On June 16, 2017, Ohio’s Seventh District Court of Appeals issued its decision in Paulus v. Beck Energy Corp. 2017-Ohio-5716, which addresses a number of issues concerning Ohio’s standard for determining whether an oil and gas lease is producing in “paying quantities,” a test that must ordinarily be met in order to continue a lease during its secondary term. The Supreme Court of Ohio first established the state’s paying quantities test nearly 40 years ago in Blausey v. Stein, finding that “paying quantities” are “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.”
In Paulus, the court ruled on several disputed issues surrounding the application of the Blausey test. Among other things, the court found:
- Royalties paid to the lessor must be deducted either from the lessee’s gross income or included as operating expenses when determining profitability.
- A one-time cost incurred by the lessee during the secondary term to replace a downhole pump and to rebuild the wellhead as a result of the pump replacement was in the nature of a non-recurring capital investment that is not subtracted from the lessee’s gross income.
- Although Blausey recognized that an individual lessee’s own labor is not an operating expense when the lessee made no direct expenditure from gross receipts for his labor, the same is not true for the labor of a corporate lessee’s salaried employee. Such labor is a direct operating expense to be subtracted from the lessee’s income.
- The determination of the “base period,” i.e., the period of time used to measure paying quantities, is made by examining the totality of the circumstances and requires consideration of the good faith of the lessee.
- In the particular facts of Paulus, the only well on the lease, which began producing in 2007, experienced a gradual decline in production through 2014. After accounting for royalties, if the base period was measured from 2007, when the well came online, to 2014, when the complaint was filed, the well would have produced roughly $6,800 in net profit. But the court found that applying this time frame may not reasonably reflect the current state of the well, in light of a considerable and continued decline in production beginning in 2010. Between 2010 and 2014, the well experienced an approximate $550 net loss, after accounting for the expense associated with the lessee’s salaries employee. And such a loss would only continue to grow, according to available figures from several months of 2015. Additionally, there was evidence that the lessee experienced difficulty supplying household gas to the lessor’s home, and that the well may have run out of producible gas. Based on the totality of the circumstances, the court upheld the trial court’s finding that the lease had expired due to lack of paying quantities.