Jennifer Thompson of Reed Smith. Jennifer Thompson of Reed Smith.

The majority rule in oil and gas producing jurisdictions is the “at-the-well” rule, pursuant to which an oil and gas producer applies the net back method to determine the value of gas at the well for royalty calculation purposes, where the gas is sold downstream of the well. The net back method starts with the value of the gas at the downstream sales point, and nets out the costs incurred between the wellhead and the point of sale, to arrive at a value of the gas at the well. Pennsylvania, along with states including Kentucky, Texas, Michigan, North Dakota and now, Ohio, follow the “at-the-well” rule. Pennsylvania first adopted the “at-the-well” rule in 2010 in Kilmer v. Elexco Land Services, 990 A.2d 1147 (Pa. 2010).

Whether Ohio would follow the at-the-well rule remained an open issue until recently. On Oct. 25, a federal district court in Ohio held that Ohio would also adopt the at-the-well rule. In Lutz v. Chesapeake Appalachia, No. 4:09-cv-2256, (N.D. Ohio Oct. 25), the court joined the majority of states that have adopted the at-the-well rule, also known as the “net-back” method, in which, to calculate the royalty to be paid to lessors, post-production costs are netted out of the downstream sales proceeds to arrive at the wellhead price.

The Lutz case actually commenced over eight years ago, on Sept. 30, 2009, when plaintiff-lessors filed a putative class action complaint against Chesapeake Appalachia, and other defendants. The plaintiffs were lessors with interests in natural gas estates underlying property in Ohio. In accordance with the leases, the lessee, Chesapeake, pays lessors a pro rata share of the downstream sales price of gas, and depending on the well and the lease, allocates a pro rata share of the post-production costs against the royalty payment. One of the relevant leases at issue in the litigation, and the focus of the federal district court’s decision, contains the following language:

The royalties to be paid by the lessee are: … (b) on gas, … produced from said land and sold or used off the premises … 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 … .

The plaintiffs alleged in the putative class action that, beginning in 1993, Chesapeake began fraudulently underpaying royalties by deducting certain post-production costs and calculating the monthly royalty payment using a price that was less than market price, among other claims. The parties filed cross-motions for summary judgment. Because no Ohio court had addressed the issue of whether Ohio applies the at-the-well rule or the marketable product rule applied by a minority of jurisdictions, the federal district court certified the following question to the Ohio Supreme 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)?

After hearing oral argument on the issue, the Ohio Supreme Court issued an opinion declining to answer the certified question, and noted:

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.

See Lutz v. Chesapeake Appalachia, 71 N.E.2d 1010, 1013 (Ohio 2016). After the Ohio Supreme Court declined to answer the question certified by the district court, Chesapeake again moved for partial summary judgment, seeking a declaration by the court that those leases with royalty clauses valuing the royalty payment at the well should be based on the value of gas at the well, and not some other location, and that the market value of gas at the well is the proper valuation measure for paying royalties in at-the-well leases. The district court agreed with Chesapeake. Applying Ohio law on contract interpretation, the court concluded that at the well was not an ambiguous term in the lease, and that Chesapeake had not breached the leases by deducting post-production costs to arrive at the wellhead price.

The court noted that the minority of states that follow the marketable-product rule conclude that the lease is silent on the issue of post-production costs, and instead fall back on implied contractual duties, including the duty to market the gas once gas is extracted from the lessor’s land. While Ohio also recognizes implied covenants, including the implied duty to market, such implied covenants only arise where the lease is silent on a subject.

The Lutz court concluded that applying the marketable-product rule would ignore the plain language of the lease requiring that royalties be paid based on the “market value at the well,” which was not ambiguous. The court granted Chesapeake’s motion for summary judgment and held that Ohio would apply the at-the-well rule. This ruling puts Ohio squarely in the majority of oil and gas producing states, including Pennsylvania. In fact, Pennsylvania’s seminal case on at- the-well rule and the net-back method, Kilmer, was recently relied upon by the West Virginia Supreme Court in Leggett v. EQT Products , 800 S.E.2d 850 (W. Va. May 26, 2017), where the court endorsed the net-back method and determined “that the most logical way to ascertain the wellhead price is, in fact, to deduct the post-production costs from the ‘value-added’ downstream price in an effort to replicate the statutory wellhead value.”

The Lutz case reaffirms the rule—followed in both Ohio and Pennsylvania—that oil and gas leases should be interpreted as ordinary contracts and in accordance with their plain meaning, and that language in a royalty clause such as at the well must be given effect. Implied covenants will not be read into oil and gas leases to change their plain meaning.

Jennifer Thompson is an associate in Reed Smith’s Energy and Natural Resources Group in Pittsburgh, Pennsylvania.