‘It’s All About that Basin, Bout Dat Basin…No Trouble (Well Maybe a Little)

Cases from the Shale Plays That Will Impact the Oil and Gas Industry

If there is a lesson to be learned from recent and pending cases in the shale plays, it might just be, “Proceed with Caution.” This is particularly true in states in the newer shale plays, like Ohio, where the local courts are revisiting settled rules governing mineral ownership, conflicts between local and state regulators, traditional lease terms, and even the very nature of oil and gas property rights. While the outcomes of these cases are unclear and sometimes even surprising, what is clear is they will impact operators far beyond the borders of the Utica and the other basins where they are decided.

Ohio, like other states, passed a Dormant Minerals Act (DMA). As originally enacted in 1989, the DMA provides that severed mineral interests shall be deemed abandoned and vested in the surface owner unless a savings event occurred within the preceding twenty years. The DMA was amended in 2006 to require surface owners to serve severed mineral interest holders with a notice of abandonment and to allow the severed interest holder an opportunity to contest abandonment. For years, many players viewed the 89 Act as self-executing (meaning that if no savings event occurred within the statute’s look-back period, the mineral interest was automatically abandoned and vested in the surface owner), that the Act is constitutional, and that the mere mention of an ancient reservation in a surface deed was not the type of “savings event” under the DMA that would prevent a severed interest from being abandoned. This may all change. It may not.

In three separate cases, Walker v. Shondrick-Nau, , Tribett v. Shepherd, and Dodd v. Croskey, the Ohio Court of Appeals for the Seventh District recently affirmed the views held by many of the 89 and 2006 DMAs. Walker held the 89 DMA is self-executing. Tribett found the 89 DMA constitutional under both the state and federal constitutions. And Dodd held that the mere mention of an ancient reservation in a surface deed does not make the severed interest “the subject of” a title transaction under the Act (and hence does not constitute a savings event under the 1989 and 2006 DMAs). Instead, the Court held that for a severed mineral interest to be the “subject of” a title transaction, the mineral interest must itself be conveyed or retained by the grantor. All three cases are now on appeal to the Ohio Supreme Court, and each potentially holds far ranging consequences for a number of oil and gas transactions.

And these are not the only important DMA issues likely to be decided in the near term. In Chesapeake v. Buell, the U.S. District Court for the Southern District of Ohio certified to the Supreme Court of Ohio the questions whether a recorded oil and gas lease and the expiration of an oil and gas lease are title transactions under the DMA. Significantly, the case prompted participation of many amicus curiae. The Ohio Attorney General filed an amicus brief arguing that oil and gas leases are mere licenses, and not real property interests, as commonly understood. This argument would seem to allow Ohio to claim ownership of mineral interests in properties where the State had only purchased surface rights. Industry groups filed their own amicus brief arguing, among other things, that oil and gas leases are in fact and law interests in real property. Buell remains pending. A significant portion of oil and gas law rests on the nature of the property interest in oil and gas (license or fee), the outcome of this case could have a significant ripple effect across much of Ohio oil and gas law.

The Ohio Supreme Court is also addressing the conflict between state and local regulation of development. In 2004, the Ohio General Assembly confirmed that the State had sole and exclusive authority to regulate exploration and production. In 2011, however, a trial court allowed a small city to enforce its municipal code against Beck Energy Corp., essentially upholding a local ban on drilling. The Court of Appeals reversed, holding that the local code was preempted by state law. The matter is now before the Ohio Supreme Court. State of Ohio ex rel. City of Munroe Falls, Ohio et al. v. Beck Energy Corp. et al. Like similar cases in New York and Pennsylvania, Beck Energy could substantially impact where and how Ohio operators can drill. And, like the New York and Pennsylvania cases before it, Beck Energy will be cited in courts across the country.

Usually, the old rules win out and settled assumptions are confirmed. In Hupp et al. v. Beck Energy Corp. et al., the Ohio Seventh District Court of Appeals affirmed the ongoing viability of several typical oil and gas lease terms. The leases contained an habendum clause that stated that the leases will continue “for a term of ten years and so much longer thereafter as oil and gas or their constituents are produced or are capable of being produced on the premises in paying quantities, in the judgment of the Lessee, or as the premises shall be operated by the Lessee in the search for oil or gas”. The landowners challenged the leases alleging that the habendum clause rendered the leases “no-term” or “perpetual” leases that were contrary to public policy and, therefore, void ab initio. The landowners also argued that the leases allowed the lessee to hold the property indefinitely and without production through the payment of minimal delay rentals or by the lessee’s assertion that the land was capable of producing oil and gas. The trial court agreed with the landowners. The operator appealed.

The Court of Appeals reversed, issuing several important rulings, including that the habendum clause in the leases was a two-tiered clause with a definite primary term and an indefinite secondary term (i.e., continuing so long as there is production in paying quantities); that delay rental provisions only apply during the primary term; that the phrase “capable of production” in the habendum clause requires that the well, and not merely the land, be capable of production; that the phrase “capable of being produced on the premises in paying quantities, in the judgment of the lessee,” does not permit the lease to continue in perpetuity at the lessee’s sole discretion but instead a good-faith standard will apply; and that implied covenants, including the implied covenant to develop, may be disclaimed by the parties. Hupp will no doubt serve as a guide to other courts, and it too may end up before the Ohio Supreme Court.

Ohio courts have not had a monopoly on important cases.   The US 5th Circuit Court of Appeals recently ruled for Chesapeake in two cases addressing the deduction of post-production costs from gas royalties. See Potts v. Chesapeake Exploration, No. 13-10601, and Warren v. Chesapeake Exploration, No. 13-10619. While some might argue that Potts and Warren are unremarkable in that they merely affirm the net-back rule for calculating price at the well-head, they are important for the court’s focus on the precise lease terms at issue, notwithstanding other factors that could have weighed in favor of the landowners.

For example, the Potts oil and gas lease provided that royalties would be “the market value at the point of sale of 1/4 of the gas sold or used.” It also provided: “Notwithstanding anything to the contrary herein contained, all royalty paid to Lessor shall be free of all costs and expenses related to the exploration, production and marketing of oil and gas production from the lease including, but not limited to, costs of compression, dehydration, treatment and transportation.” Notwithstanding the lease language and a complex relationship between the lessee Chesapeake and affiliated entities that processed and purchased the gas from Chesapeake, the 5th Circuit held that Chesapeake was entitled to calculate Potts’ royalties net of post-production costs. The Court reasoned that Chesapeake’s sale to its affiliate was at the well, the “point of sale” in the lease, and thus the market value at that point was the price Chesapeake received from its affiliate, which was properly determined by use of the net back method. “Chesapeake has sold the gas at the wellhead. That is the point of sale at which market value must be calculated under the terms of the lessors’ lease.” More post production cost cases are coming and Potts and Warren are likely to feature in many.

In Antero Resources Corp. et al. v. William G. Strudley et al., the Colorado Supreme Court is currently considering whether local courts may issue a “Lone Pine Order” requiring personal injury plaintiffs alleging exposure to frac fluids to provide prima facie evidence to support their claims before discovery may proceed. A “Lone Pine” Order requires plaintiffs to show the identity of the chemical or substance that caused the injury, the specific injury caused by the substance, and a causal link between exposure and the injury before their case may proceed.  A ruling either way will be significant for future toxic tort cases alleging injuries from hydraulic fracturing activity.