In a consolidated review of two class actions filed in the Eastern District of Kentucky, the Sixth Circuit affirmed the district court’s determination that Kentucky law follows the “at-the-well” rule, which allows lessees to deduct post-production costs for oil and gas development from the payment of royalties to lessors.

In Poplar Creek Development Co. v. Chesapeake Appalachia, L.L.C. (6th Cir., Nos. 09-5914 & 10-5373, Feb. 27, 2011) [PDF], the Court reviewed two class actions that posed similar questions about Kentucky law.  In the first case, Poplar Creek Development Co. (“Poplar Creek”) was the lessor and fee simple owner of natural gas interests in Pike County, Kentucky, and Chesapeake Appalachia L.L.C. (“Chesapeake”) was successor-in-interest to the lessee.  Chesapeake owns and operates gas wells on the leasehold and pays royalties to Poplar Creek for the gas it produces.  This gas is, in turn, sold at a market that is physically distant from the wells themselves, which requires that the gas be gathered, compressed and treated – each of which exacts a cost and also increases the value of the gas itself.  When it paid royalties to Poplar Creek, Chesapeake deducted such costs from those payments, and Poplar Creek sued, arguing that Kentucky law prohibited Chesapeake from deducting post-production costs from royalty payments.  The basic facts of the second action were similar to the first, save that, following class certification, Chesapeake entered into a proposed settlement with John Thacker and other class members worth $28.7 million with the class.  But Poplar Creek objected to the Thacker settlement because it permitted Chesapeake to continue deducting post-production costs from royalties.  After the court approved the settlement, the Poplar Creek objectors appealed.

Writing for a unanimous panel that included Circuit Judge Gilman and Chief District Judge Collier of the Eastern District of Tennessee, Circuit Judge Griffin affirmed the lower court’s rulings.  The Court looked to the relevant language in the lease, which required royalty payment on the “wholesale market value of such gas at the well.”  The Court observed that similar royalty clauses had been interpreted by courts in different states as both permitting and forbidding post-production cost deductions.  But, under Kentucky law, the Court found that the royalty had to be paid at the market value of the gas at the wellhead, not including any value added by post-production services.  Thus, deduction of the cost of those post-production services from the royalties was appropriate.  Given the Court’s determination, the Poplar Creek objectors conceded that their challenge to the Thacker settlement was rendered baseless.