Texas Supreme Court denies rehearing in Chesapeake royalty dispute

On January 29, 2016, the Texas Supreme Court denied Chesapeake’s motion for rehearing [1] of its June 12, 2015 decision in Chesapeake Exploration, L.L.C. v. Hyder—in which a majority [2] of the Court held that Chesapeake is not entitled to deduct post-production costs in calculating overriding royalties on gas under the plaintiffs’ lease.  In so holding, the Court reaffirmed the underlying premise of its 1996 decision in Heritage Resources, Inc. v. NationsBank—that is, the specific lease language used by the parties controls the royalty valuation and deductibility of post-production costs. 

Important to the majority’s decision was the language in the overriding royalty provision of the Hyders’ lease calling for a “perpetual, cost-free (except only its portion of production taxes) overriding royalty” of 5 percent of “gross production obtained from each such [directionally drilled] well.”  According to the Court, this “cost-free” language “clearly free[d]” the overriding royalty of postproduction costs, despite the lease’s purported disclaimer of any application of the holding of Heritage. 

Notably, Justice Brown, joined by Justices Willett, Guzman and Lehrmann, dissented, writing that “[t]hough the overriding royalty may not have been expressed using familiar market-value-at-the-well language, I read its value as being just that.”  Justice Brown disagreed with the majority’s interpretation of the “cost-free” designation in the overriding royalty provision, noting that “courts often read such language as simply stressing the production-cost-free nature of a royalty without struggling to ascertain any additional meaning.” 

The Court’s denial of rehearing is far from groundbreaking, but, nonetheless, serves as a reminder that the holding of Heritage remains intact and cannot be avoided by the disclaimers of its holding contained in many recent leases.  Deductibility of post-production costs has been and is still governed by a fair reading of the particular royalty lease language.