Chesapeake squeezes landowners on costs amid cash crunch

STORY

Donna Thornton made sure to include a no-cost provision in her contract with Chesapeake Energy Corp. (CHK) that let the driller harvest natural gas beneath 2.5 acres of her property in Louisiana.

Thinking she had excluded production and marketing expenses and would therefore secure higher royalty payments, the Texas accountant said she was shocked when she confirmed in July that the second-biggest U.S. gas producer was passing costs on to her. For Thornton and thousands more owners of mineral rights in the U.S., “no-costs” in drilling leases has taken on new meaning.

As gas prices were heading toward a 10-year low in April, Chesapeake began reinterpreting in its favor thousands of contracts with landowners from Pennsylvania to Texas that own the 1 trillion cubic feet of gas the company produced last year, according to interviews and documents reviewed by Bloomberg. Chesapeake, arguing that other contract language allows for cost deductions, is fighting more than a dozen lawsuits.

“I don’t want to sound like I’m a bitter, disgruntled royalty owner, but this isn’t fair,” Thornton said. “Don’t do sneaky tricks. If it belongs to the royalty owners, it belongs to the royalty owners.”

While Thornton hasn’t sued, saying she is dissuaded by the potential hassle and cost, other property owners have taken Oklahoma City-based Chesapeake to court in states including Texas, Arkansas, Oklahoma, Louisiana and Kansas alleging underpayment of royalties. The lawsuits include at least eight cases brought so far this year, two of which were filed as class actions seeking to represent multiple royalty owners.

Standard Practice

Legal battles over royalty payments on oil and gas production are as old as the industry itself, said Anthony Sabino, a law professor at St. John’s University in New York who specializes in complex litigation and oil-and-gas law. Producers such as Chesapeake have been motivated to minimize royalty payments as profits have been pinched by falling gas prices that remain 30 percent lower than two years ago.

Litigation may increase as lower gas prices — and royalty checks — lead landowners to scrutinize their contract terms and any deductions to cover the cost to bring gas to market, said Dana Kirk, a Houston-based attorney who has represented dozens of royalty owners.

“The tide goes in and out, depending on the overall economy and the specific economic prospects of the parties,” Sabino said. “Companies that are under heavy financial stress are more likely to push the envelope. Even the most honest companies, when prices and profits are dropping, will look to save money.”

Declining Value

Chesapeake lost about $9 billion in market value in the past year. Chief Executive Officer Aubrey McClendon was stripped of his chairman’s title in June amid investigations into conflicts of interest between his personal financial dealings and his management duties. Michael Kehs, a company spokesman, declined to comment on the investigations.

Chesapeake follows all state laws and contractual lease terms in compensating leaseholders, and the company has paid more in lease bonuses and royalties than any other exploration and production company, Kehs said in an e-mail message. The company, which reported $12.4 billion in revenue last year, has paid $25 billion in royalties and lease bonuses to landowners in the past 12 years, Kehs said. It has contracts to drill on more than 15 million acres in the U.S.

“The current price environment for natural gas is challenging for producers and royalty owners alike,” Kehs said. “When natural gas prices move higher, royalty owners should receive higher royalties.”

Different Approaches

Gas producers have taken different approaches to expense deductions, at times abiding by no-cost provisions, and in other cases contending the provisions are nullified by other language in the contract, or by state law.

Chesapeake argued successfully this year to a Louisiana federal court that a provision to pay royalties on “market value” of the gas allowed it to deduct costs. The U.S. Court of Appeals in Cincinnati in February 2011 found that Kentucky state law stipulating royalties to be paid on an “at the well” price also includes costs, upholding the dismissal of claims by Kentucky royalty owners who had argued otherwise.

Marathon Oil Corp. (MRO) last year agreed to pay $40 million to settle a lawsuit brought by Oklahoma royalty owners who claimed the company underpaid royalties, in part by making improper deductions. Marathon denied any liability or wrongdoing, according to the settlement agreement.

Envelope Contracts

London-based BP Plc (BP/)’s American unit won an appeals court decision last month reversing a $13 million jury verdict on underpayment claims awarded to New Mexico royalty owners in 2011.

The disputes usually come down to the sophistication of the contracts, which varies widely, said Sabino.

“You’ll see 75-page royalty agreements and other royalty deals that are written on the back of an envelope,” he said.

Royalties are a share of proceeds from the sale of oil and gas, paid to owners of mineral rights. Payments are based on state laws and the terms outlined in contracts, which vary from lease to lease. As hundreds of thousands of U.S. landowners were approached about leasing their mineral rights during the past decade’s boom in U.S. shale field production, how expenses were handled became a key point of negotiation.

Cost Drain

Deducting costs for processing, transporting and marketing gas before royalties are calculated can reduce the amount producers owe by 25 percent to 50 percent. About one in five landowners in Texas have signed contracts specifying that producers pay them based on a price before those costs are deducted, said Tom Hazlewood, an appraiser of royalty leases whose business reviews hundreds of properties annually for tax purposes.

For the same gas from the same well under the same contract terms, Thornton, the Texas accountant, says she has been paid about 25 percent more for her gas by Plains Exploration & Production Co. (PXP), which in 2008 bought a 20 percent stake in Chesapeake’s acreage in the Louisiana Haynesville shale formation.

The two companies pay her in separate checks, and she said she discovered the cost deductions when Plains paid her back for expenses it had been subtracting since 2010. Chesapeake has not refunded any costs, she said. Hance Myers, a Plains spokesman, declined to comment.

Announcing Deductions

In August 2011, when gas prices had fallen 14 percent from the year earlier and were sliding toward a 10-year intraday low of $1.902 in April, Chesapeake notified royalty owners in North Texas that it would begin deducting costs from royalties.

The decision came after Chesapeake partnered with Total SA (FP) in 2010 in a $2.25 billion deal that gave the French oil company a 25 percent stake in Chesapeake’s wells in the region. Chesapeake reviewed lease terms after Total said it wanted to deduct costs, Henry Hood, Chesapeake’s general counsel, told the Fort Worth Star-Telegram newspaper in an Aug. 10, 2011 story.

On Jan. 24, Chesapeake notified landowners in Pennsylvania of its intent to deduct costs, citing a March 2010 state supreme court ruling that confirmed deductions were allowed.

The costs range from 70 cents to $1 per 1,000 cubic feet of gas produced, Hood told the Fort Worth, Texas, newspaper. Coupled with lower gas prices, the deductions mean some royalty owners have seen their payments slashed by more than 90 percent this year, with Chesapeake paying as little as 11 percent of the price paid by rival energy producers, more than two dozen leaseholders in Texas and Louisiana said in lawsuits and interviews.

Small Fraction

Chesapeake has paid royalties in North Texas based on a gas price as low as 11 cents per million cubic feet, eight or nine times less than producers including Devon Energy Corp. (DVN) and EOG Resources Inc. (EOG), Hazlewood, the tax appraiser, and other royalty owners said.

In one of the largest lawsuits Chesapeake is fighting, about 3,000 Kansas royalty owners accuse Chesapeake of deducting costs in violation of lease agreements and state law. The suit was certified as a class action in federal court in Wichita, Kansas, in 2011 allowing well owners to pursue claims against Chesapeake as a group. A nonjury trial is set for April.

Past verdicts and settlements in royalty disputes indicate a wide range of outcomes, even when royalty owners win. In 2007, a class of West Virginia royalty owners won a $404 million jury verdict against Columbia Natural Resources, which Chesapeake purchased after the lawsuit was filed. Chesapeake paid about $40 million of the ultimate $380 million settlement, while a prior owner paid the rest. In 2001, Chesapeake paid $3.4 million to settle a class action brought by Virginia royalty owners claiming the company made improper deductions.

Mixed Results

The record in class actions is mixed. While Chesapeake settled the Virginia case and owners in Kansas won the right to sue as a group, the company has won dismissals of proposed class actions in Kentucky, Ohio and New York. The Ohio and New York cases are on appeal.

Plaintiffs are seeking to pursue their claims for underpayment of royalties as class actions in at least four other lawsuits — two in Arkansas, one each in Oklahoma and Louisiana.

In a case brought by Magnolia Point Minerals LLC, which owns mineral rights on land in the Haynesville formation in western Louisiana, the court backed Chesapeake’s interpretation that a contract allowed cost deductions despite a clause forbidding them.

Magnolia Point

Magnolia Point complained that Chesapeake pays less on a Louisiana lease than the company’s partner, a subsidiary of Houston-based Plains Exploration & Production Co. called PXP Louisiana that has a 20 percent stake. Under the same contract, PXP hasn’t been deducting production costs and Chesapeake has, Magnolia said.

U.S. District Judge S. Maurice Hicks Jr. in Shreveport, Louisiana, agreed that a provision to base royalty payments on the “market value at the well” allows the deduction of costs despite the no-cost clause.

The term market value at the well “stands for the proposition that post-production costs are to be taken out of production payments,” Hicks said in his July 30 ruling. Costs after determining market value at the well can’t be deducted, he said.
David Taggart, Magnolia’s lawyer, said he was reviewing the decision to determine the effect on the case.

Willing Fighter

PXP’s decision not to deduct costs doesn’t mean that Chesapeake is wrong to do so, Nicole Duarte, a Chesapeake lawyer, argued at a hearing April 12 in the lawsuit.

Chesapeake has been more willing to fight for its own interpretation of contracts than some other companies, Duarte said.

“There are a lot of decisions involved in whether or not you’re going to take on a fight for your interpretation,” Duarte told the court. “Chesapeake’s an 80 percent interest holder in this lease and has the biggest interest across the Haynesville Shale of anyone. So Chesapeake is probably more willing to take on the fights to get its interpretation recognized.”

What other companies pay in royalties may not be relevant or admissible in trials, the U.S. Court of Appeals in Denver ruled in July, reversing a $13 million jury verdict against BP America Production Co. in a class action brought by New Mexico royalty owners.
Evidence that ConocoPhillips didn’t take deductions shouldn’t have been admitted, the appeals court said in ordering a new trial. ConocoPhillips’ “royalty practices had no bearing” on BP’s obligations.

Tags: Chesapeake, royalty

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You will get alot of post with this story.  My take.  No matter how smart you think your attorney is there is always someone smarter or better financed on the other side of the table.  Facts are irrelevant and its more important where you lease is located and local judges interpretations.

Just as an FYI on CHK, I noticed that they actually increased the amount that is being taken for expenses effective January 2012.  I have royalties on both cost-free basis leases and on HBP old leases that do not exclude costs so it is fairly easy for me to compare the costs by looking at what CHK is paying per unit price.  When you couple the increase with the lower amount they pay for selling to themselves, the last royalty check showed they paid $1.24 per unit price for June 2012 which is about $.70 (or about 33% reduction of the approximate unit price of $1.93 which is the lowest I saw on the natural gas spot and/or futures market) and about an 18% increase over what they were charging as costs from December 2011 to January 2012.  I just mention this because CHK does not show any deductions on the royalty check-they just adjust the unit price to whatever they feel like paying and they do not seem interested in giving any useful information about these costs to the mineral owner.

Correction-this amount of $1.24 was for MAY, not June.  My Bad!!!

Moral of the story:  When courts interpret mineral statutes, judges make mineral law.

RE: Louisiana legal rulings affecting the mineral code. 

In the last 5 years the 2nd. Circuit Court Of Appeals in Shreveport has handed down 75% of the rulings state-wide  interpreting Title 30 Mineral statutes.  The judges of the 2nd. Circuit are elected by the voters of north Louisiana.  Maybe the time has come when voters (mineral owners) will look more closely at the positions of candidates for the court regarding mineral rights.  When I return from the long weekend I'll make some suggestions on how to go about electing judges who look favorably on the rights of mineral owners.

You are correct, Henry.  I was confusing Judge Hicks with a 2nd. circuit judge whose name escapes me at the moment.  I'm on the lake and do not have access to my notes.  I'll add to the thread when I get home.  Have an enjoyable Labor Day.

You have figured out chk very good. they are screwing all the small landowners.

believe me it's not just the little guy with a few acres.

you are right did not word that right. When you leave Mansfield, La. everyone is up.

Layla, you have figured out CHK's ruses.  They report on a different psi than all the other gas companies and Sonris as well.  This makes the volumes look different when reading the stub.  When they sell to their own "affiliates", there is no way to verify what they are paying those affiliates and again, we are at the mercy of CHK to accept the per mcf price that they pay us.  All we know for sure, if you get paid from multiple gas companies as I do, all the other gas companies are all within a few cents of each other and CHK is 25% to 30% less.  Also, on our "no-cost" leases that show no costs......look at your check stub in between the column labels and where the numeric info starts.  On the second paragraph, the first line talks about the deductions identified on the stub are limited to taxes and deductions by the operator/lessee.  NEXT SENTENCE tells the story....."Deductions made by the purchaser/transporter (affiliated or non-affiliated) are not shown."  Tah-dah.  I read that as an admission that the deductions are happening but are not on our stubs in black and white.  I call all of the tactics as camouflage.

Unfortunately, my royalty checkstub has absolutely no information regarding what deductions are being taken and never has, from the very first check several years ago.  There is information about the unit price, totals, mineral interest, etc and and all of the columns labeled as "tax" and "deduct" for both the lease & owner sections are filled with ".00. I wonder if Louisiana does not have any laws requiring that information be made available while Texas does?  I have cousins in TX who report there is deduction info, albeit somewhat confusing info, on their checkstubs.  I also have relatives in NWLa whose initial payments were substantially less than mine on unit price even though they had cost-free clauses were identical to mine.  By comparing those unit prices, I was able to determine that CHK was not applying the cost-free clause and that took many months and many phone calls to finally get the correct amount to those who were being charged expenses when they should not have been.  Had CHK not made the "error" (in their eyes I'm sure, anyway) of paying me correctly, no one in my family would have been any the wiser that they were being significantly shorted by the company. 

 

Just as an FYI, when I first started posting on this site, I reported that one of the operators had a "default" setting when paying royalties such that they did not bother to check leases but just paid with expenses and then left it up to the owner to figure out what was happening.  I was pooh-pooh'd (a bit abruptly, I might add) by some of those more experienced with o&g operators that this was simply not the case and no operator would do something like that.  Wonder what their opinions are now after a couple of years of watching CHK's shenanigans and the number of complaints on this site about precisely this problem? 

In Louisiana shale wells have one year of tax exempt gas. then they start showing taxes without any explanation whatsoever. the state calls the tax one thing , ckh calls it another. also from day one chk holds expenses out of your money before you get it and it is not listed and is very hard get a employee  to tell you about it. also their gas prices are below what most other companies pay. good luck.

That's exactly what chk does. They are sneaky and will not reveal or explain their operating  cost.

chk is crooked,  maybe  w/ mccledon gone its company morals will improve.

Just like the past 12 years of oil and gas opinions issued by the 9 members of the Texas Supreme Court.  All Republican.

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