Deduction of Post-Production Transportation Costs from an Overriding Royalty Interest

The San Antonio Court of Appeals Construes "Free-and-Clear" and "Cost-Free" Language in Chesapeake Exploration, LLC v. Hyder.

Determining a royalty interest holder's responsibility for post-production expenses (for example, taxes, treatment costs, and transportation) can be complicated. The general rule is that a royalty interest holder is not responsible for production expenses, but has to pay her share of post-production costs.

Of course, parties are free to modify the default rule by agreement. A recent case from the Fourth Court of Appeals in San Antonio shows that construing such agreements can be a slippery proposition, and that careless drafting can relieve a royalty interest holder of her default responsibilities.

Chesapeake Exploration, LLC v. Hyder involved a royalty clause governing one set of wells and an overriding royalty clause governing another. The first clause contained the following language:

The royalty reserved herein by [Hyder] shall be free and clear of all production and post-production costs and expenses, including but not limited to, production, gathering, separating, storing, dehydrating, compressing, transporting, processing, treating, marketing, delivering, or any other costs and expenses incurred between the wellhead and [Chesapeake Exploration's] point of delivery or sale of such share to a third party.

Chesapeake argued that this clause allowed it to deduct post-production expenses incurred after the point of delivery, but before the point of sale. According to Chesapeake, the "point of delivery or sale" language effectively limited the "free-and-clear" language. Thus, Chesapeake argued, while the clause prevented deducting expenses incurred between the wellhead and delivery, it said nothing about expenses subsequently incurred between delivery and sale.

The court rejected this argument. After observing that a royalty is normally subject to post-production costs, the court noted that the default rule could be modified by agreement and that the parties had effectively done so. Free and clear meant what it said. As a result, Chesapeake could not collect its transportation costs, notwithstanding the apparent ambiguity in the free-and-clear clause and the default rule making transportation expenses deductible.

The second clause gave Hyder "a perpetual cost-free . . . overriding royalty interest." Chesapeake argued that "cost-free" simply referred to the default rule that an overriding royalty is free of production cost and therefore post-production transportation costs were still available.

The court didn't buy this argument either. If "cost-free" only meant "production-cost-free," the language would have been unnecessary. By virtue of being an overriding royalty, the interest was already "production-cost-free," so the cost-free language had to refer to something else. According to the court, that something else was post-production costs.

The Court's ruling left Chesapeake holding the bag for $1.75 million in transportation cost without any help from Hyder. The lesson is clear. Spell out the royalty interest holder's responsibility for transportation costs. Language relieving the royalty owner of her default responsibilities may be broadly construed, so avoid any ambiguities.

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