What does "Cost-Free" mean to an Overriding Royalty?

            The issue in this case is whether the term “cost-free” in the overriding royalty provision in the lease between Chesapeake Exploration (hereinafter referred to as “Chesapeake”) and Martha Rowan Hyder, Brent Rowan Hyder, and Whitney Hyder More (hereinafter referred to as the “Hyders”) suggests that the overriding royalty is free of postproduction costs.

            The Hyder family leased 948 mineral acres in the Barnett Shale to Chesapeake Exploration. The lease contained three royalty provisions. One provision was for 25% of the market value at the well of all oil and other liquid hydrocarbons, however no oil was produced from the lease. Another royalty provision was for 25% of the price actually received by Lessee for all gas produced from the leased premises and sold or used. The lease stated that the royalty was expressly free and clear of all production and postproduction costs and expenses, and additionally listed examples of various expenses.

            The third royalty provision, and the one in dispute, called for a “perpetual, cost-free (except only its portion of production taxes) overriding royalty of 5.0% of gross production obtained from directional wells drilled on the lease but bottomed on nearby land.” The lease contained two other provisions. One was the disclaimer that the Lessors and Lessee agree that the holding in the case of Heritage Resources, Inc. v. NationsBank, 939 S.W. 2d 118 (Tex. 1996) would have no application to the terms and provisions of this Lease. The other was that each Lessor had the continuing right and option to take its royalty share in kind.

            Chesapeake sold all the gas produced to an affiliate, Chesapeake Energy Marketing, Inc. (“Marketing”), which then gathered and transported the gas through both affiliated and interstate pipelines for sale to third-party purchasers in distant markets. Marketing paid Chesapeake a “gas purchase price” for volumes determined at the wellhead or at the terminus of Marketing’s gathering system. The gas purchase price is calculated based on a weighted average of the third-party sales prices received minus postproduction costs. The overriding royalty Chesapeake paid the Hyders was 5% of the gas purchase price and the Hyders contend that their overriding royalty should be based on the gas sales price, which does not deduct postproduction costs. The Hyders argue that the requirement that the overriding royalty be “cost-free” can only refer to postproduction costs, since a royalty by nature is already free of production costs. However, Chesapeake argues that “cost-free overriding royalty” is just a synonym for overriding royalty and cannot refer to postproduction costs.

           Generally, an overriding royalty on oil and gas production is free of production costs but must bear its share of postproduction costs unless the parties modify the general rule by agreement. By express provisions, parties may agree to effectively exclude post-production costs, notwithstanding industry custom that royalties are subject to these costs. The term “cost-free” in this overriding royalty provision includes post-production costs.

           The Supreme Court disagreed with the Hyders in that “cost-free” in the Hyder-Chesapeake overriding royalty provision could not refer to production costs. However, Chesapeake still must show that while the general term “cost-free” does not distinguish between production and postproduction costs and basically refers to all costs, it nevertheless cannot refer to postproduction costs. Chesapeake argued that the gas royalty provision showed that when the parties wanted a postproduction cost-free royalty, they were much more specific in the provision. However, the Court found that the additional detail in the gas royalty provision only emphasized its cost-free nature and had no effect on the meaning of the provision and thus, the simple “cost-free” requirement of the overriding royalty achieved the same end. The overriding royalty provision stated that the overriding royalty was to be cost-free except as to taxes nothing more was needed to accomplish the intent to adequately convey an interest free of both production and postproduction costs.

            Additionally, Chesapeake argued that because the overriding royalty is paid on “gross production”, the reference is to production at the wellhead, making the royalty tantamount to one based on the market value of production at the wellhead, which includes postproduction costs. However, it is not disputed that the overriding royalty may be paid in cash and not in kind, even though the Hyders retained the right to take it in kind. Stipulating that the volume on which a royalty is due must be determined at the wellhead says nothing about whether the overriding royalty must bear postproduction costs. If the Hyders were to take their overriding royalty in kind, they have the option to use the gas on the property, transport it themselves to a buyer, or pay a third party to transport the gas to market in which they may or may not incur postproduction costs. According to the lease, the choice of how to take their royalty, and the consequences, were left to the Hyders. Therefore, the Supreme Court concluded that “cost-free” in the overriding royalty provision includes postproduction costs.

Conclusion: The Supreme Court ruled that the overriding royalty provision that called for a perpetual, cost-free (except only its portion of production taxes) overriding royalty of 5.0% of gross production obtained from directional wells drilled on the lease but bottomed on nearby land freed the overriding royalty of postproduction costs. Although an overriding royalty on oil and gas production must bear postproduction costs, the overriding royalty can be free and clear of all postproduction costs and expenses if the parties’ lease expressly states otherwise. The Supreme Court determined that the term “cost-free” in this lease meant to include postproduction expenses.