COST-FREE ROYALTY INTERESTS

By: Adam Braaten[1]

With West Texas Intermediate Crude Oil averaging around $49 per barrel in 2015 (a decrease of approximately $45 from 2014) and expected to average around $39 per barrel in 2016,[2] the terms and provisions of contracts associated with costs and who bears those costs are becoming more relevant and being closely scrutinized by all parties to the contract.  This article will briefly discuss the anti-Heritage Resources v. NationsBank provisions which have become common in oil and gas leases and how it alters the practice of allocating post-production costs to the lessor in an oil and gas lease.  In addition, this article will discuss the recent decision in Chesapeake Exploration, L.L.C. v. Hyder[3] as it applies to the allocation of post-production costs to overriding royalty interests.

If you have negotiated, drafted and/or reviewed an oil and gas lease in the last twenty (20) years then you are most likely familiar with the Texas Supreme Court�s decision in Heritage Resources v. NationsBank.[4]  In this decision, the court stated that although the landowner�s royalty �is not subject to the costs of production, royalty is usually subject to post-production costs, including taxes, treatment costs to render it marketable, and transportation costs.  However, the parties may modify this general rule by agreement.�[5]  The royalty provisions included in the NationsBank Lease contained market value at the well language.  There are two methods used to determine market value at the well.  The first and most preferred method is to use comparable sales.  The second method, which is used when there are no comparable sales, is to deduct reasonable post-production marketing costs, including transportation and processing costs, from the market value at the point of sale.[6]  As a result, in order to determine market value at the well under the second method the reasonable post-production costs must be deducted from the market value at the point of sale.  Even though the lease contained a provision stating there shall be �no deductions from the value of Lessor's royalty by reason of any required processing, cost of dehydration, compression, transportation, or other matter to market such gas�, the court allowed for the deduction of reasonable post-production marketing costs in order to determine market value at the well.  The court found the �no deductions� of post-production costs language was surplusage as a matter of law since the market value at the well already excludes post-production costs.[7]  After the court�s ruling, anti-Heritage Resources v. NationsBank provisions have become common lease provisions in custom oil and gas lease forms and addendums to form leases.  The anti-Heritage Resources v. NationsBank provisions modify the general rule and clearly shift the burden of all post-production costs, usually excluding taxes, to the lessee in an oil and gas lease and specifically state the non-deduction of post-production costs (or cost-free) language is not surplusage.

In Chesapeake Exploration, L.L.C. v. Hyder, the Fourth Court of Appeals stated an overriding royalty �is normally free of production costs, but subject to post-production costs.  However, the parties may modify this default rule by agreement.�[8]  One of the issues addressed by the court in Chesapeake Exploration, L.L.C. is the interpretation of the overriding royalty clause in the Hyder Lease.  The Hyders were to receive �a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5%) of gross production obtained from each� off-lease well.[9]  Pursuant to the provisions of the lease, the court determined the overriding royalty was to be calculated free of post-production costs and to determine otherwise �would require [the court] to rewrite the lease and alter the parties� contract which [it] may not do.�[10]  Although not discussed in much detail as to its application of the overriding royalty clause, except to state that Chesapeake Exploration, L.L.C.�s �reliance on Heritage is unpersuasive�,[11] the Hyder Lease did contain an anti-Heritage Resources v. NationsBank provision, which states �that the holding in the case of Heritage Resources v. NationsBank, 939 S.W.2d 118 (Tex. 1996) shall have no application to the terms and provisions of this Lease.�[12]  Based on the analysis of the court, it appears the inclusion of the anti-Heritage Resources v. NationsBank provision did not substantially affect the court�s decision insofar as the overriding royalty clause, but it definitely did not hurt.

Going forward, parties to a contract creating a royalty and/or an overriding royalty interest should clearly express if the interest created is free of post-production costs.  If the party drafting the document intends for the interest created to be a cost-free interest and not bear its proportionate share of post-production costs, you should consider including an anti-Heritage Resources v. NationsBank provision, which states the holding in the case of Heritage Resources v. NationsBank, 939 S.W.2d 118 (Tex. 1996) shall have no application to the terms and provisions of this document and the cost-free provisions contained herein are not surplusage.  In reviewing already executed contracts to determine which parties shall bear the burden of post-production expenses, one should keep in mind the common industry meaning of terms, how these terms may be modified by provisions in the contract, and the intent of the parties based on a review of the four corners of the document.