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Texas Supreme Court Rules Against Chesapeake in Barnett Royalties Case

The Texas Supreme Court in a 5-4 decision last week upheld two lower court rulings that Chesapeake Energy Corp. had improperly deducted post-production costs from royalty checks for natural gas production in the Barnett Shale.

The Texas high court sided with the Fourth Court of Appeals in San Antonio, which in 2014 held that a 13-year-old lease agreement with the family of Martha Rowan Hyder had been breached (see Shale DailyMarch 11, 2014). The appeals court in turn had agreed with a Tarrant County, TX court ruling in 2012, which awarded the Hyder family close to $1 million, including $700,000 in unpaid royalties, interest and attorney fees.

The case concerns a lease agreement signed by the Hyder family in 2004 with Four Sevens Oil Co. for about 1,000 acres that extend across Tarrant and Johnson counties in North Texas. The Hyder agreement included a 25% royalty for gas production, as well as a 5% override for production from other leases if the wells were drilled on the family's property. The agreement did not allow for post-production expense deductions. It also required royalties to be calculated on the sale of gas to a third party, not a Chesapeake affiliate.

Four Sevens assigned the lease in 2006 to Chesapeake. The Hyder family claimed that the issues with Chesapeake began almost immediately. Chesapeake, using the same process it had been using across its leasehold in the Barnett, sold the natural gas to affiliates and paid the Hyders a weighted average sales price based on what it was paid by an unaffiliated third party, less production costs.

In 2010, the Hyders sued (Chesapeake Exploration LLC et al, v Martha Rowan Hyder et al,  No. 04-12-00769-CV). Hyder attorney David Drez argued that the case involved a specific lease, tailored for the family. The lower court’s ruling for the Hyders basically delivered a message that "each lease and contract will have to stand on its own," Drez said.

Chesapeake's legal team argued that post-production costs were standard procedure. It said if the high court did not overturn the lower courts' decisions, it would create a "sea change in Texas oil and gas law." The Texas Oil and Gas Association also argued before the Texas Supreme Court that if the decision was not overturned, it would "generate confusion and inefficiencies" for the energy industry.

The majority on the Texas Supreme Court was unmoved.

"Generally speaking, an overriding royalty on oil and gas production is free of production costs but must bear its share of post-production costs unless the parties agree otherwise," Texas Chief Justice Nathan Hecht wrote for the majority. "The only question in this case is whether the parties' lease expresses a different agreement. We conclude that it does."

Affirming the verdict were Paul Green, Phil Johnson, Jeff Boyd and John Devine. Those dissenting were justices Jeff Brown, Don Willett, Eva Guzman and Deborah Lehrmann.

Brown, who wrote the dissenting opinion, said Chesapeake's deductions were proper and the post-production activities added value to the overriding royalties received by the Hyders. "That Chesapeake undertook to market the gas should not saddle Chesapeake with post-production costs or entitle the Hyders to more than the royalty for which they bargained."

The case has been a "five-year journey for the Hyders," Drez said of the high court's ruling. "This is the third court to agree with us."

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