RECENT CASES AFFECTING THE ENERGY INDUSTRY . Carrie J. Lilly Partner Energy & Mineral Law Foundation Kentucky Mineral Law Conference October 2016
Responsibility for Post-Production Costs • What is the specific language of the lease? • At what point are royalties calculated – at the well, or downstream? . • Does the state follow an “at the well” approach, or a “marketable product” approach? • How far does an operator’s obligation extend under the “marketable product” approach? 2
Fawcett v. Oil Producers Inc. of Kansas Supreme Court of Kansas • Operator sells raw natural gas at the wellhead to third- parties • Third-parties transport gas to processing plants, process . the gas, then sell the gas to other parties • Price operator receives, and upon which operator calculates royalties , is based on the amount the third- parties receive for sale of the processed gas, less certain processing costs incurred 3
Fawcett v. Oil Producers Inc. of Kansas Supreme Court of Kansas • Leases generally provide for royalties based on proceeds from the sale of gas at the well , or if marketed off the leased premises, then based upon market value at the well . • Issue : Can the operator deduct the processing costs when calculating royalties, or, is the operator solely responsible for all processing costs to prepare the gas for the interstate pipeline system ? – How far does the operator’s duty to market extend? 4
Fawcett v. Oil Producers Inc. of Kansas Supreme Court of Kansas • “ Marketable Condition Rule ” – Requires operators to make gas marketable at the operator’s expense . • Does the marketable condition rule extend the operator’s obligations to the interstate pipeline system? – NO, when a lease provides for royalties based on a share of proceeds from the sale of gas at the well , and when gas is sold at the well 5
Fawcett v. Oil Producers Inc. of Kansas Supreme Court of Kansas • When an operator is required to pay royalties based on proceeds from sale at the well, and when gas is sold at the well, the operator may not deduct pre-sale expenses required to make the gas acceptable to the third-party purchaser . • Post-sale, post-production expenses to transform the gas into interstate pipeline quality gas are different than expenses of drilling and equipping the well • Operator’s duty of good faith in contracting with third- parties was not challenged in this case 6
Baker et al. v. Magnum Hunter Production, Inc . Supreme Court of Kentucky • Issue: Apportionment of post-production costs under “market price at the well” royalty clauses. • Lease: “Lessee covenants and agrees: . . . To pay Lessor . one-eighth of the market price at the well for gas sold or for gas so used from each well off the premises.” • Gas was not sold at the well • Lessee gathered, compressed, and treated raw gas, then transported it to downstream purchasers 7
Baker et al. v. Magnum Hunter Production, Inc . Supreme Court of Kentucky • When calculating royalties, lessee deducted gathering, compression, treatment, and transportation costs from the downstream price received • Lessors contended that production companies had . miscalculated and underpaid royalties based on the “marketable product” approach • Lessors contended that the “marketable product” approach was necessary to give meaning to the lease terms “market price at the well” because until a product is marketable, it cannot have a market price 8
Baker et al. v. Magnum Hunter Production, Inc . Supreme Court of Kentucky • Court concluded that prior cases reflect that, absent an express contrary provision, “ royalty ” is the lessor’s cost- free share of production • Court concluded that “ production ” is raw gas captured . at the well • Court concluded that under the marketable product approach contended by lessors, production would be understood to extend to the production of a marketable product , rather than simply the initial capture of the raw mineral 9
Baker et al. v. Magnum Hunter Production, Inc . Supreme Court of Kentucky • Holding: Kentucky is an “at the well” state for gas lease royalty valuation • Under standard “ market price at the well ” royalty clauses, the lessee is solely responsible for the costs . of production – of bringing the gas to the well • Post-production costs for enhancements such as accumulating, compressing, processing, and transporting the gas may be deducted from gross receipts before calculating royalties 10
Leggett, et al. v. EQT Production Company Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV 1906 lease provides for flat-rate royalty rather than a volumetric-based royalty: . “. . . lessee shall pay to the lessor for each and every well drill[ed] upon said land which produces Natural Gas . . . Three Hundred Dollars ($300.00) per annum” 11
Leggett, et al. v. EQT Production Company Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV • Plaintiffs contended that operator did not pay the full amount of royalties due, and that under the “ marketable product rule ,” the operator should bear all costs to obtain a marketable product, without deduction for post- production costs . • Operator contended that the “ flat rate statute ” identifies the wellhead as the point of distribution at which the royalty amount is calculated • District Court concluded that Tawney cast doubt on whether West Virginia was an “at the well” state 12
Leggett, et al. v. EQT Production Company Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV “Flat rate statute” (1982), W. Va. Code 22-6-8 (generally): No permit for the drilling of a new oil or gas well or for the . redrilling, deepening, or fracturing of an existing well shall be issued where the lease provides for flat well royalty (i.e., where the royalty is not related to the volume of oil and gas extracted, produced, and marketed) 13
Leggett, et al. v. EQT Production Company Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV • To avoid the permit prohibition, the permit applicant may certify that the owner of the oil and gas will be paid “ not less than one eighth of the total amount paid or received by or allowed to the owner of the working interest at the wellhead .” . • What does “at the wellhead” mean under the “flat rate statute” for flat-rate leases that have been converted to volumetric-based leases? • Should the court rely upon case law to interpret the statute? 14
Leggett, et al. v. EQT Production Company Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV The District Court gleaned three key points from Tawney : 1. General rule under WV law is that lessee bears all costs of marketing and transporting the product to the point of sale. . 2. “At the wellhead” was found to be ambiguous in the context of the lease at issue in Tawney. 3. If a lessee seeks to deduct post-production costs, it must do so expressly, with particularly at to what deductions will be made and how the royalty will be calculated. 15
Leggett, et al. v. EQT Production Company Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV District Court’s basis for certifying questions to WV Supreme Court: 1. T awney involved “at the wellhead” language in a lease , not a statute . 2. Tawney did not mention the “flat rate statute.” . 3. The “flat rate statute” appears to apply to the awarding of permits , and it is unclear whether the statute applies to deductions for post-production costs. 4. Legislative findings of the “flat rate statute” appear to permit the abrogation of flat rate leases. 5. Legislative findings acknowledge that existing lease obligations should be respected and not impaired. 16
Leggett, et al. v. EQT Production Company Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV Certified questions (generally): – Does Tawney affect whether a lessee of a flat-rate lease, converted to a volumetric lease pursuant to the “flat rate statute,” may deduct post-production expenses from the lessor’s royalty, particularly with . respect to the “at the wellhead” language in the “flat rate statute”? – Does the “flat rate statute” only affect royalties for wells drilled or reworked after enactment of the statute, or does it abrogate flat-rate leases entirely? 17
Chesapeake Exploration et al. v. Hyder et al. Supreme Court of Texas • Chesapeake Exploration, lessee, sold gas produced to affiliate Chesapeake Energy Marketing, Inc., which then gathered and transported the gas through affiliated and interstate pipelines for sale to third-party customers . • Chesapeake Marketing paid Chesapeake Exploration a “ gas purchase price ” for volumes determined at the wellhead , based on the weighted average of third-party sales, less post-production costs • Overriding royalty paid to lessors was 5% of the “gas purchase price” 18
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