Ohio Clarifies Its Position on the Deduction of Post-Production Costs

In Lutz v. Chesapeake Appalachia, LLC, No. 4:09-cv-2256, 2017 U.S. Dist. LEXIS 176898 (N.D. Ohio Oct. 25, 2017), the Northern District certified a question to the Ohio Supreme Court regarding the deduction of post-production costs.  Specifically, the Court certified the following question:

"Does Ohio follow the 'at the well' rule (which permits the deduction of post-production costs) or does it follow some version of the 'marketable product' rule (which limits the deduction of post-production costs under certain circumstances?"

The Court stayed proceedings until the Ohio Supreme Court decided whether to accept the certified question.  On November 2, 2016, the Ohio Supreme Court ruled:

"Under Ohio law, an oil and gas lease is a contract that is subject to the traditional rules of contract construction.  Because the rights and remedies of the parties are controlled by the specific language of their lease agreement, we decline to answer the certified question and dismiss this cause."

Lutz v. Chesapeake Appalachia, LLC, 148 Ohio St. 3d 524, 2016 Ohio 7549, 71 N.E.3d 1010, 1013 (Ohio 2016).  Two justices dissented.  One dissenting justice argued that Ohio would follow the "marketable product" rule and the other dissenting justice argued that Ohio would follow the "at the well" rule.  Following the Ohio Supreme Court's decision not to accept the certified question, Chesapeake sought summary judgment in the District Court.

The District Court sought to interpret the following royalty provision and how royalties should be paid:

"3. The royalties to be paid by Lessee are: . . . (b) on gas, . . . produced from said land and sold or used off the premises . . . the market value at the well of one-eighth of the gas so sold or used, provided that on gas sold at the wells the royalty shall be one-eighth of the amount realized from such sale . . . ."

Lutz, 2017 U.S. Dist. 176898, at *11. Here, Chesapeake paid the lessors a "pro rata share of the downstream sales price of the gas, and may - depending on the circumstances of each well and each lease - allocate a pro rata share of the post-production costs against the royalty payment." Id., at *13.   This method assumes that Ohio would follow the general "at the well" approach followed by Texas and permit the net back method for calculating the royalty payment. The other approach followed by courts in calculating royalties is the "first marketable product" approach, which is followed in Oklahoma. Under the first marketable product approach, courts interpret oil and gas leases as containing an implied covenant that the lessee bears the burden of bringing the produced gas to market.

The District Court, seeking to choose the approach that the Ohio Supreme Court would choose, discussed principles of interpretation of oil and gas leases. The Court explained that oil and gas leases are contracts and that "'[c]ontracts are to be interpreted so as to carry out the intent of the parties, as that intent is evidenced by the contractual language.'" Id., at *16 (quoting Lutz, 71 N.E.3d at 1012). "'When the language of a written contract is clear, a court may look no further than the writing itself to find the intent of the parties.'" Eastham v. Chesapeake Appalachia, L.L.C., 754 F.3d 356, 361 (6th Cir. 2014) (quoting Sunoco Inc. (R&M) v. Toledo Edison, 129 Ohio St. 3d 397, 2011 Ohio 2720, 953 N.E.2d 285, 292 (Ohio 2011). Based on Ohio caselaw, the District Court concluded that the Ohio Supreme Court would adopt the "at the well" approach. The District Court noted that the language "market value at the well" would be meaningless if the "at the well" approach was not followed. Lutz, 2017 U.S. Dist. 176898, at *18.

The District Court's decision is significant because it brings Ohio in line with other majority of oil and gas jurisdictions that follow the "at the well" approach. It remains to be seen whether Ohio will further adopt Texas jurisprudence regarding the "at the well" approach and how courts will reconcile "at the wellhead" language in the royalty clause with other provisions in leases (or addenda attached to the lease) that prohibits the deduction of post-production costs. Additionally, it is unclear how Ohio courts will handle oil and gas leases where the point of valuation of the royalty payment is shifted from the wellhead to a point further downstream. It is important to pay careful attention to the specific language in the royalty provision in determining whether the deduction of post-production costs is permissible.

Eli Kiefaber is a founding partner of Kiefaber & Oliva LLP, a Houston-based, oil and gas law firm. Eli is a frequent speaker on the deduction of post-production costs and is chair of the AAPL's Task Force on Held by Production & Royalty Issues.