On August 20, 2015, the Supreme Court of Kentucky published two opinions addressing questions about the propriety of deduction of certain post-production costs from royalty payments under an oil and gas lease. In Baker v. Magnum Hunter, the court confirmed that Kentucky is an “at the well” jurisdiction, meaning that a lessor’s royalty is calculated based on the value of the raw gas extracted at the well. In Appalachian Land Company v. EQT Production Company, the court addressed the specific question of whether an oil and gas operator can properly deduct severance taxes before calculation of a lessor’s royalties. The court held that absent language to the contrary, severance taxes cannot be deducted from royalties as post-production costs.

Baker, et al. v. Magnum Hunter Production, Inc., Case No. 2013-SC-000497 (Ky. August 20, 2015) In Baker v. Magnum Hunter Production, the Supreme Court of Kentucky confirmed that absent language to the contrary, a royalty in an oil and gas lease is based on the value of the raw gas captured at the well. The plaintiff-lessors in the case had argued that royalty deductions for the cost of the gathering, compression, and treatment of gas were improper. The leases at issue provided that lessors were entitled to receive royalties of “one-eighth of the market price at the well for gas sold or for the gas so used from each well off the premises.” Plaintiffs argued that under Kentucky law, and the plain language of their leases, lessors were required to calculate their royalty based on the sale of gas made “marketable.” Plaintiffs acknowledged that bona fide transportation costs were proper deductions, but argued that the gas was not marketable until after accumulation, compression, and other treatment occurred. In support of this argument, plaintiffs challenged the Sixth’s Circuit’s recent characterization of Kentucky as an “at the well” jurisdiction, and attempted to distinguish prior Kentucky cases allowing deduction of post-production costs on the grounds that those cases dealt with transportation, rather than gathering, compression, or treatment.

The Supreme Court of Kentucky disagreed, and held that under established Kentucky law, an oil and gas royalty is the lessor’s cost-free share of production, with “production” understood as the raw gas captured at the well. The court recognized plaintiffs’ view as a version of the marketable product doctrine, which the court held is inconsistent with Kentucky law because the implied duty to market the gas did not extend beyond “selling the gas at a reasonable price at the well side.” The court noted that a reasonable well-side price could be determined by an actual well-side sale, by comparable sales in the vicinity, or by applying the net-back method to deduct downstream costs. Finally, the court rejected the plaintiffs’ argument that the word “market” in “market price at the well” required the gas to be marketable before royalties were calculated. The court found that “without more specificity,” those words could not overcome the presumption that the royalty be based on the value of proceeds of the raw gas produced at the well. The court described the “at the well” approach as “not only long-standing but also fair in every sense,” and characterized the marketable product approach as a distortion of the intent of the parties, because it resulted in the lessor receiving more than one-eighth of the value of the raw gas produced from their property.

Appalachian Land Co. v. EQT Production Co., Case No. 2013-SC-000598 (Ky. August 20, 2015) 
In Appalachian Land Company v. EQT Production Company, the Supreme Court of Kentucky considered whether the cost of a state severance tax was a valid deduction of a post-production cost from a lessor’s royalties. The issue arose out of a class action originally filed in the U.S. District Court for the Eastern District of Kentucky, in which the plaintiffs had deducted post-production costs including processing, transportation, and all severance taxes. The district court certified the following question to the Supreme Court of Kentucky:

Does Kentucky’s “at-the-well” rule allow a natural-gas processor to deduct all severance taxes paid at market prior to calculating a contractual royalty payment based on “the market price of gas at the well,” or does the resource’s at-the-well price include a proportionate share of the severance taxes owed such that a processor may deduct only that portion of the severance taxes attributable to the gathering, compression and treatment of the resource prior to calculating the appropriate royalty payment?

In a 5-2 opinion, the majority declined to adopt either proposition, and instead held that absent a specific lease provision apportioning severance taxes, a lessee may not deduct any portion of severance taxes prior to calculating royalties.

The majority reviewed the state severance tax statute at issue and held that the tax was intended to burden the business of extracting minerals, and not the land containing the minerals. The majority also distinguished Kentucky’s severance tax statute from those of other states that specifically provide for the payment of severance taxes by the royalty owner. The court also emphasized the fact that “while the sale of the gas is contingent upon payment of the severance tax, the tax does not enhance the value of the gas.” The court found “it would run contrary to the parties’ intent – and the purpose of the ‘at the well’ rule – for the royalty owner to share in an expense that does nothing to improve the quality of the product beyond the well-head.” The court acknowledged that the state legislature has the ability to modify the statute if necessary. Two dissenting justices would have found that the portion of the severance taxes attributable to the processing of gas, rather than the initial extraction, could be properly deducted in accord with the court’s decision inBaker v. Magnum Hunter Production, Inc..