Issue of Deduction of Post-Production Costs From Royalty Certified to the Ohio Supreme Court

In Lutz v. Chesapeake Appalachia, the U.S. District Court for the Northern District of Ohio 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)?

In Lutz the plaintiff-lessors seek to certify a class against the lessee alleging underpayment of royalties from natural gas production resulting from post-production costs deducted from royalty payments, including the cost of gathering gas, processing, compression and transportation costs. At issue is whether Chesapeake may deduct the costs and, if so, how such costs are to be calculated. The case involves three different royalty clauses:

1. The royalties to be paid by Lessee are…. (b) on gas, including casing head 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 to receive the field market price per thousand cubic feet for one-eighth (1/8) of all gas marketed from the premises; and
3. Lessee covenants and agrees 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.

The District Court noted that courts across the country are split as to whether these type of royalty clauses allow deductions of post-production costs from royalty payments, but found no controlling decision by the Ohio Supreme Court. If the Supreme Court agrees to answer the question, which we think is likely, the parties, and any amicus curiae, will be permitted to brief the issue for the Court’s consideration and then the Court will hear oral arguments prior to issuing its answer. Lutz, et al., vs. Chesapeake Appalachia, L.L.C., N.D. Ohio No. 4:09-cv-02256, #130 (Apr. 1, 2015). 

NOTE: This general summary of the law should not be used to solve individual problems since slight changes in the fact situation may require a material variance in the applicable legal advice.

If you have any questions concerning this client alert, please contact Attorney Gregory W. Watts at 330-497-0700.