Court Defines Drillers Right to Deduct Post-Production Costs in Ohio

From BakerHostetler:

As we previously explained, a question arose in Lutz, et al. v. Chesapeake Appalachia, L.L.C.[1] about how royalties should be calculated in oil-and-gas leases. That class-action case addressed leases with common language. Those leases required lessees to pay as royalties “the market value at the well of one-eighth of the gas [produced and sold or used off the premises].” Chesapeake argued that the plain language of the leases required using the “netback” method – which permits energy companies to deduct post-production costs from royalties – for calculating royalties. In effect, the netback method (1) recognizes that gas “at the well” isn’t as valuable as the gas brought to market, because bringing that gas to market entails costs, and (2) requires lessor/landowners to share in those costs. The plaintiffs disagreed and argued that Ohio should follow the “marketable product” rule, which calculates royalties based on the gas’s price once it’s brought to market, and thus imposes upon lessees (the oil-and-gas companies) the costs to market the gas downstream. 

Because there was no controlling rule in Ohio, the U.S. District Court for the Northern District of Ohio certified a question to the Ohio Supreme Court. That question was: “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)?” After oral argument in January 2016, the Supreme Court declined to answer the certified question regarding which rule Ohio followed. Instead, the court explained that oil-and-gas leases are contracts under Ohio law; and as contracts, the leases should be interpreted using traditional rules of contract construction. Lutz, et al. v. Chesapeake Appalachia, L.L.C., 71 N.E.2d 1010, 1013 (Ohio 2016). Two justices filed dissenting opinions – one suggesting that Ohio would follow the “marketable product” rule, and the other suggesting Ohio would follow the “at the well” rule. 

With the key question still unanswered, Chesapeake moved again for summary judgment on all the “at the well” leases, asking the District Court to determine how the royalties should be calculated. On Oct. 25, 2017, Judge Sara Lioi granted Chesapeake’s motion. The court focused on two issues: ambiguity and intent. 

Regarding ambiguity, the court rejected the plaintiffs’ argument that the leases were ambiguous, concluding instead that the leases’ clear and unambiguous language resolved the question. Based upon that language, the court concluded that “the Ohio Supreme Court would adopt the ‘at the well’ rule” in the leases that calculated royalties on “market value at the well.” In rejecting the “marketable product” rule, the court explained that states usually use that rule when leases do not address post-production costs. “Construing the lease under the ‘marketable product’ rule would ignore the clear language that royalties are to be paid based on ‘market value at the well.’” Additionally, the court emphasized that a close reading of the royalty provision showed that the parties intended to value the gas “at the well,” not downstream.

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