Source: https://www.hh-law.com/west-virginia-moves-prohibit-drillers-taking-deductions-reduce-net-royalty-12-5/
Timestamp: 2019-04-24 08:33:21+00:00

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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.
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.
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.
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.
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.
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.
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.
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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