“Free of All Costs and Expenses” Clause in Lease Applies If No Costs Exist

The Fifth Circuit’s ruling in Potts v. Chesapeake Exploration, L.L.C. is a significant win for oil and gas lessees in Texas. The crux of the dispute involved the interpretation of the royalty clause in an oil, gas, and mineral lease between Chesapeake, lessee, and Potts, lessor. In this dispute, Potts contended that Chesapeake breached the lease by improperly deducting costs and expenses from his royalty payments because the royalty clause contained a no-deduct provision, which meant his royalty payments were to be free and clear of all post-production costs and expenses.

The key part of the royalty clause in Paragraph 11 of the lease provided, in pertinent part, as follows:

The royalties to be paid by Lessee are: … on gas … the market value at the point of sale of 1/4 of the gas sold or used…. Notwithstanding anything to the contrary herein contained, all royalty paid to Lessor shall be free of all costs and expenses related to the exploration, production and marketing of oil and gas production from the lease including, but not limited to, costs of compression, dehydration, treatment and transportation. (Emphasis added)

Chesapeake argued that it had complied with its obligations under the royalty clause and that it deducted no expenses attributable to Potts’ royalty payment from the time the gas was produced at the well until the first sale. Although Chesapeake purported to sell the gas at the wellhead, it arrived at the value of gas by calculating the value of the downstream market-based sale and then subtracting the compression, dehydration, treatment and transportation costs and expenses incurred between the point of sale and the downstream resale point. Chesapeake contended that the “point of sale” or at the “well head” meant the point where there was a transfer of title in an arm’s length transaction, to a Non-Chesapeake affiliate, in exchange for compensation. Chesapeake argued this was an approved method to determine market value at the point of sale and therefore it did not breach the Lease.

The Fifth Circuit agreed with Chesapeake despite Potts’ argument that “free of all costs and expenses” meant that Chesapeake could not deduct expenses it incurred in getting the gas to the market for sale to independent, unrelated third party parties at distant locations far downstream. The Court held that that Chesapeake’s calculation of royalties was consistent with the methodology for calculating market value at the wellhead explained by the Supreme Court of Texas in Heritage Resources, Inc. v. NationsBank.

Lessees should take special note of the following analysis from the Fifth Circuit:

The above-quoted language directs that “royalty” is to be “free of all costs and expenses related to the exploration, production and marketing of” gas “including, but not limited to, costs of compression, dehydration, treatment and transportation.” As discussed above, when gas is sold at the wellhead, there are typically no costs of compression, dehydration, treatment or transportation. When there are no such costs at the wellhead, the market value at the wellhead is “free of all costs and expenses,” as contemplated by the above-quoted paragraph, and there is nothing in the royalty clause “contrary” to the “[n]otwithstanding” sentence. If the gas is sold by the lessee downstream of the wellhead, then both the sentence providing for a 1/4 royalty and the “[n]otwithstanding” sentence contemplate that costs incurred by the lessee between the point of production and the point of sale are to be borne by the lessee. Since it is undisputed that gas sales by Chesapeake have occurred at the wellhead, and since the lessors do not contend that the sales to unaffiliated purchasers were at less than market value, Chesapeake could arrive at the market value at the wellhead by deducting reasonable post-production costs to deliver the gas from the wellhead to the point at which the gas was sold to unaffiliated purchasers. (emphasis added)

This case is Potts v. Chesapeake Exploration, L.L.C., 13-10601, 2014 WL 3732641 (5th Cir. July 29, 2014).