TX Supreme Court: ORRIs Don’t Automatically Bear Post-Production Costs

In an opinion delivered June 12, 2015, a narrow 5-4 majority of the Texas Supreme Court held that overriding royalty interests (ORRIs) in leases do not always automatically bear a proportionate share of post-production costs, based on the language of a particular oil and gas lease. The Hyder family had been victorious against oil and gas producer Chesapeake Energy at the trial court and appellate court level, and this time was no different. Analysis in the case turned on whether the generally accepted industry-wide model of ORRIs bearing post-production costs was so entrenched as to disincline the court from upsetting the apple cart by concluding that different lease terms can dictate different outcomes; ultimately, the court chose to go with the latter model.

The lease at issue was one signed in 2004 for 948 net mineral acres in the Barnett Shale, and was originally entered into by the Hyders with Four Sevens Oil Company. Four Sevens Oil shortly thereafter assigned the acreage to Chesapeake Energy in 2006. Years later, the Hyders and Chesapeake began to disagree about how post-production costs were being deducted from the Hyder family’s ORRI. Chesapeake contended that the ORRI clause in question – “a perpetual, cost free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production” – allowed them to deduct post-production costs because a cost-free overriding royalty is synonymous industry parlance for an overriding royalty. The Hyders asserted that the “cost-free” language can only be referring to the post-production costs given that ORRIs by their very nature do not bear any other costs.

The court ultimately sided with the Hyders, concluding that the “cost-free” language in the ORRI term at issue did in fact include post-production costs. After the court’s decision in Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996), there was a changing in the oil and gas law tides – leases would be governed by a fair reading of their text and terms on an individual basis, and would not be subsumed by general industry meanings or understandings. The court notes that the lease at issue did disclaim that holding, stating that “Lessors and Lessee agree that the holding in the case of [Heritage] shall have no application to the terms and provisions of this lease.” However, the majority herein clarifies Heritage’s applicability, stating:

Heritage Resources does not suggest, much less hold, that a royalty cannot be made free of postproduction costs…[it] holds only that the effect of a lease is governed by a fair reading of its text. A disclaimer of that holding, like the one in this case, cannot free a royalty of postproduction costs when the lease itself does not do so. Here, the lease text clearly frees the [lease royalty as to gas] of postproduction costs, and reasonably interpreted…does the same for the overriding royalty.” (emphasis supplied).

It is important to appreciate that the Texas Supreme Court has been issuing rulings on a fair number of nuanced oil and gas law cases in the last few decades, many as to lease terminologies. However, it seems that more often than not the court has limited the overall holdings on a case-by-case analysis, and resisted the urge to pontificate broad and sweeping change from the judicial bench. The ORRI provision in the Hyder lease was, as it turns out, written by savvy mineral interest holders who were in an advantageous bargaining position when their lease was signed; it does not represent what most would think of as a “typical” ORRI. This is yet another case demonstrating that the norms of the oil and gas industry are oftentimes not sufficient to overcome specific language in lease terms that can be read to have a different meaning. The moral of the story certainly would be to carefully scrutinize the terms of the lease and don’t assume that ambiguous terms or unusual phrases in the lease will later be defeated in court by the argument of “we believe the term has a generally accepted meaning of  _____ in the industry,” because the lease terms will probably govern.

This write-up is also available on my LinkedIn page under “Posts.”

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