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Appeals court sides with Chesapeake on royalties

Max B. Baker | The Fort Worth Star-Telegram

Barnett Shale landowners fighting to keep Chesapeake Energy from deducting post-production costs from their royalty checks were dealt a potentially serious blow by two recent federal appeals court decisions, which stated that the gas-drilling giant is allowed to do so under the terms of their leases.

The 5th U.S. Circuit Court of Appeals in New Orleans said Chesapeake can subtract costs in two cases stemming from disputes over royalties on leases in Tarrant and Johnson counties. One of the lawsuits involved two individual leases, while the other case was seeking to initiate class-action litigation.

While a federal court’s ruling technically is not binding on state district court judges presiding over similar lawsuits, attorneys say the decisions by the three-judge panel may be influential since they based their opinions on a crucial Texas Supreme Court decision from almost 20 years ago.

“It really hurts the ability to have one of these cases,” said Robert O’Boyle, the Austin attorney representing landowners in one of the cases. “They [the federal judges] don’t care how hard [landowners] tried to contract around this. Big oil wins.”

Robert Aldrich, an attorney involved in the other case before the court, said the appeals court ruling may not be binding on state courts, but said of its impact on other cases: “It’s not good.”

Barry Barnett, a Dallas attorney with Susman Godfrey, said he respectfully disagrees with the court and thought some of the disputed leases in the two cases made it clear that post-production charges were prohibited.

“It is not the last word [in state court cases]. The Supreme Court of Texas will have to deal with it,” said Barnett. “But, in the meantime, it is a setback for royalty owners.”

A Chesapeake spokesman declined to comment on the 5th Circuit’s ruling, but Friday the company filed a response to the city of Fort Worth’s lawsuit against Chesapeake pointing out how its arguments had prevailed in the federal appeals court.

Ralph Duggins, an attorney at Cantey Hanger who is representing the city of Fort Worth and others in lawsuits that accuse Chesapeake of improperly deducting costs and selling gas to affiliates at below-market prices, said their case is different.

He said the city’s lease expressly forbids calculation of royalties based upon sales to affiliates. Duggins also stressed that the 5th Circuit points out in one of the rulings that each lease is different.

“We think the city has a rock-solid claim,” Duggins said. “The rulings by the Fifth Circuit have no application to the city’s leases because the terms are substantially different.”

Change in lease policy

Chesapeake, the second-largest producer in the Barnett Shale, aggressively leased millions of acres in the past decade. But as gas prices dropped, it sharply scaled back its North Texas drilling to focus on more-profitable fields in other parts of Texas and around the country.

It also began to rethink how it viewed contract language that many of those who signed leases during the boom times believed barred the gas producer from deducting any post-production costs from their royalty payments.

While Chesapeake initially took the same view, starting in late 2011 it sent letters to leaseholders saying it would begin deducting costs necessary to get the gas to market — processes such as compression, dehydration and transportation.

This gave leaseholders — individuals with holdings as small as their homes as well as large-scale landholders such as members of the Bass family — gas. Some of the landowners saw their royalty payments suddenly plummet.

Since then, Chesapeake has been sued numerous times. In just the past year, the city of Arlington, along with the Arlington and Fort Worth school districts and the Fort Worth Housing Authority, have filed lawsuits claiming that the post-production costs have been improperly deducted, with millions of dollars at stake.

A ruling on a portion of the city of Fort Worth’s lawsuit — a summary judgment request before state District Judge David Evans that Chesapeake may not use affiliate sales to calculate royalties or avoid its commitment to bare post-production costs — could come as early as this week.

Into that gaseous mix comes the latest rulings from the federal appeals court in New Orleans.

Related: Michigan AG charges Chesapeake with racketeering and fraud

The case drawing the most attention was filed by Gordon Potts and Brandy West regarding about 136 acres in Johnson and Tarrant counties. Potts and West signed leases with FSOC Gas Co. in 2005. Those leases were eventually taken over by Chesapeake.

Chesapeake, under a practice it commonly uses in the Barnett Shale, relied on a chain of affiliates and subsidiaries to drill, market, sell and calculate the royalties on the gas production. But it determined the initial market value of the gas, for the purpose of the lease, at the well head.

But the gas price Chesapeake eventually used to calculate the royalty payment to land owners is what is known as the “weighted average sales price” paid by an unaffiliated third-party — less the post-production costs incurred in moving the gas from its wellhead sales point to that point of sale.

Potts and West contended that Chesapeake improperly sold and calculated their royalties through its sales to affiliates, saying their payments should rely on what the true, third-party buyer paid for the gas without subtracting post-production costs.

Initially, Chesapeake agreed and paid Potts about $213,000 in 2011. But later, using its new system of calculating royalties, the company sent Potts a check in May 2012 for about $43,000 that it said reflected the amount of overpayment.

West had a similar experience. Originally, Chesapeake said it owed her $34,000. But later, after the company began reworking its lease payments, Chesapeake said that she had a negative balance of $49,000, which meant that she would not receive a royalty check.

In the other case, two brothers who live Dallas County — Charlie and Robert Warren — and a couple from Crowley — Abdul and Joan Javeed — joined together in an attempted class-action lawsuit against Chesapeake because it had 300 leases in the area consisting of more than 1,000 wells.

The Warrens and Javeeds, smaller leaseholders in Johnson and Tarrant counties, questioned Chesapeake’s methods when they noticed their checks were significantly smaller than those from XTO Energy, which did not deduct post-production costs, O’Boyle said.

In May 2013, U.S. district judges Reed O’Connor and Barbara Lynn dismissed the Potts and Warren cases, which allowed Chesapeake to continue deducting the post-production costs.

The 5th Circuit ruled on the Warren case July 16 and the Potts case Tuesday. In both cases, the court upheld the dismissals and applied the Texas Supreme Court ruling known as Heritage Resources vs Nationsbank that allows subtraction of post-production costs since the gas’ initial market value is being set at the wellhead.

Appeals Court Judge Priscilla Owen — who as a Texas Supreme Court justice concurred with the Heritage case — served on the panel in New Orleans. In the Potts case, the court said that the deduction of post-production costs incurred between the wellhead and a downstream point was nothing more “then a method of determining market value. …”

“The value of the gas, and therefore the value of the royalty, was not reduced,” the panel wrote.

Aldrich said he will seek a rehearing of the Potts case before the entire appeals court while O’Boyle said his clients won’t appeal the court’s decision.

‘Economic reality’

John McFarland, an Austin oil and gas attorney who has written extensively on the lease disputes, said it is possible that no judge will ever be able to stop Chesapeake from deducting post-production costs.

“Until a court rules this whole structure is a sham … they will continue to do this,” said McFarland, who writes the Oil and Gas Lawyer Blog. “I don’t know if a court will ever rule that.”

Aldrich said the appeals court ruling pushed the arguments in Heritage — the idea that gas companies can pass along post-production charges — to a whole other level.

“Heritage drove that notion to the abyss, and the Potts decision drives it over the edge of that abyss,” he said.

O’Boyle said state court judges don’t have to follow the appeals court ruling. While it could have an influence, it is not precedential. “Texas courts get to decide Texas law,” he said.

Dan McDonald, a Fort Worth attorney recruiting landowners in preparation of filing thousands of individual lawsuits against Chesapeake over the same royalty payment issue, said arguing that no costs can be subtracted at all may be a nonstarter.

The court’s decision “suggests that is a tougher row to hoe,” McDonald said.

But Harper Estes, a Midland oil and gas attorney, said the appeals court decision could carry some weight in state court since it follows the reasoning in Heritage so closely, a case that recognizes the “economic reality of how gas is produced and sold.”

“It could be very persuasive,” said Estes, who is a former State Bar of Texas president. “It appears to be the Fifth Circuit’s attempt to follow what they think Texas law ought to be.”


Max B. Baker, 817-390-7714 Twitter: @MaxBBaker