Lutz v. Chesapeake Appalachia, L.L.C. (Slip Opinion) , 2016 Ohio 7549 ( 2016 )


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  • [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.
    __________________
    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
    SUPREME COURT OF OHIO
    ‘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 decertify
    the question of law submitted by the United States District Court for the Northern
    District of Ohio, Eastern Division.
    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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    January Term, 2016
    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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    January Term, 2016
    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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    SUPREME COURT OF OHIO
    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.
    _________________
    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.
    6
    January Term, 2016
    {¶ 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.
    _________________
    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-
    7
    SUPREME COURT OF OHIO
    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 8
                                    January Term, 2016
    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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    SUPREME COURT OF OHIO
    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.
    10
    January Term, 2016
    {¶ 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.
    11
    SUPREME COURT OF OHIO
    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.
    _________________
    12
    

Document Info

Docket Number: 2015-0545

Citation Numbers: 2016 Ohio 7549

Judges: Kennedy, J.

Filed Date: 11/2/2016

Precedential Status: Precedential

Modified Date: 11/2/2016