Lutz v. Chesapeake Appalachia, L.L.C. (Slip Opinion)

[Until this opinion appears in the Ohio Official Reports advance sheets, it may be cited as Lutz
v. Chesapeake Appalachia, L.L.C., Slip Opinion No. 2016-Ohio-7549.]
NOTICE
This slip opinion is subject to formal revision before it is published in an
advance sheet of the Ohio Official Reports. Readers are requested to
promptly notify the Reporter of Decisions, Supreme Court of Ohio, 65
South Front Street, Columbus, Ohio 43215, of any typographical or other
formal errors in the opinion, in order that corrections may be made before
the opinion is published.
SLIP OPINION NO. 2016-OHIO-7549
LUTZ ET AL. v. CHESAPEAKE APPALACHIA, L.L.C.
[Until this opinion appears in the Ohio Official Reports advance sheets, it
may be cited as Lutz v. Chesapeake Appalachia, L.L.C., Slip Opinion No.
2016-Ohio-7549.]
Certified question of state law—Cause dismissed.
(No. 2015-0545—Submitted January 5, 2016—Decided November 2, 2016.)
ON ORDER from the United States District Court for the Northern District of Ohio,
Eastern Division, Certifying a Question of State Law, No. 4:09-cv-2256.
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KENNEDY, J.
I. Introduction
{¶ 1} The United States District Court for the Northern District of Ohio,
Eastern Division, has certified the following question to this court pursuant to
S.Ct.Prac.R. 9.01: “Does Ohio follow the ‘at the well’ rule (which permits the
deduction of post-production costs) or does it follow some version of the
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‘marketable product’ rule (which limits the deduction of post-production costs
under certain circumstances)?”
{¶ 2} Under 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 question of law submitted by the United States District Court for the
Northern District of Ohio, Eastern Division and dismiss the cause.
II. Facts and Procedural History
{¶ 3} The action in the federal court is a putative class action in which
respondents here, Regis and Marion Lutz, Leonard Yochman, Joseph Yochman,
and C.Y.Y., L.L.C., the landowner-lessors, claim that petitioner, Chesapeake
Appalachia, L.L.C., the lessee, underpaid gas royalties under the terms of their
leases. The leases in this case were signed in 1970 and 1971. Both petitioner and
respondents agree that by the early 1990s, deregulation had significantly changed
the natural-gas market.
{¶ 4} It is undisputed that under each lease, the lessee must bear all the
production costs, i.e., the costs of producing the gas from below the ground and
bringing it to the wellhead. The dispute centers on postproduction costs, i.e., the
costs incurred after the gas is produced at the wellhead and before it is sold. Those
postproduction costs may include, among other costs, the cost of gathering the gas
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from various wells, the cost to process and compress the gas, and the cost of
transporting the gas to the point of sale.
{¶ 5} In its certification order to this court, the federal court set out the
royalty clauses found in the leases:
[1] The royalties to be paid by Lessee are * * * (b) on gas, including
casinghead gas or other gaseous substance, produced and sold or
used off the premises or for the extraction of gasoline or other
product therefrom, 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.
[2] Lessee [sic, Lessor] to receive the field market price per
thousand cubic feet for one-eighth (1/8) of all gas marketed from the
premises.
[3] Lessee covenants and agreed to deliver to the credit of the
Lessor, as royalty, free of cost, in the pipeline to which the wells
drilled by the Lessee may be connected the equal one-eighth part of
all Oil and/or Gas produced and saved from said leased premises.
{¶ 6} At issue is whether the lessee is permitted to deduct postproduction
costs from the lessors’ royalties, and, if so, how those costs are to be calculated.
{¶ 7} The lessors assert that under the language of the leases, which
specifies that royalties are to be paid based on “market value at the well” or the
“field market price,” postproduction costs should not be deducted from the sale
price before the royalty payments are calculated. The lessors argue that because
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there is no market at the well, the lessee has an implied duty to market the product
once it is severed from the wellhead, and the lessee must bear the cost of bringing
the product to the market.
{¶ 8} The lessee asserts that the plain language of a lease controls and that
when a lease specifies that the owner’s royalty is based on the value of the product
at the well, any postproduction costs must be deducted from the sale price to arrive
at the well price before the agreed-upon royalty can be calculated. The lessee also
disputes the factual veracity and relevance of the lessors’ contention that there is
no market at the well. The lessee argues that regardless of where the gas is sold,
the lease language provides for royalty payments based on the value of gas at the
well.
III. Law and Analysis
{¶ 9} In Ohio, oil and gas leases are contracts. Harris v. Ohio Oil Co., 57
Ohio St. 118, 129, 48 N.E. 502 (1897). “The rights and remedies of the parties to
an oil or gas lease must be determined by the terms of the written instrument
* * *.” Id. Accord Chesapeake Exploration, L.L.C. v. Buell, 144 Ohio St. 3d 490,
2015-Ohio-4551, 45 N.E.3d 185, ¶ 53. 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.”
Skivolocki v. E. Ohio Gas Co., 38 Ohio St. 2d 244, 313 N.E.2d 374 (1974),
paragraph one of the syllabus. “Extrinsic evidence is admissible to ascertain the
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intent of the parties when the contract is unclear or ambiguous, or when
circumstances surrounding the agreement give the plain language special
meaning.” Graham v. Drydock Coal Co., 76 Ohio St. 3d 311, 313-314, 667 N.E.2d
949 (1996). This is particularly true “when circumstances surrounding an
agreement invest the language of the contract with a special meaning, [because]
extrinsic evidence can be considered in an effort to give effect to the parties’
intention.” Martin Marietta Magnesia Specialties, L.L.C. v. Pub. Util. Comm., 129
Ohio St. 3d 485, 2011-Ohio-4189, 954 N.E.2d 104, ¶ 29. Extrinsic evidence can
include “(1) the circumstances surrounding the parties at the time the contract was
made, (2) the objectives the parties intended to accomplish by entering into the
contract, and (3) any acts by the parties that demonstrate the construction they gave
to their agreement.” United States Fid. & Guar. Co. v. St. Elizabeth Med. Ctr., 129
Ohio App. 3d 45, 56, 716 N.E.2d 1201 (2nd Dist.1998).
{¶ 10} The certified question asks us to declare, based on the language of
the three different royalty clauses in the five leases before us, whether Ohio law
imposes the “at-the-well” rule or the “marketable product” rule. The leases at issue
were negotiated and signed prior to the culmination of deregulation of the natural
gas marketplace by the Federal Energy Regulatory Commission in 1992. See
Pipeline Serviced Obligations and Revisions to Regulations Governing Self-
Implementing Transportation under Part 284 of the Commission’s Regulations, 57
Fed.Reg. 13,267-02 (1992). The contractual relationship between the lessor and
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the lessee spans more than four decades. If the language of the leases is ambiguous,
we cannot give effect to the parties’ intent, because we do not have extrinsic
evidence. If the language of the leases is not ambiguous, then the federal court
should be able to interpret the leases without our assistance.
IV. Conclusion
{¶ 11} Under 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 and dismiss this cause.
Cause dismissed.
O’CONNOR, C.J., and O’DONNELL, LANZINGER, and FRENCH, JJ., concur.
PFEIFER, J., dissents, with an opinion.
O’NEILL, J., dissents, with an opinion.
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PFEIFER, J., dissenting.
{¶ 12} We have been asked whether Ohio follows the “at the well” rule
(which permits the deduction of postproduction costs) or the “marketable product”
rule (which limits the deduction of postproduction costs under certain
circumstances) in the calculation of royalties under an oil and gas lease. I would
answer the question certified by the federal court, and I would state that Ohio
follows the marketable-product rule.
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{¶ 13} The marketable-product rule appropriately gives lessors the benefit
of the bargain they sought in the leases at issue here—one eighth of the value of the
material pulled from the land. Three significant factors influence my answer: the
complete control that lessees have over postproduction costs, the ease with which
these costs could be manipulated, and the fact that, in most instances, the lessee
drafts the lease document.
{¶ 14} Because there is no longer a market at the wellhead, the amount due
a lessor should be based on the price at the first discernible market downstream.
Adopting this rule would, of course, result in all future leases being more finely
crafted to incorporate postproduction costs—all the better. In the meantime, lessors
would not be forced to pay for a share of postproduction costs unless specifically
required to do so by the lease.
{¶ 15} I would adopt the marketable-product rule. I dissent.
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O’NEILL, J., dissenting.
{¶ 16} The United States District Court for the Northern District of Ohio,
Eastern Division, has certified the following question to this court: “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)?” On June 03,
2015, this court agreed to answer the question. 142 Ohio St. 3d 1474, 2015-Ohio-
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2104, 31 N.E.3d 653. I disagree with the majority’s decision to decertify the
question. In response to the federal court’s question, I would hold that in Ohio, the
“rights and remedies of the parties to an oil or gas lease must be determined by the
terms of the written instrument.” Chesapeake Exploration, L.L.C. v. Buell, 144
Ohio St. 3d 490, 2015-Ohio-4551, 45 N.E.3d 185, ¶ 53. Where a lease provides that
the lessor’s royalty is based on value at the well, Ohio follows the “at the well” rule.
I would further hold that “at-the-well,” under Ohio law, is defined as the gross
proceeds of a sale minus postproduction costs.
{¶ 17} The at-the-well rule is premised on the understanding that
production is complete, for purposes of calculating royalties, when the lessee
captures the product and it is held at the wellhead. 3A Saint-Paul, Summers Oil
and Gas, Section 33.2, at 141 (3d Ed.2008); see also Piney Woods Country Life
School v. Shell Oil Co., 726 F.2d 225, 242 (5th Cir.1984) (“market value at the
well” means market value before processing and transportation). Thus, in
jurisdictions following the at-the-well rule, “at the well” lease language refers to
the location as well as the quality of the gas for calculating a royalty, regardless of
where the lessee sells the gas. Piney Woods Country Life School at 231; Schroeder
v. Terra Energy, Ltd., 223 Mich.App. 176, 187, 565 N.W.2d 887 (1997) (“ ‘At the
well’ refers to proceeds minus refining and transportation costs, as opposed to
proceeds at the point of sale, where refining and transportation costs are not
deducted”); Poplar Creek Dev. Co. v. Chesapeake Appalachia, L.L.C., 636 F.3d
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235, 244 (6th Cir.2011) (“at the well” refers to gas in its natural and unprocessed
state, and a lessee is entitled to deduct the costs of processing and transportation
from the lessor’s royalty payment); Sternberger v. Marathon Oil Co., 257 Kan. 315,
322, 894 P.2d 788 (1995) (“The lease’s silence on the issue of postproduction
deductions does not make the lease ambiguous. The lease clearly specifies that
royalties are to be paid based on ‘market price at the well’ ”).
{¶ 18} Conversely, under the marketable-product rule, production is not
considered complete until the lessee has made the product marketable. 3A Saint-
Paul, Section 33.3, at 146-147. The legal principle here is that in addition to the
express terms of the lease, there are covenants or duties that are attendant to all oil
and gas leases, one of which is the lessee’s implied covenant to market the product.
See 2 Brown, Brown & Gillaspia, The Law of Oil and Gas Leases, Section 16.01
and 16.02, at 16-5 to 16-7 (2d Ed.2016). The duty on the lessee to make the product
marketable does not arise from the express terms of the lease but from the implied
covenant to market the product. Wellman v. Energy Res., Inc., 210 W.Va. 200, 210,
557 S.E.2d 254 (2001).
{¶ 19} My view is that application of the marketable-product rule runs the
risk of giving the lessor the benefit of a bargain not made. As a Michigan appellate
court has observed, interpreting at-the-well language to refer to gross proceeds at
the market requires the lessee to pay royalties
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not only on the value of the gas at the wellhead, but also upon the
costs that [the lessee] has incurred to prepare the gas for, and
transport the gas to, market. Thus [the lessors’] royalties would be
increased merely as a function of [the lessee’s] own efforts to
enhance the value of the gas through postproduction investments
that it has exclusively underwritten.
Schroeder at 189.
{¶ 20} Although this court has not directly addressed whether an implied
covenant to market applies to oil and gas leases, this court has addressed the
imposition of an implied covenant of reasonable development. State ex rel.
Claugus Family Farm, L.P. v. Seventh Dist. Court of Appeals, 145 Ohio St. 3d 180,
2016-Ohio-178, 47 N.E.3d 836, ¶ 31-33. We concluded that an implied covenant
of reasonable development arises only when the lease is silent on the subject. Id.
at ¶ 31, citing Harris v. Ohio Oil Co., 57 Ohio St. 118, 128, 48 N.E. 502 (1807). In
Claugus, the lease included a provision requiring development to commence within
ten years and specific language disclaiming the use of implied covenants. Id. at
¶ 32. Accordingly, this court declined to impose an implied covenant to develop
the land. Id. See also Kachelmacher v. Laird, 92 Ohio St. 324, 110 N.E. 933
(1915), paragraph one of the syllabus (“There can be no implied covenants in a
contract in relation to any matter that is covered by the written terms of the contract
itself”). When a contract specifies an agreed point at which royalties are valued,
implied duties should not be applied to alter that agreement.
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{¶ 21} Naturally, as the multiple lease provisions presented in this case
demonstrate, the language of leases may differ, and the law applicable to one form
of lease may not be applicable to another form of lease. Harris at 129. That fact
notwithstanding, I would answer the question posed by the federal court. Pursuant
to existing Ohio law, the parties’ rights and remedies must be determined by the
terms of the lease. Chesapeake Exploration, L.L.C., 144 Ohio St. 3d 490, 2015-
Ohio-4551, 45 N.E.3d 185, ¶ 53. When a lease provides that the lessor’s royalty is
based on value at the well, Ohio follows the at-the-well rule. I would further hold
that “at the well,” under Ohio law, is defined as the gross proceeds of a sale minus
postproduction costs.
{¶ 22} I respectfully dissent.
_________________
Kirkland & Ellis L.L.P. and Daniel T. Donovan; Vorys, Sater, Seymour &
Pease, L.L.P., and John K. Keller; and Reed Smith, L.L.P., Kevin C. Abbott, and
Nicolle R. Snyder Bagnell, for petitioner.
Lowe, Eklund, & Wakefield Co., L.P.A., and James A. Lowe; Law Office
of Robert C. Sanders and Robert Sanders, for respondents.
Lija Kaleps-Clark, in support of petitioner for amici curiae Ohio Oil and
Gas Association, Artex Oil Company, Eclipse Resources I, L.P., Enervest
Operating, L.L.C., NGO Development Corporation, Inc., Rex Energy Corporation,
and Sierra Resources, L.L.C.
Porter, Wright, Morris & Arthur, L.L.P., L. Bradford Hughes, and
Christopher J. Baronzzi; and Matthew A. Haynie, in support of petitioner for
amicus curiae American Petroleum Institute.
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McGinnis, Lochridge & Kilgore and Bruce M. Kramer, in support of
petitioner for amicus curiae Bruce M. Kramer.
Krugliak, Wilkins, Griffiths & Dougherty Co., L.P.A., William J. Williams,
Scott M. Zunakowski, Gregory W. Watts, and Aletha M. Carver, in support of
neither side for amici curiae Sam Johnson, Zehentbauer Family Land, L.P.,
Hanover Farms, L.P., and Bounty Minerals, L.L.C.
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