Source: https://www.oilandgaslawyerblog.com/two-wins-for-chesapeake-in-5th/
Timestamp: 2019-04-23 22:19:44+00:00

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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.
There is little doubt that at least some of the parties to these agreements subjectively intended the phrase at issue to have meaning. However, the use of the words “deductions from the value of Lessor’s royalty” is circular in light of this and other courts’ interpretation of “market value at the well.” The concept of “deductions” of marketing costs from the value of the gas is meaningless when gas is valued at the well.
Several amicus briefs were filed in Heritage asking the court to reconsider its decision, but the court refused. Justice Gonzalez, however, wrote an opinion dissenting on motion for rehearing, in which Justices Cornyn, Spector and Abbott joined. It is published at 960 S.W.2d 619. In that opinion, Justice Gonzalez said that the court was evenly divided, 4 to 4, on whether to grant the motion for rehearing. Justice Enoch had recused himself from the case, for reasons not stated, and Justices Cornyn and Spector had changed their minds, now siding with Justice Gonzalez’s dissent. And Justice Phillips had decided to concur in Justice Owen’s opinion rather than join Justice Baker’s original majority opinion. Because a vote of 5 justices is required to grant rehearing, the motion failed. But, said Justice Gonzalez, there was no longer any majority opinion. “Because we are without majority agreement on the reasons supporting the judgment,” he said, “the judgment itself has very limited precedential value and controls only this case.” And, he predicted, “the Court’s error in this case will have far-reaching effects on the oil and gas industry in Texas, as millions of dollars will now be placed in dispute.” His prediction has proven true.
Payments of royalties … shall be based on sales of leased substances to unrelated third parties at prices arrived at through arms length negotiations. Royalties to Lessor on leased substances not sold in an arms length transaction shall be determined based on prevailing values at the time in the area.
As I have written before, Chesapeake has created a complex relationship among its affiliate companies. One affiliate, Chesapeake Operating, operates the lease for Chesapeake. Another affiliate, Chesapeake Energy Marketing (CEMI), buys the gas from Chesapeake Operating at the wellhead. CEMI gathers the gas from Chesapeake’s wells and resells it to purchasers at remote points of sale. The price that CEMI pays Chesapeake for the gas is based on the weighted average price of all gas sold at those remote points of sale, less the post-production costs CEMI incurs between the wellhead and the points of sale. Royalties were paid to Potts based on that net price, so that Potts, as royalty owner, was bearing his share of those post-production costs.
There are any number of ways the parties could have provided that the lessee was to bear all costs of marketing the gas. If they had intended that the royalty owners would receive royalty based on the market value at the point of delivery or sale, they could have said so.
I have seen many lease clauses attempting to prohibit deduction of post-production costs. Some of those clauses include language such as this: “This provision is intended to avoid the result in Heritage v. NationsBank.” I’ve not seen a case construing such a clause. Despite Justice Gonzalez’s insistence that Heritage has very limited precedential value, companies have made the most of it, and lessors continue to try to avoid it.

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