Articles Posted in Post-Production Costs

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.”

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.

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.

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.

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

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”:

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:

Lawsuits against Chesapeake Exploration for wrongfully deducting post-production costs from its gas royalty payments are hitting a boiling-point. Suits are being pursued against the company in every jurisdiction where it operates, including Texas, Arkansas, Lousiana, Kansas, Ohio, West Virginia, Oklahoma and Pennsylvania. Chesapeake has recently been much more aggressive in deducting post-production costs. In the Barnett Shale in North Texas, its post-production cost deductions have been as much as $.70 to $1.00 per mcf, and with such low gas prices, some royalty owners’ payments have been halved by such deductions. Chesapeake’s royalty payments in North Texas have reportedly been on a net price of as little as eleven cents per mcf, and as little as 11% of the price other producers have based their royalty payments on. A recent Bloomberg article summarizes Chesapeake’s royalty payment practices.

Chesapeake has settled some claims, including large royalty owner claims in Pennsylvania. Chesapeake’s marketing practices in Pennsylvania mirror those it uses in the Barnett Shale.  Last year, Chesapeake settled a claim brought by the Dallas-Fort Worth Airport for underpayment of royalties for $5 million. The Bass family in Fort Worth recently sued the company for wrongfully deducting post-production costs.

Chesapeake’s tactics for how it calculates its royalties cannot be understood without knowing something about how Texas courts have addressed deductibility of post-production costs. I have previously written three posts on this topic that can be seen here, here and here.