The Oil and Gas Addendum
Ohio Supreme Court Declines to Adopt Blanket “At the Well” Rule
The question of whether Ohio follows the “at the well” rule or the “marketable product” rule will have to wait for another day. And that might not be a bad thing for Ohio landowners. After months of anticipation, the Ohio Supreme Court finally issued an opinion in the closely watched Lutz v. Chesapeake Appalachia, LLC matter. The opinion, however, punted on the central question of whether gas royalties are to be valued at the wellhead or at the location where the gas is deemed marketable. Instead, the Ohio Supreme Court correctly ruled that the express language in the parties’ oil/gas lease determines the royalty valuation point. Although drillers and landowners alike were initially disappointed by the Ohio Supreme Court’s “non-decision”, the author believes that the rationale espoused by the Lutz court is the right approach and should be adopted by Pennsylvania.
The Lutz litigation originated in federal court in 2009. At issue were two oil/gas leases which were executed in the early 1970s. The landowners, Regis and Marion Lutz, argued that because there is no market for the gas at the well itself, the lessee, Chesapeake, has an implied duty to market the gas once it is brought to the surface. Given this implied duty, the landowners further argued that Chesapeake must bear all of the costs incurred between the wellhead and the eventual point-of-sale. In essence, the landowners urged the Ohio Supreme Court to adopt the “marketable product” rule and hold that no costs can be deducted unless and until the raw gas is transformed into a marketable condition.
Chesapeake, on the other hand, argued that Ohio should follow the “at the well” rule and give effect to the language set forth in the parties’ lease. The royalty clauses in each lease provided that the royalties were to be paid based on “the market value at the well”. Since the gas was sold downstream from the wellhead, Chesapeake used the netback method to deduct the costs incurred between the wellhead and the eventual sale location. Chesapeake argued that Ohio follows the “at the well” rule, which permits the use of the netback method to calculate the market value of the gas at the wellhead. Contrary to the landowner’s suggestion, Chesapeake urged the Ohio Supreme Court to reject the “marketable product” rule and confirm that Ohio is, in fact, an “at the well” jurisdiction.
The Lutz matter took a rather uncommon path to the Ohio Supreme Court. As noted, the litigation was originally commenced in the United States District Court for the Northern District of Ohio sitting in Akron (the “Federal Suit”). In August 2014, Chesapeake moved for summary judgment in the Federal Suit. Chesapeake requested that the landowner’s contract claim be dismissed since the deductions were taken in accordance with the netback methodology. The landowners filed their own motion for summary judgment seeking an order that Chesapeake had breached the leases by taking improper and unauthorized deductions. The judge in the Federal Suit was unable to decide the cross-motions because of the murky status of Ohio law on deductions. As such, in March 2015, the judge requested clarification from the Ohio Supreme Court on this certified question of Ohio law:
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)?
A certified question is a formal request by one court to another for a clarification of state law. See, Rule 9.01 of the Ohio Supreme Court’s Rules of Practice (“[t]he Supreme Court may answer a question of law certified to it by a court of the United States”). On April 6, 2015, the Ohio Supreme Court accepted the request and agreed to “answer” the certified question.
In a rather surprising and unexpected opinion, the Ohio Supreme Court declined to answer the certified question as posed. Instead, the Lutz court opined that the precise language in the underlying lease controls and that the deduction analysis must essentially begin and end there:
“[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 decline to answer the certified question…”
The Court noted that, like other contracts, oil and gas leases are to be interpreted so as to carry out the intent of the parties. If the lease is unclear or ambiguous, the Lutz court observed that a reviewing court may resort to extrinsic evidence to ascertain the parties’ intent. In the instant matter, the Court did not reach the question of whether the royalty clauses were ambiguous. This was a question for the judge in the Federal Suit since there was no record or other testimony before the Lutz panel on this threshold issue. Conversely, the Lutz panel noted that if the royalty clauses were unambiguous, the judge in the Federal Suit “should be able to interpret the leases without our assistance.” In short, the Ohio Supreme Court declined to adopt a sweeping “one-size-fits-all” rule of law and instead correctly framed the issue as one of contract interpretation.
For now, questions concerning the deduction of post-production costs in Ohio will be decided on a lease-by-lease basis. The message from the Ohio Supreme Court is clear: the intent of the parties, as evidenced by the language set forth in the underlying lease, will determine the royalty valuation point. If the royalty clause is unclear or ambiguous, the Lutz court also suggested that it may be proper to introduce extrinsic evidence to ascertain the intent of the parties. This means that oral testimony concerning what was discussed or not discussed during the lease negotiations may be admissible as critical evidence. This may benefit landowners who were told during the negotiations that “no deductions” will be taken or that only the cost of transporting the gas will be deducted. Likewise, the Lutz opinion suggests that lease clauses which provide that the royalty shall be calculated on the “proceeds received by the lessee” or on the “price paid to the lessee” should be interpreted and applied exactly as written. Arguably, the intent of such clauses is to value the royalty at the point-of-sale. The Lutz opinion will restore the import of such language and remove the fiction of the netback method. In any event, Pennsylvania would be wise to revisit the deduction issue and adopt the approach recently articulated by the Ohio Supreme Court in Lutz.
Oil and gas development can present unique and complex issues that can be intimidating and challenging. At Houston Harbaugh, P.C., our oil and gas practice is dedicated to protecting the interests of landowners and royalty owners. From new lease negotiations to title disputes to royalty litigation, we can help. Whether you have two acres in Washington County or 5,000 acres in Lycoming County, our dedication and commitment remains the same.
We Represent Landowners in All Aspects of Oil and Gas Law
The oil and gas attorneys at Houston Harbaugh have broad experience in a wide array of oil and gas matters, and they have made it their mission to protect and preserve the landowner’s interests in matters that include:
- New lease negotiations
- Pipeline right-of-way negotiations
- Surface access agreements
- Royalty audits
- Tax and estate planning
- Lease expiration claims
- Curative title litigation
- Water contamination claims
Robert Burnett - Practice Chair
Robert’s practice is exclusively devoted to the representation of landowners and royalty owners in oil and gas matters. Robert is the Chair of the Houston Harbaugh’s Oil & Gas Practice Group and represents landowners and royalty owners in a wide array of oil and gas matters throughout the Commonwealth of Pennsylvania. Robert assists landowners and royalty owners in the negotiation of new oil and gas leases as well as modifications to existing leases. Robert also negotiates surface use agreements and pipeline right-of-way agreements on behalf of landowners. Robert also advises and counsels clients on complex lease development and expiration issues, including the impact and effect of delay rental and shut-in clauses, as well as the implied covenants to develop and market oil and gas. Robert also represents landowners and royalty owners in disputes arising out of the calculation of production royalties and the deduction of post-production costs. Robert also assists landowners with oil and gas title issues and develops strategies to resolve and cure such title deficiencies. Robert also advises clients on the interplay between oil and gas leases and solar leases and assists clients throughout Pennsylvania in negotiating solar leases.
Brendan A. O'Donnell
Brendan O’Donnell is a highly qualified and experienced attorney in the Oil and Gas Law practice. He also practices in our Environmental and Energy Practice. Brendan represents landowners and royalty owners in a wide variety of matters, including litigation and trial work, and in the preparation and negotiation of:
- Pipeline right of way agreements
- Surface use agreements
- Oil, gas and mineral conveyances