On May 26, 2017, the West Virginia Supreme Court of Appeals filed an opinion in response to two certified questions by the United States District Court for the Northern District of West Virginia relating to the calculation of royalty payments for oil and gas leases. At issue are leases that pay royalties on natural gas at a fixed amount regardless of the level of production.[i] As a disclaimer, the reader should know that I have no involvement in this matter or with these parties. I have not been privy to any of the record or any of the proceedings. My analysis derives solely from the text of the opinion and my anecdotal experience in oil and gas matters. I stand ready to defer to those with a more complete knowledge of the facts and procedural history.
The “flat-rate” leases that are the subject of this case were executed many decades ago when the use of natural gas was less prevalent and its value much lower than today. In those days, many landowners who were also mineral owners, generally far less knowledgeable and sophisticated than the frequently unscrupulous operators of the period, were likely more interested in the provision of the lease providing for a free supply of gas for their own domestic use than the royalty. Owing to the operation of the secondary term of such leases which allows them to remain in effect so long as oil or gas is produced, many of these leases signed around the end of the 19th century are still in effect today.[ii]
The payment of small flat-rate royalties became an ever decreasing percentage of the natural gas production revenue, resulting in an increasing working interest income at the expense of mineral owners as the value of the gas rose over the intervening years. The West Virginia Legislature in 1982 sought to address and correct this inequity. In what would eventually be codified in chapter twenty-two, article six, section eight e (§ 22-6-8(e)) of the West Virginia Code,[iii] with an eye toward avoiding a conflict with both the United States Constitution and the West Virginia Constitution, the Legislature required the conversion of all flat-rate royalties to production-based royalties for all wells requiring remedial work for which a permit was required.[iv]
As is its wont, the Court reformulated the first of two certified questions submitted by the federal district court as follows:
Are royalty payments pursuant to an oil or gas lease governed by West Virginia Code § 22-6-8(e) (1994) subject to pro-rata deduction or allocation of post-production expenses by the lessee?
In reformulating and responding to the first certified question (the second certified question was not addressed in this opinion), the Court, after deriding the decisions in both Tawney v. Columbia Natural Resources, 219 W. Va. 266, 633 S.E.2d 22, (2006), and Wellman v. Energy Resources, Inc., 210 W. Va. 200, 557 S.E.2d 254 (2001), ultimately opined, correctly, that the rules of contract interpretation and statutory construction differ and that one might arrive at opposing results in the analysis of virtually identical facts, depending upon which rule controlled. The Court held, again correctly, that the intent of the Legislature is the standard by which statutes are to be construed and that judicial interpretation is to be applied only in instances of statutory ambiguity.[v]
OK, fine. Let’s look at § 22-6-8(e) under the standard set by the Court. The Court concentrates its analysis of the potential statutory ambiguity on the term “at the wellhead.” After unnecessarily daggering (for the purposes of this case, at least) the declaration in Tawney that “at the wellhead” is ambiguous because it fails to describe the allocation of post-production costs, the Chief Justice, in his analysis for the Court and in agreement with both the petitioner and the respondent, suggests that the meaning of that term is unambiguous, citing numerous federal circuit court cases and foreign state cases as persuasive authority, as well as the petitioner’s brief. With this we agree. “At the wellhead” is a term that can be understood even by a dumb engineer like me.[vi]
The Court then suggests that the statute requires a lessee to pay the lessor not less than one-eighth of the value of the gas “at the wellhead.” In order to arrive at the value of the gas at the wellhead, the Court understandably reasons that it is the value at the sale point less the cost of transporting it to and in a form that is desirable for purchase by the buyer at that point. The Court informs its analysis of the value of natural gas at the wellhead by review of the Pennsylvania case, Kilmer v. Elexo Land Servs, Inc. [sic], 990 A.2d 1147 (Pa. 2010), in which the “net-back” method of calculating the value of gas at the wellhead was at issue.
The net-back method of calculating the value of gas at the wellhead as discussed in Kilmer makes perfect logical sense. It normalizes the value of the gas regardless of the downstream point at which it is ultimately sold, since it backs out the cost of transporting and treating the gas to the sale point, wherever it may be. If § 22-6-8(e) was indeed clear and unambiguous, one would be hard-pressed to successfully argue any alternative to the net-back method of calculating the value of gas at the wellhead. However, with all due respect to the Court, the statute is not clear and unambiguous.
In its analysis, the Court states that “[w]here the language of a statute is free from ambiguity, its plain meaning is to be accepted and applied without resort to interpretation.”[vii] Conversely, therefore, it follows that where the language is not free from ambiguity, judicial interpretation by the courts is required. The language of § 22-6-8(e) is indeed susceptible to two interpretations. Judicial intervention is thus necessary. By the Court’s own pronouncement and precedent, the intent of the Legislature is the standard by which § 22-6-8(e) must be construed.[viii] As noted, supra, the Court focused its analysis of ambiguity in § 22-6-8(e) upon the term “at the wellhead.” This is the wrong analysis. Instead, it should have focused its attention on the larger phrase, “the owner of the working interest at the wellhead.”
Section 22-6-8(e) of West Virginia Code describes the minimum royalty to be paid to a lessor in a flat-rate lease. But, who is to pay the royalty? Of course, the payor is the “owner of the working interest.” This then begs the question, who is the owner of the working interest? Ostensibly, the working interest owner is the exploration and production company that leases the minerals from the mineral owner, explores for oil and gas, and drills the wells. But what if the producing company, the gathering company, the treating company, and other “value adders” along the way are sister companies or otherwise closely related? Could not the argument be made that it is the parent entity that is the “owner of the working interest” and that, therefore, all of the sister companies are, in effect, owners as well? If this is the case, as it is here, then § 22-6-8(e) can be read in two contexts.
First, it can be read to mean that the owner of the working interest shall tender not less than one-eighth of the value of the gas at the wellhead to the owner of the oil and gas in place. This is the interpretation made by the Court with virtually no analysis of identity of the owner of the working interest. However, if the same parent company owns and operates both the upstream and the midstream portions (and perhaps even downstream portions) of the natural gas stream, might the statute also be read so as to identify which of the related working interest owners is to pay the royalty (i.e., the “the owner of the working interest at the wellhead” as opposed to the working interest owner in some other section of the stream, or even the parent entity), rather than where and how the gas is to be valued? If this is so, then the value of the gas is undefined and the statute is silent on the issue of post-production costs.
In which context did the Legislature mean “owner of the working interest at the wellhead?” Certainly there is no punctuation that helps us to discern which of the two meanings the legislators had in mind. Had the Legislature intended the statute to have the meaning interpreted by the Court, it could have written the statute to say that the owner of the working interest, “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 for the oil or gas so extracted, produced or marketed at the wellhead.” Although the Court suggests that prior to 1993 sellers of gas “most likely” would have been selling gas at the wellhead, it ignores its own persuasive authority that marketing downstream of the wellhead may have been occurring as early as 1978. Is one interpretation of the statute superior to the other? Perhaps. Is the language ambiguous? Yes.
By the Court’s own analysis, the text of the statute is the key to ambiguity or clarity. So, if the statute is susceptible to two separate interpretations by reasonable minds, the Court has held that the intent of the Legislature shall be employed to construe it. Clearly, the Legislature perceived great inequities in the lessor-lessee relationship vis-à-vis flat-rate leases. Section 22-6-8(a)(2) of the statute is informative on this relationship: “. . . continued exploitation of the natural resources of this state in exchange for such wholly inadequate compensation is unfair, oppressive, works an unjust hardship on the owners of the oil and gas in place, and unreasonably deprives the economy of the state of West Virginia of the just benefit of the natural wealth of this state (emphasis added).” A reasonable interpretation of this subsection of the statute is that at the time it was enacted, the Legislature observed that oil and gas producers/lessees were taking unfair advantage of West Virginia mineral owners and the legislative intent at that time was remedial in nature and intended to correct such exploitation.[ix] Thus, it is clear that the benefit of any doubt should certainly be in favor of the mineral owner and not the working interest owner.
Finally, the Court intimates in its discussion of the statutory versus freely-bargained lease royalties that it is unfair to the lessees to impose post-production costs upon them by not allowing them to “net-back” a proportionate share of these costs to the lessor, since they had no ability to negotiate the statute.[x] However absurd this position may be given the immense lobbying power of the industry even at the time of the enactment of the statute (remember, it was only four years after the second Arab oil embargo), the Court does not appear interested in extending the same courtesy to mineral owners who, for the years preceding 1993, apparently received their royalty interest free of such post-production costs only to suddenly see their meager payments decrease according to lessors’ often arcane, obtuse and incoherent cost calculations.
That the Court allows for the question of the reasonableness of a given post-production expense to be determined by a “fact-finder” (i.e., jury or court), is of little moment to a majority of West Virginia mineral owners whose income, including royalty, is insufficient to mount a challenge to oil and gas producers, their corporate counsel and their large, well-staffed and well-paid outside counsel. Moreover, the conflict that this opinion tees up between statutory royalties and contractual royalties will serve to confuse mineral owners, many of whom receive both flat-rate and production rate royalties, and will also permit land agents to more easily obfuscate the issue in order to obtain negotiated leases from mineral owners containing the right to deduct post-production costs, notwithstanding the Court’s suggestion to the contrary.
Unfortunately, the venerable West Virginia Supreme Court of Appeals, for which I have great respect, has sailed a little wide of the mark in this case. Even on casual reading, the dicta in the opinion belies the purported technical application of existing law to statutory construction. This Leggett opinion does not serve to clean up the mess left by past courts. Rather, it leaves to the Legislature the job of clearing up the confusion brought about by this decision. The opinion casts doubt on prior common law, creates tension between statutory and contractual leases, emboldens the gas industry in other controversial matters detrimental to lessors, and once again sacrifices West Virginia mineral owners on the altar of the extraction industries.
[i] Leggett v. EQT Production Company, No. 16-0136, January 2017 Term, filed May 26, 2017.
[ii] With respect to flat-rate leases, the West Virginia Supreme Court of Appeals in Bruen v. Columbia Gas Transmission Corp., 188 W. Va. 730, 426 S.E.2d 522 (1992) (citing McCutcheon v. Enon Oil & Gas Co., 86 W. Va. 198, 135 S.E. 238 (1926)), has ruled that payment under the terms of the lease of the agreed flat-rate royalty preserves the secondary term regardless of the volume of production, even if there is no production.
[iii] § 22-6-8(e) states: “To avoid the permit prohibition of subsection (d), the applicant may file with such application an affidavit which certifies that the affiant is authorized by the owner of the working interest in the well to state that it 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 before deducting the amount to be paid to or set aside for the owner of the oil or gas in place, on all such oil or gas to be extracted, produced or marketed from the well. If such affidavit be filed with such application, then such application for permit shall be treated as if such lease or leases or other continuing contract or contracts comply with the provisions of this section.”
[iv] Section 10, article I of the United States Constitution and section 4, article III of the West Virginia Constitution.
[v] See Syl. Pts. 4 and 5 of Leggett, supra.
[vi] Conversely, unlike a dumb engineer, the Court appears confused as to the difference between untreated and “sour” gas, and the difference between removing impurities in general as opposed to “sweetening” gas.
[vii] Id. at Syl. Pt. 5.
[viii] “The basic and cardinal principle, governing the interpretation and application of a statute, is that the Court should ascertain the intent of the Legislature at the time the statute was enacted, and in the light of the circumstances prevailing at the time of the enactment.” (citations omitted.) Id. at Syl. Pt. 7.
[ix] Compare with case dicta: “We are likewise left with the inescapable conclusion that the petitioners herein seek to unfairly maximize their royalty payments without commensurately bearing the cost of achieving that maximum value.” Id. at page 37. Certainly this statement exposes the predilection of the Court.
[x] “Dogmatic imposition, therefore, of West Virginia’s so-called marketable product rule—which was developed upon these considerations—to prohibit allocation of post-production expenses as requested by the petitioners yields little parity when the parties were not free to contract otherwise.” Id. at page 24.
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