Steptoe & Johnson

Energy Law Update: Kentucky Federal Court Holds that "At the Well" Language in Oil and Gas Leases Unambiguously Allows Deduction of Post Production Expenses from Royalty

The United States District Court for the Eastern District of Kentucky recently rejected a royalty owner's challenge to the deduction of post-production expenses from oil and gas royalty payments and predicted that Kentucky would likely adopt the rule followed by the majority of jurisdictions nationwide when interpreting "at the well" lease language for purposes of calculating royalty payments.

In Poplar Creek Dev. Co. v. Chesapeake Appalachia, L.L.C., Poplar Creek Development Company ("Poplar Creek") challenged the method used by Chesapeake Appalachia, L.L.C. ("Chesapeake") to calculate royalty payments on oil and gas leases, contending that Chesapeake was making impermissible deductions for post-production costs before calculating and paying royalties to Poplar Creek and other oil and gas lessors in Kentucky. In its complaint, which sought to certify the lawsuit as a class action, Poplar Creek alleged breach of contract and breach of the implied covenant to market gas. At issue was a lease provision requiring Chesapeake to pay a royalty of 1/8 of the wholesale market value of the gas "at the well based on the usual price paid therefore in the general locality" of the leased premises.

Chesapeake moved for judgment on the pleadings, arguing that a majority of courts in other jurisdictions interpret "at the well" lease language to mean the price in the market where the gas is sold, minus the costs incurred to get the gas from the well to market in the form in which it is sold. Although Kentucky state courts have not yet ruled on the specific issue, Chesapeake supported its position by citing prior Kentucky case law that allowed developers to subtract certain costs from royalty calculations. Conversely, Poplar Creek advocated for application of the "marketable-product rule" adopted by some states, which prohibits the developer from deducting post-production costs prior to calculating royalties.

After surveying the prior case law, District Judge Gregory F. Van Tatenhove predicted that Kentucky courts would adopt the majority rule and interpret the lease provision "requiring Chesapeake to pay royalties based on the gas's value `at the well', to unambiguously mean just that-that Chesapeake must pay royalties on the value of the gas at the well, before it has been gathered, treated, or compressed." Accordingly, the Court found in favor of Chesapeake and held that Chesapeake could properly calculate royalties by first deducting reasonable post-production costs.

Patricia Proctor
1000 Fifth Avenue, Suite 250
Huntington, WV 25701 
304.526.8088
patricia.proctor@steptoe-johnson.com

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