Baker v. Magnum Hunter Prod., Inc., 2013–SC–000497–DG

• Decision Date: 20 August 2015
• Docket Number: 2013–SC–000497–DG
• Citation: 473 S.W.3d 588
• Parties: Nobe Baker (Individually and as Administrator of the Estate of Joann Baker), et al., Appellants v. Magnum Hunter Production, Inc., Appellee
• Court: United States State Supreme Court — District of Kentucky

473 S.W.3d 588

Nobe Baker (Individually and as Administrator of the Estate of Joann Baker), et al., Appellants

v.Magnum Hunter Production, Inc., Appellee

2013–SC–000497–DG

Supreme Court of Kentucky.

RENDERED: AUGUST 20, 2015

Rehearing Denied December 17, 2015

Counsel for Appellants: George E. Stigger, III, John C. Whitfield, Madisonville.

Counsel for Appellee: Anne Adams Chesnut, Lexington, Harry Don Callicotte, Radcliff, Richard Clayton Larkin.

Counsel for Amicus Curiae Kentucky Oil and Gas Association, Inc.: Karen J. Greenwell, Lexington, Gregory Brian Wells.

Counsel for Amicus Curiae National Association of Royalty Owners: James Lincoln Hamilton.

OPINION OF THE COURT BY JUSTICE ABRAMSON

Two sets of Harlan County landowners, the Bakers¹ and certain heirs (together with their spouses) of Chester Jackson (the "Jackson heirs")² jointly brought suit in Harlan Circuit Court seeking, among other things, damages and a declaration of their rights under oil and gas leases executed in 2004 with Daugherty Petroleum, Inc. Daugherty is Appellee Magnum Hunter Production, Inc.'s ("MHP's") predecessor. The landowner-lessors sought a declaration to the effect that the lessee production companies had miscalculated and underpaid royalties due under the leases. Alternatively, they sought a declaration that the leases had expired. The trial court rejected these claims as a matter of law and, under Kentucky Rule of Civil Procedure (CR) 12.02, dismissed the corresponding portions of the landowners' Complaint. The Court of Appeals affirmed, unanimously agreeing with the trial court that given royalty provisions such as those in the leases at issue here, Kentucky law does not embrace the so-called "marketable product" approach to royalty calculation. We granted the landowners' motion for discretionary review to address their contention that the lower courts in this case, as well as a recent spate of federal court decisions on the "marketable product" question, including that of the United States Court of Appeals for the Sixth Circuit in Poplar Creek Dev. Co. v. Chesapeake Appalachia, L.L.C., 636 F.3d 235 (6th Cir. 2011),³ have misconstrued Kentucky law. We reject the landowners' contention and therefore affirm.

RELEVANT FACTS

The pertinent facts are not in dispute.⁴ In May 2004, the Jackson heirs executed an oil and gas lease (the "Jackson Lease") giving Daugherty Production Company the exclusive right to explore for and produce if discovered "oil, gas, casing-head gas, and casing-head gasoline" on some 130 acres situated "on Laurel Fork of the Greasy Fork of the Kentucky River in Harlan County, Kentucky." In October of that year, the Bakers executed a lease (the "Baker Lease") giving the same rights to Daugherty on some sixty acres "situated on waters of Laurel Creek of the Greasy Creek of the Middle Fork of the Kentucky River in Harlan County, Kentucky." Both Leases provide, in pertinent part, that the Lease will remain in effect for a primary term (one year under the Baker Lease and three years under the Jackson Lease), "and as long thereafter as oil, gas, casing-head gas, casing-head gasoline or any of them is produced from said leased premises." In exchange for the Lessee's right to produce and market oil and gas from the leased premises, the Leases provide for royalties. With respect to gas, under both Leases the "Lessee covenants and agrees: ... To pay Lessor one-eighth of the market price at the well for gas sold or for the gas so used from each well off the premises."

Within the Leases' respective primary terms the Lessee completed gas wells on both properties and commenced paying royalties on the gas produced and sold. The raw gas is not suitable for sale at the well (or at least it is not sold there), so prior to sale the Lessee gathers, compresses, and treats the raw gas, and then transports the refined and enhanced product to purchasers elsewhere, "downstream" from the well. From the sale price it ultimately receives for its enhanced gas, the Lessee deducts its gathering, compression, treatment, and transportation costs (as well as some other post-production costs), before calculating the landowners' one-eighth royalty share on the remaining net revenue. For example, according to a September 2011 royalty statement for one of the Jackson heirs, MHP sold its processed and transported natural gas during the accounting period for $4.15 per Mcf (thousand cubic feet), but for royalty purposes MHP deducted from that sale price $3.65 per unit for "transportation" expenses (The statement apparently lumps all of the post-production costs together under that heading.). That "work-back" calculation left $.50 per unit as the market price of the raw gas at the well—the amount upon which the landowners' royalty was to be calculated under the Lease—and resulted in a royalty of $.0625 per unit.

Dissatisfied with what they regarded as an inadequate return on their Leases, the Jackson heirs and the Bakers (whose royalty was similarly determined) brought suit alleging, in part, that the Lease provision basing their royalty on "one-eighth the market price at the well" should be understood to contemplate not a hypothetical sale of raw gas "at the well," but rather the sale of gas made "marketable,"—by accumulating, compressing, and treating, if need be—and then sold "at the well," again hypothetically, by deducting the expenses of transporting the marketable gas to some other point of sale. Thus, the landowners urged that royalty should be calculated by deducting bona fide transportation costs from the sales price received downstream from the well, but any costs otherwise necessary to render the raw gas marketable are the producer's responsibility and cannot be deducted from gross receipts in the calculation of royalty.⁵ This "marketable product" or "first marketable product" approach, the landowners insist, is necessary to give meaning to the Lease's inclusion of the term "market price at the well" because, in their view, until a product is marketable it cannot have a market price. Both courts rejected this argument, with the Court of Appeals noting that "market value (price) at the well" is even defined in BLACK'S LAW DICTIONARY (" BLACK'S ") as "[t]he value of oil or gas at the place where it is sold, minus the reasonable cost of transporting it and processing it to make it marketable." BLACK'S at 1058 (9th ed. 2011) (emphasis supplied).

ANALYSIS

I. "Market Price at the Well" Has an Established Meaning in Kentucky that Allows for the Deduction of Post–Production Costs Before Calculating Royalty.

According to the landowners, the trial court's and the Court of Appeals' failure to make a distinction between transportation costs and the costs of otherwise making raw gas marketable ("processing costs"), resulted in the same misreading of Kentucky law that has occurred in the federal courts. Specifically, the landowners contend that to give effect to a covenant implicit in oil and gas leases whereby the lessee undertakes not merely to extract the raw mineral, natural gas in this case, but to make a reasonably diligent effort to market it as well, the lessee must bear the full responsibility for all processing costs necessary to achieve a marketable product.⁶ Our analysis begins, then, with this claim that Kentucky has not heretofore committed itself on the question of the apportionment of post-production costs under "market price at the well" royalty clauses, and that fairness demands a different apportionment of costs under such clauses than that approved by the trial court and the Court of Appeals. Neither aspect of the landowners' claim persuades us that either the trial court or the Court of Appeals was wrong.

Oil and gas leases are contracts, of course, and like other contracts are to be construed as a whole so as to give effect to the parties' intent as expressed in the language they chose. City of Louisa v. Newland, 705 S.W.2d 916 (Ky. 1986) ; Wilcox v. Wilcox, 406 S.W.2d 152 (Ky. 1966). Such leases are highly specialized contracts, however, often employing terms and clauses that have been judicially construed. Levin v. Maw Oil & Gas, LLC, 290 Kan. 928, 234 P.3d 805 (2010). While courts should be careful not to stymie intended departures from previously construed terms, id. absent a clear intent to depart, parties who employ terms that have been judicially construed may be presumed to have intended the established meaning. Prudential Ins. Co. of America v. Harris, 254 Ky. 23, 70 S.W.2d 949 (1934) ; Zachry Construction Corp. v. Port of Houston Authority, 449 S.W.3d 98, 112 n.66 (Tex. 2014) ("Contracting parties generally select a judicially construed clause with the intention of adopting the meaning which the courts have given to it." (citation and internal quotation marks omitted)).

Many oil and gas lease terms have acquired judicially recognized meanings. "Royalty" has been defined as "the landowner's share of production, free of expenses of production." Ramming v. Natural Gas Pipeline Company of America, 390 F.3d 366, 372 (5th Cir. 2004) (citing Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118, 121–22 (Tex. 1996) ); see also BLACK'S LAW DICTIONARY (9th ed. 2009) ("landowner's royalty. A share of production or revenues provided for the lessor in the royalty clause of the oil-and-gas lease and paid at the well free of any costs of production.") And "production," has been widely understood to mean "the oil, gas, and other minerals that the lessee extracted from the ground at the well-head, where the lessee reduced the minerals to its physical possession." Byron C. Keeling and Karolyn King Gillespie, The First Marketable Product Doctrine: Just What Is The "Product"?, 37 St. Mary's L.J. 1, 29 (2005) (collecting cases in footnote 116) ("Keeling and Gillespie"). "Royalty," then, has commonly been understood as the lessor's cost-free share of the raw mineral "produced" at the point of capture (in the case of gas "at the well").

If the gas is not...