473 S.W.3d 588
Ky.2015Background
- In 2004 Bakers and Jackson heirs leased Harlan County land to Daugherty (predecessor to MHP) with royalties set at "one-eighth of the market price at the well for gas sold or used."
- Lessee completed wells within the primary terms, processed raw gas (gathering, compression, treatment), transported it downstream, and sold the processed gas to purchasers.
- Lessee deducted post-production costs (gathering, compression, treatment, transportation) from downstream receipts and calculated the lessors’ one‑eighth royalty by "working back" to an implied well price.
- Landowners sued claiming (1) improper deductions — advancing the "marketable product/first marketable product" rule that processing costs required to make gas marketable should be borne by lessee and not deducted from royalties; and (2) leases expired because raw gas at the well was not marketable and thus not produced in "paying quantities."
- Trial court dismissed those claims under CR 12.02; Court of Appeals affirmed; Kentucky Supreme Court granted review and affirmed the lower courts.
Issues
| Issue | Plaintiff's Argument | Defendant's Argument | Held |
|---|---|---|---|
| Whether "market price at the well" requires lessee to bear processing costs to reach a first marketable product (no deduction of processing/gathering/compression from royalty) | Marketable-product rule: lessee’s implied duty to market means costs to make gas marketable are lessee’s burden; royalty should be based on first marketable product, not net-back below downstream price | Kentucky common law treats royalty as share of raw production at the well; post-production costs may be deducted to compute value at the well (work‑back/net‑back) | Held: Kentucky follows the "at-the-well" rule; lessee may deduct reasonable post-production costs (including processing and transportation) before calculating royalty under "market price at the well." |
| Whether leases terminated because raw gas at well was not marketable and thus not "produced in paying quantities" | If production at the well is not marketable/saleable there, then production isn’t "paying quantities" and habendum clause therefore expired the leases | "Paying quantities" judged on marketed production after reasonable marketing; habendum and royalty clauses use related but distinct senses of "production"; actual royalties being paid show paying quantities | Held: Leases remain in effect. Sufficient quantities are produced and marketed reasonably; habendum clause not frustrated by downstream marketing or post‑production processing. |
Key Cases Cited
- Reed v. Hackworth, 287 S.W.2d 912 (Ky. 1956) (adopts "at-the-well" valuation and approves work‑back deduction of transportation to determine well value)
- Rains v. Kentucky, 255 S.W. 121 (Ky. 1923) (lease silent as to value/place of sale; royalty measured at well side)
- Warfield Natural Gas Co. v. Allen, 88 S.W.2d 989 (Ky. 1935) (same principle: royalty based on sale at the well side absent contrary provision)
- Poplar Creek Dev. Co. v. Chesapeake Appalachia, L.L.C., 636 F.3d 235 (6th Cir. 2011) (applies Kentucky law and affirms "at-the-well" rule permitting deduction of post‑production costs)
- Kilmer v. Elexco Land Servs., Inc., 990 A.2d 1147 (Pa. 2010) (rejection of first marketable product in favor of allowing post‑production cost deductions)
- Bice v. Petro‑Hunt, L.L.C., 768 N.W.2d 496 (N.D. 2009) (rejecting first marketable product rule)