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West Virginia Supreme Court of Appeals Holds Certain Lessees May Deduct Post-Production Costs

By Jay Carr

On Friday, May 26, 2017, the West Virginia Supreme Court of Appeals released its decision in Patrick D. Leggett, et al. v. EQT Production Company, et al. and held that lessees subject to West Virginia Code § 22-6-8 may deduct post-production costs actually incurred from the lessor's royalty.  The reasonableness of post-production expenses, however, is a question of fact. The Court's decision is more fully explained below.

As background, West Virginia Code § 22-6-8 prohibits the "extraction, production or marketing of oil or gas under a lease . . . providing a flat well royalty or any similar provisions for compensation to the owner of the oil and gas in place, which is not inherently related to the volume of oil or gas produced or marketed * * *"  To this end, West Virginia Code § 22-6-8 (1994) prohibits the issuance of any permit to drill, deepen, fracture, or stimulate a well "where the right to develop, extract, produce or market the same is based upon such leases * * *." Lessees may avoid this prohibition if they file an affidavit certifying that they shall "tender to the owner of the oil or gas in place not less than one eighth of the total amount paid to or received by or allowed to the owner of the working interest at the wellhead for the oil or gas so extracted, produced or marketed * * *" (emphasis added).

The plaintiffs/petitioners argued that the foregoing statutory language is ambiguous and should be interpreted to prohibit the deduction of post-production costs.  Such an interpretation, plaintiffs/petitioners contended, would be consistent with West Virginia's common law rule. The defendants/respondents, on the other hand, argued that the statute was not ambiguous since "at the wellhead" is a very precise and definite location. In the wake of deregulation, the only method to mathematically calculate the lessor's royalty at the wellhead is to utilize a "net-back" or "work-back" method. This method utilizes the interstate pipeline sales price and makes deduction for post-production costs.

In reaching its decision, the Court first rejected the notion that West Virginia Code § 22-6-8 must be interpreted in light of the policy-driven issues of whether West Virginia is a "marketable product" state or "at the well" state. The Court found that the issue presented is solely one of statutory interpretation.  Next, the Court applied well-established canons of statutory construction and found that the phrase "at the wellhead" as used in the statute is not ambiguous on its face. The Court noted that the phrase "at the wellhead" has a very precise and definite meaning in the oil and gas industry. That phrase, when used with reference to oil and gas royalty valuation, is understood to mean that oil and gas will be valued in its unprocessed state as it comes to the surface at the mouth of the well. As a result, the Court was persuaded that "the most logical way to ascertain the wellhead price is, in fact, to deduct the post-production costs from the 'value-added' downstream price in an effort to replicate the statutory wellhead value."

The Court's decision may be viewed here. It is important to note that oil and gas lessees not subject to West Virginia Code § 22-6-8 are not bound by this decision.

Tags: West Virginia, Oil and Gas, Energy, Royalty

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