Cost free royalty clauses are being challenged. A Louisiana federal court has issued a recent opinion that could affect mineral owners' ability to rely on cost-free royalty clauses included in Addendums to lease forms. In Magnolia Point Minerals, LLC v. Chesapeake Louisiana, LP, et. al.,Chesapeake ("CHK") leased Magnolia's 447.7 acre tract in Caddo and Bossier Parishes, Louisiana (links to the opinion and subject lease are below). The lease was a paid up lease form provided by CHK, to which Magnolia made changes and provided its own addendum with 19 additional provisions drafted by Magnolia. The addendum included the standard provision: "The language and terms set forth in this Exhibit shall prevail in the event of a conflict between this Exhibit and the foregoing printed Lease." Also, Magnolia included a cost-free royalty clause in the lease, which stated, "No cost shall be charged or allocated to Lessor's interest except severance and other applicable taxes." The court referred to this as the "no-cost" clause. Magnolia filed suit against CHK and PXP (owner of 20% of the lease) for underpayment of royalty asserting that pursuant to the no-cost royalty clause, CHK could not deduct post-production costs in calculating payments.
Cost-Free Royalty Provision Interpretation
The parties filed competing motions for summary judgment asking the court to interpret the lease and addendum as a matter of law. Under Louisiana law, the purpose of interpreting a contract "is to determine the common intent of the parties." Words of art are to be given their technical meaning, and it is assumed the parties bind themselves to "whatever the law, equity, or usage regards as implied in a contract of that kind or necessary for the contract to achieve its purpose." Further, the contract must be viewed as a whole, with all of its terms given meaning if possible.
The lease form CHK provided established that royalty was to be calculated based on the "market value at the well." This is a term of art in Louisiana (as it is in other jurisdictions, such as Texas). In Louisiana, "market value at the well" is determined using the "reconstruction approach" (a/k/a "net-back" in other states), wherein "market value is reconstructed by beginning with the gross proceeds from the sale of the gas and deducting therefrom any additional costs of taking the gas from the wellhead (the point of production) to the point of sale." The issue was how to construe the market value royalty provision in the form with the no cost clause in the addendum. The court states initially that it appears the two provisions conflict, and, therefore, the addendum and the no cost clause prevail. However, the court holds that its job is not to ignore a provision but to give effect to all, such that if there is a reasonable interpretation that harmozines both the market value and no cost provisions, that interpretation must be adopted.
Having established its intended direction, the court states: "The only way for the Court to rule in Magnolia's favor would be for the undersigned to find that the 'market value at the well' and 'no cost' provisions are in direct conflict; therefore, triggering the application of Paragraph (2) of the Exhibit's language, i.e., the Exhibit trumps the original Lease form. This result would effectively read out, or ignore, the 'market value at the well' provision entirely." On the other hand, the court noted that it would have to ignore the no cost provision to find in favor of CHK. The court blames its apparent predicament on "the imprecise drafting of the specialized language authored by [Magnolia]. . ." The court held that Magnolia is shown to be "a sophisticated landowner in relation to the rights and obligations surrounding mineral leases." In that regard, Magnolia could have deleted the "market value at the well" provision, but did not. The court holds that by including the term "market value at the well," it was the intent of the parties that royalties be calculated based on the reconstruction approach, discussed above. As for the no cost provision, the court states that it "is a broad provision that provides no inkling of the intent behind the provision and its relationship to the contract as a whole." "There is nothing in the 'no cost' provision that shows its intent was to override the 'market value at the well' provision." Accordingly, the court holds that taking the lease as a whole, "the intent found within the four corners of the document can only mean that no further costs can be deducted after the 'market value at the well' has been determined." The court states further that if the no-cost clause was intended to apply to the market value clause, it "should have so stated."
What about the True Intent of the No-Cost Royalty Provision?
At first reading, it could be argued that the court ignored the parties' true intent, which was to give Magnolia a true cost-free royalty. In this regard, it seems the court set forth the parties' intent early on when it says that the market value at the well and no cost provision conflict, and therefore, the no-cost clause prevails, because the addendum contained the standard "in the event of conflict, this addendum prevails" provision. By holding as it did, the court arguably failed to give effect to this latter provision. Moreover, one might pose the question, "What costs would be covered by the no-cost clause as interpreted by the court?" Perhaps another interpretation giving affect to all provisions is that the market value at the well is initially determined using the reconstruction approach, but once so determined, the post-production costs taken into account are then added back in prior to making the royalty payment. Reading more closely, however, it seems clear that Magnolia's problem was it failed to draft the no-cost clause with sufficient specificity.
How To Draft a Cost-Free Royalty Clause
The reconstruction approach, or net-back approach, is used in many states to determine market value, including Texas, Louisiana and Oklahoma. So the question becomes how to draft a true no-cost royalty clause. One simple answer is to not tie the royalty to market value at the well, but rather tie it to the amount realized or proceeds received by the lessee from the first arms-length, non-affiliated sale. Then specifically tie the no-cost clause into the royalty clause, providing that no post-production costs are to be factored in or charged to lessor when calculating lessor's royalty. Alternatively, if the lessee requires "market value at the well" be used, then provide that in the event a net-back or reproduction approach is used to determine market value at the well, once such market value is determined, any post-production costs factored into such determination shall be added back in prior to payment of lessor's royalty. These are just some suggestions.
Ultimately, what this case teaches is that how a particular provision is drafted is extremely important. If the words are unambiguous, they will be construed by a court as a matter of law even if the result does not match what one or both of the parties had in mind at the time they signed the lease. The reason being, when the terms are unambiguous, evidence of one party's intent is not admissible to alter the plain meaning of the unambiguous term, especially if a term of art is involved. For this reason, it is highly recommended that mineral owners engage an oil and gas attorney to assist in the negotiation and drafting of leases, rather than try and tackle the intricacies of drafting particular clauses themselves.
UPDATE
On September 19, 2012, the Court vacated its opinion. Here is a copy of the Court's decision: Order Vacating Ruling.pdf
Ben Elmore
Board Certified in Oil, Gas & Mineral Law by the TX Board of Legal Specialization. He represents mineral owners and companies in all varieties of oil and gas disputes, as well as negotiation of oil and gas leases in Texas in the Eagle Ford Shale, Haynesville Shale and Permian Basin plays.