On May 21, 2020, the Sixth Circuit Court of Appeals ruled for a lessee in an oil and gas lease dispute, finding that the lessee properly considered post-production costs when calculating the landowners’ royalties.  See Henceroth v. Chesapeake Exploration, LLC, 6th Cir. No. 19-3942.

The lessee, Chesapeake Exploration (Chesapeake), produced oil and gas from the plaintiff-landowners’ property, which it sold at the wellhead to its affiliate, Chesapeake Marketing (Marketing).  Marketing then prepared the products for sale downstream.  This involved arranging for pipeline transportation and processing natural gas into methane and natural gas liquids.  Once downstream, Marketing sold the finished products to third parties at prices that reflected the added value of these post-production services.  Marketing paid Chesapeake based on the prices it received from these third parties, less Marketing’s post-production costs.  Chesapeake, in turn, paid the landowners on the amounts it received from Marketing.  The landowners sued Chesapeake, claiming it underpaid their royalties because the royalties were based on the amounts Chesapeake received from Marketing, rather than on the higher downstream prices that Marketing realized on its sales to third-party purchasers.

The Sixth Circuit found that Chesapeake properly paid the landowners according to the terms of their leases.  Those leases provided that Chesapeake would pay royalties on gas and oil “produced and marketed from the Leasehold.”  Thus, “the first sale price is the proper royalty base.”  Chesapeake extracted, i.e., “produced,” the raw products from the ground and immediately sold, i.e., “marketed,” the products to Marketing.  “And all of this happens at the property (‘from the Leasehold’), not downstream.”  The court disagreed with the landowners’ claim that Chesapeake did not “market” the oil and gas and that the only actual marketing occurred when the products were sold to unaffiliated third parties.  Citing a recent Ohio appeals decision involving similar leases, the court noted that the dictionary “definition of ‘market’ is ‘to expose for sale in a market’ or to ‘sell’ . . . which is what happens when [Chesapeake] sells oil and gas to [Marketing].”

Read the decision here.