Chesapeake Energy will pay the city of Arlington $700,000 to settle a lawsuit accusing the company of using a complicated scheme devised to reduce royalty checks for gas pumped from under parks, airports and other pieces of public property.
The Arlington City Council voted 8-0 Tuesday to approve a deal reached with the Oklahoma City-based company and Total E&P USA, a French energy company that owns 25 percent of Chesapeake’s Barnett Shale holdings.
Mayor Robert Cluck, who recently had surgery, was not present.
The city sued in August, saying that Chesapeake, which holds leases on about 1,900 acres of public property, based its royalty payments on gas prices that were well below the actual sales price and improperly deducted certain post-production costs.
Under the agreement, Chesapeake will no longer subtract post-production costs and the city’s royalty will be calculated based on the highest price received by Chesapeake when the gas is sold or the price established by a formula.
Initially, attorneys representing the city stated that they reasonably expected damages to exceed $1 million. But in the end, the city and Chesapeake decided to settle out of court for a lower price.
“I think it is a fair settlement,” said City Attorney Jay Doegey. “It clarifies the methodology that Chesapeake will use in the future to pay the city its royalties.”
In settling, Chesapeake denied doing anything improper. As a matter of fact, in court documents, Chesapeake, the second-largest producer in the Barnett Shale, and Total said that Texas law allows certain post-production costs to be deducted from royalty payments. Two recent federal appeals court decisions back that assertion.
“We are pleased to have reached a mutually acceptable agreement with the city of Arlington and look forward to continuing our partnership,” said Gordon Pennoyer, a spokesman for Chesapeake.
The settlement, which covers 25 leases of varying size, resolves most of the substantive issues between the city and Chesapeake and Total, although some issues still need to be ironed out.
Chesapeake still faces a number of other lawsuits filed by large property owners, other public entities and a number of individuals whose lease covers not much more than their home.
The deal with Arlington doesn’t mean that other lawsuits will be settled. For example, no outreach has been made to the city of Fort Worth or the Fort Worth school district.
The Arlington school district, which joined the city’s lawsuit in November with similar claims of royalty miscalculation, also continues to negotiate with Chesapeake on its claims.
‘Engaged in a scheme’
Arlington’s lawsuit made claims that are repeated in other litigation against Chesapeake — that the company underpays royalties by basing them on proceeds from sales to affiliates or other “sham transactions” and after production costs had been taken out.
Arlington said its lease agreements “prohibit or significantly limit deductions” such as transportation and production costs and taxes, and “provide for cost-free royalties.”
But even after raising concerns about underpayments and improper cost deductions. the city said, Chesapeake continued to “engage in a scheme of affiliated transactions aimed at hiding or embedding impermissible cost deductions and suppressing the royalties it pays to the city.”
It also said the charges deducted from the royalty payments were “excessive and unreasonable in instances where only limited deductions are authorized.” The lawsuit also stated that the deductions were not apparent from information provided to the city.
But Chesapeake has argued that the procedures it uses to drill, market and sell the gas are acceptable and done within the letter of the law and the leases. They also said royalties in the Arlington case, and others, are to be based on the price of the gas at the wellhead.
But after that sale takes place, an affiliate, Chesapeake Energy Marketing, transports the gas through a gathering system downstream through pipelines to the next buyer to maximize the price, records show.
What Chesapeake Energy Marketing eventually pays is what is known as the “weighted average sales price” that it gets from an unaffiliated third-party less the actual post-production costs incurred in moving the gas.
Since 2006, Chesapeake has paid Arlington more than $12 million in royalties, Pennoyer said.
While some argue that their leases prohibit any post-production costs from being deducted, the 5th U.S. Circuit Court of Appeals in two cases stemming from disputes over royalties in Tarrant and Johnson counties said it is allowed. The court also stressed that each lease is different.
Arlington’s deal mirrors one that Chesapeake reached with Dallas/Fort Worth Airport in 2012 for $5 million. That deal also established a formula for royalty payments.
Chesapeake also quietly settled with the Tarrant Regional Water District earlier this year when it agreed to pay the district $1.8 million for royalties on 100 leases from January 2008 through October 2011. After conducting an audit, the water district challenged the deduction of post-production costs.
The district recently approved another forensic audit to double-check payments from Chesapeake.
“It is a pattern to improperly pay the landowners,” said Jim Lane, a water board member, who described what Chesapeake does as a “numbers game.”
“We assumed the oil and gas company would follow their own rules, and it is a shame that a company as big as Chesapeake is not,” he said.
Chesapeake has been in a period of retrenchment. The company, struggling to reduce a large debt load after the collapse of natural gas prices, recently sold its 20-story glass-and-steel office tower on the edge of downtown Fort Worth to a Houston-based real estate firm.
At one time, Chesapeake had about 400 employees working from the top half of the building. But in recent years, the company has scaled back and sold numerous Barnett Shale properties.