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.