Gordon Potts v. Chesapeake Exploration, L.L

Case: 13-10601 Document: 00512714817 Page: 1 Date Filed: 07/29/2014

IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
United States Court of Appeals
Fifth Circuit

FILED
No. 13-10601 July 29, 2014
Lyle W. Cayce
GORDON POTTS; BRANDY WEST, Clerk

Plaintiffs–Appellants,
v.

CHESAPEAKE EXPLORATION, L.L.C.,

Defendant–Appellee.

Appeal from the United States District Court
for the Northern District of Texas

Before JONES, SMITH, and OWEN, Circuit Judges.
PRISCILLA R. OWEN, Circuit Judge:
The meaning of royalty provisions in an oil and gas lease are in dispute.
Gordon Potts and Brandy West (the lessors) appeal the district court’s grant of
summary judgment in favor of the lessee, Chesapeake Exploration, L.L.C.
(Chesapeake). We affirm.
I
Potts and West are two of the lessors in an oil, gas, and mineral lease in
which Chesapeake is the successor-lessee to FSOC Gas Co., Ltd. (FSOC).
Three paragraphs of the lease are at issue. Paragraph 11 provides in relevant
part:
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
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No. 13-10601
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.
Paragraph 29 contains a “favored nation” provision, which states:
Lessee agrees if Lessee or any of its Working Interest Partners has
agreed to pay or later agrees to pay a higher royalty or bonus
consideration to another landowner, mineral owner or other
parties, (in the same drilling unit, spacing unit or pooled or utilized
land to which the leased lands are included), then Lessee shall pay
to Lessor an amount based on such higher royalty, or bonus
consideration retroactive to the effective date of the Lease(s).
Paragraph 37 provides, in pertinent part:
Payments of royalties to Lessor shall be made monthly and shall
be based on sales of leased substances to unrelated third parties at
prices arrived at through arms length negotiations. Royalties to
Lessor or leased substances not sold in an arms length transaction
shall be determined based on prevailing values at the time in the
area. Lessee shall have the obligation to disclose to Lessor any
information pertinent to this determination.
An affiliate of Chesapeake, Chesapeake Operating, Inc. (COI), operates
the lease on Chesapeake’s behalf. COI, as agent for Chesapeake, sells gas
produced from the lease to Chesapeake Energy Marketing, Inc. (CEMI),
another affiliate of Chesapeake, at the wellhead located on the lessors’
property. CEMI then transports the gas through a gathering system and
resells it to unaffiliated purchasers at gas pipeline hubs that are considerable
distances from the wellhead. The sales to unaffiliated purchasers occur at
delivery points that include the Houston Ship Channel and locations in
Louisiana and Alabama. CEMI pays Chesapeake the weighted average sales
price that CEMI receives when it sells the gas downstream, after deducting
post-production costs that CEMI incurs between the wellhead and the points
at which deliveries to unaffiliated purchasers occur. The royalty that
Chesapeake pays to the lessors is 1/4 of the price it receives from CEMI.

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Potts protested to Chesapeake that his royalty payments were
improperly calculated because post-production costs had been deducted in
arriving at the value on which royalty was based. Potts also questioned
whether Chesapeake had complied with the favored nation clause and
demanded access to Chesapeake’s records. Chesapeake initially agreed that it
should not have deducted post-production costs in calculating royalties and
paid Potts accordingly. However, Chesapeake subsequently changed its
position, asserting that its original concession regarding post-production costs
was a mistake. Chesapeake conceded that it had failed to pay Potts the amount
he was due under the favored nation provision, but in tendering what was owed
under that provision of the lease, Chesapeake withheld the amount it
contended was an “over-payment” of royalties due to post-production costs that
Chesapeake had not, but was entitled to, deduct.
Potts filed suit against Chesapeake in Texas state court, alleging breach
of contract and seeking a declaratory judgment that Chesapeake was not
permitted to deduct post-production costs in calculating royalty. After
Chesapeake removed the case to federal district court on the basis of diversity
jurisdiction, West joined the litigation as a plaintiff. West claimed that
Chesapeake initially paid her royalties without deductions for post-production
costs, but then ceased remitting payments altogether on the ground that she
had been overpaid and Chesapeake was recouping the difference out of future
payments.
The parties filed cross-motions for summary judgment. The district
court granted Chesapeake’s motion and denied that of the lessors. Construing
the lease under Texas law, the court held that Chesapeake was permitted to
calculate “market value at the point of sale” by starting with the market value
received from unaffiliated purchases and subtracting reasonable post-

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No. 13-10601
production costs incurred between the downstream points of sale to
unaffiliated purchasers and the point of sale to CEMI.
The lessors moved for reconsideration, arguing inter alia that because
royalty payments are to be calculated based on sales to unrelated third parties
under paragraph 37 of the lease, the “point of sale” to be considered is the point
at which CEMI sold the gas to unaffiliated purchasers. The district court
denied the motion. The lessors timely appealed.
II
“We review a district court’s grant of summary judgment de novo,
applying the same standard as the district court.” 1 Under that standard,
“[s]ummary judgment is proper ‘if the movant shows that there is no genuine
dispute as to any material fact and the movant is entitled to judgment as a
matter of law.’” 2 “We generally review a decision on a motion to alter or amend
judgment under [Federal Rule of Civil Procedure] 59(e) for abuse of discretion.
To the extent that a ruling was a reconsideration of a question of law, however,
the standard of review is de novo.” 3
III
The parties agree that Texas law applies in construing the lease. 4 Under
Texas law, “[a]n oil and gas lease is a contract, and its terms are interpreted
as such.” 5 The parties further agree that the lease in this case is unambiguous.
“In construing an unambiguous oil and gas lease our task is to ascertain the

1 10 Ring Precision, Inc. v. Jones, 722 F.3d 711, 717 (5th Cir. 2013) (citation omitted).
2 Id. (quoting FED. R. CIV. P. 56(a)).
3 Miller v. BAC Home Loans Servicing, L.P., 726 F.3d 717, 721-22 (5th Cir. 2013)
(citations and internal quotation marks omitted).
4 See Clardy Mfg. Co. v. Marine Midland Bus. Loans Inc., 88 F.3d 347, 352 (5th Cir.
1996) (“We look to state law to provide the rules of contract interpretation.”).
5 Tittizer v. Union Gas Corp., 171 S.W.3d 857, 860 (Tex. 2005) (per curiam).
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No. 13-10601
parties’ intentions as expressed in the lease.” 6 We are to “examine the entire
document and consider each part with every other part so that the effect and
meaning of one part on any other part may be determined.” 7 Additionally,
“[w]e give terms their plain, ordinary, and generally accepted meaning unless
the instrument shows that the parties used them in a technical or different
sense.” 8
A
We begin our analysis of the lease’s provisions with the royalty clause in
paragraph 11. It provides that royalties on gas are “the market value at the
point of sale of 1/4 of the gas sold or used.” This unambiguously requires
Chesapeake to pay 1/4 of the market value of the gas at the point at which
Chesapeake sells the gas. If, as in the present case, the lessee sells the gas at
the wellhead, there generally will be no post-production costs incurred by the
lessee. If the lessee sells the gas downstream from the wellhead, then the
lessee would be required to pay 1/4 of the market value of the gas calculated at
that point of sale and could not deduct post-production costs incurred between
the wellhead and the point of sale.
The lessors contend that there are other provisions in the lease that
modify or override this part of the royalty clause. They rely on the following
language, also found in the royalty clause in paragraph 11 of the lease:
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.

6 Heritage Res., Inc. v. NationsBank, 939 S.W.2d 118, 121 (Tex. 1996).
7 Id.
8 Id.
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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.
The district court correctly concluded that Chesapeake’s calculation of
royalties is consistent with the methodology for calculating market value at
the wellhead explained by the Supreme Court of Texas in Heritage Resources,
Inc. v. NationsBank. 9 In Heritage, the royalties to be paid under the leases
were a percentage of the gas’s “market value at the well.” 10 The leases further
provided that “there shall be no deductions from the value of [the] Lessor’s
royalty by reason of any required processing, cost of dehydration, compression,

9 939 S.W.2d 118 (Tex. 1996).
10 Heritage, 939 S.W.2d at 120-21.
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transportation, or other matter to market such gas.” 11 The Supreme Court of
Texas held that the lessee had not breached the lease in arriving at market
value of gas at the wellhead by deducting post-production transportation costs
from the market value ascertainable at a downstream point. 12 The court
explained, “[t]here are two methods to determine market value at the well.” 13
“The most desirable method is to use comparable sales” at the well. 14 When
information about such sales is not readily available, the market value at the
well is determined by taking the market value of the gas at a point downstream
where sufficient information is available, and then “subtracting reasonable
post-production marketing costs,” such as transportation and processing
expenses. 15 The “no deductions” clause, the court continued, simply “restate[d]
existing law” by providing that the lessors’ royalty, which could be calculated
using the two methods described, may not be further reduced because of
costs. 16
The lessors insist that that the “[n]otwithstanding” sentence is
distinguishable from the “no deductions” clauses at issue in Heritage and
should be given a different meaning. The clauses in Heritage stated that “there
shall be no deductions from the value of [the] Lessor’s royalty by reason of any
required processing, cost of dehydration, compression, transportation, or other
matter to market such gas.” 17

11 Id.
12 Id. at 123-24.
13 Id. at 122.
14 Id.
15 Id.
16 Id.
17 Id. at 120-21.
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The lessors contend that, unlike the clauses at issue in Heritage, a
sentence in their lease provides that all royalties shall be free of all costs. The
lessors argue that the lease does not simply prohibit deductions from a given
value, but provides affirmatively that the royalty may not be “burdened” with
any costs. They maintain that subtracting post-production costs from sales
that occur miles from the wellhead to derive the market value at the point of
sale, in this case the wellhead, burdens the royalty with such costs.
This argument misunderstands Heritage and is mathematically
unsound. The Heritage court held that the “no deductions” clauses were not
in conflict with the royalty provisions. The deduction of post-production costs
incurred between the wellhead and a downstream point at which market value
could be ascertained was nothing more than a method of determining market
value at the well in the absence of comparable sales data at or near the
wellhead. The value of the gas, and therefore the value of the royalty, was not
reduced. As the concurring opinion stated, “[t]he 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.” 18
That reasoning is equally applicable to the clause at issue in this case.
The value of the lessors’ royalty is a percentage of the market value at the point
of sale, which in this case is at the well. A “net-back” method of calculation
does not “burden” or reduce the value of the royalty. 19
B
The lessors contend, however, that the lease prohibits the point of sale
from being at the wellhead if Chesapeake sells the gas to an affiliated entity.

18 Id. at 130 (Owen, J., concurring).
19 See also Warren v. Chesapeake Exploration, L.L.C., No.13-10619, 2014 WL 3511880,
at *3 (5th Cir. 2014).
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The lessors rely on paragraph 37 of the lease, which requires that royalty
payments be “based on sales . . . to unrelated third parties at prices arrived at
through arms length negotiations.”
Chesapeake argues that the lessors waived their reliance on paragraph
37 by failing to raise the issue in the district court until the lessors’ motion for
reconsideration. Even if the lessors preserved their reliance on paragraph 37,
a question that we do not reach, it does not support their position. Paragraph
37 says, in pertinent part:
Payments of royalties to Lessor shall be made monthly and shall
be based on sales of leased substances to unrelated third parties at
prices arrived at through arms length negotiations. Royalties to
Lessor or leased substances not sold in an arms length transaction
shall be determined based on prevailing values at the time in the
area. Lessee shall have the obligation to disclose to Lessor any
information pertinent to this determination.
This section of the lease specifically contemplates that if the lessee sells
the gas to an affiliate, the royalty shall “be determined based on prevailing
values at the time in the area.” Paragraph 37 does not require the point of sale
to be the point at which the gas is ultimately sold to a non-affiliated entity.
The lessors argue that construing “point of sale” as the point where
Chesapeake sells the gas to CEMI would frustrate the parties’ expectations
and their reliance on the concurring opinion in Heritage. They rely on the
following passage from the concurring opinion:
There are any number of ways the parties could have provided that
the lessee was to bear all costs of marketing the gas. If they had
intended that the royalty owners would receive royalty based on
the market value at the point of delivery or sale, they could have
said so. 20

20 Heritage, 939 S.W.2d at 131 (Owen, J., concurring) (emphasis in original).
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The concurring opinion emphasized that the parties to a lease “may allocate
costs . . . as they choose” and that courts must examine the specific language
chosen in order to “determine how . . . costs were allocated under [the]
particular leases” at issue. 21 In this case, the language of the lease, including
paragraph 37, make clear that the royalty due the lessors is a percentage of
the market value of the gas at the point at which the lessee sells the gas. As
discussed above, had Chesapeake sold the gas at a point downstream from the
wellhead, then the royalty would be 1/4 of the market value of the gas at that
point. Post-production cost incurred between the wellhead and the point of
sale could not be deducted in arriving at the market value at the point of sale
under either the “1/4” royalty sentence in the royalty clause of paragraph 11,
or any other provision in the lease. But Chesapeake has sold the gas at the
wellhead. That is the point of sale at which market value must be calculated
under the terms of the lessors’ lease.
C
The lessors contend that the district court erred by relying on Heritage,
asserting that the case has limited precedential value. They note that after
the opinion in Heritage issued, one of the Justices who had joined the majority
opinion recused himself. The other members of the Supreme Court of Texas
split 4-4 in ruling on a motion for rehearing. An opinion dissenting from the
denial of rehearing reflects that two of the Justices who had originally joined
the majority opinion had changed position and had expressed their agreement
with the original dissenting opinion. 22 The lessors argue that the Texas court

21 Id. at 124.
22 See Heritage Res., Inc. v. NationsBank, 960 S.W.2d 619, 619 (Tex. 1997).
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was thus without a majority that agreed on the reasons supporting the
judgment in Heritage.
Because rehearing was denied, the court’s opinion in Heritage was not
withdrawn. The Texas court’s decision in Heritage remains binding law, as the
numerous cases from both the Supreme Court of Texas and this court citing
that decision demonstrate. 23
* * *
For the foregoing reasons, the judgment of the district court is
AFFIRMED.

23See, e.g., Ramming v. Natural Gas Pipeline Co. of Am., 390 F.3d 366, 372 (5th Cir.
2004); El Paso Field Servs., L.P. v. Mastec N. Am., Inc., 389 S.W.3d 802, 808 (Tex. 2012);
Union Pac. Res. Grp., Inc. v. Hankins, 111 S.W.3d 69, 71 (Tex. 2003).
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