Title: Lutz v. Chesapeake Appalachia, L.L.C.

State: ohio

Issuer: Ohio Supreme Court

Document:

[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 
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‘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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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 
January Term, 2016 
 
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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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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. 
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{¶ 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-
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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 
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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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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. 
January Term, 2016 
 
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{¶ 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. 
SUPREME COURT OF OHIO 
 
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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. 
_________________