Watch your Language with Oil and Gas Leases in Ohio

By: Stephen D. Richman-Senior Counsel at Kohrman, Jackson & Krantz, PLL

As established in other “Watch Your Language” articles for this Blog, as a general rule, courts will uphold language in commercial agreements, unless it is contrary to statutory law or public policy. Because of this judicial deference to “commercial language”, you must say what you mean, precisely, or a judge will decide what you meant. Compounding the problem is the fact that courts typically refuse to consider extrinsic evidence of a party’s intent (offered by such party) if they determine the contract language is clear and unambiguous. What is said within the “four corners of an agreement” is simply deemed the best evidence of intent.  

The Ohio Supreme Court in Lutz v. Chesapeake Appalachia, L.L.C., Slip Opinion No. 2016-Ohio-754 recently espoused this basic tenet of Ohio law in regards to oil and gas leases.

Lutz v. Chesapeake came to the Ohio Supreme Court in a different manner than most cases. Frequently, a trial court decision in Ohio gets appealed to an Ohio court of appeals, and that decision may then be appealed to the Ohio Supreme Court. In Lutz, the case originated in the United States District Court for the Northern District of Ohio (Eastern Division), and then this federal court certified a question of law to the Supreme Court of Ohio pursuant to Ohio S.Ct.Prac.R. 9.01. A certified question is a formal request by one court to another for an opinion on a question of law.

The question of law the U.S.District Court wanted answered, was in an oil and gas lease, when figuring royalty payments due the landowner, “Does Ohio follow the ‘at the well’ rule (which permits the deduction of post-production costs [before royalty payments are calculated]) or does it follow some version of the ‘marketable product’ rule (which limits the deduction of post-production costs under certain circumstances)?”

The Ohio Supreme Court in Lutz respectfully declined to answer the question of law before it, basically because the court had no unique, broad oil and gas law for the U.S. District Court to apply to all oil and gas leases; rather, its holding would depend much more on facts and general contract (interpretation) law.

The facts of the case are as follows: The respondents, Regis and Marion Lutz, Leonard and Joseph Yochman, and C.Y.Y., L.L.C., the landowner-landlords claimed that petitioner, Chesapeake Appalachia, L.L.C., the tenant-oil and gas company, underpaid gas royalties under the terms of their leases. No one disputed that the oil and gas company needed to pay for all the production costs (i.e., the costs of producing the gas from below the ground and bringing it to the wellhead) incurred. The dispute centers on “postproduction costs”(such as the cost to gather, process and compress the gas, the cost to transport the gas and other costs incurred after the gas is produced at the wellhead and before it is sold). Specifically, the issue is whether or not postproduction costs should be deducted from the sale price of gas before royalty payments to the landowner are calculated. The language of the leases specifies that royalties are to be paid based on “market value at the well” and on the “field market price.”

The oil and gas company argued that the plain language of the leases controls and that since the leases specify that the  royalty is based on the value of the gas at the well, any postproduction costs would need to be deducted from the sale price to arrive at the well price before the royalty percentage can be calculated. The landowners claimed that there is no real market at the well, so the oil and gas company “has an implied duty to market the product once it leaves the wellhead, and therefore the lessee must bear the cost of bringing the product to the market and not deduct the costs before calculating the royalty.”

The Ohio Supreme Court declined to answer the U.S. District Court’s question, basically because it was the wrong question. The Supreme Court of Ohio concluded that there is no specific rule of law particular to oil and gas prices at the well head vs. afterwards. Instead, the law to be applied in this case would be the traditional rules of contract construction, because according to the court, an oil and gas lease is basically, a contract. Specifically, the court stated that the law to be applied should be the “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 contract language.”  

It will have to be the U.S. District Court, however to apply the law in this case, because the case was dismissed by the Ohio Supreme Court. The court explained that if the contract (lease) language is ambiguous, they cannot look to intent because there was no extrinsic evidence brought before their court. Alternatively, the Supreme Court of Ohio reasoned that if the lease language is not ambiguous, then the federal court should have no trouble interpreting the leases without its assistance.

What is the moral of this story? The only thing clear about Lutz v. Chesapeake (other than there being no specific rule of law in Ohio re: deduction of post production costs when calculating oil and gas royalties) is the need to be clear when drafting oil and gas leases. If the parties had specified exactly what costs are to be deducted when determining gas prices and calculating royalties, there would have been no need for litigation, and no worry regarding what  a judge will decide they meant.