Last week the Ohio Northern District Court, Eastern Division issued a decision in Lutz v. Chesapeake Appalachia, LLC, N.D. Ohio No. 4:09-cv-2256, 2017 U.S. Dist. LEXIS 176898 (Oct. 25, 2017), which involved a dispute about whether Ohio follows the “at the well” rule (which allows oil and gas royalty payments to be downward adjusted to account for a lessor’s pro rata share of post-production costs) or the “marketable product” rule (which does not allow producers to adjust royalty payments to account for post-production costs).
The case has an interesting history. In 2015 District Judge Lioi certified a question of law regarding post-production costs to the Ohio Supreme Court. The Ohio Supreme Court accepted briefing and heard oral argument before returning the issue to the Judge Lioi with instructions to interpret the disputed leases according to their plain language. The Ohio Supreme Court held, “[u]nder 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 decertify the question of law submitted by the United States District Court for the Northern District of Ohio, Eastern Division.”
Judge Lioi’s subsequent decision interpreted the following lease language: “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. . . .” Judge Lioi clarified that “[t]he specific dispute focuses on how the above royalty provision should be interpreted and how royalties should be paid, when, as is often the case, the gas extracted from the wells on the lessors’ land is sold at some point downstream, not ‘at the well.’” After surveying applicable law, Judge Lioi found the plain language of the contract to be unambiguous and ultimately held, “[h]ere, a close reading of the royalty provision, in light of Ohio’s contract law, leads to the conclusion that the parties’ intent was that the location for valuing the gas for purposes of computing the royalty was ‘at the well.’ Accordingly, the court concludes that Ohio would apply the ‘at the well’ rule.” (emphasis original). Thus, the decision allows oil and gas operators to deduct post production costs for leases that contain the above-cited language.
There are two other points worth mentioning in the decision. First, Judge Lioi found that the express language “at the well” in the royalty provision rebutted plaintiffs’ argument that implied lease covenants required Chesapeake to bear the responsibility and cost of marketing the oil and gas. In short, the court held that in Ohio, implied covenants only arise if there are no express provisions to the contrary, and since “at the well” is an express provision that allows post-production deductions, implied covenants do not apply, even though the Judge found that Ohio generally recognizes an implied covenant to diligently market produced oil and gas. Second, the court clarified that the post-production costs at issue “may generally be categorized into ‘gathering, compression, treatment, processing, transportation and dehydration.’”
Finally, it should be noted that this is only a federal district court decision. So, even though Judge Lioi endeavored to render a decision consistent with what the Ohio Supreme Court would decide, the decision is not equivalent to an Ohio Supreme Court decision. Further, as indicated in the decision, the analysis is heavily dependent on the exact language of the lease. Despite these caveats, this remains an important decision, and is a clear win for Ohio oil and gas operators.