Articles Posted in Post-Production Costs

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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.

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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.”

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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.

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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.

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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 http://royaltyripoff.com/.  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.

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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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The 5th Circuit Court of Appeals in New Orleans has ruled for Chesapeake in two cases, holding that it can deduct post-production costs from gas royalties. Potts v. Chesapeake Exploration, No. 13-10601, and Warren v. Chesapeake Exploration, No. 13-10619. Both cases were decided by the same three judges, and both opinions were written by Judge Priscilla R. Owen. In both cases, Judge Owen relied on the Texas Supreme Court case of Heritage Resources v. NationsBank, 939 S.W.2d 118 (Tex. 1996). Judge Owen was on the Texas Supreme Court when Heritage v. NationsBank was decided, and she wrote an opinion in that case. Judge Owen cites her own opinion in Heritage as the principal precedent for her opinions in Potts and Warren.

The Potts and Warren cases were tried in federal district court. Because Chesapeake’s home office is in Oklahoma, it has the right to remove suits filed against it in Texas to federal court. Federal courts have “diversity” jurisdiction over cases between citizens of different states. In diversity cases, federal courts must follow the law of the states. No federal law is involved. So, in deciding Potts and Warren, the 5th Circuit judges were attempting to predict what a Texas court would do, following prior precedent from Texas courts — in this case, Heritage v. NationsBank.

Heritage v. NationsBank is a seminal case in oil and gas law, some would say infamous. The question in Heritage was whether Heritage, the lessee, could deduct transportation costs for gas from royalties owed to NationsBank. NationsBank’s lease provided that royalties on gas would be “the market value at the well of 1/5 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 Texas Supreme Court held that Heritage could deduct transportation costs from NationsBank’s royalty. In her concurring opinion, Justice Owen said that the no-deductions proviso on NationsBank’s lease was “circular” and “meaningless”:

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Last week, the Fourth Court of Appeals in San Antonio issued its opinion in Chesapeake v. Hyder.pdf, on gas royalties owed to the Hyder family for production in Johnson and Tarrant Counties, in the Barnett Shale. The court upheld a judgment against Chesapeake for more than a million dollars, including $250,000 in attorneys’ fees. The result is not surprising considering the language in the lease, but the case is interesting because it reveals Chesapeake’s structure for marketing of gas in the Barnett Shale, obviously designed to reduce its gas royalty obligations.

The principal issue on appeal was whether Chesapeake could reduce the Hyders’ royalty by the amount of transportation costs paid by Chesapeake to unrelated pipeline companies. The trial court and court of appeals held that it could not. As I have written before (here, here and here), deductibility of post-production costs is a continuing issue for gas royalty payments in Texas. Prior Supreme Court cases have held that such costs are deductible under most standard gas royalty clauses.

The Hyders’ royalty clause was not a standard lessee-form lease. It provided:

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