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Royalties in West Virginia

By Paul R. Yagelski, Esq.

Royalties in West Virginia: “Marketable Product” Rule or “At the Well” Rule?

In calculating the deduction of post-production costs, does West Virginia follow the “marketable product” rule or “at the well” rule of cost allocation?  Under the marketable product rule, lessees impliedly covenant 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).  To state it another way, the marketable product rule essentially requires a lessee to bear the costs incurred for obtaining a marketable product.  Leggett v. EQT Production Company, CA. No. 1:13 CV 4, 2016 WL 297714 (N.D. W.Va. January 22, 2016).  Under the “at-the-well” rule, lessees are permitted to deduct most of the post-production costs from the royalty payment.  See Piney Woods Country Life School v. Shell Oil Co., 726 F. 2d 225, 240-41 (5th Cir. 1984).  Currently, West Virginia has adopted its own version of the marketable product rule.  Wellman v. Energy Resources, Inc., 210 W.Va. 200, 557 S.E. 2d 254 (2001) forms the foundation of the current state of West Virginia’s law, and Estate of Tawney v. Columbia Natural Resources, L.L.C., 219 W.Va. 266, 633 S.E. 2d 22 (2006) addresses the scope and impact of Wellman’s holdings.

Under Wellman, if an oil and gas lease provides for a royalty based on proceeds received by the lessee, 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.  Wellman, 557 S.E.2d at 265.[i]  In other words, Wellman stands for the proposition that unless a lease “provides otherwise,” lessees may not deduct post-production costs before calculating royalties.”

In Tawney, the West Virginia Supreme Court addressed the question as to whether an oil and gas lessee must bear all costs incurred in marketing and transporting the product where the lease states that royalties are to be calculated “at the well,” or “at the wellhead.”  Tawney 639 S.E.2d at 24.

Tawney found the “at the wellhead” language ambiguous because it is “imprecise.”  The language does not indicate how or by what method the royalty is to be calculated or the gas is to be valued.  Tawney, 633 S.E. 2d at 28.  Tawney then went on to hold that language in an oil and gas lease that is intended to allocate between the lessor and lessee the costs of marketing the product and transporting it to the “point of sale must” meet certain specificity standards.  First, the language must expressly provide that the lessor shall bear some part of the costs incurred between the wellhead and the point of sale.  Second, the language must identify with particularity the specific deductions the lessee intends to take from the lessor’s royalty.  Finally, the language must indicate the method of calculating the amount to be deducted from the royalty for such post-production costs.  Tawney, 633 S.E. 2d at 30.

Based then on Wellman and Tawney, if an oil and gas lease provides for a royalty based on proceeds received by 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 part 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 the royalty for such post-production costs.

Although West Virginia follows its own version of the marketable product doctrine, the doctrine does not apply to flat rate leases.

In Leggett v. EQT Production Co., 239 W. Va. 264, 800 S.E. 2d 850 (2017), the West Virginia Supreme Court decided whether:

  1. Royalty payments under a flat rate lease governed by West Virginia Code § 22-6-8(e)(1994) were subject to pro-rata deduction or allocation of post-production expenses by the lessee, and
  2. An oil and gas lease may utilize the “net-back” or “work-back” method to calculate royalties owed to a lessor pursuant to a flat rate lease governed by West Virginia Code § 22-6-8.

The Court answered both questions in the affirmative.  In so doing the Court noted that its decision did not apply to the leases in Wellman and Tawney or other such leases.  Such leases are unaffected by the statute, West Virginia Code § 22-6-8, which addresses flat rate leases.  The Court found no inconsistent result where two distinct types of leases of completely differing character were involved, one type of which is the product of free and open negotiation and the other is encumbered by the operation of a statute.

Although West Virginia currently follows its own version of the marketable product rule, in Leggett, the West Virginia Supreme Court questioned the continued vitality and scope of West Virginia’s version as set forth in Wellman and Tawney.  The Supreme Court felt compelled to illustrate the “faulty legs” upon which the precedent of Wellman and Tawney and its iteration of the marketable product rule purports to stand.  Leggett, 800 S.E. 2d at 862.  In so doing, the Supreme Court referenced a number of commentators who have criticized Wellman and Tawney as nothing more than a rewriting of the parties’ contract to take money from the lessee and give it to the lessor.  Leggett, 800 S.E. 2d at 863.  In concluding its review of the criticism generated by Wellman and Tawney, the Supreme Court stated:

The foregoing notwithstanding, however underdeveloped or inadequately reasoned this Court observes Wellman and Tawney to be, the issue presently before the Court simply does not permit intrusion into these issues.  We therefore leave for another day the continued vitality and scope of Wellman and TawneyLeggett, 800 S.E. 2d at 863 (emphasis added).

Except for flat rate leases, under West Virginia’s own version of the marketable product rule, the lessee, unless otherwise indicated in the lease, bears all of the post-production costs to the point of sale as opposed to the point where the product is marketable.  The continued application of the rule is, however, very suspect.  Based upon the West Virginia Supreme Court’s language in Leggett, West Virginia’s marketable product rule appears to be on its last legs; only waiting for a case to raise the issue of the rule’s continued vitality and scope at which time the rule will most likely be rejected.  If rejected, presumably, the “at the well” rule will be adopted.

 


[i] The West Virginia version of the “marketable products” doctrine 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 in its natural state at the wellhead or 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 has had value added to it solely at the lessee’s expense.  See Leggett v. EQT Production Company, 239 W. Va. 264, 800 S.E. 2d 850, 862-863 (2017).  W.W. McDonald Land Co. v. EQT Production Co., 983 F. Supp. 2d 790 (2013) interprets Wellman and Tawney as requiring that the lessee must bear the cost of bringing the gas to market; the first place downstream of the well where the gas can be sold to any willing buyer and title passes to that buyer.  In Leggett, however, the West Virginia Supreme Court interprets Wellman and Tawney as adopting the “point of sale approach;” i.e., unless the lease provides otherwise, the lessee must bear all costs to the point of sale, not just the point where the gas becomes marketable.

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