wellhead measurement of gas volume. “The royalty is therefore owed on the substance so measured: raw gas, including all of its components. ‘When there is a wellhead measurement, payment is due for gas in its natural state, not on the liquid hydrocarbons which are later extracted.’ ConocoPhillips Co. v. Incline Energy, Inc., 198 S.W.3d 377, 381 (Tex.App.–Eastland 2006, pet denied)(citing Carter v. Exxon Corp., 842 S.W.2d 393 (Tex.App.–Eastland 1992, writ denied)).”

To my knowledge, this is the first appellate decision applying the Heritage rationale to a royalty clause that does not contain “market-value-at-the-well” language.

The GLO intends to appeal to the Texas Supreme Court. The Supreme Court has already agreed to hear Chesapeake’s appeal in the Hyder case, which also implicates Heritage.

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A team of lawyers in Pennsylvania has filed an anti-trust suit against Chesapeake and Williams Partners (Formerly Access Midstream Partners) alleging that they conspired to restrain trade in the market for gas gathering services in and around Bradford County, Pennsylvania. The plaintiffs also sued Anadarko, Statoil, and Mitsui, all of whom own interests in Chesapeake’s leases. The suit alleges violation of the oil and gas leases granted by the plaintiffs, violations of ant-trust law, and violation of the Racketeer Influenced and Corrupt Organizations Act (RICO). A copy of the complaint, filed in federal court in Pennsylvania, can be found here.

The team of lawyers who filed this suit have their own website, “Marcellus Royalty Action.” They say that their approach differs from other suits against Chesapeake in that they will not seek class action status, they intend to pursue discovery before negotiating settlements, and they will sue all working interest owners responsible for royalty payments.

Royalty owner suits against Chesapeake have become a growth industry for attorneys. Recently, Chesapeake requested that multiple royalty owner suits against it in the Barnett Shale region of Texas be assigned to a pretrial court for consolidated and coordinated pretrial proceedings.  (Defendants Joint Motion for Transfer and Request for Stay) The request says that more than 3,200 landowners have filed 97 separate suits in Johnson, Tarrant and Dallas Counties alleging that Chesapeake and Total E&P, USA, Inc. (Chesapeake’s working interest partner in the Barnett Shale) have charged excessive post-production costs. This request results primarily from multiple suits filed by the McDonald Law Firm. See  McDonald has said he does not oppose Chesapeake’s request.

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As I have written, Chesapeake has asked the Texas Supreme Court to reverse the San Antonio Court of Appeals’ decision in Chesapeake v. Hyder. The court of appeals ruled that Chesapeake could not deduct post-production costs from the Hyders’ royalty.

The Texas Land & Mineral Owners’ Association and the National Association of Royalty Owners – Texas have filed an amicus brief in Hyder supporting the Hyders’ case. The brief can be viewed here. Final Amicus_Brief_Chesapeake_v__Hyder.pdf It was authored by my firm and by Raul Gonzalez, who was a member of the Texas Supreme Court when the court decided Heritage v. NationsBank, the case relied on by Chesapeake as authority for its deduction of post-production costs.

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Chesapeake has asked the Texas Supreme Court to hear its appeal of Chesapeake v. Hyder, decided by the San Antonio Court of Appeals in March of this year. The Supreme Court has asked the parties to file briefs on the merits, and Chesapeake filed its brief last week. Although the Court has not yet agreed to hear the case, its request for briefs is an indication that the Court may do so.

I wrote about the Hyder case when it was decided last March. Since then, the U.S. Court of Appeals for the 5th Circuit has decided two other Chesapeake cases, Chesapeake v. Potts and Chesapeake v. Warren, ruling in Chesapeake’s favor in both cases. All three cases involve deduction of post-production costs from royalties. Multiple cases have been filed against Chesapeake challenging its post-production-costs deductions, because of its aggressive method of calculating those costs. In all three cases, Chesapeake relies heavily on a Texas Supreme Court case decided in 1996, Heritage Resources v. NationsBank. The Texas Supreme Court has not discussed its opinion in Heritage since it was decided. Hyder may be its opportunity to do so.

The oil and gas lease in Hyder provides that “the royalty reserved herein by Lessors shall be free and clear of all production and post-production costs and expenses.” It also states that “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 provision of this Lease.” The Court of Appeals held that the lease prohibited Chesapeake from deducting transportation costs.

The Court of Appeals opinion has an interesting discussion of Chesapeake’s structure for marketing and selling its gas. The owner of the lease is Chesapeake Exploration, LLC. Chesapeake Operating, Inc., drills and operates the wells and pays the royalty. Chesapeake Energy Marketing, Inc., buys the gas from Chesapeake Operating (as agent for Chesapeake Exploration). Chesapeake Midstream Partners, LP gathers the gas from the leases and delivers it to pipelines owned and operated by unrelated parties. Those pipelines in turn deliver the gas to purchasers, who pay Chesapeake Energy Marketing, Inc.

A recent investigative report by Pro Publica describes how Chesapeake spun off its subsidiary, Chesapeake Midstream Partners (which became Access Midstream), in the process raising $4.76 billion.  According to the report, Chesapeake sold its network of gathering lines in Pennsylvania, Ohio, Louisiana, Texas and the Midwest to Access, and entered into an agreement with Access for Access to gather and transport Chesapeake’s gas. Over a ten-year period, Chesapeake pledged by this contract to pay Access enough in fees to repay Access’s purchase price plus a 15 percent return on the investment. The agreement also provides for Access to pay Chesapeake for use of certain Chesapeake equipment. According to the report, the result of these transactions was to greatly increase Chesapeake’s cost of gathering its gas, to an average of 85 cents per mcf. That gathering cost greatly increased the deductions on Chesapeake’s royalty owners’ checks. In effect, it could be argued that Chesapeake has monetized some of its gas reserves by locking itself into a long-term gathering agreement with Access, in exchange for a $4.76 billion payment from Access, and in the process created an inflated gathering charge which can be passed on to its royalty owners.

In June, attorneys in Pennsylvania filed suit against Chesapeake, seeking certification of a class action on behalf of Pennsylvania royalty owners, alleging that the system used by Chesapeake for marketing its gas constitutes a violation of the Racketeer Influenced and Corrupt Organizations Act, or RICO. (Complaint can be viewed here.) The lawsuit claims that  “defendants, under the guise of Chesapeake’s subsidiaries’ agreements with lessors, exploited deductions language from the lease agreements to, among other things, shift repayment of Chesapeake’s off-balance sheet loan from Access Midstream to the lessors.”

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Last month I wrote about two cases recently decided by the U.S. Court of Appeals for the 5th Circuit in which Chesapeake defeated royalty owners’ efforts to prevent it from reducing their royalties by deducting post-production costs. One of those cases is Potts v. Chesapeake. The plaintiffs in that case have asked the Court of Appeals to reconsider its appeal “en banc,” meaning that it has asked the other judges on the court to grant its petition for rehearing and reconsider the decision of the three-judge panel who decided the case. Plaintiffs’ Petition for Rehearing may be viewed here:  Potts Petition for Rehearing En Banc.pdf

Yesterday, our firm filed a friend-of-the-court brief in the Potts case, on behalf of the Texas Land and Mineral Owners Association and the National Association of Royalty Owners – Texas, asking the Court to grant the plaintiff’s motion for rehearing and either consider the case en banc or refer the question to the Texas Supreme Court for its consideration. A copy of our brief may be viewed here:  Potts v. CHK Amicus Brief.pdf

Meanwhile, in Pennsylvania, suit has been filed against Chesapeake claiming that its conduct in selling gas to its affiliate company at prices well below market, and then selling its affiliate company for a substantial profit, constituted fraud on its royalty owners in violation of the Racketeer Influenced and Corrupt Organizations Act, known as RICO.  That petition can be viewed here:  Suessenbach v. Chesapeake.pdf

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