On November 4, 2024, the West Virginia Supreme Court released two new opinions on oil and gas royalty issues: Romeo v. Antero Resources Corp., No. 23-589, 2024 WL 4784706 (W. Va. Nov. 14, 2024); and Kaess v. BB Land, LLC, No. 23-522, 2024 WL 4784609 (W. Va. Nov. 14, 2024). These cases confirm that, on the law governing the calculation of oil and gas royalties, West Virginia stands in a class by itself.
Most states agree that if a royalty clause specifies that a royalty owner is entitled to a fractional share of the price or value of the producer’s oil or gas production “at the wellhead,” the producer may use a workback methodology to determine the price or value of its production at the wellhead — i.e., at the point where the producer physically extracts the oil or gas from the ground. Some states, such as Colorado, Oklahoma, and Kansas, have adopted the first marketable product doctrine, holding that even under an “at the wellhead” royalty clause, a producer generally must calculate its royalty payments on the basis of the price or value of its production at the point where it first acquires a marketable product.
Although many commentators, including myself, have identified West Virginia as a first marketable product state, West Virginia is more accurately a point of sale state. Back in 2001 and 2006, the West Virginia Supreme Court ruled that a producer generally must calculate its royalty payments at the point of sale: specifically, even under an “at the wellhead” royalty clause, a producer generally must pay its royalty owners their fractional share of the gross proceeds which the producer received on selling the production at a downstream sales location. Estate of Tawney v. Columbia Nat. Res., L.L.C., 633 S.E.2d 22, 28 (W. Va. 2006); Wellman v. Energy Res., Inc., 557 S.E.2d 254, 265 (W. Va. 2001).
In 2017, the West Virginia Supreme Court criticized its prior opinions in Estate of Tawney and Wellman, noting that its point of sale rule stood on “faulty legs.” Leggett v. EQT Prod. Co., 800 S.E.2d 850, 862 (W. Va. 2017). But just five years later in 2022, the same court reaffirmed Estate of Tawney and Wellman and concluded that those opinions were still good law. SWN Prod. Co. v. Kellam, 875 S.E.2d 216, 226-27 (W. Va. 2022).
The West Virginia Supreme Court reaffirmed its point of sale rule yet again in Romeo and Kaess. The producer in Romeo argued that the court in Wellman merely intended, albeit inartfully, to adopt the first marketable product doctrine. The court in Romeo disagreed, stating: “Not only can Wellman be read to hold that ‘the lessee must bear all costs incurred in exploring for, producing, marketing, and transporting the product to the point of sale,’ that is exactly what it did hold.” Romeo, 2024 WL 4784706, at 6 (cleaned up; emphasis in original). The court acknowledged that its “‘point of sale’ rule may make West Virginia a minority of one.” Id. at 7.
As Leggett recognized, the West Virginia point of sale rule stood on faulty legs back in 2001. And it still does today. A few observations about the West Virginia Supreme Court’s new Romeo and Kaess opinions:
The supreme court argued that its point of sale rule was “grounded in this State’s long-established practice,” and it cited Estate of Tawney for the proposition that from the beginning of the oil and gas industry in West Virginia, “it has been the practice to compensate the landowner by selling the oil by running it to a common carrier and paying to him ... one-eighth of the sale price received.” Kaess, 2024 WL 4784609, at *5 & n.11. That “long-established practice,” however, was not unique to West Virginia: even today, a producer may, if willing and able, sell its oil production to a pipeline purchaser, which may “purchase” the royalty owner’s share of the production under a division order; and because the producer generally delivers the production to the pipeline purchaser at or near the wellhead free of cost, the sales price that the pipeline purchaser will pay for the oil will be consistent with the value or price of the oil at the wellhead. See, e.g., A.W. Walker, The Nature of the Property Interests Created By an Oil and Gas Lease in Texas, 10 TEX. L. REV. 291, 312-13 (1932). The long-established practice by which oil producers sold their production to a pipeline purchaser at or near the wellhead is hardly any binding precedent which would properly dictate how producers must calculate their royalty payments when they sell their production at downstream markets hundreds of miles from the wellhead.
The supreme court argued, as previously had in Estate of Tawney, that the term “at the wellhead” is ambiguous. Romeo, 2024 WL 4784706, at *5. Both then and now, however, the supreme court has never adequately explained how a royalty of a “1/8th of the market value at the wellhead” entitles the royalty owner to receive “1/8th of the gross proceeds at the point of sale.” Nothing in the term “at the wellhead” implies “at the point of sale.” Even assuming for the sake of argument that the term “at the wellhead” is ambiguous, a court in construing an ambiguous contract should apply the canons of contract construction to resolve the ambiguity. The West Virginia Supreme Court has never truly done so. It has instead rewritten countless oil and gas instruments in West Virginia to impose a default rule that the parties themselves likely never intended or even contemplated — specifically, a rule requiring that the producer calculate its royalty payments on the basis of its gross proceeds at the point of sale. See Byron C. Keeling, Contra Proferentem in the Oilpatch? The “Against the Lessee” Rule of Lease Construction, 9 LSU J. ENERGY L. & RES. 346, 371 (2021) (criticizing Estate of Tawney and its failure to apply the proper canons of contract construction).
The supreme court argued that overruling Estate of Tawney and Wellman would result in “instability and uncertainty, particularly for the thousands of leases that have been executed in the years since those opinions were published.” Kaess, 2024 WL 4784609, at *8 (quoting Kellam, 875 S.E.2d at 227). That is doubtful. Even back in Estate of Tawney, the supreme court acknowledged that as long as the parties used explicit language, they could properly negate the default rule and negotiate leases which allowed the producer to calculate its royalty payments on the basis of the value of its production at the point of production. Estate of Tawney, 633 S.E.2d at 28. And indeed, many, if not most, leases since Estate of Tawney have used explicit language to specify exactly how the producer must calculate its royalty payments to its royalty owners. The problem is that the West Virginia Supreme Court continues to rewrite “at the well” royalty clauses in leases and other instruments that the parties entered into long before 2001.
Interestingly, the supreme court in Kaess addressed how a producer should calculate its royalty payments under an in-kind royalty clause which entitles the royalty owner to receive “the equal one-eighth (1/8) part of all [oil and gas production] from the premises.” Kaess, 2024 WL 4784609, at 2. The court in Kaess correctly recognized that, under an in-kind royalty clause, the royalty owner owns its fractional royalty share of the production. Id. at 11. And citing one of my articles, the court in Kaess correctly recognized that if the royalty owner does not take physical possession of its royalty share of the production, the implied covenant to market may require the producer to market and sell the royalty owner’s share of the production along with the producer’s share of the production. Id. (citing Byron C. Keeling, Fundamentals of Oil and Gas Royalty Calculation, 54 ST. MARY’S L.J. 705, 711-12 (2023)).
But where I had concluded, at least under the law in most states, that a producer which sells the royalty owner’s royalty share of the production must account to the royalty owner for the royalty owner’s share of the net proceeds, see Keeling, supra at 712, the court in Kaess concluded that the producer must “tender to the lessor a royalty consisting of the lessor’s percentage share of the gross proceeds, free from any deductions for postproduction expenses, received at the first 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.” Kaess, 2024 WL 4784609, at *14 (emphasis added).
In fairness, the court’s conclusion in Kaess is consistent with its view of West Virginia as a point of sale state. Id. at 13 (arguing that Estate of Tawney and Wellman “should govern leases containing in-kind royalty provisions as well”). Even so, the court in Kaess did not properly distinguish between a producer’s role as royalty payor and a producer’s role as marketer or seller. See id. at 14 (concluding that the producer must “tender ... a royalty”). Under an in-kind royalty clause, the royalty owner’s royalty is a share of the production itself — e.g., 1/8th of the oil and gas production. If the producer then sells the royalty owner’s share of the production, the producer is at that point acting as a marketer or seller under the implied covenant to market: its duty is simply to account to the royalty owner for the royalty owner’s share of the sales price.
The implied covenant to market historically does not impose a fiduciary duty that would require a producer to elevate the royalty owner’s interests over the producer’s interests. Instead, the implied covenant to market has required merely that the producer market its production — including not only its own share of the production, but also the fractional share that any royalty owner may own in the production — in a way that would mutually benefit both the producer and its royalty owner. See, e.g., James C.T. Hardwick, Private Landowner Royalties on Oil — Theory and Reality, SPECIALINST. ON PRIVATE OIL & GAS ROYALTIES § 10.5[2] (Rocky Mtn. Min. L. Found. 2003) (“If there is an expense to get the oil to market, then the royalty owner must bear that expense. ... These are but the consequences that inhere in ownership.”).
Although the court in Kaess suggested that its opinion advanced the goal of stability and certainty, Kaess, 2024 WL 4784609, at *8, Kaess and Romeo continue to ensure that there is no uniformity in oil and gas royalty law from state to state. Some states, like Texas, construe the term “at the wellhead” to mean what it says. Some states, like Colorado, Oklahoma, and Kansas, have adopted the first marketable product states. West Virginia is in a league all its own.
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