The Oil and Gas Addendum

In the ongoing royalty dispute in Lutz v. Chesapeake Appalachia, LLC, the federal district court sitting in Akron, Ohio recently ruled that Chesapeake did not breach the parties’ lease when it deducted post-production costs. The result is not surprising and does not represent a radical departure of existing law. The lease at issue in Lutz stated that the royalty was to be based on the “market value at the well.” Given this language, the district court applied Ohio law and concluded that Chesapeake acted in accordance with the lease when it used the “net back method” to arrive at the wellhead value. Despite rumblings suggesting otherwise, the Lutz decision is not a game-changer.

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, had an implied duty to market the gas once it is brought to the surface. Given this implied duty, the landowners further argued that Chesapeake was responsible for all of the costs incurred between the wellhead and the eventual point-of-sale. In essence, the landowners urged the federal district 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. As noted, 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 federal district court to reject the “marketable product” rule and confirm that Ohio is, in fact, an “at the well” jurisdiction.

The Lutz litigation took a rather unusual and protracted path. 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 proper and 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 a unique question 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 announced on November 2, 2016 that it had 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…”

In its November 2, 2016 opinion, the Ohio Supreme 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. The panel, however, did not reach the question of whether the royalty clauses were ambiguous. On the contrary, the Supreme Court stated that 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.

The matter then returned to the Federal Suit. In August 2016, Chesapeake renewed its motion for summary judgment. This time the judge in the Federal Suit (i.e., The Honorable Sara Lioi) issued a ruling.

In accordance with the Ohio Supreme Court’s directive, Judge Lioi applied “traditional rules of contract interpretation” when evaluating the meaning and effect of the “at the wellhead” language. Judge Lioi concluded that this language was unambiguous and that it simply reflected the parties’ intent to designate the wellhead as the royalty valuation point:

“[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.”

This conclusion was significant. Because the gas was not sold at the wellhead but rather at a down-stream location, Judge Lioi ruled that Chesapeake acted in accordance with the Lease when it utilized the net-back method to back-out the intervening post-production costs. In other words, even though the gas may have been sold for $4.00 per MCF at the downstream point-of-sale, that price was not reflective of the purported “value” of the gas at the wellhead. To arrive at that value, Chesapeake deducted the post-production costs incurred between the wellhead and the point-of-sale. Given the parties’ intent to value the royalty “at the wellhead”, Judge Lioi concluded that Chesapeake acted properly when it deducted the intervening post-production costs.

So what is the take away from the Lutz decision? Lutz simply confirms that the language in the parties’ lease will dictate and govern how the royalty is calculated. If the lease language designates the wellhead as the royalty valuation point, the driller might be authorized to deduct intervening costs if the gas is sold downstream. This is what happened in Lutz. Conversely, if the lease language designates the royalty valuation point as being the point-of-sale, there is no need to back-out intervening costs and driller may not be authorized to deduct any costs. In any event, special care and attention must be given to the location designated as the royalty valuation point. Lutz reaffirms the notion that the outcome of any royalty dispute will often turn on the precise language in the parties’ lease.