Southern District of West Virginia interprets Tawney requirements strictly to find that lessees have a duty to bear all costs incurred until gas reaches the downstream, third-party market. W.W. McDonald Land Co, v. EQT Production Co., 2013 U.S. Dist. LEXIS 165427 (S.D. W. Va. November 21, 2013).

The plaintiffs in McDonald Land Co. sued EQT Production, claiming that EQT improperly deducted “post- production” costs from royalty payments, including monetary expenses incurred by the EQT to transport and market the gas after production and the volume differential between wellhead and downstream volumes sold at the interstate pipeline. From 2000 to 2005, EQT produced gas from wells it leased from the plaintiffs and transported it to an interstate pipeline connection, where it was marketed to third parties. EQT passed some of these costs on to the plaintiffs by charging them a flat rate per unit of gas based on the volume sold at the interstate pipeline connection. In 2005, EQT reorganized into separate entities, with only EQT Production as a party to the leases and different EQT entities then handling the collection, transportation, and sale of the gas. EQT Production argued that it did not make post-production deductions after the reorganization because it pays royalties based on the price received from its affiliate EQT Energy.

The plaintiffs’ arguments were primarily premised on the case of Estate of Tawney v. Columbia Natural Resources, L.L.C. Based on Tawney and other relevant case law, the Court held that lessees have an implied duty to bear all post-production costs incurred until the gas reaches the market, which it defined as “the first place downstream of the well where the gas can be sold to any willing buyer and title passed to that buyer.” The Court accordingly found that EQT Production could not avoid this obligation by merely dealing with a sister company (i.e. a “work- back” method), because that did not constitute an arms’ length transaction. The Court further held that Tawney applied retroactively.

The plaintiffs also argued that the royalties should be calculated on the gas volume produced at the wellhead, not the smaller volume that is sold at an interstate pipeline connection. The Court rejected this notion, stating that it would be “illogical and inequitable” to require lessees to pay royalties on gas that is never sold. Like other courts to consider this question, the Southern District of West Virginia held that Tawney’s requirements did not include volumetric losses.

Oil and gas lessees should note the treatment of the Tawney case and its implications for post-production deductions and royalty accounting calculations.