The Oil and Gas Addendum

In a rather surprising move, the West Virginia Supreme Court has decided to revisit the November 17, 2016 opinion it issued in the Leggett v. EQT Production Company litigation. In that opinion, the High Court declared that the State’s minimum royalty statute, which mandates a minimum royalty of 12.5%, must be calculated and applied without any post-production costs being deducted. The Leggett decision brought much needed clarity and consistency to West Virginia oil and gas law. Prior to Leggett, it was unclear if a driller could deduct post-production costs if the lease was subject to the State’s minimum royalty statute, §22-6-8. The Leggett panel removed this ambiguity and held that all leases, whether signed in 1916 or 2016, are subject to West Virginia’s “marketable product” rule, which generally prohibits the deduction of post-production costs. EQT, however, filed a petition for a rehearing under Rule 25, claiming that the High Court “misapprehended several critical points of law…” On January 31, 2017, the West Virginia Supreme Court granted the petition and the matter will now be reargued.

The November 17, 2016 Leggett v. EQT Production Company Opinion

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 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.

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 royalty valuation point.

The salient issue presented before the Leggett 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.

In 1982, the West Virginia legislature enacted §22-6-8 which declared that flat-rate royalty leases were contrary to public policy. Specifically, the legislature found that the continued “exploitation” of oil/gas leases for “wholly inadequate compensation” was unfair and oppressive and worked an “undue hardship” on landowners. Along these lines, §22-6-8 provided that no drilling permits would thereafter be issued if the underlying oil and gas lease contained a flat-rate royalty clause. To avoid this prohibition, the driller could file an affidavit certifying that it:

“…shall tender to the owner of the oil and gas in place not less than one-eighth (i.e., 12.5%) of the total amount paid to or received…at the wellhead for the oil and gas so extracted…”

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.

EQT’s purported interpretation of the “at the wellhead” phrase in §22-6-8 was at odds with the West Virginia Supreme Court’s doctrine on royalties. West Virginia is a “marketable product” jurisdiction. Under this approach, the driller must bear all of the costs of transforming the gas into a marketable product and the costs of transporting the gas to the eventual point-of-sale. West Virginia first adopted the “marketable product” doctrine in the Wellman v. Energy Resources decision in 2001 where it said:

“[T]his Court believes that the rationale employed by Colorado, Kansas and Oklahoma in resolving the question of whether the lessor or the lessee should bear post-production costs is persuasive. Like those states, West Virginia holds that a lessee impliedly covenants that he will market oil or gas produced.”

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.

In Leggett, 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 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.

EQT Files Petition for Rehearing

As noted, the Leggett majority prevailed by only a slim 3-2 margin. The author of the majority opinion, Justice Benjamin, was defeated in his re-election bid and is no longer a member of the West Virginia Supreme Court. He was replaced by Beth Walker, an attorney who previously worked for the West Virginia University Health System. Against this back-drop, EQT filed its petition requesting that the newly constituted Supreme Court withdraw its November 17, 2016 opinion and schedule a new argument on the merits.

In its petition, EQT proffered three arguments in support of its rehearing request. First, EQT argued that the phrase “at the well-head” in §22-6-8 is not ambiguous and therefore the Leggett panel had no basis to “read into” the statute some other royalty valuation point. EQT’s argument, however, fails to appreciate or recognize that the West Virginia Supreme Court already determined in Tawney that the phrase “at the well-head” was, and is, ambiguous as a matter of law. Remarkably, EQT now contends that the phrase is suddenly unambiguous simply because it is codified in a statute, as opposed to an oil and gas lease.

Second, as it must in order to avoid losing on argument #1 above, EQT argues that Tawney and the “marketable product” rule should not apply to flat-rate leases and consequently, §22-6-8. EQT attempts to distinguish Tawney on the grounds that the royalty clause at issue in that case calculated the royalty based on the volume of gas produced. Given this metric, Tawney concluded that a driller has an implied duty to market the gas, which requires the driller to absorb all costs necessary to transform that volume of gas into a marketable product. Since flat-rate leases, such as Mr. Leggett’s original lease, do not calculate the royalty based on the volume of gas produced, EQT argues that Tawney is inapplicable. EQT’s argument misses the mark. Once the driller files the affidavit under § 26-6-8, the flat-rate royalty is superseded and replaced by the statutory royalty of 12.5%. The statutory royalty is volume based. As such, it is axiomatic that the operator of a converted lease should have the same implied duty to market and transport the gas as the operator of a traditional volume-based lease.

Third, EQT argues that the High Court “strayed far beyond the certified question” and decided issues that were not “adequately argued or briefed.” Specifically, EQT contends that the November 17, 2016 Opinion will have unintended consequences because the High Court never considered the issue of line loss (i.e., gas lost below the well-head and the point-of-sale). EQT laments that it will now be required to calculate Mr. Leggett’s royalty based on the volume recorded at the well-head meter, as opposed to the volume at the downstream point-of-sale. Since the volume of gas at the point-of-sale is often less than the well-head volume, EQT suggests that the court’s ruling gives an unfair windfall to landowners with “converted” leases under §26-6-8. It is submitted that this argument is nothing more than a red herring. The Leggett decision does not require that EQT pay the statutory royalty on unsold or lost gas. It simply held that the statutory royalty cannot be burdened or reduced by post-production costs.

While the arguments advanced by EQT in support of its petition for rehearing are relatively weak and unpersuasive, it is unclear how this newly constituted West Virginia Supreme Court will view them. To date, no briefing schedule or oral argument date has been set.