The Oil and Gas Addendum

A landmark decision on the practice of deducting post-production costs was recently issued by the Supreme Court of Kentucky. Specifically, the court held that a lessee could not deduct any portion of the Kentucky severance tax from the lessor’s production royalty. As the debate in Harrisburg intensifies over the Governor’s severance tax proposal, this decision could serve as a guidepost for the legislature and the Pennsylvania courts when considering the proper scope and application of any such tax.

In Appalachian Land Company v. EQT Production Company, the lessor, Appalachian Land Company (Appalachian), was to receive a production royalty “at the rate of one-eighth (1/8) of the market price of gas at the well.” Appalachian brought suit alleging that EQT Production Company (EQT) wrongfully deducted a pro rata portion of the severance tax from its royalty. As a result, Appalachian claimed that EQT underpaid royalties.

As with a number of royalty disputes, the issue arose from EQT’s practice of deducting certain costs prior to calculating Appalachian’s royalty. Depending on the language in the lease, producers often deduct from a landowner’s royalty the costs incurred between the well-head and the downstream point-of-sale. As the gas moves downstream from the well-head, producers incur certain expenses known as “post-production costs.” These post-production costs typically include expenses incurred while gathering, processing, dehydrating and transporting the gas. At issue before the Supreme Court of Kentucky, however, was whether the severance tax could be deducted from the landowner’s royalty in the same manner as other post-production costs. The court held that unless the parties’ lease expressly authorizes such a deduction, producers such as EQT cannot deduct any portion of the severance tax from the royalty calculation.

The court analyzed the issue in the context of both statutory and contractual liability. From a statutory perspective, the Appalachian court concluded that nothing in the statute itself authorized the imposition of tax liability on the landowner/lessor. Significant to the court’s analysis was that Kentucky’s severance tax statute provides that the tax applies to “all taxpayers severing and/or processing natural resources in this state….” KRS § 143A.020(2). The court reasoned that since the producer, and not the landowner, was ultimately “severing” or “processing” the gas, the tax burden must fall solely and exclusively upon the producer. The court further noted that, based on the clear language set forth in the statute, the natural gas tax is assessed upon the “privilege of severing or processing” the gas. By entering into an oil/gas lease, the lessor/landowner surrenders this “privilege” to sever or process the underlying hydrocarbons. The court observed that the “only party to the lease that engages in severing the gas is EQT.” The court then opined that the granting of this extraction “privilege” to the lessee also transfers significant property rights to the lessee:

“[I]n the present case, title to the gas became vested with EQT the moment it brought the gas to the wellhead. Therefore, even viewing the severance tax as analogous to a property tax, the owner of the property being taxed is EQT, not Appalachian”

Finally, the court noted that the severance tax statute itself specifically excludes from the definition of taxpayer “[a] party…who receives only an arm’s length royalty.” Since the statute expressly excludes a royalty owner from the definition, the court concluded that no portion of the tax liability could be imposed on or shifted to the royalty owner.

With respect to contractual liability, the court reviewed the language of the parties’ lease. The lease itself, which was executed in 1944, was silent on the apportionment of taxes. This was significant to the court for several reasons. First, since the severance tax was not enacted until thirty-six years after the parties’ lease was executed, the court opined that the original parties to the lease could not have intended the apportionment of any taxes at that time. Second, given that the lease was silent in regard to any deduction or allocation of a severance tax, the court examined whether the tax should nonetheless be treated as a deductible post-production cost. The court reasoned that traditional post-production costs such as gathering, compression, and transportation can enhance the value of the raw gas. In contrast, while the sale of natural gas is contingent upon payment of the severance tax, the tax itself does not enhance the value of the gas. Since the imposition of the tax does not benefit the lessor, the court concluded that it should not be treated as a typical post-production cost:

“. . . it would run contrary to the parties’ intent‑and the purpose of the “at the well” rule – for the royalty owner to share in the expense that does nothing to improve the quality of the product beyond the well head.”

Accordingly, the Kentucky Supreme Court held that since the parties’ lease did not expressly authorize the apportionment of the tax, no portion of the tax could be deducted by EQT.

Currently, Pennsylvania does not impose a severance tax, although it does levy an impact fee on every “unconventional” well drilled into the Marcellus Shale formation. Governor Wolf has proposed a 5% tax on the “value” of the extracted gas, plus 4.7 cents for every thousand cubic feet of gas produced. Recently, a separate proposal to implement a 3.2% severance tax, in addition to the impact fee, was referred to the House Committee on Environmental Resources and Energy on June 29, 2015. Supporters of the severance tax argue that Pennsylvania is the only major gas producing state that does not impose a severance tax. Opponents claim that the imposition of the tax, along with unfavorable market conditions, will crush the industry and hinder further exploration and development. As of this publication, the Governor and the General Assembly have yet to agree on a budget for the upcoming year and at the center of the impasse is the issue of the severance tax. While it is unclear whether a severance tax will ever become law in Pennsylvania, the Appalachian decision is nonetheless instructive. The logic and rationale espoused by the Appalachian court is compelling. Given that a severance tax by definition does not increase or enhance the value of the gas in any way, a strong argument can be made that any such tax should be treated differently than typical post-production costs. As such, landowners negotiating new leases should oppose any language expressly authorizing or allowing the deduction of any type of tax.