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.”