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In West Virginia, Can Post-Production Costs Be Deducted From A Flat Rate Lease?

By Paul R. Yagelski, Esq.

What Is The Effect Of W.Va. Code, § 22-6-8 On The Deduction Of Post-Production Costs From A Flat Rate Lease?

West Virginia follows the marketable product rule of cost allocation.  Under the marketable product rule, the lessee impliedly warrants to bear the costs of getting gas into marketable condition and transporting it to market.  W.W. McDonald Land Co. v. EQT Production Co., 983 F. Supp. 2d 790, 801 (S.D.W.Va. 2013).  West Virginia’s version of the marketable product rule, however, adopts the point of sale as opposed to the point where the gas reaches the market as the point to which the lessee is responsible for bearing post-production costs.  Under the “point of sale” approach, a lessor will not only receive a royalty valued upon the gas when the gas becomes marketable, but in addition, the lessor will receive a royalty valued upon the gas in its processed state at the point of sale after the gas had value added to it solely at the lessee’s expense.

In West Virginia, if an oil and gas lease provides for a royalty based on proceeds received by a lessee:

  1. Unless the lease provides otherwise, the lessee must bear all costs incurred in exploring for, producing, marketing and transporting the product to the point of sale and the costs must be actually incurred and reasonable.
  2. If an oil and gas lease intends that the lessor shall bear some of the costs incurred between the wellhead and the point of sale, or if it intends to allocate the same:

(a) the lease must expressly provide that the lessor shall bear some part of the costs incurred between the wellhead and the point of sale;

(b) the language must identify with particularity the specific deductions the lessee intends to take from the lessor’s royalty; and

(c) the language must indicate the method of calculating the amount to be deducted from a royalty for such post-production costs.

See Wellman v. Energy Resources, Inc., 210 W.Va. 200, 557 S.E. 2d 254 (2004) and Estate of Tawney v. Columbia Natural Resources, L.L.C., 219 W.Va. 266, 633 S.E. 2d 22 (2006).

Although West Virginia follows the marketable product doctrine, albeit its own version, in Leggett v. EQT Production Co., 239 W.Va. 264, 800 S.E.2d 850 (2017), the West Virginia Supreme Court determined that West Virginia’s marketable product doctrine does not apply to flat rate leases.  Specifically, the West Virginia Supreme Court in Leggett determined that (1) royalty payments under a flat rate lease governed by West Virginia Code § 22-6-8(e) (1994) are subject to pro-rata deduction or allocation of all reasonable post-production costs actually incurred by the lessee, and (2) an oil and gas lessee may utilize the “net-back” or “work-back” method to calculate royalties owed to a lessor pursuant to a flat rate lease governed by the West Virginia Code, § 22-6-8(e).  Leggett, however, was overturned by West Virginia’s amendment, effective May 31, 2018, to W.Va. Code, §22-6-8(e).

Under W.Va. Code, § 22-6-8(b), the West Virginia legislature declared that it is the policy of West Virginia, to the extent possible, to prevent the extraction, production or marketing of oil or gas under lease or leases or other continuing contract or contracts providing a flat well royalty, a royalty which is based solely on existence of a producing well and not inherently related to the volume of oil and gas produced or marketed, and that toward these ends, the legislature declared that it is the obligation of the state to prohibit issuance of any permit required by it for the development of oil or gas where the right to develop, extract, produce or market the same is based upon such leases or other continuing contractual agreements.

Under W.Va. Code, § 22-6-8(d), unless the provisions of § 22-6-8(e) of the West Virginia Code are met, no permit may be issued for drilling of a new oil or gas well, or for the redrilling, deepening, fracturing, stimulating, pressuring, converting, combining or physically changing to allow the migration of fluid from one formation to another, of an existing oil or gas production well, where or if the right to extract, produce or market the oil and gas is based upon a lease or leases or other continuing contract or contracts providing for a flat well royalty or any similar provision for compensation to the owner of the oil or gas in place which is not inherently related to the volume of oil and gas so extracted, produced and marketed.

Under § 22-6-8(e), as amended, to avoid the permit prohibition of § 22-6-8(d) of the code, the applicant may file with such application an affidavit which certifies that the affiant is authorized by the owner of the working interest in the well to state that it shall tender to the owner of the oil or gas in place not less than 1/8th of the gross proceeds, free from any deductions for post-production expenses, received at the first point of sale to an unaffiliated third-party purchaser in an arms-length transaction for the oil and gas so extracted, produced or marketed before deducting the amount to be paid or set aside for the owner of the oil or gas in place, on such oil or gas to be extracted, produced or marketed from the well.  If such an affidavit is filed with such application, then such application for permit shall be treated as if such lease or leases or other continuing contract or contracts comply with the provisions of this section.

With the amendment to § 22-6-8(e), and as to permits as of or after May 31, 2018, post-production costs cannot be deducted from a flat rate royalty lease. If you are a West Virginia landowner in need of assistance, contact us online or at (412) 338-1124.

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