West Virginia Moves to Prohibit Drillers From Taking Deductions Which Reduce Net Royalty Below 12.5%

Robert J. Burnett  is a director and chair of Houston Harbaugh’s Oil and Gas practice. To learn more about our work with landowners and royalty owners, visit our Oil and Gas Law practice page.

Last week the West Virginia Legislature took a bold and decisive step on behalf of West Virginia landowners. In a remarkable 34-0 vote on February 28, 2018, the West Virginia Senate passed SB 360, which essentially reverses and nullifies the West Virginia Supreme Court’s controversial decision in Leggett v. EQT Production (No. 16-0136, May 26, 2017). The bill then passed the House with a dramatic 96-2 tally. It is now sitting on the Governor’s desk awaiting signature. As detailed below, SB 360 will prohibit drillers from taking deductions which reduce the landowners “net” royalty below the statutory minimum of 12.5%. Unlike Pennsylvania, it appears that 12.5% actually does mean 12.5% in West Virginia.

Leggett v. EQT Production – Act 1

In order to understand and appreciate the significance of SB 360, a brief review of the Leggett controversy is warranted. The genesis of SB 360 can be traced to a lawsuit that was filed back in 2013 (“Leggett I”). 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 post-1982 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 royalty valuation point.

The salient issue presented before the Leggett I panel 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 and 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 I 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 I, the West Virginia Supreme Court rejected EQT’s interpretation by a 3-2 vote. The majority opinion, authored by former Justice Brent Benjamin, held that EQT’s interpretation was inconsistent with the remedial nature of §22-6-8 and the “marketable product” doctrine espoused in Wellman and Tawney. The Leggett I 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 reduced by any costs incurred downstream from the wellhead. The panel further concluded that the phrase “at the well-head” as it appears in §22-6-8 will be interpreted and applied in the same manner that West Virginia construes that same phrase in oil and gas leases. In other words, under Tawney and the “marketable product” rule, the driller must bear all costs or expenses incurred transforming the gas into a marketable product. For Mr. Leggett and the other plaintiffs, this meant that EQT could no longer deduct post-production costs from the royalties generated by the Converted Wells.

Leggett v. EQT Production – Act 2

As noted, the Leggett I majority prevailed by only a slim 3-2 margin. The author of the majority opinion, Justice Benjamin, was defeated in his re-election bid in 2016 and was replaced by Justice Beth Walker. Shortly after the election, EQT file a petition for rehearing under Rule 25 claiming that the High Court “misapprehended several critical points of law.” On January 31, 2017, the West Virginia Superior Court surprisingly granted the petition and allowed re-argument before the newly constituted court (“Leggett II”).

In Leggett II, EQT argued that the phrase “at the wellhead” in §22-6-8 was not ambiguous and therefore the panel in Leggett I had no basis to “read into” the statute some other royalty valuation point. Specifically, EQT argued that the only way to mathematically calculate the “at the well head” price is to utilize the “net-back” method, which requires the driller to net out post-production costs incurred between the wellhead and the point-of-sale. As such, EQT suggested that its practice of deducting the costs was entirely consistent with the royally valuation point (i.e. the wellhead) mandated by the statute. EQT further argued that “marketable product” rationale espoused by Tawney and Wellman was inapplicable because those cases involved the interpretation of a private oil and gas lease as opposed to a statute such as §22-6-8. Since the rules of statutory construction are different from the rules of contract interpretation, EQT argued that the Liggett I panel erred by applying Tawney and Wellman to §22-6-8.

On May 26, 2017, the West Virginia Supreme Court, in a 4-1 decision, vacated its prior opinion in Leggett I and ruled in favor of EQT. In a stunning about-face, the Leggett II panel concluded that EQT did not violate §22-6-8 by paying a net royalty below the statutory minimum:

“We therefore hold that royalty payments pursuant to an oil or gas lease governed by West Virginia Code §22-6-8(e) may be subject to pro-rata deduction or allocation of all reasonable post-production expenses actually incurred by the lessee. Therefore, an oil or gas lessee may utilize the “net-back” or work-back” method to calculate royalties owed to a lessor pursuant to a lease governed by West Virginia Code §22-6-8(e). The reasonableness of the post-production expenses is a question for the fact-finder.”

The Leggett II decision garnered immediate criticism as it created two different sets of rules for evaluating the legality of deductions: privately negotiated leases would be governed by the Tawney “marketable product” rule but converted §22-6-8 leases would be governed by the “net back” rule. Recognizing this inherent inconsistency, the Leggett II panel implored “the Legislature to resolve [these] tensions as it sees fit. . .” On January 24, 2018, Senator Charles Clements (R-Wetzel) accepted the High Court’s invitation and introduced SB 360.

Curtain Call for Leggett v. EQT Production – Act 3

 The intent and purpose of SB 360 is to “fix” the inconsistency created by the Leggett II opinion. This is accomplished by removing the “at the wellhead” language in §22-6-8(e) and replacing it with language which designates the point-of-sale as the royalty valuation point:

“…shall tender to the owner of the oil and gas in place not less than one-eighth of the gross proceeds, free from any deductions for post-production expenses, received at the first point of sale to an unaffiliated third-party purchaser in an arm’s length transaction…”

The designation of the point-of-sale as the valuation point is significant. Most, if not all, post-production costs are typically incurred between the wellhead and the downstream point-of-sale. When a royalty is calculated and valued at the point-of-sale, there are no intervening costs which must be netted out to arrive at a fictional wellhead value. In such circumstances, the “net back” method is inapplicable and cannot be used to justify the deduction of the post-production costs. By moving the royalty valuation point to the point-of-sale, SB 360 foreclosed the practice of deducting post-production costs in connection with §22-6-8. It also restored some consistency to West Virginia oil/gas law with respect to the deduction issue. This simple yet profound measure should be adopted by the General Assembly here in Pennsylvania.

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03/08/2018