Source: https://www.hh-law.com/deduction-of-post-production-costs-not-authorized-per-wv-supreme-court/
Timestamp: 2019-04-24 08:00:27+00:00

Document:
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.
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.
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.
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.
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.

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