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New Ohio Court Ruling Tackles Issues Critical to Lessees

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Another significant oil and gas law decision has recently been published out of the Ohio Seventh District Court of Appeals. In the case of Hogue v. Whitacre, 2017-Ohio-9377, released on December 22, 2017, the Seventh District addressed two important issues.  First the Court concluded that indirect costs such as costs of accounting, interest, postage, office supplies, telephone charges, and depreciation of office equipment are to be excluded in determining whether a well is producing in paying quantities while royalties, gas severance tax, maintenance, and operating costs directly relating to production of oil and gas are direct costs and will be considered.  On the second issue, dealing with temporary cessation of production, the Court considered mechanical issues of an off-lease third party’s facilities as the cause of the temporary cessation, and evaluated the reasonableness of the lessee’s actions in response to that event, rather than limiting a consideration of temporary cessation to mechanical issues only as to the well or lease as is the case in some jurisdictions.

In Hogue, the lessors asserted that the well on the lease entered into in 2006, had failed to produce in paying quantities during the period of 2014 to 2015. Production records showed that the well produced a profit in excess of $1,000 per year from 2006 to 2012, a small profit in 2013, a small loss in 2014 and 2015, and a profit of over $1,000 a year after that. During the time period of the loss, the well was shut in or had minimal production due to the shutdown of the third party transporter’s compressor station for repair and replacement. The trial court ruled for the well operator on consideration of cross motions for summary judgment.

On appeal, the lessors argued that cost exhibits provided by lessee should not have been considered and that certain indirect costs of operation were improperly excluded from the exhibits as prepared by the operator. The Seventh District, in reviewing the content of the exhibits, concluded that, in a determination of paying quantities in Ohio, only direct costs of operation of the well or wells in dispute should be considered and not indirect costs. The Court cited the recent decision of Paulus v. Beck Energy Corporation, 7th Dist. No. 16 MO 0008-2017-Ohio-5716 regarding the consideration of direct costs but acknowledged that there is no prior Ohio case law addressing what would be considered indirect costs,. In its decision, the Court included royalties, gas severance tax, maintenance, and operating costs directly relating to production of oil and gas as direct costs to be considered and refused to consider administrative overhead costs. Citing Mason v. Ladd Petroleum 1981 OK 73, 630 P. 2d 1283 (OK 1981),  the Court characterized charges such as costs of accounting, interest, postage, office supplies, telephone charges, and depreciation of office equipment as examples of general administrative charges which are indirect costs, not to be considered in a production in paying quantities analysis.

On the issue of whether a cessation of production from January 2014 to November 2015 resulted in termination of the lease as asserted by the lessors, the Court affirmed the ruling below, concluding that the cessation was the result of the compressor outage of the third party who transported the gas from the lease. The Court further held that the lessee acted reasonably in keeping the well shut in, even though other operators on the third party system produced small amounts of gas during the repair period. The Court noted that while there is no bright line rule in Ohio, no cases in Ohio have found a lease to be forfeited for lack of production for a cessation of less than two years. In addition, the Court noted that the lessee undertook to construct his own compressor on the lease during the shut in and that the third party repairs and the lessee-constructed compressor restored the lease to full production after November 2015. The Court’s conclusion regarding temporary cessation is noteworthy in considering the mechanical issues of an off-lease third party’s facilities as the cause of the temporary cessation, and in evaluating the reasonableness of the lessee’s actions in response to that event, rather than limiting a consideration of temporary cessation to mechanical issues of the well or lease as is the case in some jurisdictions.

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