The habendum clause of an oil and gas lease establishes the period of time for which the rights given in the granting clause will extend. John S. Lowe, Oil and Gas Law in a Nutshell, at 192 (5th ed. 2009). Modern habendum clauses typically provide for a primary term, during which the lessee has no obligation to operate on the leased premises, and a secondary term, which is triggered by production on the leased premises prior to the expiration of the primary term. Id. Moreover, most modern habendum clauses specify that production must be in “paying quantities” in order to perpetuate the secondary term. As such, disputes often arise as to what constitutes production in “paying quantities.” Thankfully, Ohio courts have shed some light on how to interpret production in “paying quantities” in the state.
Paying Quantities Test
In 1980, the Supreme Court of Ohio defined “paying quantities” as quantities of oil or gas sufficient to yield a profit, even small, to the lessee over operating expenses, even though the drilling costs, or equipping costs, are not recovered, and even though the undertaking as a whole may thus result in a loss. Blausey v. Stein, 61 Ohio St.2d 264, 265-266 (1980).
Burden of Proof
We note that in Ohio, a lessee is typically given discretion to determine whether a well is profitable. Hogue v. Whitacre, 2017-Ohio-9377, 103 N.E.3d 314, ¶ 21 (7th Dist.). However, the lessee must make its determination of profitability in good faith. Id. Nonetheless, when a “paying quantities” dispute arises between a lessor and lessee, it is important to understand which party bears the burden of proof. In Ohio, the Plaintiff (lessor) bears the burden of proving by the preponderance of the evidence that the well is not producing in “paying quantities.” Id. That is, the lessor’s evidence that the well is not producing in “paying quantities” must convince the fact finder that there is more than a 50% chance that his or her claim is true.
Direct Operating Expenses
While Blausey sets forth the standard by which production in “paying quantities” disputes are analyzed, litigation in Ohio has focused, in large part, on the characterization of “operating expenses.” Though a comprehensive list of “operating expenses” has yet to be decided by the Ohio courts, several recent decisions lend guidance on the issue.
- Royalties Paid to Lessor
In Paulus v. Beck Energy Corp., 2017-Ohio-5716, 94 N.E.3d 73 (7th Dist.), the Seventh District Court of Appeals, examined whether royalties should be subtracted from gross income (along with other operating expenses) in order to determine a lessee’s profit. The lessee in Paulus calculated its profit figures for the life of the well by subtracting operating expenses from the well’s total income, without removing royalties from income. The Court held that royalties paid to the lessor should be included in the lessee’s operating expenses, stating, “[l]ogically, a lessee cannot report income under the Blausey equation without first subtracting the royalties paid to the lessor from income or adding the royalties to the operating expenses.” Id. at ¶ 53. Thus, prior to the ultimate calculation of a well’s profit or loss, the lessee must include the lessor’s royalties in its operating costs.
- Labor Directly Related to Production
In Paulus, the Court also addressed whether the lessee’s operating expenses include direct expenditures for labor performed by the lessee’s employees or contractors. Prior to 2013, the lessee in Paulus allocated amounts of operating expenses for the time spent by a salaried employee working the well. However, in 2013, six years after the well went into production, the lessee stopped accounting for labor involved in pumping the well. In citing the California case of Lough v. Coal Oil, Inc., 217 Cal.App.3d 1518, 1531, 266 Cal. Rptr. 611 (1990), the Seventh District states, “[l]abor directly related to production is considered an operating expense; the portion of labor incurred for lifting costs represents a periodic cash expenditure incurred in the daily operation of the well.” Paulus at ¶ 63. The Court ultimately held that the lessee artificially deflated its operating expenses after 2013 by failing to account for the salaried employee’s time spent working on the well. Id. at ¶ 64.[1]
Exclusions from Direct Operating Expenses
- Lessee’s Personal Labor Directly Related to Production
In Blausey, the Supreme Court of Ohio addressed whether the value of a lessee’s own labor should be included as a component of its operating costs. During the six-year period for which evidence was introduced, the trial court found that the lessee’s gross receipts from the well in dispute totaled $2,220.28, while his operating costs totaled $3,741.04. However, the trial court included the sum of $2,887.50, being the value attributed to the lessee’s own labor, in his total operating costs. On appeal, the Court of Appeals reversed the trial court’s ruling, holding that the lessee’s own labor should not be included as a component of his operating costs. The Supreme Court of Ohio affirmed the ruling of the Court of Appeals, and states, “because an oil and gas lessee bears the risk of nonproduction in a lease of this kind, we believe that appellee should be allowed to attempt to recoup his initial investment for as long as he continues to derive any financial benefit from production.” Blausey, 61 Ohio St.2d at 266, 400 N.E.2d 408.
- Drilling and Equipping Costs
The Seventh District, in Paulus, later examined whether drilling and equipping costs incurred after the initial drilling of the well should be included in operating costs. The Court noted thatin Blausey, the Supreme Court of Ohio excludes drilling and equipping costs from operating costs in its definition of “paying quantities.” Paulus at ¶ 56 (citing Blausey, 61 Ohio St.2d at 265-266, 400 N.E.2d 408). It is key to note that the Court in Blausey did not include the modifier of “initial” drilling and equipping costs in its “paying quantities” definition. Paulus at ¶ 56. In Paulus, the lessee spent $10,503.31 to “rework” the well by replacing a downhole pump and rebuilding the wellhead six years after the well went into production.
In Paulus, the Court looked to several out-of-state cases in its analysis of the lessee’s “reworking” costs. Specifically, the Court cited Imperial Colliery Co. v. Oxy USA Inc., 912 F.2d 696 (4th Cir. 1990), in which the United States Court of Appeals for the Fourth Circuit read West Virginia law as excluding capital expenditures from operating expenses as part of the paying quantities analysis. Paulus at ¶ 57. The Court also cited Pshigoda v. Texaco, Inc., 703 S.W.2d 416 (Tex.App.1986), which states that “one time investment expenses, such as drilling and equipping costs are to be treated as capital expenditures,” and that “a reworking expenditure is analogous, and closely related, to the initial drilling expenses.” Paulus at ¶ 58 (quoting Pshigoda,at 418-419). Similarly, the Court noted that in Louisiana, courts have ruled that “workover expenses, considered to be extraordinary expenses, are generally distinguished from operating expenses and should not be included as an operating expense when determining if there was production in paying quantities.” Paulus at ¶ 59 (quoting O’Neal v. JLH Enterprises, Inc., 862 So.2d 1021, 1027 (La.App.2003)). Lastly, the Court distinguished Laugh, in which the Court of Appeals of California, Second District, Division Seven, found that re-perforation and testing of an existing casing is an operating expense because it did not involve the installation of new equipment on an existing well. Laugh at 1531, 266 Cal.Rptr. 611 (1990).
The Court in Paulus found that the downhole pump was new equipment, and rebuilding of the wellhead was required by the new equipment’s installation. Paulus at ¶60. Therefore the Court held that the $10,503.31 spent to replace the pump in 2013 was a nonrecurring capital investment, which was to be excluded from operating expenses as an equipping cost under Blausey.
- Business Overhead Costs
In Hogue, the Court examined whether business overhead costs, which were not directly attributable to the well in dispute, should be categorized as direct operating costs for the purpose of a “paying quantities” analysis. The lessee in Hogue paid a third-party entity various sums of money for things such as office payroll, office lease, software, postage, professional services, building utilities, fire resistant clothing, vehicles, and machinery. The lessor argued that such payments should be included in the lessee’s operating costs. However, the lessee countered by explaining that the aforementioned payments would have been made regardless of the disputed well’s existence, and do not contribute to production from any specific well.
The Court referenced a Williams & Myers, Oil and Gas Law, footnote which noted “that a regulation of the United States Department of Interior has interpreted the term ‘paying quantities’ as a ‘positive stream of income after subtracting normal expenses, which include royalties and direct operating costs.’” Hogue at ¶ 26 – 27 (quoting 6 Williams & Myers, Oil and Gas Law, Section 604.5 (2010), fn. 4). Ultimately, the Court found traction in the aforementioned footnote and stated that, “in a ‘paying quantities’ analysis, we look to direct operating costs and exclude any indirect costs that do not contribute to the production of oil or gas.” Hogue. at ¶ 27. The Court went on to hold that the monthly administrative fees paid by the lessee to a third-party entity are not directly related to oil and gas production from the disputed well, and should not be included in a “paying quantities” analysis. Id. at 31.
- Gathering and Compression Costs
In Neuhart v. Transatlantic Energy Corp., 2018-Ohio-4099, 121 N.E.3d 802 (7th Dist.), the Seventh District addressed whether gathering and compression costs paid by the lessee should be included in a “paying quantities” analysis. The Court found guidance from the United States Court of Appeals for the Sixth Circuit in its definition of gathering as “the movement of lease production to a central accumulation and/or treatment point on the lease, unit or communitized area, or to a central accumulation or treatment point off the lease, unit or communitized area.” Id. at ¶ 31 (quoting Poplar Creek Dev. Co. v. Chesapeake Appalachia L.L.C., 636 F.3d 235, fn. 1 (6th Cir. 2011)). The Sixth Circuit also defined compression as “the process of raising the pressure of gas,” and further stated that “[compression] is often used to transport low pressure gas through the pipeline to a place where it can be sold.” Poplar Creek Dev. Co. at fn. 2, 636 F.3d 235 (6th Cir. 2011). Importantly, the Sixth Circuit reasoned that gathering and compression are post-production processes. Id. at 239. Relying on the Sixth Circuit’s decision in Poplar Creek Dev. Co., the Court in Neuhart held that “gathering and compression costs are not directly related to the production of oil and gas” and that “gathering and compression fees are not expenses for purposes of a paying quantities analysis in this matter.” Neuhart at ¶ 32.
Duration of Loss
While weighing revenue against operating expenses is a major component of the “paying quantities” analysis, there is also a temporal aspect. Critical to the “paying quantities” analysis is the timeframe during which production does not result in a profit over operating expenses. Ohio courts have not yet adopted a bright-line rule on this issue. However, as the Court of Appeals acknowledged in Hogue, “no case can be found where an Ohio appellate court deemed a lease forfeited based on less than two years of nonproduction.” Hogue at ¶ 45 (quoting RHDK Oil & Gas, L.L.C. v. Dye, 2016-Ohio-4654, 2016 WL 3522555, ¶ 22). The Court further stated that “[i]n addition to the length of cessation, a court must consider all attendant circumstances.” Id. at ¶ 45 (citing RHDK at ¶ 21).
Conclusion
The test for determining production in “paying quantities” in Ohio is a relatively simple equation on its face, which balances revenue generated from a well with its operating expenses. Blausey. However, identifying direct operating expenses is critical in the application of the Blausey equation. For this reason, accurate recordkeeping is imperative. We have seen that lessor royalties and payment for labor related to production are costs to be included in direct operating expenses. On the contrary, a lessee’s own personal labor, drilling and equipping costs, general business overhead costs, and gathering and compression costs have been excluded from operating expenses. As “paying quantities” disputes continue in Ohio, we anticipate continued development in the categorization of direct operating expenses.
[1] We note that the holding in Paulus can be distinguished from the Ohio Supreme Court’s holding in Blausey that a lessee’s own personal labor performed in the production from the leasehold is not an operating expense. Blausey, 61 Ohio St.2d at 266, 400 N.E.2d 408.
