The Oil and Gas Addendum

Federal Court in Kentucky Allows Novel Royalty Claim to Move Forward

An ongoing debate between landowners and drillers is where and how the royalty should be valued. This is especially true when the underlying lease does not identify or designate a specific royalty valuation point. If the lease is silent, drillers often argue that the royalty should be valued and calculated at or near the well-head. This location implicitly allows the driller to “net” out and deduct post-production costs that are incurred between the well-head and the downstream point-of-sale. Moreover, utilization of this location is consistent with the driller’s theory that the key metric for royalty calculation is the volume of gas measured at the well-pad. Price, in the driller’s view, is simply an accounting value that is assigned to a “volume” measured at the pad meter. Landowners, conversely, want the royalty to be valued downstream at the point-of-sale, which necessarily forecloses use of the so-called “net back” method. If the royalty is valued at the point-of-sale, post-production costs generally cannot be deducted from the landowner’s royalty. Landowners further contend that price, not well pad volume, is the critical metric when calculating the production royalty. As such, landowners argue that their royalty should always be based on the actual sale proceeds received at the downstream sale. Identifying where and when the gas is actually sold is not easy as it seems. Gas sales can involve complex and complicated transactions. A federal court in Kentucky recently recognized this complexity and allowed a landowner’s novel royalty claim to move forward.

At issue in Back v. Chesapeake Operating, LLC, (No. 7:16-192, Eastern District of Kentucky, February 18, 2020) was an oil and gas that was originally signed in 1940 (the “1940 Lease”). The 1940 Lease provided that the lessor was to receive “one-eighth 1/8 of the gas produced from each gas well at the rate of 12 cents per thousand cubic feet…” Several years later, the 1940 Lease was amended and the flat-rate royalty provision was replaced with a “market value” royalty clause.

Consistent with this modification, the lessee, Chesapeake Operating, LLC (“CHK”), paid Mr. Back 12.5% of the purported market price, less gathering costs. Mr. Back disputed his royalty payments on the grounds that the purported “price” CHK reported was artificial and not based on an actual market price. Mr. Back asserted that his royalty should be based on the “price” CHK received from several banks pursuant to a sophisticated volumetric production payment (“VPP”) transaction. Specifically, Mr. Back alleged that, pursuant to the VPP, CHK sold 208 billion cubic feet of gas in 2007 to certain investment banks at a sales price of approximately $5.27/mcf. The VPP included the anticipated natural gas production from over 4,000 wells in Kentucky and West Virginia. Several of those wells were located in or around the 1940 Lease. According to Mr. Back, the VPP represented the true market price for his gas and CHK breached the 1940 Lease by calculating his royalty on a lower index-based price.

A volumetric production payment is a common form of oil and gas financing. A producer, such as CHK, sells its future production for a limited duration in exchange for capital funds. The buyer receives an ownership share in the oil and gas produced “free and clear of any costs of production". EOG Resources v. Dept. of Revenue, 86 P.3d 1280 (Wyoming 2004). Because the buyer owns the future oil and gas production, it has protection from the bankruptcy of the producer. In some ways, a volumetric production payment is akin to an overriding royalty interest in future production but with greater protection. See, McCall v. Chesapeake Energy Corp., 817 F.Supp. 2d 307 (S.D.N.Y. 2011) (“[A] production payment is substantially the same thing as an overriding royalty interest, except that its duration is limited to the time required for the stated number of units or the sum specified in the instrument creating the payment…”). In Back, the VPP entitled the banks to receive approximately 208 billion cubic feet of gas over a 15 year period. In exchange, the banks immediately provided CHK with $1.1 billion in cash. Mr. Back argued that his royalty should have been based on the VPP price ($5.27/mcf) and not a fluctuating index price.

In response to Mr. Back’s complaint, CHK field a motion to dismiss. CHK argued that Mr. Back’s breach of contract claim should be dismissed because the VPP did not actually “sell” any gas to the banks. Rather, the VPP merely assigned a portion of CHK’s working interest in the wells and underlying leases. In other words, CHK asserted that it only sold to the banks a share of its 87.5% revenue interest in the future gas to be produced from the wells. Since no actual sale of gas occurred, CHK argued that no royalty obligation was triggered.

The district court rejected CHK’s argument and denied CHK’s motion to dismiss. The district opined that dismissal was premature and noted that “[W]ithout reviewing the VPP, the Court has no basis for ruling that the VPP conveys only Chesapeake’s revenue interest in the gas produced from wells.” As such, Mr. Back’s royalty claim will now move forward.

The Back decision, although favorable to landowners, must be viewed through the lens of the procedural stage at which the district court ruled. The district court simply ruled that Mr. Back had alleged sufficient “facts” in his complaint to state a breach of the 1940 Lease. While it is encouraging that the district court recognized that the VPP could constitute a “sale” of gas so as to trigger a royalty obligation, the case itself is far from over. Both sides must now create a factual record to support their respective claims and defenses. Once this factual record is complete, the district court will be in a better position to issue a more definitive ruling on the royalty claim. Nonetheless, the Back decision suggests that courts may now be more willing to scrutinize and question when and how gas sales actually occur for royalty purposes. Landowners and drillers alike should carefully monitor the outcome of Back as any decision could impact hundreds of royalty-related claims.

The Pennsylvania Supreme Court in Kilmer v. Elexco Land Services, 990 A.2d 1147 (Pa. 2010) described the “net back” method as follows: “. . . to calculate the price of natural gas at the wellhead . . . we must work backward from the value-added price received at the point-of-sale by deducting the companies’ cost of turning the gas into a marketable commodity.”

Mr. Back is entitled to a royalty of 12.5% under the 1940 Lease. The remaining interest retained by CHK under the 1940 Lease is known as the “net revenue interest” (87.5% + 12.5% = 100.00%)