The Texas Supreme Court ruled in Chesapeake Exploration, LLC v. Hyder that an overriding royalty was not subject to postproduction expenses. 2015 WL 3653446 (Tex. June 12, 2015). An overriding royalty under Texas law is “a given percentage of the gross production carved from the working interest but, by agreement, not chargeable with any of the expenses of operation.” While an overriding royalty is usually free of production expenses under Texas law, it is usually subject to postproduction expenses. But, according to the 5-4 majority, the terms of the Hyder lease freed the overriding royalty from postproduction expenses.
The Hyder lease contained “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production obtained” from certain wells. The parties agreed that the overriding royalty was free of production costs, but disputed whether it was free of postproduction costs (e.g., gathering, transportation, and marketing costs). Chesapeake argued that the phrase “cost-free overriding royalty” was just a synonym for “overriding royalty,” so that the phrase “cost-free” was redundant surplusage that emphasized that the overriding royalty was free of production costs. But the court disagreed, and found that the phrase “cost-free” referred to postproduction costs, with the noted exception for “its portion of production taxes” (which are postproduction costs).
The Hyder lease also contained the following disclaimer: “Lessors and Lessee agree that the holding in the case of Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996) shall have no application to the terms and provisions of this Lease.” The Heritage case concluded that a “no deductions” phrase in a lease did not free an overriding royalty of postproduction costs. So a disclaimer of that holding, according to the Hyders, showed that the parties intended for the overriding royalty to be free of postproduction costs. But, according to the court, the Heritage case held “only that the effect of a lease is governed by a fair reading of its text. A disclaimer of that holding . . . cannot free a royalty of postproduction costs when the text of the lease itself does not do so.” So the Hyder court did not rely on the Heritage disclaimer in reaching its conclusion.
Hyder highlights the importance of carefully drafting contract terms in oil and gas leases. While Texas law provides default rules for certain industry terms, the parties may modify those default rules by expressing an intent to do so. According to the majority, the Hyder lease did just that, so Chesapeake could not deduct postproduction expenses from the overriding royalty.