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Satisfying West Virginia’s Requirements for Allocating Post-Production Costs to Lessors in an Oil and Gas Lease

By Paul R. Yagelski, Esquire

In Young v. Equinor USA Onshore Properties, Inc., 982 F.3d 201 (4^th Cir. 2020), the Fourth Circuit Court of Appeals dealt with the issue as to whether an oil and gas lease satisfied the three-prong test necessary under West Virginia law to rebut the presumption that the lessee bears all post-production costs.

Plaintiffs, Travis Young and Michelle Bee Young (the “Youngs”), sued Equinor USA Onshore Properties, Inc. (“Equinor”) and SWN Production Company (“SWN”) to challenge the deduction of post-production costs from royalties paid to the Youngs pursuant to an oil and gas lease between the parties.  The United States District Court for the Northern District of West Virginia agreed with the Youngs, holding that the lease failed to properly provide for the method of calculating post-production costs, granting summary judgment in favor of the Youngs.  Equinor and SWN appealed.  The Fourth Circuit vacated and remanded to the district court to enter judgment for SWN and Equinor.

The Youngs are Lessors of 69.5 acres of land in Ohio County, West Virginia (the “Property”).  SWN (as the lessee) and Equinor (as an assignee under the lease) have the rights to drill and operate wells on the Property for the production and sale of oil and gas.  In exchange, the Youngs receive royalties based on a share of the proceeds.  Specifically, the lease’s royalty clause: (1) grants the Youngs a royalty share equal to “fourteen percent of the net amount realized” by SWN and Equinor; (2) states that post-production costs shall be deducted from the “gross proceeds” to calculate the net amount realized; (3) specifies seven types of such post-production costs, including a “catchall” provision for “any and all other” post-production costs; and (4) allows SWN and Equinor to either contract with others to perform the post-production operations or perform them using their own pipelines and equipment, in which case post-production costs also include the “reasonable depreciation and amortization expenses related to such facilities, together with Lessee’s costs of capital and a reasonable return on its investment.”

In addition to the royalty clause, the lease also provided that royalty payments are to be proportional to the Youngs’ actual ownership percentage of the Property in the event that they divest some of their leased fee interest.  The lease also allowed SWN and Equinor to pool or combine the Property with other lands to create drilling or production units.  In the event of such pooling, which happened in this case, royalty payments are to be proportional to the Property’s share of the total land acres included in the unit.  The lease also expressly disclaimed the duty to market the resources on the Property during the “primary term or any extension of term of this Lease.”  In the absence of such a provision, West Virginia’s default rule is “that a lessee impliedly covenants that he will market oil or gas produced” on leased land.  Wellman v. Energy Resources, Inc., 210 W.Va. 200, 557 S.E. 2d 254, 265 (2001).

In April 2016, SWN began deducting post-production costs from the Youngs’ royalty payments.  The Youngs objected, contending that deductions were not allowed under West Virginia law.  SWN responded that the lease provided for the deductions, which were calculated by “tak[ing] their decimal interest in the unit,” or the fraction that the Property bears in relation to the total pooled acreage, “and multiply[ing] it times such specific deduction” in the lease.

Not satisfied with that explanation, the Youngs sued in state court for damages and a declaratory judgment that the lease failed to satisfy West Virginia’s requirements for allocating post-production costs to the lessors in an oil and gas lease under Estate of Tawney v. Columbia Natural Resources, LLC, 219 W. Va. 266, 233 S.E. 2d 22 (2006).

In Tawney, the West Virginia Supreme Court of Appeals held that an oil and gas lease must satisfy a three-pronged test to rebut a presumption that the lessee bears all post-production costs and to thereby allocate some of those costs to the lessor.  Tawney, 633 S.E. 2d at 30.  Specifically, the lease must (1) “expressly provide that the lessor shall bear some part of the [post-production] costs”; (2) “identify with particularity the specific deductions that a lessee intends to take from the lessors’ royalty”; and (3) “indicate the method of calculating the amount to be deducted from the royalty for such post-production costs.”  Id.

SWN and Equinor removed the case to the Northern District of West Virginia.  At the close of discovery, the parties filed cross-motions for summary judgment.  The district court granted summary judgment to the Youngs, holding that under Tawney, the lease failed to properly provide for the method of calculating the amount to be deducted from the Youngs’ royalties.  SWN and Equinor appealed.

On appeal, SWN and Equinor contended that they properly deducted post-production costs from the Youngs’ royalty payments either because the lease satisfies Tawney’s requirements for deducting such costs, or because the lease’s disclaimer of the implied duty to market means that it’s not subject to Tawney at all.

In applying Tawney’s three-prong test, the Fourth Circuit noted that as to the first prong the parties agreed that the lease expressly provided that the Youngs will bear post-production costs, thereby satisfying the first prong.  As to the second prong, for the most part, the parties also agreed that the lease identified post-production costs with particularity, thus satisfying the second prong. The parties, however, disputed the third prong – that is, whether the Lease adequately “indicates the method of calculating the amount that will be deducted from the royalty for such post-production costs.”  Tawney, 623 S.E. 2d at 30.

The district court found that the lease failed on the third prong of Tawney because it merely states that the lessee will deduct post-production costs, yet says absolutely nothing as to how those costs would be calculated, other than to leave the amount of the deduction wholly to the lessee’s discretion.  In short, the district court held that the lease lacks a “mathematical formula” that would constitute a method of calculation.

The Fourth Circuit disagreed.  It noted that Tawney doesn’t demand that an oil and gas lease set out an Einsteinian proof of calculating post-production costs.  By its plain language, the case merely requires that an oil and gas lease that expressly allocates some post-production costs to the lessor identify which costs and how much of those costs will be deducted from the lessor’s royalties.  These conditions may be satisfied by a simple formula, like the one in this case.

The very notion of deduction implies the first component of the formula:  Some part of the post-production costs specified in the lease are subtracted from the pot of money from which the royalty percentage is calculated.  Tawny, 633 S.E. 2d at 30.  In this case, the lease tells us that this sum consists of “the gross proceeds received by Lessees from the sale of . . .   gas.”

To determine the precise amount of the specified post-production costs to be deducted from the “gross proceeds” and arrive at the “net amount,” under the lease, one adds up “all” of the receipts corresponding to the costs specifically enumerated in the lease and, if applicable, in the depreciation clause.  (“[T]he term ‘net amount realized by Lessee, computed at the wellhead’ shall mean the gross proceeds received by Lessee from the sale of oil and gas minus post-production costs incurred by Lessee between the wellhead and the point of sale . . . . [T]he term “post-production costs” shall mean all of the costs and expenses of (a) . . . , and (g) . . . . [and] reasonable depreciation and amortization expenses . . . . ”(emphasis added)).

Thus, the lease’s royalty provision tells all that is needed to be known to determine “the amount to be deducted from the royalty for such post-production costs.”  See Tawney, 633 S.E. 2d at 30.  To calculate the Youngs’ royalty payment, one then multiplies the “net amount realized by Lessee” by 0.14, or 14 percent.

The Youngs also contended that the lease fails Tawney’s third prong because the royalty clause fails to apportion the costs between lessors.  But as SWN and Equinor pointed out, the lease deals with that issue elsewhere.  Specifically, the lease explains how to adjust the overall calculation of royalties in the event that the Youngs transfer some of their interest in the Property: by multiplying the “net amount realized” by the fraction of the Property they still own, and it describes how to adjust the calculation where, as in their case, SWN and Equinor have pooled the Property with other production units: by multiplying the “net amount realized” by the fraction that the property bears in relation to the total pooled acres.

In setting out these methods for calculating not only the amount of designated post-production costs to be deducted, but also the pool from which to deduct them, and the manner in which to arrive at the ultimate royalty payment, the lease effectively mirrors the work-back method of calculation that was approved by the Supreme Court of Appeals in Leggett v. EQT Production Co., 239 W.Va. 264, 800 S.E. 2^nd 850 (2017).  Under that method one simply “deduct[s] the post-production costs from the ‘value-added’ downstream price” that the gas fetches at market.  Id. at 866.  Because that’s exactly what the lease did here, it followed that the language at issue bears the same “precise and definite meaning” that Leggett approved.  Id. at 865.

The district court’s view of why the lease lacked a method for calculating the amount of post-production costs to be deducted was similarly unpersuasive to the Fourth Circuit.  At bottom, the district court failed to recognize that the lease’s directive to add all of the specified, reasonable, and actually incurred post-production costs, then subtract that figure from the gross proceeds, and finally multiply that sum by 0.14 as well as the Youngs’ fractional share of the total pooled acreage, sufficed as a  method of calculation.

In sum, the Fourth Circuit was satisfied that under Tawney, the lease sufficiently  indicated the method for calculating the amount of post-production costs to be deducted when calculating the Youngs’ royalty.  That method was simply to add up all of the identified, reasonable, and actually incurred post-production costs, and deduct them from SWN and Equinor’s gross proceeds.  The amount is then adjusted for the Youngs’ fractional share of the total pooled acreage and their royalty rate.  According to the Fourth Circuit, West Virginia law demands nothing more.

If you have questions about an oil and gas lease in West Virginia, Ohio or Pennsylvania, contact us online or call (412) 338-1124.