A recent decision by the West Virginia Supreme Court of Appeals has called into question its own precedent on the permissibility of post-production deductions and the calculation of oil and natural gas royalties, reversing course from a previously lessor-friendly stance on these issues. In Leggett v. EQT Production Company, No. 16-0136, 2017 W. Va. LEXIS 407 (May 26, 2017), the plaintiff lessors (Plaintiffs) filed suit against defendant EQT Production Company for the alleged underpayment of royalties resulting from EQT’s deduction of post-production gathering and transportation costs. The leases at issue were “flat-rate” leases subject to West Virginia Code § 22-6-8, which requires that a lessor be paid at least “one-eighth of the total amount paid to or received by or allowed to the owner of the working interest at the wellhead,” rather than a flat rate per well as was once customary in the industry. Thus, the royalty at issue was set at 12.5 percent by statute, and not by a freely bargained lease agreement.

In calculating Plaintiffs’ royalties, EQT utilized the “net-back” or “work-back” method, taking allocable post-production deductions from the sales price it received at the interstate pipeline to recreate the “wellhead” price. Plaintiffs argued that neither West Virginia Code § 22-6-8 nor West Virginia common law, specifically Wellman v. Energy Resources, Inc., 557 S.E.2d 254 (W. Va. 2001) and Tawney v. Columbia Natural Resources, L.L.C., 633 S.E.2d 22 (W. Va. 2006), permitted EQT’s use of the “net-back” method for post-production deductions. The Court, however, on certified questions from the U.S. District Court for the Northern District of West Virginia, answered in EQT’s favor, stating that such “flat-rate” leases subject to West Virginia Code § 22-6-8 “may be subject to pro-rata deduction or allocation of all reasonable post-production expenses actually incurred by the lessee,” and that “an oil or gas lessee may utilize the ‘net-back’ or ‘work-back’ method to calculate royalties.”

In reaching this decision, the Court declined Plaintiffs’ suggestion that it look to the Wellman and Tawney decisions for guidance because, although those cases similarly involved the calculation of royalties “at the wellhead,” the royalty provisions at issue in those cases were freely bargained and not subject to a statutorily prescribed royalty amount as in this case. Under Wellman and Tawney, the Court utilized principles of contract interpretation to adopt the “marketable product rule,” which provides that the implied duty to market requires the lessee to bear all costs until the product is rendered “marketable” unless expressly provided otherwise in the subject lease. Here, however, the Court analyzed the phrase “at the wellhead” as used in West Virginia Code § 22-6-8(e) using principles of statutory construction, stating that concerns related to the interpretation of contracts were inapplicable to the flat-rate leases at issue. Finding the statutory phrase “at the wellhead” to be “clearly indicative of a legislative intention to value the royalties paid pursuant to the statute based on the unprocessed wellhead price,” the Court stated that it did not believe “permitting lessors to benefit from royalties based upon an enhanced, downstream price without commensurately sharing in the expense to create the enhanced value effectuates the ‘adequate’ and ‘just’ compensation sought by the statute.”

Interestingly, the Court took the opportunity in dicta to distinguish and even criticize Wellman and Tawney, suggesting that those cases may now be subject to challenge. (“Before leaving our discussion of Wellman and Tawney, however, we are compelled to further illustrate the faulty legs upon which this precedent and its iteration of the marketable product rule purports to stand.”) The Court criticized Wellman’s adoption of a novel variation of the first marketable product doctrine, which the Court said has caused “chaos” and reflects a “complete misunderstanding of the industry.” (“[H]owever under-developed 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 Tawney.”) The Court closed its decision in Leggett by imploring the West Virginia legislature to resolve “the inherent tension between holders of leases subject to our interpretation of West Virginia Code § 22-6-8 and those freely-negotiated leases which remain subject to the holdings of Wellman and Tawney.”

Thus, opportunities now exist for oil and gas producers to challenge Wellman and Tawney based on the Court’s own reservations about the foundation for their rulings or to participate in the drafting and presentation of legislation aimed at this issue. If nothing else, the Leggett decision tells us that the current makeup of the West Virginia Supreme Court of Appeals may look more favorably on the industry than did its predecessors.