Lead Opinion
delivered, the opinion of the Court, in which
We deny the motion for rehearing. We withdraw our opinion of June 12, 2015, and substitute the following in its placel'
Generally, speaking, an overriding royalty on oil and gas production is free of production costs but must bear its share of postproduction costs unless the parties agree otherwise.- The only question in this case is whether the parties’ lease expresses a different agreement. We conclude it does and therefore affirm the court of appeals’ 'judgment.
The Hyder family leased 948 mineral acres in the Barnett Shale.
The lease contains three royalty provisions. One is for 25% of “the market value at the well of all oil and other liquid hydrocarbons”. No oil is produced from the lease. Another . royalty is for 25% “of the price actually received by Lessee” for all gas produced from the leased premises and sold or used.
The Hyders and Chesapeake agree that the overriding royalty is free of production costs; they dispute whether it- is also free of postproduction costs. There are twenty-nine producing gas wells on the leased or pooled land, seven of which are directional wells bottomed on and producing from lands not subject to the lease. Chesapeake sells all the gas produced to an affiliate, Chesapeake Energy Marketing, Inc. (“Marketing”), which then gathers and transports the gas through both affiliated and interstate pipelines for sale to third-party purchasers in distant markets. Marketing pays Chesapeake a “gas purchase price” for volumes determined at the wellhead or — during earlier periods — 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 (the “gas sales price”) less postproduction costs.
After a bench trial, the trial court rendered judgment for the Hyders, awarding them $575,359*90. in postproduction costs that Chesapeake wrongfully deducted from their overriding royalty. The court of appeals affirmed.
In Heritage Resources, Inc. v. Na-tionsBank, we noted that a royalty is free of production expenses but “usually subject to post-production costs, including taxes ... and transportation costs.”
Two of the royalty provisions in the Hyder-Chesapeake lease are clear. ..The oil royalty bears postproduction costs because it is paid on the market value of the oil at the well.
The gas royalty in the lease does not bear postproduction costs because it is based on the price Chesapeake actually receives for the gas through its affiliate, Marketing, after postproduction costs have been paid.
The overriding royalty in the Hy-der-Chesapeake lease is not as clear as either of the other two royalty provisions. The Hyders argue that the requirement that the overriding royalty be “cost-free” can only refer to postproduction costs, since the royalty is by nature already free of production costs without saying so. But as with the gas royalty, “cost-free” may simply emphasize that the overriding roy
The exception for production taxes, which we have said are postproduction expenses,
We thus disagree with the Hyders that “cost-free” in the Hyder-Chesapeake overriding royalty provision cannot refer to production costs. As noted above, drafters frequently specify that an overriding royalty does not bear production costs even though an overriding royalty is already free of production costs simply because it is a royalty interest.
Chesapeake argues 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 bears postproduction costs. “Gross” means “[u]ndiminished by deduction; entire”.
Chesapeake argues that the gas royalty provision shows that when the parties wanted a postproduction-cost-free royalty, they were much more specific. But as we have already said, the additional detail in the gas royalty provision serves only, if anything, to emphasize its cost-free nature. The simple “cost-free” requirement of the overriding royalty achieves the same end.
The overriding royalty provision reads as though the royalty is in kind, but Chesapeake does not argue that it must be, and in fact the royalty has always been paid in cash., Were the Hyders to take their overriding royalty in kind, as they are entitled to do, they might use the gas on the property, transport it themselves to a buyer, or pay a third party to transport the gas to market as they might negotiate. In any event, the Hyders might or might not incur postproduction costs equal to those charged by Marketing. The lease gives them that choice. The same would be true of the gas royalty, which is to be paid in cash but can be, taken in kind. The fact that the Hyders might or might not be subject to postproduction costs by taking the gas in kind, does not suggest-that, they must be subject - to those costs when the royalty is paid in cash. The choice of how to take their, .royalty, and -the consequences, are left to the Hyders. Accordingly, we conclude that -“cost-tree” in the overriding, royalty provision includes post-production costs.
The Hyders offer another reason for our conclusion. They argue that the' lease’s disclaimer of any application Of the holding of Heritage Resources shows that the parties intended'an overriding royalty free of postproduction costs. That case involved royalty provisions based on the market value of gas at the well with “no deductions from the value of the Lessor’s royalty ■by reason of. any” .postproduction costs.
There is little doubt that at least some of the parties to these agreements subjectively intended the phrase at issue to have meaning. However, the use of the words “deductions from the value of Lessor’s royalty” is circular in light of this and other courts’ interpretation of “market value at the well.” The concept of “deductions” of marketing costs from the value of the gas is meaningless when gas is valued at the well. Value at the well is already net .of reasonable marketing costs. The value of gas “at the well” represents its value in the. marketplace .at any given point of sale, less the reasonable cost to get the gas to that point of sale, including compression, transportation, and processing costs. Evidence of market value is often comparable sales, as the Court indicates, or value can be proven by the so-called net-back approach, which determines the prevailing market price at a given point and backs out the necessary, reasonable costs between that point and the wellhead. But, regardless of how value is proven in a court of law, logic and economics tell us that there are no marketing costs to “deduct” from value at the wellhead.
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As long as “market value at the well” is the benchmark for valuing the gas, a phrase prohibiting the deduction of post-production costs from that value does not change the meaning of the royalty clause.... All costs would already be borne by the lessee. ■ It- could not be said under that circumstance that the clause is ambiguous. It could only be said that the proviso is surplusage.26
Market value, if calculated without reference to factors necessary to that determination, is not market value.
Heritage Resources does not suggest, much less hold, that a royalty cannot be made free of postproduction costs. Heritage Resources 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 text of the lease itself does not do so. Here, the lease text clearly frees the gas royalty of post-production costs, and reasonably interpreted, we conclude, does the same for the overriding royalty. The disclaimer of Heritage Resources’ holding does not influence our conclusion.
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The court of appeals’ judgment is affirmed.
.
. The Hyder respondents include Martha Rowan Hyder, individually and .as independent executrix and trustee under the Will of Elton M. Hyder Jr„ deceased, as trustee under the Elton M," Hyder Jr. Residuary Trust, and as trustee of the Elton M. Hyder Jr. Marital Trust; Brent Rowan Hyder, individually and as trustee of the Charles Hyder Trust and as trustee of the Geoffrey Hyder Trust; Whitney Hyder More, individually and as trustee of the Elton Matthew Hyder IV Trust, as trustee of the Peter Rowan More Trust, as trustee of the Lili Lowdon Hyder Trust, and as trustee of the Samuel Douglas More Trust; and Hyder Minerals, Ltd. We refer to the lessors as the Hyders.
. Petitioners are Chesapeake Exploration, L.L.C., and an affiliate that acts as its agent for all natural gas operations on the property, Chesapeake Operating, Inc. We refer to them .. collectively as Chesapeake.
. The lease provides that this royalty is “for natural gas,, including casinghead gas and other gaseous substances produced from the Leased Premises and sold or used on or off the Leased Premises” and that ‘‘[i]n no event shall the volume of gas used to calculate Lessors’ royalty be reduced for gas used by Lessee. as fuel for lease operations or for compression or dehydration of gas.”
.The lease states that "Lessee shall, within sixty (60) days from the date of first production from each [directional] well, convey to Lessors” the overriding royalty. The parties treat this royalty provisión like a conveyance, and so do we. Only two of the respondents, Brent Rowan Hyder and Whitnéy Hyder More, are alleged to own overriding royalties. Because all respondents join in the arguments made here, we refer to the overriding royalties as due to the Hyders.
. Marketing deducts, as postproduction costs, gathering and transportation costs and a 3% marketing fee.
. 427 S,W.3d 472 (Tex.App.-San Antonio 2014).
. 58 Tex. Sup.Ct. J. 227 (Jan. 30, 2015). ,
.
. Heritage Res.,
. MacDonald v. Follett,
. See Paradigm. Oil, Inc. v. Retamco Operating, Inc.,
. See Heritage Res.,
. See Heritage Res.,
. Id.
. Having lost on the issue in the court of appeals, 427 S,W.3d 472, 482, Chesapeake does not dispute in this Court that "the price actually received by the Lessee” for purposes of the gas royalty is the gas sales price its affiliate, Marketing, received, nor do the Hy-ders argue that the gas sales price was unfair. Cf. Phillips Petroleum Co. v. Yarbrough,
. The court of appeals reasoned otherwise, relying on the "free and clear.” language to conclude that both the oil and gas royalties are free of postproduction costs.
. See, e.g., McMahon v. Christmann,
. Heritage Res.,
. See, e.g., Martin v. Glass,
. See supra n.19.
. Black's Law Dictionary 818 (10th ed.2014).
. Heritage Res., 939 S.W.2d at 120-121.
. 'Justice Baker initially delivered the opinion for the Court, joined, by Chief Justice Phillips, Justice Cornyn, Justice Enoch, and Justice Spector. Id. at 120. Justice Owen, joined by then-Justice Hecht, concurred in the judgment. Id. at 124. Justice Gonzalez, joined by Justice Abbott, dissented. Id. at 131. On rehearing, Chief Justice Phillips joined Justice Owen, Justice Cornyn and Justice Spectot joined Justice Gonzalez, and Justice Enoch recused himself.
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Dissenting Opinion
I withdraw my June 12, 2015 dissenting opinion and substitute the following in its place.
I disagree with the Court that the overriding royalty clause expresses an intent to modify the default rule that such an interest bears post-production costs. I would reverse the court of appeals and hold that Chesapeake’s deduction of post-production costs was proper. I respectfully dissent.
The disputed clause gives the Hyders a “cost-free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production obtained from each [directionally drilled] well.” This Court has held that “[a]n overriding royalty is an interest in the oil and gas produced at the surface, free of the expense of production.” Paradigm Oil, Inc. v. Retamco Operating, Inc.,
I agree with the Court that the measure of the overriding royalty here — “gross production obtained from each such well”— refers to the total volume of minerals extracted from the ground before any are used to fuel production or transportation or are lost en route to market. Exxon Corp. v. Middleton,
By contrast, the Hyders’ gas royalty is “twenty-five percent (25%) of the price actually received” upon resale by Chesapeake. That price necessarily reflects any post-production value added, and the Court rightly observes it thus does not bear post-production costs. See ante at 871; cf. Judice v. Mewbourne Oil Co.,
Post-production activities will add value to the Hyders’ overriding royalty — their share of minerals produced from the directional wells — but they have not yet done so at the time of production. Though the overriding royalty may not have been expressed using the familiar market-value-at-the-well • language, I read its value as being just that. Cf. Heritage,
I further disagree that whether the Hy-ders accept cash rather than their share of production in kind should affect that value. Had they taken the actual gas as it was produced, they certainly would incur post-production and transportation costs in marketing the gas. They could, of course, also use that gas on the property for whatever purpose they found useful. But the manner in which they accept their royalty should not determine the value they receive. That Chesapeake undertook to market the gas should not saddle Chesapeake with post-production costs or entitle the Hyders to more than the royalty for which they bargained.
Likewise, I think the “cost-free” designation should not operate to add value to the Hyders’ overriding royalty, and I disagree with the Court that it expresses an
The Court points out that the ¡disputed clause excepts from the “cost-free” designation the Hyders’ share of production taxes, which — everyone knows — are actually post-production- costs. See ante at 874. From this, the Court reasons that “cost-free” must cover post-production costs, otherwise there would be nothing to except. See ante at 874. This logic rests on the assumption that the parties, no doubt in studied fidelity, to our precedents, considered production taxes to be post-production costs. ■
It is true that we have, on occasion, generally categorized taxes as a post-production cost. See Heritage,
Moreover, as the Court recognizes, parties often allocate tax liability on the royalty owner while at the same time specifically emphasizing that the royalty is free from production costs. See, e.g., Martin,
In addition to Heritage, the Court cites section 201.205 of the Tax Code in support of its view that production taxes are' post-production costs. See ante at 874 n.20. Section 201.205 provides that production taxes “shall be borne ratably by all interested parties, including royalty interests.” The Court presumably believes this statute negates the argument that production taxes can .be considered a production cost. If an overriding-royalty interest is free of post-production costs but shares in the production tax, the argument goes, the production tax cannot be a production cost.
Two problems arise. First, a statutory provision requiring that a royalty interest bear its share of production taxes does not morph a production cost into a post-production cost. Instead, it simply .creates a statutory exception to the common-law default rule that an overriding-royalty interest is free of production costs. Second, the pro-rata nature of production taxes only bolsters the reading that “cost-free” does not refer to post-production costs. The clause grants Hyder a “cost-free (except only its portion of production taxes) overriding royalty.” (emphasis added). The clause does not require Hyder to pay all production taxes, but rather appears to be written with an awareness of the pro-rata scheme imposed by statute. What follows is a much easier reading than the Court’s construction: the parties intended “cost-free” to emphasize the default rule that Hyder’s royalty interest is free of production costs but; sensibly assuming production taxes might be production costs, clarified that Hyder was not relieved of his statutory share of the production-tax burden. .
As recognized in Heritage, royalty clauses that purport to modify a royalty valued at the well are inherently problematic.
Where the overriding royalty interest is merely “cost-free,” the 25% oil-and-gas royalty is specified as being:
free and dear 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 Lessee’s point of delivery or sale of such share to a third party.
(emphasis added). The Court touches on the interpretive issues this language presents. Because the gas royalty is valued by sale price after post-production value has already been added, the Court deems the language ineffective and suggésts it is sur-plusage or it at most emphasizes the cost-free nature of the gas royalty.- Ante at 873. I agree. Application to the oil royalty, defined as “twenty-five percent (25%) of the market value at the well,” is no less problematic.. As Heritage illustrates, a market-value-at-the-well royalty is calculated by deducting post-production costs, and a court may have difficulty giving effect to. language that may be read as intent to free the royalty from those costs. While the “free and clear” language here may seem to express intent that both royalties do not bear post-production- costs, giving.it that effect- is logically difficult.
■We are not asked to resolve these interpretive issues. But the vast difference between the royalty and overriding royalty clauses drills home my interpretation of the latter. If the extensive,. specific, and detailed “free and clear”.language should be read as only emphatic or surplusage, so should the mere “cost-free” designation. If the “free and .clear” language expresses intent to modify the market-value-at-the-well oil royalty so that it does not bear post-production costs, the mere “cost-free” adjective cannot express the same intent as to the overriding royalty.
For the same reasons, I disagree with the Hyders: that the Heritage disclaimer requires a broad ■ construction ■ of “cost-free.” Where the oil-and-gas royalty’s extensive “free and clear” language resembles the language interpreted in Heritage, the overriding royalty’s language does not. Where the “no deductions” language in Heritage was meaningless and ineffective, I read “cost-free” as redundant but not meaningless. And though the disclaimer expressly extends to-“the terms and provisions of this Lease,” its location in the oil- and-gas-royalty clause highlights that it is intended to support the “free and clear” language, not to give the simple “cost-free” designation any additional meaning.
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Parties are free to allocate post-production costs as they wish, and “[o]ur task is to determine how those costs were allocated under [this] particular lease[].” Heritage,
JUSTICE WILLETT, JUSTICE GUZMAN, and JÚSTICE LEHRMANN, dissenting.