The Oil and Gas Addendum

Landowners in West Virginia received an early Christmas gift from the West Virginia Supreme Court last month. In a landmark opinion, the Supreme Court in Leggett v. EQT Production Company declared that the state’s minimum royalty statute, which mandates a minimum royalty of 12.5%, must be calculated and paid without any deductions. Prior to Leggett, it was unclear under West Virginia law if a driller could deduct costs if the lease itself was subject to the state’s minimum royalty statute, §22-6-8. This ambiguity created an inconsistency: royalties paid under older “flat-rate” leases subject to §22-6-8 could be burdened with post-production costs while more modern leases with “volume-based” royalty clauses generally were not. The Leggett decision eliminated this inconsistency and reaffirmed the rule under West Virginia law that the lessee alone must bear all post-production expenses necessary to put the gas into a marketable form. This “marketable product” rule now applies whether the lease was signed in 1916 or 2016.

The Leggett litigation originated in federal court in 2013. At issue was an oil/gas lease that was executed in 1906 (the 1906 Lease). The 1906 Lease provided for a “flat-rate” royalty of $300.00 per year for each gas well drilled upon the leased premises. EQT Production Company (EQT) operated a number of shallow, conventional wells pursuant to the 1906 Lease. With respect to wells that were drilled prior to 1982, EQT paid the flat-rate royalty of $300.00 per year to the landowners. The majority of the wells, however, were subject to the minimum royalty statute, §22-6-8, which became effective on June 13, 1982. EQT paid the statutory royalty rate of 12.5% on these wells (the Converted Wells) but also deducted post-production costs from the royalty. The landowners brought suit claiming that EQT violated §22-6-8 by deducting post-production costs from the royalties generated by the Converted Wells.

EQT defended the suit on the grounds that the language set forth in §22-6-8 expressly designated the royalty valuation point as being “at the wellhead.” Since the gas was actually sold downstream from the wellhead, EQT used the net-back method to deduct the costs incurred between the wellhead and the eventual point-of-sale. EQT argued that such deductions were implicitly allowed given the statute’s express designation of the wellhead as the valuation point.

The Leggett matter took an unusual path to the West Virginia Supreme Court. The landowners originally asserted three claims against EQT: breach of contract, fraud, and breach of fiduciary duty. On January 22, 2016, the federal court sitting in the Northern District of West Virginia granted summary judgment in favor of EQT on the fraud and breach of fiduciary duty claims. With respect to the contract claim (i.e., that EQT had breached the 1906 Lease by taking deductions), the federal court deferred ruling given uncertainty and ambiguity of the language set forth in §22-6-8. Instead, the federal court requested clarification from the West Virginia Supreme Court on this certified question of West Virginia law:

Does Tawney v. Columbia Natural Resources, L.L.C., 219 W.Va. 266, 622 S.E.2d 22 (2006), which was decided after the enactment of W.Va. Code §22-6-8, have any effect upon the Court’s decision as to whether a lessee of a Flat-Rate Lease, converted pursuant to W.Va. Code §22-6-8, may deduct post-production expenses from the lessor’s royalty, particularly with respect to the language of “1/8 at the wellhead” found in W.Va. Code §22-6-8(e)?

A certified question is a formal request by one court to another for clarification of state law. See, W.Va.Code §51-1A-1 (“[T]he court of appeals of West Virginia may answer a question of law certified to it by any court of the United States…”). On April 16, 2016, the West Virginia Supreme Court accepted the request and agreed to “answer” the certified question.

The salient issue presented by the certified question was whether the phrase “at the wellhead” as it appears in §22-6-8 should be interpreted in the same manner as royalty clauses containing identical language. The landowners argued that the statute and oil/gas leases should be read the same way and that the interpretation adopted by the West Virginia Supreme Court in Tawney v. Columbia Natural Resources was binding on the statute. EQT argued that the phrase “at the wellhead” in §22-6-8 should be interpreted differently than oil/gas leases given the historical context of the original statute. EQT also argued that the Tawney holding was only applicable to oil/gas leases. Since the question before the court was the interpretation of a statute, Tawney should not be binding or controlling.

In 1982, the West Virginia legislature enacted §22-6-8 which declared that flat-rate royalty leases were contrary to public policy. Specifically, the legislature found that the continued “exploitation” of oil/gas leases for “wholly inadequate compensation” was unfair and oppressive and worked an “undue hardship” on landowners. Along these lines, §22-6-8 provided that no drilling permits would thereafter be issued if the underlying oil and gas lease contained a flat-rate royalty clause. To avoid this prohibition, the driller could file an affidavit certifying that it:

“…shall tender to the owner of the oil and gas in place not less than one-eighth (i.e., 12.5%) of the total amount paid to or received…at the wellhead for the oil and gas so extracted…”

Once the affidavit is filed, the underlying lease is then “converted” from a flat-rate lease to a 12.5% royalty based on the actual volume produced. In the Leggett matter, EQT and/or its predecessor filed the aforesaid affidavit, thereby converting certain wells under the 1906 Lease to a 12.5% royalty. EQT paid the 12.5% royalty but deducted post-production costs given the “at the wellhead” language in §22-6-8.

EQT’s purported interpretation of the “at the wellhead” phrase in §22-6-8 was at odds with the West Virginia Supreme Court’s doctrine on royalties. West Virginia is a “marketable product” jurisdiction. Under this approach, the driller must bear all of the costs of transforming the gas into a marketable product and the costs of transporting the gas to the eventual point-of-sale. West Virginia first adopted the “marketable product” doctrine in the Wellman v. Energy Resources decision in 2001 where it said:

“[T]his Court believes that the rationale employed by Colorado, Kansas and Oklahoma in resolving the question of whether the lessor or the lessee should bear post-production costs is persuasive. Like those states, West Virginia holds that a lessee impliedly covenants that he will market oil or gas produced.”

The doctrine was further expanded by the West Virginia Supreme Court in Tawney v. Columbia Natural Resources in 2006. In Tawney, the issue presented was whether the “at the wellhead” type royalty clauses were “sufficient to alter [the State’s] generally recognized rule that the lessee must bear all costs of marketing and transporting the product to the point-of-sale.” The Tawney panel concluded that the “at the wellhead” language as used in the underlying oil and gas leases was ambiguous and not sufficient to alter the rule adopted in Wellman. The court noted that while the language indicates that the royalty is to be calculated at well, it did not “indicate how or by what method the royalty is to be calculated or the gas is to be valued.” Given this ambiguity, the Tawney court held that the phrase “at the wellhead” could not be used to shift post-production costs to the lessor.

In Leggett, the West Virginia Supreme Court correctly rejected EQT’s interpretation, noting the remedial nature of §22-6-8 and the “marketable product” doctrine espoused in Wellman and Tawney. The Leggett panel observed that EQT’s interpretation created an inconsistency that would undermine the original purpose of the statute:

“[I]t would have been perversely inconsistent with the overarching remedial intent of the flat-rate statute for a Legislature so passionately dedicated to ensuring the future flow of adequate compensation to oil and gas landowners to have purposefully provided a mechanism of royalty valuation specifically designed to curtail that compensation…”

The Leggett court went on to clarify that when a driller files an affidavit under §22-6-8, it means that the 12.5% royalty payment will not be “diluted” by costs and expenses incurred downstream from the wellhead. In other words, 12.5% means 12.5% and deductions cannot reduce the royalty below that threshold.

Pennsylvania’s minimum royalty statute, 58 P.S. §33 (the “GMRA”), does not contain any reference to the “wellhead”. As currently drafted, the GMRA simply requires the driller to pay the lessor “at least one eighth (i.e., 12.5%) royalty of all oil, natural gas…removed or recovered from the subject real estate.” Although the GMRA does not designate the wellhead as the royalty valuation point, drillers in Pennsylvania have applied the GMRA as if it does. This is erroneous. This error is a result of an overbroad reading of the 2010 Pennsylvania Supreme Court’s decision in Kilmer v. Elecxco Land Services. To correct this erroneous application of the GMRA, Rep. Garth Everett (R – Lycoming County) introduced HB 1391 in June 2015. The bill was voted out of the “Environmental Resources and Energy Committee” on June 27, 2016 but never received a full floor vote. Nonetheless, it is believed that a similar version of HB 1391 may be introduced sometime in the next legislative session. Landowners in Pennsylvania can only hope that the General Assembly, when considering this bill, follow these words of wisdom from the Leggett panel:

“In a properly functioning royalty system, lessor-owners of oil and gas interests are accurately cast as suppliers of raw materials necessary to develop a finished product. For such raw materials, such lessor-owners are paid a one-eighth proportionate price accounted for as a cost of goods sold. Lessor-owners do not sign on to be the lessee’s business partner or a participant in a joint venture with the lessee, and they should not be compelled to assume risks or expenses that would typically be associated with that sort of role.”