The Oil and Gas Addendum

Your family owns a 300 acre farm in Ritchie County, West Virginia. There is a lease from 1978 on the property that has now been incorporated into a Marcellus drilling unit and the gas company has begun to tender royalty payments. But, those royalty payments contain deductions for post-production costs even though the 1978 Lease does not mention or reference post-production costs. Worse yet, severance taxes are being deducted from your royalties. Are those deductions proper? A recent federal court decision from West Virginia says “no”.

In Cather v. EQT Production Company, (No. 1:17-CV-208 N.D.W.V. August 13, 2019) the landowners brought suit against EQT Production Company (“EQT”) challenging EQT’s practice of deducting post-production costs and severance taxes from their royalty. The lease at-issue was signed in 1963 (the “1963 Lease”) and the royalty clause provided as follows:

Lessee shall pay to the Lessor for each and every well drilled upon such land, which produces Natural Gas and/or Casinghead Gas in a quantity sufficient for the Lessee to convey to market, a money royalty computed at the rate of one-eight (1/8) of the wholesale market value which is based on the average current price paid by the Lessee to independent operators in the general area . . . payment to be on or before the 25th day of the month following that in which the gas has been delivered into the marketing pipeline. . .

The landowners’ royalty statements clearly showed that EQT was deducting post-production costs along with a portion of the severance tax. EQT did not contest that it was taking such deductions. Instead, EQT took the position that because the 1963 Lease was “silent” on the issue of post-production costs, it was entitled to “allocate” expenses and taxes against the calculation of the landowners’ royalty.

Granting summary judgment in favor of the landowners, the United States District Court for the Northern District of West Virginia flatly rejected EQT’s argument. The District Court noted the longstanding authority in West Virginia that, unless a lease expressly provides otherwise, the lessee must bear all costs to transport the product to the point of sale. See, Wellman v. Energy Res., Inc., 557 S.E.2d 254, Syl. Pt. 4 (W.Va. 2001) (“[I]f an oil and gas lease provides for a royalty based on the proceeds received by the lessee, unless the lease provides otherwise, the lessee must bear all costs incurred in examining for, producing, marketing and transporting the product to the point of sale”); Estate of Tawney v. Columbia Natural Resources, LLC, 633 S.E.2d 22, Syl. Pt. 10 (W.Va. 2006). Reviewing the language of the 1963 Lease, the District Court opined that there was no language that authorized the deduction of post-production costs:

“Wellman and Tawney remain the law of the state of West Virginia. The principles of those cases apply here. There is no genuine issue of material fact that deductions made unlawful by Wellman and Tawney were made from royalty payments provided for under the terms of the Cather Lease. Summary Judgment is therefore appropriate on the question of deductions. Plaintiff’s motion is GRANTED.”

Similarly, the District Court rejected EQT’s argument about charging the landowners for severance taxes. EQT took the position that the landowners were responsible for their share of severance taxes but the District Court found no support for this proposition in the Severance and Business Privilege Tax Act of 1993, where the severance tax originates. The District Court concluded that the severance tax applies to those who exercise the privilege of extracting the natural gas – the gas company. The District Court also dismissed EQT’s contention that the landowners were “taxpayers” under the law and responsible for taxes because, although the definition of “taxpayer” in the statute contemplated an economic interest, the landowners were not involved in the extraction or sale of the natural gas. In addition, the District Court also opined that the deduction of severance taxes was improper because there was no authorization in the 1963 Lease for such deductions.

Cather is a well-reasoned decision. It affirms the well-established but often ignored principle that a driller cannot unilaterally insert or read new terms into the parties’ oil and gas lease. Here, the 1963 Lease did not authorize the deduction of post-production costs or severance taxes. Since EQT did not have the express authority to deduct these items, the District Court correctly concluded that EQT’s practice of deducting costs and taxes was unauthorized and improper. Although not binding on Pennsylvania courts, the Cather decision reflects a growing judicial trend of simply applying the royalty clause as written and rejecting efforts by drillers to re-write or re-invent the language years later. In short, the Cather opinion sends a strong message to drillers: royalty clauses will be interpreted and applied as written. Both landowners and drillers can, and will, benefit from this guidance.