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EQT Production Co. v. Magnum Hunter Production, Inc.

United States District Court, E.D. Kentucky, Central Division, Lexington

July 19, 2017

EQT PRODUCTION COMPANY, Plaintiff,
v.
MAGNUM HUNTER PRODUCTION COMPANY, Defendant.

          MEMORANDUM OPINION AND ORDER

          Joseph M. Hood Senior U.S. District Judge

         I. INTRODUCTION

         This matter is before the Court upon Defendant Magnum Hunter Production Company's Motion for Partial Summary Judgment [DE 23] and Motion for Summary Judgment [DE 62], as well as Plaintiff EQT Production Company's Motion for Partial Summary Judgment [DE 63]. All Motions have been fully briefed a nd are ripe for the Court's review. [DE 27, 28, 48, 52, 62, 63, 67, 68, 71, 72]. For the reasons stated herein, IT IS ORDERED that Magnum Hunter's Motion for Partial Summary Judgment is GRANTED, while the Motion for Summary Judgment is GRANTED IN PART AND DENIED IN PART. EQT's Motion for Partial Summary Judgment is GRANTED IN PART AND DENIED IN PART.

         II. FACTUAL AND PROCEDURAL BACKGROUND

         EQT and Magnum Hunter are in the business of producing and selling oil and natural gas. [DE 1, p. 1-2, ¶ 1-6]. Between 1996 and 2002, the predecessors in interest of both companies entered into eleven Farmout Agreements (“FOAs”) which allocated exploration and drilling rights on lands situated in Eastern Kentucky.[1] [Id. at p. 2-5, ¶ 9]. Specifically, the FOAs allowed Magnum Hunter to drill wells on lands owned or leased by EQT and sell oil and/or gas produced from those wells.[2] [DE 1-1, 1-2, 1-3, 1-4, 1-5, 1-6, 1-7, 1-8, 1-9, 1-10, 1-11]. In exchange, EQT would receive a royalty, amounting to a percentage of “8/8 of the gross proceeds received from the sale of oil and/or gas produced from wells drilled hereunder without deductions of any kind.”[3] [DE 1-1, p. 6, ¶ 4A].

         Notwithstanding the general prohibition on deductions, eight of the FOAs specifically authorized Magnum Hunter to deduct EQT's “proportionate share of applicable severance tax” from the royalty payments.[4] [DE 1-1, p. 17; 1-2, p. 8-9, ¶ 4B; 1-3, p. 9, ¶ 4B; 1-4, p. 12, ¶ 4D; 1-5, p. 12, ¶ 4D; 1-6, p. 9, ¶ 4B; 1-7, p. 40; 1-8, p. 8, ¶ 4D]. Two of the FOAs provided for escalation of overriding royalties “[u]pon the payout of the first two (2) wells drilled and completed as a well capable of production in paying quantities.”[5] [DE 1-1, p. 6-7, ¶ 4A; 1-7, p. 7-8, ¶ 4A]. All of the FOAs required Magnum Hunter to pay EQT a shut-in fee for each well capable of production that it closed for an extended period of time.[6] [DE 1-1, p. 8-9, ¶ 7A; 1-2, p. 11, ¶ 7B; 1-3, p. 12, ¶ 7B; 1-4, p. 15, ¶ 7B; 1-5, p. 15, ¶ 7B; 1-6, p. 10-11, ¶ 7B; 1-7, p. 9, ¶ 7A; 1-8, p. 9-10, ¶ 7B; 1-9, p. 9, ¶ 7C; 1-10, p. 7, ¶ 9C; 1-11, p. 7, ¶ 9C].

         With the exception of the 7/21/04 FOA which only featured a modified MOA [DE 1-10, p. 15-38], all of the FOAs attached and incorporated by reference an Agreement and Assignment of Operating Rights (“AAOR”), memorializing Magnum Hunter's right to operate wells on the lands in question and specifying that royalties must be paid to EQT on or before the 28th day of the month.[7" name="FN7" id="FN7">7] [DE 1-1, 1-2, p. 21-23; 1-3, p. 24-26; 1-4, p. 29-31; 1-5, p. 29-31; 1-6, p. 22-24; 1-7, p. 17-18; 1-8, p. 23-25; 1-9, p. 69-71; 1-11, p. 14-16]. Of those ten FOAs, six incorporated by reference a Model Form Operating Agreement (“MOA”), which the parties modified to include specifics about Magnum Hunter's operations.[8] [DE 1-2, p. 24-46; 1-3, p. 27-49; 1-4, p. 36-58; 1-5, p. 36-58; 1-8, p. 32-53; 1-9, p. 23-46].

         Ten of the FOAs had clauses indicating that, “[i]n the event that there exists any conflict between the terms and conditions of this Agreement and the provisions of any Exhibit attached hereto, the terms and conditions of this Agreement shall control.” [DE 1-2, p. 15, ¶ 15H; 1-3, p. 17, ¶ 15G; 1-4, p. 20, ¶ 15G; 1-5, p. 20, ¶ 15G; 1-6, p. 15, ¶ 15G; 1-7, p. 17; 1-8, p. 13, ¶ 15H; 1-9, p. 12, ¶ 16F; 1-10, p. 11, ¶ 20J; 1-11, p. 11, ¶ 20J]. The 4/12/96 FOA did not contain a conflict clause. Nine of the FOAs also included the following provision:

A failure by any party hereto to exercise any right or rights or to take any authorized action shall in no way serve to permanently amend or modify this Agreement, nor shall a departure from the terms and conditions of the Agreement establish a course of conduct of amending this Agreement. This Agreement cannot be modified except in writing. Activities of parties cannot be construed to modify the terms.

[DE 1-2, p. 15, ¶ 15I; 1-3, p. 17, ¶ 15H; 1-4, p. 20, ¶ 15G; 1-5, p. 20, ¶ 15G; 1-6, p. 15, ¶ 15H; 1-8, p. 13, ¶ 15G; 1-9, p. 12, ¶ 16G; 1-10, p. 10, ¶ 20F; 1-11, p. 10, ¶ 20F].

         In December 2008, Magnum Hunter built a processing plant and began transporting gas from FOA wells to that facility, where it was converted into NGLs. [DE 52-3 at 3-5]. This endeavor was part of Magnum Hunter's effort to comply with new requirements imposed by the Federal Energy Regulatory Commission (“FERC”).[9] [DE 23-4, 27-2 at 15-16]. Magnum Hunter deducted transportation and processing costs from the NGL sales price, then used the difference as the basis for calculating EQT's royalty on NGLs. [Id.]. EQT maintains that Magnum Hunter's executives made this decision internally, while Magnum Hunter insists that it consulted with EQT before taking post-production deductions.[10] [Id.].

         After receiving payments for six years, EQT realized that it was losing revenue and exercised its contractual right to audit Magnum Hunter's production records related to the FOAs. [Id. at p. 5, ¶ 10-12; 1-9; 1-14]. The Audit Report, prepared by Mercadante and Company, PC, reported that Magnum Hunter had failed to pay the full amount of shut-in fees, royalties, and escalation fees due under the terms of the FOAs. [DE 1-14]. It also indicated that Magnum Hunter had made unauthorized deductions in calculating the royalties owed to EQT. [Id.]. In sum, the Report identified net exceptions totaling $2, 367, 307 for the audit period of 2011 to 2013. “Net exceptions in the amount of $3, 620, 661 … were identified” for the audit period of 2011 to 2013. [Id.]. EQT was entitled to $2, 367, 307 of that total. [Id.]. The remainder was allocated to KRCC Oil & Gas, LLC, EQT's co-Farmor in the 12/11/02 FOA. [Id.].

         On December 15, 2015, Magnum Hunter filed a Chapter 11 bankruptcy petition in the United States Bankruptcy Court for the District of Delaware. [DE 1, p. 5, ¶ 15]. During this proceeding, “EQT asserted a claim in the amount of $5, 896, 907.00 for the unremitted shut-in fees, royalties, overriding royalties; underpayment for the sale of natural gas liquids; improper post-production deductions from royalties; and other amounts related to the [FOAs].” [Id. at p. 6, ¶ 19; DE 1-12]. In addition to the $2, 367, 307 allegedly owed to EQT for 2011 to 2013, EQT sought additional sums for 2002 to 2010 and 2013 to 2015 “based on production records from Magnum Hunter.” [DE 1-14]. The parties ultimately agreed that Magnum Hunter would pay EQT $1, 833, 780 for amounts owed for natural gas between January 2011 and October 2013. [Id. at p. 6-7, ¶ 23-24]. Although EQT withdrew the remainder of its claims from the bankruptcy petition, it reserved the right to pursue them in a separate proceeding. [Id.].

         Accordingly, on May 19, 2016, EQT filed the instant action against Magnum Hunter, asserting the following claims: (1) breach of contract for failure to render payment for wells in production; (2) breach of contract for failure to render shut-in royalty payments; (3) breach of contract for failure to escalate royalty or overriding royalty percentages after the specified time period; (4) breach of contract for failure to escalate royalty or overriding royalty percentages after proceeds from production exceeded costs; (5) breach of contract for improper royalty and overriding royalty deductions; (6) prejudgment interest on the EQT cash payment; (7) unjust enrichment; (8) accounting; (9) declaratory relief; and (10) injunctive relief. [DE 1].

         Before discovery closed, Magnum Hunter moved for partial summary judgment on the claim for unauthorized deductions relating to NGL royalties. In its Motion, Magnum Hunter argues that the FOAs did not address the production of NGLs at all and that, thus, they did not prohibit Magnum Hunter from taking post-production deductions in calculating EQT's royalty payments. In the alternative, Magnum Hunter asserts that it was not required to pay royalties to EQT because it was acting as a processor, rather than a lessee, with regard to NGLs.

         Once discovery closed, the parties contacted United States Magistrate Judge Robert E. Wier, seeking assistance in resolving a discovery dispute. [DE 41]. Magnum Hunter complained that it had repeatedly asked EQT to provide evidence relating to its damages calculations but received only the Mercadante audit materials. [DE 43]. When Magnum Hunter deposed John Bergonzi, EQT's corporate representative, he could not explain how EQT had calculated certain categories of damages that were not covered by the audit, except to say that it had “brought forward” production figures from its Enertia database. [Id.]. EQT had not provided this data to Magnum Hunter. [Id.].

         Judge Wier provisionally “exclude[d] as a preclusive sanction under Rule 37(c) and (d), from further proceedings in this case any evidence on which EQT relied to make damages calculations that EQT did not produce to Magnum Hunter.” [DE 43]. EQT filed a Motion for Reconsideration, which Judge Wier denied in a written Memorandum Opinion and Order on May 25, 2017. [DE 49, 54, 55, 61]. EQT then submitted Objections to Judge Wier's ruling, which this Court overruled in a separate Memorandum Opinion and Order.

         Shortly thereafter, Magnum Hunter moved for summary judgment on all remaining claims, arguing that EQT could not prove its damages in light of Judge Wier's ruling. [DE 62]. EQT simultaneously moved for partial summary judgment on Count I (Breach of Contract for Failure to Render Payment for Wells in Production), “as it relates to royalty due and owing from October, 2015-present.” [DE 63-1 at 3]. EQT also sought summary judgment on Count V (Breach of Contract for Improper Royalty and Overriding Royalty Deductions) and Count VI (Prejudgment Interest), “as it relates to damages for Counts I and V.” [Id.].

         According to EQT, “[t]he undisputed evidence demonstrates that [Magnum Hunter] has breached the contracts by failing to make full and complete payments for royalty.” [Id.]. In support of this assertion, EQT notes that it has not received a payment from Magnum Hunter in two years. [Id.]. As for Count V, EQT reiterates arguments made in responding to Magnum Hunter's Motion for Partial Summary Judgment. [Id.]. Specifically, EQT insists that the FOAs address the production of NGLs and explicitly prohibit Magnum Hunter from taking any royalty deductions, apart from severance taxes. [Id.]. Finally, EQT argues that prejudgment interest should be awarded because it has not had the use of these sums for several years now. [Id.]. The Court will address each of these Motions, and the numerous arguments raised therein, in turn.

         III. ANALYSIS

         A. Applicable Law

         Federal courts sitting in diversity apply federal procedural law. Hanna v. Plumer, 380 U.S. 460, 465 (1965). The substantive law of the forum state governs the claims asserted. Erie R. Co. v. Tompkins, 304 U.S. 64 (1938); Moore, Owen, Thomas & Co. v. Coffey, 992 F.2d 1439 (6th Cir. 1993). Accordingly, the Court will evaluate the Motions in accordance with the Federal Rules of Civil Procedure while applying substantive Kentucky law to the underlying claims.

         B. Standard of Review

         Summary judgment is appropriate when there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law. Fed.R.Civ.P. 56(a). If there is a dispute over facts that might affect the outcome of the case under governing law, then entry of summary judgment is precluded. Anderson v. Liberty Lobby, Inc., 77 U.S. 242');">477 U.S. 242, 248 (1986). The moving party has the ultimate burden of persuading the court that there are no disputed material facts and that he is entitled to judgment as a matter of law. Id.

         Once a party files a properly supported motion for summary judgment by either affirmatively negating an essential element of the non-moving party's claim or establishing an affirmative defense, “the adverse party ‘must set forth specific facts showing that there is a genuine issue for trial.'” Id. at 250 (quoting Fed.R.Civ.P. 56(e)). “The mere existence of a scintilla of evidence in support of the [non-moving party's] position will be insufficient; there must be evidence on which the jury could reasonably find for the [non-moving party].” Id. at 252.

         C. Magnum Hunter's Partial Motion for Summary Judgment

         1. Interpretation of the FOAs

         “A contract between parties dealing in oil and gas is subject to the same rules of construction as any ordinary contract.” Oliver v. Louisville Gas & Elec. Co., 732 S.W.2d 509');">732 S.W.2d 509, 511 (Ky. Ct. App. 1987). Interpretation of a contract “must begin with an examination of the plain language of the instrument.” Ky. Shakespeare Festival, Inc. v. Dunaway, 490 S.W.3d 691, 694 (Ky. 2016). “‘[I]n the absence of ambiguity a written instrument will be enforced strictly according to its terms, ' and a court will interpret the contract's terms by assigning language its ordinary meaning and without resort to extrinsic evidence.” Frear v. P.T.A. Indus., Inc., 103 S.W.3d 99, 106 (Ky. 2003) (quoting O'Bryan v. Massey-Ferguson, Inc., 413 S.W.2d 891, 893 (Ky. 1966)). “A contract is ambiguous if a reasonable person would find it susceptible to different or inconsistent interpretations.” Hazard Coal Corp. v. Knight, 325 S.W.3d 290, 298 (Ky. 2010). In such instances, “the court's primary objective is to effectuate the intentions of the parties.” Dunaway, 490 S.W.3d at 695 (citing Cantrell Supply, Inc. v. Liberty Mut. Ins. Co., 94 S.W.3d 381, 384 (Ky. Ct. App. 2002)).

         The FOAs state that EQT is entitled to royalties based on a percentage of “8/8 of the gross proceeds received by [Magnum Hunter] from the sale of oil and/or gas, without deductions of any kind, produced from wells drilled hereunder.” [See DE 1-1, p. 6, ¶ 4A]. This language indicates that Magnum Hunter only owes EQT royalties from the sale of NGLs if they qualify as “oil and/or gas, ” as that term is used in the FOAs.

         Although none of the FOAs explicitly define “oil and/or gas, ” some of them provide more guidance as to the meaning of this term than others. Accordingly, the Court will divide the FOAs into three subsets: (1) FOAs that define “oil well” and “gas well” and attach and incorporate an MOA defining “oil and gas”; (2) FOAs that define “oil well” and “gas well” but do not attach and incorporate an MOA defining “oil and gas”; and (3) FOAs that do not define “oil well” and “gas well” and do not attach and incorporate an MOA defining “oil and gas.” The Court will then analyze each subset in turn.

         a. FOAs that define “oil well” and “gas well” and attach and incorporate an MOA defining “oil and gas”

         Nine of the FOAs include definitions for the terms “oil well” and “gas well.” [See DE 1-2, p. 2, ¶ 2M; 1-3; 1-4; 1-5; 1-8; 1-9; 1-10]. “Gas Well” means “gas well as defined by Kentucky Revised Statute Number 353.010, ” which provides as follows:

         “Gas well” means any well which:

(a) Produces natural gas not associated or blended with crude petroleum oil any time ...

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