Chapter 22 Deduction of Post-Production Costs An Analysis of Royalty Calculation Issues Across the Appalachian Basin

Transcription

1 Chapter 22 Deduction of Post-Production Costs An Analysis of Royalty Calculation Issues Across the Appalachian Basin Peter A. Lusenhop John K. Keller 1 Vorys, Sater, Seymour and Pease LLP Columbus, Ohio Synopsis CITE AS 36 Energy & Min. L. Inst. 22 (2015) Introduction Royalty Valuation and Post-Production Costs: The Competing Rules [1] At the Well Rule [a] Origin and History of the At the Well Rule [b] The Rationale for the At the Well Rule [c] Criticisms of the At the Well Rule [2] The Marketable Product Rule: A Diverging Approach to Royalty Calculations [a] Origin and Evolution of the Marketable Product Theory [b] Recent Precedent: Variations of the Marketable Product Theory [c] Criticisms of the Marketable Product Theory [3] Other Issues Related to Royalty Valuation: Price Terms and Market Value v. Proceeds Clauses State of the Law Across the Appalachian Basin [1] Kentucky [a] The United States Court of Appeals for the Sixth Circuit Court Determines that Kentucky Follows the At The Well Rule in Poplar Creek [b] The Court of Appeals of Kentucky Follows Poplar and Determines At-The-Well Language Is Unambiguous and Permits the Deduction of Post-Production Costs A special thanks is due to our colleague, Steven A. Chang, who pulled the laboring oar on much of the work for this chapter. His work and contributions are greatly appreciated. Thanks are also due to other Vorys colleagues, W. Jonathan Airey, Gregory D. Russell and Timothy B. McGranor, all of whom reviewed and offered helpful comments.

2 22.01 ENERGY & MINERAL LAW INSTITUTE [2] Pennsylvania [a] The Guaranteed Minimum Royalty Act [b] The Supreme Court of Pennsylvania Adopts a Definition of Royalty Consistent with the At the Well Rule in Kilmer v. Elexco Land Servs [3] West Virginia [a] West Virginia Adopts a Variation of the Marketable- Product Rule Wellman v. Energy Res., Inc [b] West Virginia Sets Standards for What Language Is Sufficient to Allocate Post-Production Costs in In re Tawney v. Columbia Natural Res., LLC [c] Authorities and Analysis Post-Tawney Difference Between Other Marketable Product Jurisdictions and Uncertainty of Whether Lessee Must Bear Costs To the Market or to The Point of Sale [4] Ohio: The State of the Law Is Unsettled But May Be Resolved Soon [a] There Is Limited Ohio Oil and Gas Law on the Specific Subject of Post-Production Costs [b] Ohio Contract Law and the Competing Rules Conclusion Introduction. Traditional royalty calculation analysis involved a determination of the physical point at which natural gas was to be valued for royalty purposes. Historically, a lease calling for a royalty based upon the value of production at the wellhead allowed the lessee to deduct the cost of transporting, compressing, treating, and processing natural gas to arrive at a wellhead value for purposes of calculating royalties. A minority view began to develop, however, which held that the lessee s implied covenant to market the gas requires the lessee to bear the costs of placing natural gas production in a marketable condition and thus to bear at least some post-production costs. 2 In this chapter, these differing approaches have been analyzed in terms of whether the jurisdiction in question follows the at the well rule or the marketable product rule. The at the well rule holds that under most 2 Patrick H. Martin and Bruce M. Kramer, 3-6 Williams & Meyers, Oil and Gas Law, 645 (LexisNexis 2015) ( Williams & Meyers ). 838

3 Royalty Calculation Issues standard lease provisions, a royalty is only owed on production, and production occurs when gas is captured at the wellhead. The lessee-operator is permitted to net-back all expenses incurred in processing, gathering, compressing, and transporting the gas to a marketplace, and the lessee can recoup all or its proportionate share of the commercial value the lessee adds to the gas after it is produced at the wellhead. 3 Under the marketable-product rule, production is not viewed as being complete until the gas has been placed in the condition in which it can be sold (i.e., marketable ). Since production is the responsibility of the lessee, these costs fall to the lessee alone. Some jurisdictions hold that it is the lessee s obligation to bear all expenses necessary to put the natural gas in a marketable condition (such as dehydration, purification, and compression and gathering on the leasehold premises), but it is the obligation of the royalty owner to bear a proportionate share of the cost to transport the gas from the leasehold premises to the marketplace. 4 Additionally, some jurisdictions have read an implied covenant to market into every lease, regardless of its express terms, and hold that lessees have the obligation to bear not only all expenses required to put the gas in a marketable condition, 5 but also all expenses of transporting the gas to a viable marketplace. 6 This chapter surveys the law governing royalty calculations within the Appalachian Basin states of Kentucky, Ohio, Pennsylvania and West Virginia. It addresses the majority at the well and minority marketable product rules, the origins and reasoning behind each rule, how each state has addressed the two rules to date, and how the issue might play out in states, like Ohio, that have yet to formally adopt one of the rules. 3 See, e.g., Ramming v. Natural Gas Pipeline Co., 390 F.3d 366, 372 (5th Cir. 2004) (interpreting Texas law); Heritage Res., Inc. v. Nationsbank, 939 S.W.2d 118, 122 (Tex. 1996). 4 See, e.g., Mittelstaedt v. Santa Fe Minerals, Inc., 954 P.2d 1203 (Okla. 1998); Sternberger v. Marathon Oil Co., 894 P.2d 788 (Kan. 1995). 5 See Garman v. Conoco, Inc., 886 P.2d 652 (Colo. 1994). 6 See, e.g., Rogers v. Westerman Farm Co., 29 P.3d 887 (Colo. 2001); Savage v. Williams Prod. RMT Co., 140 P.3d 67 (Colo. Ct. App. 2005); Wellman v. Energy Res., Inc., 557 S.E.2d 254 (W. Va. 2001); Estate of Tawney v. Columbia Nat. Res., L.L.C., 633 S.E.2d 22 (W. Va. 2006). 839

4 22.02 ENERGY & MINERAL LAW INSTITUTE Royalty Valuation and Post-Production Costs: The Competing Rules. [1] At the Well Rule. A majority of oil and gas jurisdictions have adopted the at the well rule, determining that oil and gas leases that are either silent on the point at which royalty calculations are to occur, or provide for royalties at the wellhead, authorize lessees to apportion post-production costs in determining the value of the lessor s royalty. States that have given effect to at the well language in oil and gas leases include traditional oil and gas states: Texas 7 Louisiana 8 Mississippi 9 States more recently affected: California 10 Kentucky 11 New Mexico 12 7 Danciger Oil & Refineries, Inc. v. Hamill Drilling Co., 171 S.W.2d 321 (Tex. 1943); Heritage, 939 S.W.2d Wall v. United Gas Public Serv. Co., 152 So. 561 (La. 1934); Merritt v. Sw. Elec. Power Co., 499 So. 2d 210 (La. Ct. App. 1986). 9 Piney Woods Country Life School v. Shell Oil Co., 726 F.2d 225 (5th Cir. 1984). 10 Atl. Richfield Co. v. State of Cal., 214 Cal. App. 3d 533 (Cal. Ct. App. 1989). 11 Baker v. Magnum Hunter Prod., No CA MR, 2013 Ky. App. Unpub. LEXIS 545 (Ky. Ct. App. June 28, 2013); see also Poplar Creek Dev. Co. v. Chesapeake Appalachia, L.L.C., 636 F.3d 235 (6th Cir. 2011). 12 Creson v. Amoco Prod. Co., 10 P.3d 853 (N.M. Ct. App. 2000); ConocoPhillips Co. v. Lyons, 299 P.3d 844 (N.M. 2012). Recent federal decisions, however, have called into question whether the Supreme Court of New Mexico would adopt the at the well rule. At least one federal court has made an Erie guess that New Mexico would adopt the marketable product rule. See Anderson Living Trust v. WPX Energy Prod. LLC, No. CIV JB/ LFG, 2015 U.S. Dist. LEXIS 37256, at *369 (D.N.M. Mar. 19, 2015) ( The Court believes that, if and when the Supreme Court of New Mexico determines that the existence of the marketable condition rule is ripe for review, it will find that the rule is included in oil-andgas contracts as part of the implied duty to market. ). The New Mexico Supreme Court has expressly declined to reject or adopt the marketable product rule on several occasions. The most recent decision to address the issue, however, suggests that even if New Mexico were to 840

5 Royalty Calculation Issues North Dakota 13 Michigan 14 Montana 15 Pennsylvania. 16 [a] Origin and History of the At the Well Rule. Until the 1960s, the law governing the calculation of royalty payments was uniform it was well recognized that a lessee would bear all the costs necessary to achieve production, which occurred when the oil and gas was extracted at the wellhead, and the royalty paid to lessors would be based on the value of the price of production at the wellhead. 17 Likewise, it adopt the marketable product rule in some form, it would still give effect to at the well language as allocating post-production costs. ConocoPhillips Co., 10 P.3d at ( In oil and gas leases it is typical for the royalty clause to specify the calculation of net proceeds at the well. When the well is specified as the point of valuation, it is generally understood that the lessee is entitled to deduct all costs that are incurred subsequent to production, including those necessary to transport the gas to a downstream market and those costs, such as dehydrating, treating, and processing the gas, that are either necessary to make the gas saleable in that market or that increase the value of the gas.... New Mexico courts have endorsed this approach to interpreting a royalty obligation when the language provides that such payments are to be payable on net proceeds at the well.... Thus, if the 1931 and 1947 statutory lease forms provided for royalty on net proceeds at the well, there would be little controversy because such language typically entitles the lessee to deduct all post-production expenses. ) (citations omitted, emphasis in original). 13 Bice v. Petro-Hunt, L.L.C., 768 N.W.2d 496 (N.D. 2009). 14 Schroeder v. Terra Energy, 565 N.W.2d 887 (Mich. Ct. App. 1997). The at the well rule, however, only applies to leases signed before March 28, By statute, leases after this date in Michigan are not subject to deduction for postproduction costs in calculating the lessor s royalty, unless explicitly provided for in the parties lease. Mich. Comp. Laws b ( A person who enters into a gas lease as a lessee after March 28, 2000 shall not deduct from the lessor s royalty any portion of postproduction costs unless the lease explicitly allows for the deduction of postproduction costs. ). 15 Montana Power Co. v. Kravik, 586 P.2d 298 (Mont. 1978). 16 Kilmer v. Elexco Land Servs., 990 A.2d 1147 (Pa. 2009). 17 David E. Pierce, The First Marketable Product Doctrine: Just What Is the Product?, 37 St. Mary s L. J. 1, 30 (2005) ( The First Marketable Product Doctrine ) ( The general rule establishing that a lessee could properly calculate its royalty payments at the wellhead was a well recognized, basic concept of oil and gas law for many decades. ) (quoting La Fitte Co. v. United Fuel Gas Co., 284 F.2d 845, 849 (6th Cir. 1960)). See also Williams & 841

6 22.02 ENERGY & MINERAL LAW INSTITUTE was also generally accepted that a lessee could calculate royalty payments at the wellhead even when the lease was silent concerning the place of determination, unless there was express language in the lease to the contrary. 18 In fact, until around 1992 when the United States deregulated the gas industry with the promulgation of various orders from the Federal Energy Regulatory Commission 19 Kansas and Arkansas were the only states to hold otherwise. 20 Although natural gas has been produced in the United States since 1815, 21 natural gas production did not become a major player until the large natural gas reservoirs in the mid-continental U.S. located primarily in Meyers, 645 (noting that that a contrary view did not arise until the 1960s). Even in states that have adopted the marketable product rule, such as Kansas and Oklahoma, early cases had previously permitted a lessee to use the workback method as calculating the value of the lessor s royalty. See e.g. Matzen v. Hugoton Prod. Co., 321 P.2d 576, 581 (Kan. 1958); Molter v. Lewis, 134 P.2d 404, 407 (Kan. 1943); Scott v. Steinberger, 213 P. 646, 647 (Kan. 1923); Harding v. Cameron, 220 F. Supp. 466, 471 (W.D. Okla. 1963); Johnson v. Jernigan, 475 P.2d 396, 398 (Okla. 1970); Cimarron Utils. Co. v. Safranko, 101 P.2d 258, 260 (Okla. 1940). 18 See e.g., La Fitte Co. v. United Fuel Gas Co., 284 F.2d 845, 849 (6th Cir. 1960) (holding that the market value of gas was to be determined at the wellhead); Warfield Natural Gas Co. v. Allen, 88 S.W.2d 989, 992 (Ky. 1935) (royalty was to be determined by gross proceeds, as determined at the well, when the lease was silent as to the place of valuation). See also Brief of Amicus Curiae of Bruce M. Kramer, Kilmer v. Elexco Land Servs, Doc #114-10, filed August 6, 2014, at 16 ( Amicus Brief ) ( In 1979, there was an almost universal understanding in the oil-and-gas industry that royalties were to be measured at the wellhead in the absence of express language to the contrary. ). 19 Bruce M. Kramer credits the deregulation of the natural gas industry to Order No. 636, promulgated by the Federal Energy Regulation Commission in 1992, which de-coupled the interstate pipeline companies roles as both merchants and transporters of natural gas. Amicus Brief, at See, e.g., Gilmore v. Superior Oil Co., 388 P.2d 602 (Kan. 1964); Schupbach v. Continental Oil Co., 394 P.2d 1 (Kan. 1964); Hanna Oil & Gas Co. v. Taylor, 759 S.W.2d 563 (Ark. 1988). See also Wood v. TXO Prod. Corp., 854 P.2d 880 (Okla. 1992) (noting that the Kansas and Arkansas approach of burdening the lessee with post-production compression costs originated in a trilogy of cases, citing Gilmore, Schupbach, and Hanna Oil) (dissenting opinion). 21 Amicus Brief, at 4 (citing Eugene Kuntz, Law of Oil and Gas 1.10 (1987) (noting that the first known natural gas production was in connection with a salt well located in Charleston, West Virginia)). 842

7 Royalty Calculation Issues Texas, Louisiana, Kansas and Oklahoma were discovered. 22 Initially, due to the capital-intensive requirements of pipeline construction, most natural gas production was sold at the well to interstate pipeline companies akin to common carriers such as railroads and then resold by these companies to local distribution companies or end users along the pipeline. 23 Because this practice tended to create a monopoly or oligopoly pricing power, 24 in 1938 Congress enacted the Natural Gas Act of 1938 (NGA), which restrained the practices of lessees related to the production, sale, transportation and marketing of natural gas throughout the United States. 25 Some of the requirements under the NGA included federal price regulation, applications for certificates of public convenience and necessity to enter the industry or construct a facility, adequate reserve requirements, and other restrictions on lessees. 26 The NGA, however, still retained the existing system of producers selling to pipeline companies, who then re-sold the gas to local distribution companies or end users. Because the new laws and regulations demanded adequate reserves, pipeline companies similarly demanded long-term contracts for the sale of natural gas at the wellhead. 27 As a result, the nearuniversal method by which natural gas was sold in the United States was through long-term contracts with the sale taking place at the wellhead[.] 28 Accordingly, consistent with the predominant method by which gas was sold during this time frame, many oil and gas leases pre-dating 1990 provided for royalties to be based on their price or value of gas at the well. 29 Because gas was typically sold at the well, calculating royalties 22 Amicus Brief, at Id. at Id. 25 Id. 26 Id. 27 Id. at Id. at Id. at 12. See also Matzen v. Hugton Prod. Co., 321 P.2d 576, (1958) ( When plaintiffs leases were executed it was the established custom and practice in the field to measure, determine the price, and pay royalty at the wellhead for gas produced. Pipeline 843

8 22.02 ENERGY & MINERAL LAW INSTITUTE was straightforward the agreed-upon percentage of the sales price or value of the gas at the wellhead and post-production costs were not apportioned because there simply were no post-production costs incurred by the producer. Some commentators have also argued that older leases using at the well language typically did not identify which post-production costs were deductible because through the life of a typical lease which can span several decades new techniques of production and processing may be developed, new gas formations may be discovered, or new government regulations may be enacted. 30 Prior to 1960, in cases where post-production costs were incurred by a producer for gas that was not actually sold at the well, courts uniformly permitted the use of the net back method approach as one method of calculating the value of the lessor s royalty at the wellhead, 31 and, in the facilities did not exist and there was no general market for gas in the area. Although the leases are silent as to where a market must be found, it is evident that the parties anticipated, from the very nature and character of natural gas, that pipe-line transportation would be required in the event of production and they could not reasonably have contemplated that the lessee alone would bear the expense of providing such transportation to a point off the leases for sale and delivery to a purchaser for ultimate compensation. ). 30 Brian S. Wheeler, Deducting Post-Production Costs When Calculating Royalty: What Does the Lease Provide?, 8 Appalachian J. L. 1, at 4 (2008) ( What Does The Lease Provide? ). 31 See e.g., David E. Pierce, The First Marketable Product Doctrine: Just What Is the Product?, 37 St. Mary s L. J. 1, 30 (2005) ( The First Marketable Product Doctrine ) ( The general rule establishing that a lessee could properly calculate its royalty payments at the wellhead was a well recognized, basic concept of oil and gas law for many decades. ) (quoting La Fitte Co. v. United Fuel Gas Co., 284 F.2d 845, 849 (6th Cir. 1960)). See also Williams & Meyers, 645 (noting that that a contrary view did not arise until the 1960s). Even in states that have adopted the marketable product rule, such as Kansas and Oklahoma, early cases had previously permitted a lessee to use the workback method as calculating the value of the lessor s royalty. See e.g. Matzen v. Hugoton Prod. Co., 321 P.2d 576, 581 (Kan. 1958); Molter v. Lewis, 134 P.2d 404, 407 (Kan. 1943); Scott v. Steinberger, 213 P. 646, 647 (Kan. 1923); Harding v. Cameron, 220 F. Supp. 466, 471 (W.D. Okla. 1963); Johnson v. Jernigan, 475 P.2d 396, 398 (Okla. 1970); Cimarron Utils. Co. v. Safranko, 101 P.2d 258, 260 (Okla. 1940). See e.g., La Fitte Co. v. United Fuel Gas Co., 284 F.2d 845, 849 (6th Cir. 1960) (holding that the market value of gas was to be determined at the wellhead); Warfield Natural Gas Co. v. Allen, 88 S.W.2d 989, 992 (Ky. 1935) (royalty was to be determined by gross proceeds, as determined at the well, when the lease was silent as to the place of valuation). See also Brief of Amicus Curiae of Bruce M. Kramer, Kilmer v. Elexco Land 844

9 Royalty Calculation Issues absence an express agreement otherwise, the value of the lessor s royalty was to be determined at the well. 32 [b] The Rationale for the At the Well Rule. The rationale used by courts for adopting the at the well rule vary from state to state, but generally involve giving literal interpretation to at the well language in oil and gas leases, common usage of the phrase and Servs, Doc #114-10, filed August 6, 2014, at 16 ( Amicus Brief ) ( In 1979, there was an almost universal understanding in the oil-and-gas industry that royalties were to be measured at the wellhead in the absence of express language to the contrary. ). Under a market value at the well clause, courts would typically permit one of two methods of calculating royalties. The first, known as the comparable sales method, determined the market value of oil or gas production at the wellhead by looking to the average prices for the same oil and gas of comparable quality, quantity, and availability that were being received by the lessee or other producers. The second, the workback or netback method, determined the market value of the oil or gas production at the wellhead by taking the sales price and then subtracting reasonable post-production costs (including, but not limited to, transportation, gathering, compression, processing, treating, and marketing). Of the two methods, the comparable sales method was usually preferred. The First Marketable Product Doctrine, at See, e.g., Scott v. Steinberger, 213 P. 646, (Kan. 1923) (holding that the value of lessor s royalty should be determined at the point of measurement and delivery where the pipeline and the well connected); Rains v. Kentucky Oil Co., 255 S.W. 121, (Ky. 1923) (holding that lessor was entitled to one-eighth of the fair market price of the gas at the well); Wall v. United Gas Public Serv. Co., 152 So. 561 (La. 1934) (holding that the lessor s royalty should be determined based on the market price or value of the gas as it emerges at the wellhead); Kretni Dev. Co. v. Consolid. Oil Corp., 74 F.2d 497, 500 (10th Cir. 1934) (holding that the lessors are entitled to the royalty gas at the connection with the pipe line or the proceeds from its sale at that point ); Danciger Oil & Refineries, Inc. v. Hamill Drilling Co., 171 S.W.2d 321 (Tex. 1943) (holding that royalty payments were to be based on the value of the gas as produced, before processing). The 10 th Circuit s early decision in Kretni specifically rejected the lessor s argument that the implied duty to market obligated the lessee to provide for transportation costs to a viable market. See Kretni, 74 F.2d at 500 ( It may be conceded for the purpose of this case that a lessee is obligated to put forward a reasonable effort to market gas produced on the leased premises, but certainly that duty does not extend to the point of providing pipe line facilities ninety miles in length at a large outlay of money with an attending financial hazard due to possible exhaustion of the supply and other frequently encountered factors, in order to reach a market at which the product may be sold. ). The court s decision in Rains v. Kentucky also rejected this argument. See Rains, 200 Ky. at 483 ( While the lessee of a gas well may be under the duty of using reasonable effort to market the gas, we are not inclined to view that this duty, in the absence of a contract to that effect, is so exacting as to require him to market the gas by obtaining a franchise from some town or city and distributing the gas to the inhabitants thereof. ). 845

10 22.02 ENERGY & MINERAL LAW INSTITUTE terminology in the oil and gas industry, and practical considerations such as bringing consistency to royalty payments. Early decisions in Louisiana endorsed the traditional view that production occurs when the oil or gas is severed at the wellhead because that is the point at which the parties come into ownership of the commodity, and thus title vests in the lessor and lessee in the proportions set forth in the lease. 33 For example, in Wall v. United Gas Public Service Co., the Supreme Court of Louisiana evaluated a royalty clause calling for a royalty of one-eighth (1/8) of the value of such gas calculated at the market price per thousand feet[.] 34 The pivotal question was whether the term market price meant the price at the well or the price the gas would bring in a market remote from the well. 35 The court held that the clause provided for the market price at the well, reasoning that title vests in the commodity at this point, and while there is to be no division of the gas in kind, it is nevertheless contemplated that there shall be a division, not of the gas in kind but of its value as fixed by the market price. 36 The court further rejected the premise that it was the duty of the lessees to bear all the expense of carrying the gas to a market beyond the gas field. 37 Decisions in other jurisdictions have cited to, and endorsed, this view. 38 Other jurisdictions, including Texas, California, Kentucky, and Pennsylvania, have reasoned that the words market value at the well is well-established lexicon in the oil and gas industry, and is used as a means of distinguishing between gas sold in the form in which it emerges at the wellhead and gas which has had value added by transportation or processing. 39 For example, the Fifth Circuit Court of Appeals decision in 33 Wall, 152 So. at Id. at Id. 36 Id. 37 Id. at See, e.g., Heritage Res. v. Nationsbank, 939 S.W.2d 118, 129 (Tex. 1995); Montana Power Co. v. Kravik, 586 P.2d 298, 302 (Mont. 1978); Kretni Dev. Co. v. Consol. Oil Corp., 74 F.2d 497, 500 (10th Cir. 1934). 39 Piney Woods Country Life School v. Shell Oil Co., 726 F.2d 225, 240 (5th Cir. 1984). See also Ramming v. Natural Gas Pipeline Co., 390 F.3d 366, 372 (5th Cir. 2004) ( Market 846

11 Royalty Calculation Issues Piney Woods Country Life School v. Shell Oil Co., applying Mississippi law, reasoned that the function of the at the well language is to adjust for imperfect comparisons in determining market value. 40 Deduction for processing and transportation costs is an indirect means of determining what a buyer would have paid at the wellhead. 41 Yet another reason articulated by courts for adopting the at the well rule is to ensure that lessors do not obtain different royalties depending on when and where in the value-added production process the gas was sold. 42 The Supreme Court of Pennsylvania in Kilmer v. Elexco Land Servs. recognized the value of the use of the net-back method as eliminating the potential for inconsistent royalties to lessors on the same quality and quantity of gas value at the well is an established term in oil and gas lexicon. ); Heritage Res. v. Nationsbank, 939 S.W.2d 118, 122 (Tex. 1996) ( The terms royalty and market value at the well have well accepted meanings in the oil and gas industry. ); Martin v. Glass, 571 F. Supp. 1406, 1411 (N.D. Tex. 1983) ( It is well settled that the phrase at the well received, or similar terminology, establishes the point at the mouth of the well.... Accordingly, the royalty is free of all costs (e.g. exploration, drilling, operation, etc.) up to this point. ); Atl. Richfield Co. v. Cal., 214 Cal. App. 3d 433, 541 (Cal. Ct. App. 1989) ( The term at the well when used with reference to oil and gas royalty valuation, is commonly understood to mean that the oil and gas is to be valued in its unprocessed state as it comes to the surface at the mouth of the well. ); Kilmer v. Elexco Land Servs., 990 A.2d 1147, 1157 (Pa. 2009) ( In the industry, as referenced above, the expenses of production relate to the costs of drilling the well and getting the product to the surface, but do not encompass the costs of getting the product from the wellhead to the point of sale, as those costs are termed post-production costs. Although the royalty is not subject to costs of production, usually it is subject to costs incurred after production, e.g. production or gathering taxes, costs of treatment of the product to render it marketable, costs of transportation to market. ) (citations omitted); Baker v. Magnum Hunter Prod., No CA MR, 2013 Ky. App. Unpub LEXIS 545, at *4-5 (Ky. Ct. App. June 28, 2013) (holding that the language market value at the well was unambiguous, and adopting the definition provided in Black s Law Dictionary as [t]he value of oil or gas at the place where it is sold, minus the reasonable cost of transporting it and processing it to make it marketable. ). See also Bice v. Petro-Hunt, L.L.C., 768 N.W.2d 496, 502 (N.D. 2009) ( We conclude the term market value at the well is not ambiguous. We join the majority of states adopting the at the well rule and rejecting the first marketable product doctrine. Thus, we conclude the district court properly determined Petro-Hunt can deduct post-production costs from the plant tailgate proceeds prior to calculating royalty. ). 40 Piney Woods, 726 F.2d at Id. 42 Kilmer, 990 A.2d at

12 22.02 ENERGY & MINERAL LAW INSTITUTE coming out of the well. 43 The practical reality is that there is seldom a market at the place of production, and the deregulation of the gas industry no longer necessitates the sale of gas to pipeline companies at the wellhead. 44 In the modern natural gas market, gas may be sold at several locations downstream and using a net-back approach provides consistency in the royalties received by the lessors. 45 Finally, several courts, applying traditional rules of contract interpretation and analysis, have reasoned that the words at the wellhead must be given some meaning and cannot be mere subterfuge, and the only reasonable interpretation of such language is to establish the point at which the value of the lessor s royalty is to be determined. For example, the Court of Appeals of Michigan s decision in Schroeder v. Terra Energy, reasoned that the use of the language gross proceeds at the wellhead... appears meaningless in isolation because the gas is not sold at the wellhead[.]... However, if the term is understood to identify the location at which the gas is valued for purposes of calculating a lessor s royalties, then the language at the wellhead becomes clearer and has a logical purpose in the contract. 46 Further, based on [b]asic principles of economics, the court reasoned, the use of the netback method provides a means of determining what the value of such proceeds at the well would be required in the absence of an actual sale of gas at the wellhead. 47 Thus, as a matter of pure contract law, the only reasonable interpretation of at the well language is to determine the point of valuation of the lessor s royalty interest Id. 44 Amicus Brief, at Kilmer, 990 A.2d at Schroeder v. Terra Energy, 188, 565 N.W.2d 887, 894 (Mich. Ct. App. 1997). 47 Id. at 893 ( [b]asic principles of economics require that, in determining the gross proceeds at the wellhead in the absence of an actual sale of gas at the wellhead resulting in ascertainable gross proceeds, the gross proceeds from a sale elsewhere must be extrapolated, backwards or forwards, to reflect the appropriate adjustments due to differences in the location, quality, or characteristics of what is being sold. ). 48 Id. at 894 ( We adopt the interpretation of at the well(head) as used in these cases because we believe that it better conforms with the parties intent as gleaned from the contractual language. In interpreting contracts capable of two different interpretations, we 848

13 Royalty Calculation Issues [c] Criticisms of the At the Well Rule. Although the at the well approach was widely adopted and uniformly recognized until the 1960s, it was not without its critics. In addition to general criticisms by academics that oil and gas leases were inherently unfair to lessors who lack the necessary expertise to negotiate clauses to protect their interests, 49 the at-the-well approach has also been criticized as giving the lessee (which is in the best position to control post-production costs) a windfall. The lessee has the greater insight into what precise charges are being deducted from the ultimate sale price and whether those charges are fair, reasonable, and adequately supported. The lessor, who generally has no industry knowledge, is left without the ability to determine whether the charges (many of which may be with affiliates of the lessee) are appropriate. Because the lessor (who owns the minerals) is receiving a significantly smaller share of the benefits, these courts reason that it is fair to place the burden of these charges on the producer. 50 Courts have also criticized the at the well default rule as turning royalty interest holders into working interest ownership without the attendant rights. 51 In Wood, the Oklahoma Supreme Court reasoned that working interest owners share costs under an operating agreement because they have input into the cost-bearing decisions. Because a royalty interest owner has no such rights, it would be unfair to burden such owners with the burdens of working interest ownership when they have no input on cost-bearing decisions. 52 The Supreme Court of Colorado echoed this view when it adopted the marketable product rule in Garman v. Conoco, Inc., reasoning that [a]llocating these costs to the lessee is also traceable to the prefer a reasonable and fair construction over a less just and less reasonable construction. ) (citations omitted). 49 The First Marketable Product Doctrine, at 38 (noting the criticism of Professor Maurice Merrill, who argued in his treatise that the lessor s opportunity to protect himself by exact stipulation is illusory, in light of the unequal bargaining power, as he saw it, between lessors and lessees). 50 Wood v. TXO Prod. Corp., 854 P.2d 880, (Okla. 1992). 51 Id. 52 Id. 849

14 22.02 ENERGY & MINERAL LAW INSTITUTE basic difference between cost bearing interests and royalty and overriding royalty interest holders, and that [n]o such right [to object to the operator s course of conduct] exists for nonworking interest owners. 53 [2] The Marketable Product Rule: A Diverging Approach to Royalty Calculations. A minority of jurisdictions, beginning in the 1960s, have adopted what is now referred to as the marketable-product rule, placing upon the lessee the burden of certain post-production costs for both enhancing and transporting the raw gas severed from the wellhead. Although there are several permutations of this theory and, in fact, no two states adopting the marketable product rule have endorsed the exact same rule 54 in a pair of decisions in 1992 and 1998, the Oklahoma Supreme Court adopted what is commonly attributed as the modern first-marketable product rule, holding that a royalty interest may bear post-production costs of transporting, blending, compression, and dehydration, when the costs are reasonable, when actual royalty revenues increase in proportion to the costs assessed against the royalty interest, and when the costs are associated with transforming an already marketable product into an enhanced product. 55 Absent express language to the contrary, the default rule is that royalties are not subject to those post-production costs required to make the gas marketable. 56 Jurisdictions that have adopted the marketable-product rule in some form include Oklahoma, 57 Colorado, 58 Kansas, 59 West Virginia, 60 and Virginia 53 Garman v. Conoco, Inc., 886 P.2d 652, 660 (Colo. 1994). 54 For a further state-by-state discussion on the various permutations of this rule, see The First Marketable Product Rule, at Mittelstaedt v. Santa Fe Minerals, Inc., 954 P.2d 1203, 1210 (Okla. 1998). 56 Rogers v. Westerman Farm Co., 29 P.3d 887, 906 (Colo. 2001). 57 Wood v. TXO Prod. Corp., 854 P.2d 880 (Okla. 1992); Mittelstaedt, 954 P.2d Garman v. Conoco, Inc., 886 P.2d 652 (Colo. 1994); Rogers, 29 P.3d Gilmore v. Superior Oil Co., 388 P.2d 602 (Kan. 1964); Sternberger v. Marathon Oil Co., 894 P.2d 788 (Kan. 1995). 60 Wellman v. Energy Res., Inc., 557 S.E.2d 254 (W.V. 2001); Estate of Tawney v. Columbia Natural Res., LLC, 633 S.E.2d 22 (W. Va. 2006). 850

15 Royalty Calculation Issues (through a federal decision). 61 However, Oklahoma s characterization of the first-marketable product rule has not been adopted wholesale by other jurisdictions. [a] Origin and Evolution of the Marketable Product Theory. Until the 1960s, all of the states that had addressed the issue of whether the netback methodology was permissible, either by default or by interpreting language providing for the royalty to be calculated at the well, came out in favor of permitting the lessee to calculate royalties by using the netback methodology. 62 Beginning with the work of two professors at the University of Oklahoma in the mid-20th century, a contrary view emerged that was adopted, at least in part, by the Supreme Court of Kansas in It was not until decades later, however, that other states followed suit. Beginning with the Supreme Court of Oklahoma s decision in Wood v. TXO Prod. Corp. in 1992, other states soon followed and adopted variations of the rule Colorado in 1994, West Virginia in 2001, and Virginia (through a federal court Erie guess ) in Commentators have often credited the origins of the marketable product theory to the works of two academics, Maurice H. Merrill and Eugene O. Kuntz both former professors at the University of Oklahoma School of Law who have been cited by courts that have rejected the at the 61 Legard v. EQT Prod. Co., No. 1:10cv00041, 2011 U.S. Dist. LEXIS 2943 (W.D. Va. Jan. 11, 2011). For purposes of this chapter, we do not address other states that may have altered, by statute, the method of royalty calculations in their respective jurisdictions. The substance and focus of this chapter is on how courts in the United States have addressed the issue of post-production costs and the judicial creation of the marketable product rule. The enactment of statutes that supersede one or both rules does not inform this analysis. 62 Amicus Brief, at 16 ( In 1979, with the singular exception of Kansas, all of the states that had discussed the issue of whether the netback methodology could be used had come out in favor of allowing the lessee to calculate royalties by taking a downstream price or value and then netting it back to the wellhead through the use of the netback methodology. ). 63 Although Arkansas issued a decision in 1988 that did not permit the deduction of post-production costs in determining the lessor s royalty, the Supreme Court of Arkansas did not adopt, reject, or address at all the marketable product rule in its decision in Hanna Oil. 851

16 22.02 ENERGY & MINERAL LAW INSTITUTE well doctrine in favor of the marketable product view. 64 Both professors were highly critical of the current state of the law as it developed in the early to mid-20th century. Professor Merrill published two editions of a treatise entitled The Law Relating to Covenants Implied in Oil and Gas Leases in 1926 and 1940, 65 in which he argued for the imposition of additional implied covenants in oil and gas leases to protect lessors and other royalty owners. 66 Professor Merrill expressed doubt that lessors could protect themselves in lease negotiations lacking expertise or knowledge regarding the provisions necessary for protecting their interests and thus the lessor s ability to protect themselves by stipulation was illusory. In his second edition, Professor Merrill specifically argued that the implied covenant to market should include the obligation to prepare [the product] for market, if it is unmerchantable in its natural form. 67 It was this second treatise that was cited to, and relied on, in the first known court case to expand the duty to market to include the duty to make a marketable product Gilmore v. Superior Oil Co., explained in further detail below See, e.g., The First Marketable Product Doctrine, at Maurice H. Merrill, The Law Relating to Covenants Implied in Oil and Gas Leases (1926); Maurice H. Merrill, The Law Relating to Covenants Implied in Oil and Gas Leases (2d ed. Supp. 1964). 66 The First Marketable Product Doctrine, at 38. See also What Does The Lease Provide?, at 12 (noting that [t]he reasoning behind using the implied covenant to market to prohibit or limit deductions for certain post-production costs was first enunciated by Professor Maurice Merrill in 1940 ). 67 The First Marketable Product Doctrine, at 39 (quoting Merrill, 2d ed., at ). 68 Gilmore v. Superior Oil Co., 388 P.2d 602, 607 (Kan. 1964). See also West v. Alpar Res., 298 N.W.2d 484, 490 (N.D. 1980) (citing to Merrill s treatise on the implied covenant to market). The court in Gilmore cited Merrill s treatise for the proposition that [i]f it is the lessee s obligation to market the product, it seems necessary to follow that his is the task also to prepare it for market, if it is unmerchantable in its natural form. No part of the costs of marketing or of preparation for sale is chargeable to the lessor. This is supported by the general current of authority. Gilmore, 388 P.2d at 607. Although the court noted that Professor Merrill s statement was unqualified, it nonetheless adopted this general proposition of law. Id. Other commentators have noted that Professor Merrill s blanket statement that [t]his is supported by the general current of authority, was patently wrong. The First Marketable Product Doctrine, at 40 ( He was wrong. The general current of 852

17 Royalty Calculation Issues Professor Eugene Kuntz, on the other hand, is largely credited as originating the second rationale adopted by courts for endorsing the marketable product rule that lessees should not be permitted to deduct all of its downstream expenses in determining the value of the lessor s royalty because the duty of production of the lessee does not cease until a marketable product has been created. 69 While not all courts that have adopted the marketable product rule have focused on the point at which production has been achieved, and instead relied on the implied duty to market alone, the production rationale was adopted by Colorado in its pair of decisions Garman v. Conoco, Inc. (1994) and Rogers v. Westerman Farm Co. (2001). 70 Thus, the origins of the marketable product rule have been credited by some commentators as beginning with the works of these two professors. 71 authority did not support his interpretation of the implied covenant to market; rather, the case law at the time of Merrill s treatise uniformly recognized that a lessee could properly deduct marketing costs and other expenses in applying a workback calculation to determine the value of price of its production at the wellhead. ). 69 Eugene Kuntz, A Treatise on the Law of Oil and Gas (W. H. Anderson Co. 1962). See also The First Marketable Product Doctrine, at See, e.g., Garman v. Conoco, Inc., 886 P.2d 652, (rejecting the rationale of at the well states that gas is produced when it is severed from the land at the wellhead); Rogers v. Westerman Farm Co., 29 P.3d 887, 900 (Colo. 2001) ( In Colorado, we decline to follow the rule that gas is produced once physically severed, and thus, decline to adopt the reasoning regarding the deductibility of costs adopted by these jurisdictions. ). The Supreme Court of Colorado in Rogers also cited Professor Kuntz s treatise directly for the proposition that [The] broader rule holds that costs incurred after a marketable product has been obtained, that either enhance the value of the product or cause the product to be transported to another location, are shared by the lessee and the lessor. Rogers, 29 P.3d at 900 (citing 3 Eugene Kuntz, A Treatise on the Law of Oil and Gas, 40.5, at 351 (1989 & 2001 Supp.). 71 For a discussion on the works of these professors and their influence on the creation of the marketable product rule, see The First Marketable Product Rule, at 38. Notably, an additional academic that is not discussed here, but had an influence on the marketable product rule as it developed in these jurisdictions, is Professor Owen Anderson, who published a series of law review articles in the late 1990s. Id. at 42. At the time of the writing of his first articles, however, Oklahoma, Kansas, and Colorado had already adopted the marketable product rule. Notwithstanding this, the Supreme Court of Colorado in Rogers v. Westerman Farm Co. looked heavily to Anderson s analysis in determining that at the well language is silent as to post-production costs and should be construed against the lessee. See Rogers 29 P.3d at

18 22.02 ENERGY & MINERAL LAW INSTITUTE The first state to expressly adopt some version of the marketable product rule was the Supreme Court of Kansas in In Gilmore v. Superior Oil Co., the Supreme Court of Kansas, citing to Merrill on Covenants Implied in Oil and Gas Leases, was the first court to hold that the lessee s implied obligation to market the product included the obligation to make the gas marketable. Gilmore involved the interpretation of an oil and gas lease providing for a royalty of 1/8 of the market value of such gas at the mouth of the well[.] 72 The court, noting that [c]onstruction of oil and gas leases containing ambiguities shall be in favor of the lessor and against the lessee, ultimately concluded that the implied obligation controlled and that, absent an express provision in the lease, it was the lessee s duty to prepare the gas into a marketable condition. 73 Shortly thereafter, the same court in Schupbach v. Continental Oil Co. determined that a lease providing for a royalty of 1/8th of the proceeds of the sale thereof at the mouth of the well, did not permit the lessee to deduct post-production costs in determining the value of the lessor s royalty. 74 Ironically, both of these decisions appeared to be a departure from the court s decision in Matzen v. Hugoton Prod. Co., only eight years earlier, that seemingly upheld the lessee s ability to use the netback method in determining the value of the lessor s royalty. 75 In Matzen, the Supreme Court of Kansas interpreted a royalty clause providing for a royalty of one-eighth of the proceeds from the sale of gas, as providing a royalty to be determined by proceeds from the sale of gas, wherever and however ultimately sold... less reasonable expenses incurred in its gathering, transporting, processing and marketing. 76 In fact, the court in Matzen explicitly rejected the view that the duty to market obligated the lessee to incur all costs to transport and process gas, concluding that the duty did not extend to providing a gathering system to transport and process the gas off the leases at a large 72 Gilmore v. Superior Oil Co., 388 P.2d 602, 605 (Kan. 1964). 73 Id. 74 Schupbach v. Continental Oil Co., 394 P.2d 1 (Kan. 1964). 75 Matzen v. Hugoton Prod. Co., 321 P.2d 576, , 582 (1958). 76 Id. at

19 Royalty Calculation Issues capital outlay with attending financial hazards in order to obtain a market at which the gas might be sold. 77 Despite these two decisions that appeared to depart from both Kansas law and well-established precedent throughout all the states, these decisions did not gain traction in any other jurisdiction for over three decades. In fact, only three years after Gilmore and Schupbach, a federal court interpreting these decisions held that the holdings of these cases were limited, and did not require a lessee to bear all the costs of transporting gas to a distant commercial market, including compression and gathering costs. 78 In 1988, the Supreme Court of Arkansas in Hanna Oil & Gas Co. v. Taylor was the second court to deny the use of the netback method in calculating royalties in a lease that contained at the well language, but for different reasons. In Hanna Oil, the Arkansas Supreme Court, in evaluating a royalty clause providing for one-eighth of the proceeds received by Lessee 77 Id. at Ashland Oil & Ref. Co. v. Staats, Inc., 271 F. Supp. 571, 575 (D. Kan. 1967) ( We will not enlarge the lessee s duty to market production so as to require it to devote a long and costly gathering system to transport gas to the nearest commercial market. The two states cases do not support such a holding and nowhere have we found the lessee s duty to market thus extended. ). Three decades letter, the Supreme Court of Kansas attempted to reconcile its holding in Matzen with its prior decisions Gilmore and Schubach. In the 1995 case Sternberger v. Marathon Oil Co., the Supreme Court of Kansas confirmed that Kansas endorses the marketable product rule holding that [t]he lessee... under an oil and gas lease has the duty to produce a marketable product, and the lessee alone bears the expense in making the product marketable but also holding that non-operating interest holders nonetheless must bear their proportion of post-production expenses, at least for transportation, when the lease provides that royalties are to be paid based on the market price at the well, and there is no market at the well. Sternberger v. Marathon Oil Co., 894 P.2d 788, paragraphs 1 and 2 of syllabus (1995). In its decision, the court determined that the royalty language calling for a royalty of one-eighth (1/8) of the market price at the well for gas sold or used, was not ambiguous, although it was silent as to deduction [of post-production costs]. Id. at 794. The court then determined that the language at the well clearly specified the location at which the value of the lessor s royalty would be calculated, and that transportation costs are borne proportionately by the lessor and the lessee where the royalty is to be determined at the well but no market exists at the well. Id. at As explained further below, this variation has come to be known as the first marketable product rule, as Kansas is one of two jurisdictions that does not require gas to be transported to a market before it can be deemed marketable. 855

20 22.02 ENERGY & MINERAL LAW INSTITUTE at the well for all gas, determined that the word proceeds means total proceeds, rather than net proceeds, and did not permit the deduction of post-production costs in calculating the royalty. 79 Notably, the court did not rely on any implied covenant in Hanna Oil, but rather, decided the case based on contract interpretation and the clear language of the agreement[.] 80 Further, the court did not cite to or rely on either the Gilmore or Schupbach decisions rather, it was a case of pure contract interpretation under Arkansas law. As such, although Hanna Oil is often cited in cases adopting the marketable product rule, 81 its analysis neither explicitly adopts nor rejects a variation of the theory. At least two federal decisions interpreting Hanna Oil have concluded that, despite marketableproduct decisions citing Hanna Oil in support of the marketable product rule, the Arkansas court s ruling neither adopts nor rejects the marketable product rule, and the law in Arkansas is unclear on the issue. 82 Relying on the trilogy of cases from Kansas and Arkansas Gilmore, Schupbach, and Hanna Oil & Gas Co. v. Taylor Oklahoma became the second state to explicitly expand the implied duty to market as including the cost of preparing the gas for market in In Wood v. TXO Prod. Corp., 79 Hanna Oil & Gas Co. v. Taylor, 759 S.W.2d 563, (Ark. 1988). 80 Id. at See, e.g., Garman v. Conoco, Inc., 886 P.2d 652, 658 (Colo. 1994); Mittelstaedt v. Santa Fe Minerals, 954 P.2d 1203, 1212 (Okla. 1998); Rogers v. Westerman Farm Co., 29 P.3d 887, 897 (Colo. 2001). 82 See, e.g., Riedel v. XTO Energy, Inc., 257 F.R.D. 494, 505 (E.D. Ark. 2009) ( The Court agrees that Arkansas law is, in fact, unclear, and that, it can not be said that Arkansas has joined the states of Colorado and Oklahoma in adopting what is a minority position with respect to the deduction of post-production costs. ); Wallace v. XTO Energy, Inc., Case No. 4:13-cv-00608, 2014 U.S. Dist. LEXIS , at *8 (E.D. Ark. Aug. 22, 2014) ( Defendants are mistaken in asserting that Arkansas law clearly rejects the marketable condition rule. Arkansas law as to the marketable condition rule is unclear, and, thus, its purported rejection cannot be the basis for dismissal of plaintiffs breach of contract claim. ) (citing Riedel, 257 F.R.D. at ). 83 Wood v. TXO Prod. Corp., 854 P.2d 880, (Okla. 1992). Ironically, although the Wood court stated that it was choos[ing] to follow the holdings of the Kansas and Arkansas courts, the Supreme Court of Arkansas in Hanna Oil & Gas Co. v. Taylor, 759 S.W.2d 563, (Ark. 1988), did not rely on the duty to market, or mention it at all. Rather, as explained in Hanna Oil, the Arkansas Court determined the term proceeds to mean 856