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Ohio Supreme Court Expected to Weigh-In Soon on Post-Production Royalty Deductions

The Ohio Supreme Court is expected to soon decide on a case that could determine whether oil and natural gas producers in the state can deduct post-production costs, such as those for compression, dehydration and transmission, from landowners' royalty checks.

In 2009, a group of landowners filed a class action lawsuit against Chesapeake Energy Corp. affiliate Chesapeake Appalachia LLC in the U.S. District Court for the Northern District of Ohio. The landowners alleged that Chesapeake and non-affiliated predecessor companies had underpaid gas royalties due to them under the terms of their leases by deducting post-production costs.

The case dragged on, and last year the federal court certified a question to the Ohio Supreme Court asking if the state follows the "at the well" rule, which allows post-production deductions, or if it follows some version of the "marketable product" rule, which limits post-production deductions.

In June 2015, the state supreme court agreed to hear the case (Regis F. Lutz et al, v Chesapeake Appalachia LLC, No. 2015-0545). While neighboring states have addressed the issue, there is no controlling precedent from the Ohio Supreme Court. It's the high court's first time addressing the issue.

Chesapeake, which has settled or is fighting similar cases in other states, including Pennsylvania, Texas and Oklahoma (see related story), has argued that Ohio contract law makes clear that the state should follow the "at the well" rule and allow the netback method to calculate deductions from royalties. It has maintained that Ohio courts have long held that oil and gas leases -- similar to contracts -- must be applied as written.

Oral arguments in the case were held in January. Those proceedings were largely consumed by education, with attorneys explaining to the justices how oil and gas is produced and what it takes to get production to market. Chesapeake, though, argued that the court should follow the language in its leases. The landowners' counsel argued that the court should ignore the "at the well" language in the lease because there are no more true sales of natural gas at the wellhead in today's industry.

The justices could also not select a rule and let state courts determine royalty calculation methods on a case-by-case basis. Ohio Supreme Court spokesman Bret Crow said he wasn't exactly sure when an opinion would be issued in the case, but said this week that "we are within the average time frame in which a decision could come out." John Keller, one of the attorneys representing Chesapeake with the Columbus-based firm Vorys, Sater, Seymour and Pease LLP, said he expects an opinion by this summer, but he added that the "court moves at its own speed."

Regardless of the high court's opinion, it's not likely to be the last time state courts hear about the issue. A similar case was decided in neighboring Pennsylvania in 2010. In Kilmer v Elexco Land Services and Southwestern Energy Production Co., the Pennsylvania Supreme Court ruled in favor of producers saying the netback method of calculating royalties did not violate state law (see Daily GPI, March 29, 2010) .

Since then, a spate of lawsuits have been filed against Chesapeake and other producers for the deduction of post-production costs. An $18 million settlement with thousands of landowners in the state and Chesapeake is currently pending, while last year the Pennsylvania Attorney General's office filed a wide-ranging lawsuit against Chesapeake and some of its affiliates for deceptive marketing practices related to the deductions (see Shale Daily, March 2; Dec. 9, 2015).

Pennsylvania lawmakers have also tried and failed in the wake of those lawsuits to pass legislation that would clarify language in the state’s Guaranteed Minimum Royalty Act of 1979, which does not address marketing costs or how they should be factored in royalty payments (see Shale Daily, June 26, 2015).

In the Ohio case, the Ohio Oil and Gas Association, the American Petroleum Institute and Gulfport Energy Corp. have all filed friend-of-the-court briefs in support of Chesapeake.

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