North Texans Challenge Drillers Over Royalties

Chesapeake Energy’s mark on Fort Worth is hard to miss.

The company’s 20-story office building is a prominent fixture of the Fort Worth skyline. And Chesapeake, the second-biggest driller in the Barnett Shale in North Texas, owns many of the hundreds of drilling pads nestled among the city’s homes, schools and playgrounds.

Chesapeake also has the drilling rights to more than half of the nearly 500 mineral leases that Fort Worth has issued for city property. Since 2006, the Oklahoma City-based driller has produced more than 200 billion cubic feet of natural gas on city-owned land and has paid the city tens of millions of dollars in royalties.

For years, city officials asked few questions.

“No municipality has ever been closer to a particular operator than Fort Worth was to Chesapeake,” said Jim Bradbury, a lawyer and former member of the city’s drilling task force. But Fort Worth’s relationship with Chesapeake, which declined to comment for this article, has shifted. Put in social media terms: It’s complicated.

Fort Worth is now battling Chesapeake in a Tarrant County District Court, claiming that the company and its business partner Total E&P USA have shortchanged the city millions of dollars in unpaid royalties. The companies, the complaint states, “have fallen well short of their obligations to the city and its citizens,” while "willfully and knowingly violating” their duties.

The company’s deductions practice is not illegal per se, nor is it rare, but Fort Worth and other parties suing Chesapeake argue that their contracts forbid it.

In Fort Worth’s contract, the parties agreed that royalty payments would “be free of all costs of any kind, including, but not limited to, costs of gathering, production, transportation” and several other listed activities “directly or indirectly incurred by lessee without prior permission from the city.”

In court filings, Chesapeake disputes the meaning of the clauses and points to legal precedent that allows a company to deduct the costs.

Fort Worth’s suit, filed in October, is hardly an outlier. Dozens of mineral owners across North Texas have filed over similar claims, accusing them of shaving off significant fractions of royalty payments to cover post-drilling costs. Litigants include the city of Arlington, the Arlington Independent School District and Ed Bass, a prominent Fort Worth investor who derives much of his wealth from oil and gas.

The company has faced similar complaints — some in class-action suits — in other states where it bought up shale leases, including Arkansas, Louisiana, Ohio, Oklahoma and Pennsylvania.

In 2011, with plummeting natural gas prices eroding its bottom line, Chesapeake began to sharply scale back its presence in North Texas. It also sent notices to some mineral owners that it would ramp up deductions from monthly royalty checks for post-production costs, such as for gathering, transporting and compressing the gas before selling it. The policy shift came after auditors realized it had long neglected to deduct the full amounts it should have, the company said. Chesapeake officials said deductions would vary based upon production but might average about 25 percent, according to a 2011 article by the Fort Worth Star-Telegram. 

“You can tie everything to prices tanking, but they’ve also gotten more brazen,” said Shayne Moses, a Fort Worth lawyer who says he has represented as many as 10 mineral owners. One client, the Dallas/Fort Worth International Airport, netted $5.3 million in additional royalties after settling with Chesapeake in September 2012, according to Moses’ firm.

Monthly statements tell mineral owners that deductions are embedded in the payments, but they are not listed as line items. Those wanting to find out how much money the company is deducting must request production and sales records — typically located at Chesapeake’s Oklahoma City headquarters — and perform the complex math themselves, plaintiff’s lawyers say.

Officials in Fort Worth, whose royalty percentage from Chesapeake ranges from 25 percent to 27.5 percent depending on the lease, said they were unaware of the deductions until news reports revealed the practice.

After traveling to Oklahoma City to examine the company’s records in August, the officials determined that deductions ranged from 12 percent to 38 percent of royalty payments, depending on the lease and production. That probably adds up to tens of millions of dollars for Fort Worth, said Gerald Pruitt, the city’s deputy attorney. The city has not calculated the full amount it believes the company owes; auditors will do that math if the court grants the city a summary judgment.

What further irks Fort Worth and other landowners is that Chesapeake in many cases sells the gas to an affiliate, Chesapeake Energy Marketing. In essence, the company is setting the price and paying itself. Fort Worth’s complaint calls the arrangement a sham.

Moses and other plaintiffs’ lawyers acknowledge that their clients face an uphill battle in Texas, whose courts have set a high bar for those looking to recoup royalties. Additionally, Texas judges rarely certify class-action lawsuits, making it difficult for mineral owners to pool their resources.

The Texas Supreme Court ruled in 1996 that the “trade meaning” of “royalty” and “market value of the well” included possible built-in deductions, rendering meaningless a clause barring deductions from the “value of the Lessor’s royalty.” Courts have cited that ruling — Heritage Resources v. Nationsbank— in recent decisions favoring drillers.

But Pruitt said Fort Worth might be in better shape than some mineral owners, because its contract also prohibits Chesapeake from selling to an affiliate without written notice — an action, the city says, Chesapeake failed to take.

“Through the use of these sham arrangements among affiliates,” the city’s complaint says, the companies “have pocketed millions of dollars that belong to the city of Fort Worth and its affiliates.”

Despite the suit’s strong language, Fort Worth officials insist that they are not severing ties with the company.

“Chesapeake remains a strong community partner, but there is a difference of opinion about the terms of the agreements Chesapeake made with the city,” Mayor Betsy Price said in an email. “It’s an unfortunate situation, but we will do what it takes to ensure the citizens of Fort Worth realize the benefits they’re due.”