Shale Law in the Spotlight: Background of Recent West Virginia Legislation Addressing the Deduction of Post-Production Costs from Oil and Gas Royalties

Written by Chloe Marie – Research Fellow

Recently, the West Virginia legislature passed a bill limiting the ability of oil and gas companies to deduct post-production costs from landowner royalty payments. This article provides a brief description of this legislation as well as the background that led to the consideration of this bill.

Senate Bill 360

On March 9, 2018, West Virginia Governor Jim Justice signed into law Senate Bill No. 360, whose purpose is to amend and reenact West Virginia Code §22-6-8, which addresses flat rate royalty leases and seeks to eliminate this type of oil and gas lease. The statute states that “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.” More precisely, the statute effectively mandates the payment of a minimum royalty by prohibiting the issuance of a well permit where the oil and gas lease or contractual agreement provides for flat well royalty or any similar compensation provision, unless the permit application is accompanied by an affidavit stating that the lessor shall receive at least a one-eighth royalty.

Senate Bill 360 makes a small, but very significant, change to West Virginia Code §22-6-8, and by so doing dramatically limits the ability of oil and gas operators to deduct post-production costs from landowner royalties. The bill clarifies that the one-eighth royalty is to be calculated based upon “gross proceeds, free from any deductions for post-production expenses, received at the point of sale to an unaffiliated third-party purchaser in an arm’s length transaction for the oil or gas so extracted, produced, or marketed. . .” 

The provisions in Senate Bill 360 will become effective on May 31, 2018 and will overturn a West Virginia Supreme Court of Appeals ruling dated May 26, 2017, in Leggett v. EQT Production Co., which allowed oil and gas companies to deduct post-production costs from royalty payments made out of flat rate royalty leases.

Leggett v. EQT Production Company lawsuit

To place matters within their proper context, in December 2012, some owners of undivided oil and gas mineral interests in Doddridge County filed a lawsuit against EQT Production Company in the Circuit Court of Doddridge County, West Virginia, alleging wrongful deduction of post-production costs from their royalty payments incurred for the gathering and transport of natural gas. On January 10, 2013, this matter was removed from the Circuit Court of Doddridge County to the U.S. District Court for the Northern District of West Virginia (see Leggett et al. v. EQT Production Company et al., docket no. 1:13-cv-00004).

In their initial complaint, the plaintiffs argued that such deduction was not allowed, either pursuant to the terms of the lease agreement, West Virginia Code § 22-6-8, and/or pursuant to the contractual duty of good faith and fair dealing in all contracts as well as the fiduciary obligations of the oil and gas lessee who assumes the duty of handling the sales and accounting functions for the transaction.

On January 21, 2016, the U.S. District Court remitted to the West Virginia Supreme Court of Appeals two certified questions inquiring as to whether West Virginia law, specifically Code §22-6-8, allows a lessee to deduct post-production expenses from royalty payments made pursuant to a flat-rate royalty oil and gas lease. (see Leggett et al. v. EQT Production Company et al., docket no. 16-0136).

Initially, on November 17, 2016, the state Supreme Court of Appeals held that the language found in West Virginia Code § 22-6-8(e) means that “the royalty payment is not to be diluted by costs and losses incurred downstream from the wellhead before a marketable product is rendered.” Disagreeing with the Court’s interpretation of West Virginia Code § 22-6-8(e), EQT Production Company filed a petition for rehearing on December 19, 2016. The Supreme Court agreed to rehear the matter on January 25, 2017.

Following rehearing, the West Virginia Supreme Court of Appeals reversed its earlier interpretation and certified to the U.S. District Court on May 26, 2017, that oil and gas companies are allowed to deduct “reasonable” post-production costs in the calculation of royalty payments in the specific case of flat-rate royalty oil and gas leases governed by section 22-6-8 of the West Virginia Code. The Court also held that “the industry-recognized ‘net-back’ or ‘work-back’ method of royalty calculation is equally just to both parties and, more importantly, the closest appreciable method of effectuating what the Legislature envisioned.”

With the enactment of Senate Bill 360, however, the West Virginia legislature has clarified that, under Code §22-6-8, the minimum one-eighth royalty is to be calculated free from post-production costs.

This material is based upon work supported by the National Agricultural Library, Agricultural Research Service, U.S. Department of Agriculture.