Ohio does not follow a blanket rule for allocating the postproduction costs of preparing natural gas for sale between oil and gas producers and mineral rights owners, and judges will have to examine leases between oil and gas producers and mineral rights owners to determine royalty payments, the Ohio Supreme Court ruled today.

In a 5-2 vote, the Supreme Court declined to answer a question from a U.S. federal court asking if Ohio law always permits oil and gas producers to calculate royalty payments based on the value of gas or oil when it leaves the wellhead rather than the final sale value when it is sold in the market. Writing for the Court majority, Justice Sharon L. Kennedy announced the court declined to issue a blanket rule to govern the deduction of postproduction costs in oil and gas leases, and that oil and gas leases are contracts subject to the traditional rules for interpreting contracts.

In separate dissenting opinions, Justice Paul E. Pfeifer wrote that Ohio follows the “marketable product” rule that requires the gas companies to assume all production costs, while in contrast, Justice William M. O’Neill indicated the state follows the “at the well” rule, which allows gas suppliers to deduct some costs before paying royalties.

Deregulation Changed Natural Gas Market
A class action lawsuit filed in the U.S. District Court for the Northern District of Ohio, Eastern Division, by numerous landowners claimed that Chesapeake Appalachia LLC underpaid gas royalties under the terms of their oil and gas leases. The leases were signed in 1970 and 1971, decades before the natural gas industry’s deregulation in the 1990s.

The parties agreed the leases require that Chesapeake bear all the “production costs,” which are the costs for producing the gas underground and bringing it to the wellhead. The dispute centers on the postproduction costs, which incur from taking the gas from the wellhead and selling it. Those expenses include the cost to process and compress the gas, and to transport it to an entry point in a pipeline for sale.

The court was presented with three different royalty clauses. In the first royalty clause, the landowners’ leases with Chesapeake indicate the royalty payment is one-eighth of the market value on gas sold “at the wells,” and in the second royalty clause, the landowners are to receive the “field market price” for “one-eighth of all gas marketed from said premises.” In the third royalty clause, the oil and gas producer promised “to deliver to the credit of the lessor, as royalty, free of cost . . . the equal one-eighth part of all oil and/or gas produced.”

The landowners claimed that since the lease mentions both “at the well” and “field market price,” they are entitled to a royalty based on the sale price without Chesapeake deducting its postproduction costs. They also claimed in the modern era of a deregulated natural gas industry there no longer are sales of gas at the wellhead. Without a wellhead price, the contracts imply Chesapeake has a duty to bear all the costs of taking the product to the market and providing the landowners a royalty based on the sale price.

Chesapeake claimed there are still sales of gas at the wellhead and that the contract language is clear that an “at the well” price should be paid, which allows the company to deduct its postproduction costs from the royalty payments in order to pay the royalty based on the value of the gas “at the well” as the contract requires.

The federal district court paused the proceedings of the lawsuit to get clarification from the Ohio Supreme Court. It posed in a certified question: “Does Ohio follow the ‘at the well’ rule or does it follow some version of the ‘marketable product’ rule (which limits the deduction of postproduction costs under certain circumstances)?” The Court agreed to answer the question, and heard oral arguments.

Contract Language Determines Payments
Justice Kennedy wrote that oil and gas leases are contracts and that the “rights and remedies” of parties to an oil and gas lease are determined by the written contract.

“It is a well-known and established principle of contract interpretation 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,’” she wrote, citing the Supreme Court’s 1974 Skivolocki v. E. Ohio Gas Co. decision.

When contract language is unclear and ambiguous, a court can examine evidence other than the written contract to determine the intent of the parties, Justice Kennedy explained. That evidence can include the circumstances surrounding the parties at the time the contract was made, the objectives the parties intended to accomplish, and any acts by the parties that demonstrate how they intended it to operate.

Because there were three different royalty clauses in the five leases provided to the Supreme Court, the court would have to examine each royalty clause separately to determine its meaning. Justice Kennedy wrote that the Court was not provided any additional evidence that explained the parties’ intent when the contracts were signed more than 40 years ago, which was before new rules implemented by the Federal Energy Regulatory Commission in 1992 deregulated the industry.. As a result, the Supreme Court could not give effect to the parties’ intent, she noted.

Justice Kennedy wrote the Court “decline[s] to answer the question of law” asked by the federal court, and directed the federal court to use the traditional rules of contract interpretation to clarify the contracts.

Chief Justice Maureen O’Connor and Justices Terrence O’Donnell, Judith Ann Lanzinger, and Judith L. French joined Justice Kennedy’s opinion.

Dissenting Justices Find Rules Govern Royalty Payments
In his dissent, Justice Pfeifer wrote he would answer the federal court’s question and find that Ohio follows the marketable product rule. He indicated three significant factors led him to the conclusion: first, the gas suppliers have complete control of the postproduction costs; second, the ease with which those costs could be manipulated; and finally, that in most cases the gas suppliers drafted the leases.

He also wrote that there is no market at the wellhead and the price should be based on the first discernable price where the gas is placed for sale. Following the marketable product rule would lead to future contracts being more finely crafted, and would likely include the right to deduct the postproduction costs.

“In the meantime, (landowners) would not be forced to pay for a share of postproduction costs unless specifically required to do so by the lease,” he wrote.

Justice O’Neill wrote that he also would answer the federal court’s question and, like the majority, would hold that the rights and remedies are determined by the contact. Where a lease stated the royalty is based on the value of the gas at the well, Ohio follows the “at the well” rule, he concluded.

Justice O’Neill noted a number of federal and state court decisions have ruled that other states, including Michigan and Kansas, follow an “at the well” rule when the term is in a contract. He wrote the “marketable product” approach is based on an implied promise to prepare the gas for sale, and when there is an expressed term to pay a price based on the “at the well” value, it should control the contract.

“My view is that application of the marketable-product rule runs the risk of giving the (landowner) the benefit of a bargain not made,” he wrote. “When a contract specifies an agreed point at which royalties are valued, implied duties should not be applied to alter that agreement.”

2015-0545. Lutz v. Chesapeake Appalachia, Slip Opinion No. 2016-Ohio-7549.

View oral argument video of this case.

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