As I wrote last spring, the case of Lutz v. Chesapeake Appalachia, LLC, Case No. 2015-0545, offered the Ohio Supreme Court the chance to significantly impact Ohio law on the calculation of oil and gas royalties. Parties seeking some clarity on that topic will be disappointed to learn that the Ohio Supreme Court chose not to decide the question presented, instead sending the question back to the federal courts.
Under a standard oil and gas lease, the energy company (the lessee) pays the owner of the mineral interests (the lessor) a certain royalty for the oil and gas produced from the leased property. The lessee generally bears the costs of production, such as drilling and operating the well. The Lutz case posed the related question of whether lessees are permitted to deduct postproduction expenses, such as the costs of refining or transporting the oil and gas before sale, from those royalty payments to lessors. There are two competing views: the “at the well” rule, under which the lessee may deduct postproduction expenses to determine the value of the oil and gas “at the well,” and the “marketable-product” rule, under which the lessee’s ability to deduct postproduction expenses is limited. Lutz was originally filed in federal court in Akron, but the federal judge certified the following question directly to the Ohio Supreme Court for resolution: does Ohio follow the “at the well” rule or the “marketable-product” rule?
In a majority opinion authored by Justice Sharon Kennedy, five members of the court agreed that oil and gas leases in Ohio are subject to standard rules of contractual interpretation. Therefore, the majority reasoned, the oil and gas leases at issue had to be interpreted in accordance with the parties’ intent. If the leases were unclear or ambiguous as to the parties’ intent, or if the otherwise plain language of the leases was subject to “special meaning” due to circumstances surrounding the leases, then the court must resort to extrinsic evidence to ascertain the parties’ intent. The majority did not reach the question of whether the multiple oil and gas leases at issue were ambiguous; instead, the court reasoned that if the leases were not ambiguous, the federal court could interpret them without assistance, and even if the leases were ambiguous, the court did not have the necessary extrinsic evidence to determine the parties’ intent. Therefore the court declined to answer the question presented and sent the case back to the federal court.
While the majority’s decision may be a disappointing dodge to some, the two dissents in the case did provide answers to the question presented––albeit conflicting ones. Justice Pfeifer wrote that he would’ve ruled that Ohio follows the “marketable-product” rule, basing his reasoning on three factors: “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.” Adopting the marketable-product rule would likely result in oil and gas leases “being more finely drafted to incorporate postproduction costs” in the future, reasoned Justice Pfeifer––but that was “all the better” for the parties and courts trying to interpret those leases. In contrast to Justice Pfeifer, Justice O’Neill wrote that he would’ve adopted the “at the well” rule because the contrary marketable-product rule “runs the risk of giving the lessor the benefit of a bargain not made.”
It is likely a matter of when, not if, the Ohio Supreme Court is confronted with this issue again––hopefully with a better-developed factual record that will allow the court to render a decision on the merits. In the meantime, both sides of the debate can take some solace from the competing dissents in the Lutz case and use them to further hone their arguments. Unfortunately for Ohio landowners and other proponents of the marketable-product rule, Justice Pfeifer will not be on the bench to take up their arguments next time: he is retiring at the end of 2016. Either way, stakeholders on both sides of the issue would be well-advised to continue monitoring how Ohio courts address the issue of postproduction expenses in the coming years.