Drafting Oil and Gas Royalty Provisions; KISS- “Keep it Simple, Stupid!”

The KISS principle that systems perform best with simple rather than complex designscan apply in the world of legal drafting. This lesson was recently learned by lawyers who drafted a complex “work-around” to avoid a judicial interpretation of standard oil and gas lease royalty language on whether post-production costs should be included in the royalty calculation. In Chesapeake Exploration, L.L.C. v. Hyder, 2015 WL 3653446, 58 Tex. Sup. Ct. J. 1182, the Texas Supreme Court rejected the “work-around” language, reaffirming its prior holding that standard gas royalty language has a particular meaning and that attempts to add language to “clarify” the parties intent to alter the language will be deemed “surplusage” and given no effect.

June 12, 2015, Texas Supreme Court addressed whether an overriding royalty (“ORR”) with “cost-free” language should bear postproduction costs. The lease included three royalty provisions: (1) a 25% royalty of the market value at the well of all oil and liquid hydrocarbons; (2) a 25% royalty “of the price actually received by Lessee” on all gas produced and sold or used; and (3) “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5%) of gross production” from directional wells drilled on the leased lands but bottomed on adjacent lands. The gas royalty provision also included additional language that the royalty is to be “free and clear of all production and post production costs and expenses” and listed various examples. The lease contained two other relevant provisions: (1) that the lessor has the continuing right to take the royalty in kind and (2) a disclaimer that “Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996) shall have no application to the terms and provisions of this Lease.”

While the ultimate issue before the Court was the ORR calculation, the Court took the opportunity to weigh in on the gas royalty provision. The Court noted that the royalty provision’s “price actually received” language, which generally creates a “proceeds lease” based on the price-received for calculating royalty payments, was adequate to exempt the lessors from bearing post-production costs and that a royalty does not bear production costs. Therefore, the Court held that the additional language that the royalty “is free and clear of all production and post production costs and expenses” was either meaningless, merely emphasized the cost-free nature of the gas royalty, or “surplusage.” The import of the Court’s dicta (discussion of issues not decided) is that language in a royalty provision is given specific meaning and will be interpreted based on the language that creates the royalty and efforts to clarify the royalty with additional language may be disregarded entirely.

The real issue before the Court was whether the “cost-free” language in the ORR exempted the Hyders from paying their proportionate share of post-production costs. The parties agreed that an ORR is like a landowner’s royalty, i.e., free of production costs but bears post-production costs unless agreed otherwise.

The Hyders argued that the term “cost-free” could only apply to post-production costs because the ORR is already free of production costs. The Court, however, was not persuaded because, like the gas royalty, the term “cost-free” may simply emphasize that the ORR is free of production costs. Chesapeake argued that “cost-free” was a synonym for overriding royalty, citing numerous lease provisions from other cases to support its contention that the phrase “cost-free” could not refer to post-production costs.

The Court held that because the ORR was drafted as an “in kind” royalty to be paid on gross production with the option to take the royalty in cash, the royalty must be calculated on the volume of gas produced at the wellhead. If taken in kind, the Hyders would receive their share of gas free of post-production costs. Accordingly, if the Hyders elected instead to take their ORR in cash, the term “cost-free” must include post-production costs.

While having already resolved the question before it, the Court nonetheless chose to address the Hyders’ last argument that the lease’s disclaimer of any application of Heritage Resources showed an intent that the ORR be free of post-production costs. Heritage Resources involved a gas royalty calculated on “the market value at the well” but also added that there would be “no deductions from the value of the Lessor’s royalty by reason of any” post-production costs. The Heritage Court held that because “market value at the well” is already net of reasonable marketing costs, additional language regarding “no deductions” for post-production costs does not change the meaning of the royalty clause and can only be said to be “surplusage.”

The Court noted that Heritage Resources does not hold that a royalty cannot be free of post-production costs. Rather, Heritage Resources stands for the proposition that a lease’s effect is governed by a fair reading of its text. Accordingly, a disclaimer of Heritage Resources could not free a royalty of post-production costs when the text of the lease did not clearly do so. Thus, the primary take-away point of the Hyder case is that drafters of royalty provisions must be precise in their word choice, ecause courts will construe royalty provisions as drafted according to established industry custom and are not inclined to look to clarifying language that is redundant, emphasizes, or otherwise conflicts with the royalty provisions.