RECENT CASES AFFECTING THE ENERGY INDUSTRY . Carrie J. Lilly - - PowerPoint PPT Presentation

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Energy & Mineral Law Foundation Kentucky Mineral Law Conference October 2016 Carrie J. Lilly

Partner

RECENT CASES

AFFECTING THE

ENERGY INDUSTRY

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Responsibility for Post-Production Costs

• What is the specific language of the lease?
• At what point are royalties calculated – at the

well, or downstream?

• Does the state follow an “at the well”

approach, or a “marketable product” approach?

• How far does an operator’s obligation

extend under the “marketable product” approach?

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Fawcett v. Oil Producers Inc. of Kansas

Supreme Court of Kansas

• Operator sells raw natural gas at the wellhead to third-

parties

• Third-parties transport gas to processing plants, process

the gas, then sell the gas to other parties

• Price operator receives, and upon which operator

calculates royalties, is based on the amount the third- parties receive for sale of the processed gas, less certain processing costs incurred

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Fawcett v. Oil Producers Inc. of Kansas

Supreme Court of Kansas

• Leases generally provide for royalties based on

proceeds from the sale of gas at the well, or if marketed

• ff the leased premises, then based upon market value

at the well

• Issue: Can the operator deduct the processing costs

when calculating royalties, or, is the operator solely responsible for all processing costs to prepare the gas for the interstate pipeline system? – How far does the operator’s duty to market extend?

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• “Marketable Condition Rule”

– Requires operators to make gas marketable at the

• perator’s expense
• Does the marketable condition rule extend the
• perator’s obligations to the interstate pipeline system?

– NO, when a lease provides for royalties based on a share of proceeds from the sale of gas at the well, and when gas is sold at the well

Fawcett v. Oil Producers Inc. of Kansas

Supreme Court of Kansas

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• When an operator is required to pay royalties based on

proceeds from sale at the well, and when gas is sold at the well, the operator may not deduct pre-sale expenses required to make the gas acceptable to the third-party purchaser

• Post-sale, post-production expenses to transform the

gas into interstate pipeline quality gas are different than expenses of drilling and equipping the well

• Operator’s duty of good faith in contracting with third-

parties was not challenged in this case

Fawcett v. Oil Producers Inc. of Kansas

Supreme Court of Kansas

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Baker et al. v. Magnum Hunter Production, Inc. Supreme Court of Kentucky

• Issue: Apportionment of post-production costs under “market

price at the well” royalty clauses.

• Lease: “Lessee covenants and agrees: . . . To pay Lessor
• ne-eighth of the market price at the well for gas sold or for

gas so used from each well off the premises.”

• Gas was not sold at the well
• Lessee gathered, compressed, and treated raw gas, then

transported it to downstream purchasers

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Baker et al. v. Magnum Hunter Production, Inc. Supreme Court of Kentucky

• When calculating royalties, lessee deducted gathering,

compression, treatment, and transportation costs from the downstream price received

• Lessors contended that production companies had

miscalculated and underpaid royalties based on the “marketable product” approach

• Lessors contended that the “marketable product”

approach was necessary to give meaning to the lease terms “market price at the well” because until a product is marketable, it cannot have a market price

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• Court concluded that prior cases reflect that, absent an

express contrary provision, “royalty” is the lessor’s cost- free share of production

• Court concluded that “production” is raw gas captured

at the well

• Court concluded that under the marketable product

approach contended by lessors, production would be understood to extend to the production of a marketable product, rather than simply the initial capture of the raw mineral

Baker et al. v. Magnum Hunter Production, Inc. Supreme Court of Kentucky

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• Holding: Kentucky is an “at the well” state for gas

lease royalty valuation

• Under standard “market price at the well” royalty

clauses, the lessee is solely responsible for the costs

• f production – of bringing the gas to the well
• Post-production costs for enhancements such as

accumulating, compressing, processing, and transporting the gas may be deducted from gross receipts before calculating royalties

Baker et al. v. Magnum Hunter Production, Inc. Supreme Court of Kentucky

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Leggett, et al. v. EQT Production Company

Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV 1906 lease provides for flat-rate royalty rather than a volumetric-based royalty: “. . . lessee shall pay to the lessor for each and every well drill[ed] upon said land which produces Natural Gas . . . Three Hundred Dollars ($300.00) per annum”

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Leggett, et al. v. EQT Production Company

Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV

• Plaintiffs contended that operator did not pay the full

amount of royalties due, and that under the “marketable product rule,” the operator should bear all costs to

• btain a marketable product, without deduction for post-

production costs

• Operator contended that the “flat rate statute” identifies

the wellhead as the point of distribution at which the royalty amount is calculated

• District Court concluded that Tawney cast doubt on

whether West Virginia was an “at the well” state

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Leggett, et al. v. EQT Production Company

Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV “Flat rate statute” (1982), W. Va. Code 22-6-8 (generally): No permit for the drilling of a new oil or gas well or for the redrilling, deepening, or fracturing of an existing well shall be issued where the lease provides for flat well royalty (i.e., where the royalty is not related to the volume of oil and gas extracted, produced, and marketed)

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Leggett, et al. v. EQT Production Company

Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV

• To avoid the permit prohibition, the permit applicant may

certify that the owner of the oil and gas will be paid “not less than one eighth of the total amount paid or received by or allowed to the owner of the working interest at the wellhead.”

• What does “at the wellhead” mean under the “flat

rate statute” for flat-rate leases that have been converted to volumetric-based leases?

• Should the court rely upon case law to interpret the

statute?

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Leggett, et al. v. EQT Production Company

Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV The District Court gleaned three key points from Tawney:

• 1. General rule under WV law is that lessee bears all costs
• f marketing and transporting the product to the point of

sale.

• 2. “At the wellhead” was found to be ambiguous in the

context of the lease at issue in Tawney.

• 3. If a lessee seeks to deduct post-production costs, it

must do so expressly, with particularly at to what deductions will be made and how the royalty will be calculated.

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Leggett, et al. v. EQT Production Company

Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV District Court’s basis for certifying questions to WV Supreme Court:

• 1. Tawney involved “at the wellhead” language in a lease,

not a statute.

• 2. Tawney did not mention the “flat rate statute.”
• 3. The “flat rate statute” appears to apply to the awarding
• f permits, and it is unclear whether the statute applies

to deductions for post-production costs. 4. Legislative findings of the “flat rate statute” appear to permit the abrogation of flat rate leases. 5. Legislative findings acknowledge that existing lease

• bligations should be respected and not impaired.

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Leggett, et al. v. EQT Production Company

Supreme Court of Appeals of West Virginia - Certified Questions from the U.S. District Ct. for the N. District of WV Certified questions (generally): – Does Tawney affect whether a lessee of a flat-rate lease, converted to a volumetric lease pursuant to the “flat rate statute,” may deduct post-production expenses from the lessor’s royalty, particularly with respect to the “at the wellhead” language in the “flat rate statute”? – Does the “flat rate statute” only affect royalties for wells drilled or reworked after enactment of the statute, or does it abrogate flat-rate leases entirely?

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Chesapeake Exploration et al. v. Hyder et al. Supreme Court of Texas

• Chesapeake Exploration, lessee, sold gas produced to

affiliate Chesapeake Energy Marketing, Inc., which then gathered and transported the gas through affiliated and interstate pipelines for sale to third-party customers

• Chesapeake Marketing paid Chesapeake Exploration a

“gas purchase price” for volumes determined at the wellhead, based on the weighted average of third-party sales, less post-production costs

• Overriding royalty paid to lessors was 5% of the “gas

purchase price”

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Chesapeake Exploration et al. v. Hyder et al. Supreme Court of Texas

Oil and Gas Lease Contained Three Royalty Provisions:

• 1. Oil Royalty: 25% of the “market value at the well of all
• il and other liquid hydrocarbons”
• Oil royalty bears post-production costs
• 2. Gas Royalty: 25% “of the price actually received by

Lessee” for all gas produced from the leased premises and sold or used “free and clear of all production expenses”

• Gas royalty does not bear post-production costs –

royalty is based on the price actually received after post-production costs have been paid

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Chesapeake Exploration et al. v. Hyder et al. Supreme Court of Texas

Clause in dispute: 3. Overriding Royalty: “a perpetual, cost-free (except

• nly its portion of production taxes) overriding

royalty of five percent of the gross production

• btained” from directional wells drilled on the lease

but bottomed on nearby land What does this clause mean with regard to post- production costs? Does “cost-free” refer to production costs only, or does it also include post-production costs?

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Chesapeake Exploration et al. v. Hyder et al. Supreme Court of Texas

• The Court reasoned that: “It would make no sense to

state that the royalty is free of production costs, except for postproduction taxes.”

• Chesapeake argued that because the ORR is paid on

“gross production,” the reference was to production at the wellhead, which bears production costs

• Supreme Court of Texas did not agree: “Specifying that

the volume on which a royalty is due must be determined at the wellhead says nothing about whether the

• verriding royalty must bear production costs.”

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Chesapeake Exploration et al. v. Hyder et al. Supreme Court of Texas

• The lease frees the overriding royalty of post-production

costs – “Cost-free” in the overriding royalty provision includes post-production costs

• Supreme Court of Texas affirmed rulings of lower courts

and awarded $575,359.90 in post-production costs that Chesapeake had deducted from the overriding royalty

• What if the lease had not contained the express

reference to production taxes (a post-production expense)?

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Lindauer v. Williams Production RMT Co. Colorado Court of Appeals

Case raises two undecided questions of Colorado law regarding payment of royalties: 1. Must costs incurred to transport natural gas to markets beyond the first commercial market “enhance” the value of the gas, such that actual royalty revenues increase, in order to be deductible from royalty payments? NO 2. If the “enhancement test” applies to such transportation costs, must the enhancement, and the reasonableness

• f the costs, be shown on a month by month basis?

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Lindauer v. Williams Production RMT Co. Colorado Court of Appeals

• Leases were silent regarding transportation costs
• Lessors asserted that lessee improperly deducted

transportation costs incurred to transport gas to downstream markets beyond the first commercial market when calculating royalties

• Lower court entered judgment in favor of the lessors for

$5.1 million and lessee appealed

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Lindauer v. Williams Production RMT Co. Colorado Court of Appeals

• Once processed, the gas reached the “tailgate” of the

processing plant and entered a large main pipeline – Parties agreed that the tailgate was the first commercial market for gas and that transportation costs prior to that point were not deductible

• Lessee sold gas in downstream markets for higher

prices, and transported the gas to the point of sale

• Lessee incurred downstream transportation charges to

reserve space on main pipelines (“demand charges”) and charges per unit volume actually shipped on the pipeline (“commodity charges”)

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Lindauer v. Williams Production RMT Co. Colorado Court of Appeals

Plaintiffs contended that downstream transportation costs could only be deducted if:

• 1. The costs were reasonable (not contested in this

case), and

• 2. Actual royalty revenues increase in proportion with

the costs assessed against the royalties (“enhancement”) on a month-by-month basis

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Lindauer v. Williams Production RMT Co. Colorado Court of Appeals

• Lessee contended that the court should consider the
• verall reasonableness of its decisions to enter into long

term transportation contracts, and the long-term benefits to royalty owners

• Lessee demonstrated at trial that its downstream

marketing strategy allowed it to substantially increase the volume of production from plaintiffs’ wells, such that

• verall revenues for the eight year period were

approximately $6 Million higher than if gas had been sold at the tailgate market

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Lindauer v. Williams Production RMT Co. Colorado Court of Appeals

• The lower court concluded that all costs incurred after

the gas becomes marketable must meet the enhancement test on a month-by-month basis to be deducted from royalty payments.

• On appeal, the court distinguished prior cases which

applied the enhancement test to processing costs (Garman) and production costs (Rogers), but not to transportation costs.

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Lindauer v. Williams Production RMT Co. Colorado Court of Appeals

• Transportation costs beyond the first commercial

market need not enhance the value of the gas, such that actual royalty revenues increase in proportion to those costs, to be deductible from the royalty payments

• Post-marketability transportation costs are deductible if

they are reasonable

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American Energy – Marcellus, LLC v. Poling et al. Circuit Court of Tyler County, WV

• 1894 oil and gas lease that did not contain an express

pooling clause

• Plaintiff sought declaratory judgment, and summary

judgment on the declaratory judgment request, that the subject lease contained the implied right to pool or unitize the lease with oil and gas interest in other lands and to develop the lands jointly

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American Energy – Marcellus, LLC v. Poling et al. Circuit Court of Tyler County, WV

• “There is an implied right to pool or unitize the oil and

gas at issue in this matter with other mineral and leasehold interests for the purpose of developing oil and gas.”

• An implied covenant to pool and unitize promotes

development, prevents delay and unproductiveness, implements the intents of the parties, and is consistent with public policy

• The court specified usual and customary contract terms

applicable to pooling and unitization.

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American Energy – Marcellus, LLC v. Poling et al. Circuit Court of Tyler County, WV

The court considered several factors, including:

• Traditional vertical wells cannot contact enough spatial

area in the shale to make extraction economically viable from the vertical wellbore

• The oil and gas cannot be economically produced unless

it is developed as part of a unit large enough to accommodate horizontal well bores

• The oil and gas must be pooled or unitized with other

tracts and developed in one or more units to provide sufficient horizontal wellbore length for development and production of the oil and gas

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American Energy – Marcellus, LLC v. Poling et al. Circuit Court of Tyler County, WV

Technological considerations:

• Use of new technology did not bar development or the

right to pool or unitize the lease

• Technology and methods used to extract oil and gas will

inevitably evolve of the life of a lease

• Further operations should be “reasonably calculated to

effectuate the controlling intention of the parties as manifested in the lease, which was to make the extraction of oil and gas from the premises of mutual advantage and profit.” Compare to Schoene v. McElroy, discussed next.

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Schoene v. McElroy

U.S. Dist. Ct. for N. Dist. Of WV, on appeal to U.S. Ct. of Appeals for the Fourth Circuit

• 1902 Pittsburgh coal severance deed:

“Together with all the rights and privileges necessary and useful in the mining and removing of the said coal, including the right of mining the same without leaving any support for the overlying stratas and without liability for any injury which may result to the surface from the breaking of said strata . . .”

• Does the language waive common law claims for

subsidence damage caused by longwall mining?

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Schoene v. McElroy

U.S. Dist. Ct. for N. Dist. Of WV, on appeal to U.S. Ct. of Appeals for the Fourth Circuit

• District Court’s Memorandum Order and Opinion

Denying Defendants’ motion for Summary Judgment: [T]he broad form waiver of subjacent support is not a valid waiver against the subsidence damage caused by longwall mining. Longwall mining was unknown in Marshall County and to the lessors at the time the instrument was executed.

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Schoene v. McElroy

U.S. Dist. Ct. for N. Dist. Of WV, on appeal to U.S. Ct. of Appeals for the Fourth Circuit

• Footnote 9:

“This Court is not suggesting that the invalidity of the waiver prevents the mining of the coal. The Lessors clearly intended for the coal to be removed. This holding is limited to a ruling that the coal producer must pay the landowner for all of the damage caused by the mining

• perations.”
• Mining of coal by what mining method?
• Mining had already occurred in this case

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Schoene v. McElroy

U.S. Dist. Ct. for N. Dist. Of WV, on appeal to U.S. Ct. of Appeals for the Fourth Circuit

• Jury:

– Pre-mining fair market value of home: $184,000 – Post-mining fair market value with no repairs: $90,000

• Reduction in value = $94,000.

‒ Cost to repair the plaintiffs’ dwelling: $350,000 ‒ Cost to repair plaintiffs’ land: $172,000 ‒ $25,000 would compensate plaintiffs for annoyance, inconvenience, aggravation, and/or loss of use

• District Court: “the awards under the statutory scheme

and the common law will be the same.”

• $547,000 awarded to plaintiffs

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Schoene v. McElroy

U.S. Dist. Ct. for N. Dist. Of WV, on appeal to U.S. Ct. of Appeals for the Fourth Circuit

• Defendants filed a motion to alter or amend judgment,

asking the District Court to limit the damages to $94,000 (diminution in value to the structures)

• WV SCMRA: Requires an operator to restore land, and

to repair structures or compensate the owner for the diminution in value to the structures

• The District denied. “Mining methods not

contemplated at the time of the severance deed may not be utilized.”

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Contraguerro et al. v. Gastar Exploration, et al. Marshall Co. Circuit Ct., on appeal to Supreme Court of Appeals of West Virginia

• Must non-executory and/or non-participating royalty
• wners ratify or approve pooling provisions in oil and gas

leases in order for the pooling provisions, and the units created thereby, to be valid? – Circuit Court: Yes

• Plaintiffs own a ¼ non-executive, non-participating

interest in O&G in a single tract that is part of a larger 700-acre unit

• Lease provides for pooling or unitization

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Contraguerro et al. v. Gastar Exploration, et al. Marshall Co. Circuit Ct., on appeal to Supreme Court of Appeals of West Virginia

• Issue of first impression in West Virginia
• Gastar contended that because WV common law gives

an executive rights holder the right to lease without the consent of the royalty interest holder, common law should also provide that the non-executive, non- participating royalty interest holder should not be required to consent to effectuate an agreement to pool or unitize a mineral estate interest subject to the lease

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Contraguerro et al. v. Gastar Exploration, et al. Marshall Co. Circuit Ct., on appeal to Supreme Court of Appeals of West Virginia

• Circuit Court cited cases from Texas and Illinois

– Cross-conveyance approach: Unitization effects a cross-conveyance and mineral owners own undivided interests in the unitized tract in proportion to their contribution

• Gastar contended that Boggess reflects that WV adopts

a contractual approach ‒ Boggess: Unitization agreement did not effect a merger of title - it consolidated only the contractual interest under the leases – Circuit Court distinguished Boggess as not involving executive rights, and as involving a unitization agt.

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Contraguerro et al. v. Gastar Exploration, et al. Marshall Co. Circuit Ct., on appeal to Supreme Court of Appeals of West Virginia

• “PPG did not have authority to permit the pooling of the

Plaintiff’s mineral interests without first receiving consent from the Plaintiffs to do so.”

• “[T]he pooling and unitization clause contained in the

PPG/Gastar lease and the [ ] production unit created under the authority thereof, is invalid and void until such time as the Plaintiffs’ consent to and authorize those operations.”

• Consider which parties are indispensable to resolve title

issues under contractual v. cross-conveyance approaches

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Corban v. Chesapeake Exploration, L.L.C. et al.

Supreme Court of Ohio (Certified Questions)

• June 30, 2006 version of the Dormant Mineral Act

applies to all claims asserted after its effective date – As of June 2006, surface owners seeking to claim dormant mineral rights must follow statutory notice and recording procedures

• 1989 Dormant Mineral Act is not self-executing --

Surface owner is required to bring a quiet title action seeking a decree that the mineral rights have been abandoned in order to merge mineral rights into the surface estate

• Payment of a delay rental is not a title transaction or a

“savings event” under the Dormant Mineral Act

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Corban v. Chesapeake Exploration, L.L.C. et al.

Supreme Court of Ohio (Certified Questions)

• O&G was severed in 1959 when surface was conveyed

to plaintiff’s predecessors in title

• O&G was leased in 1974. Lease was recorded, drilling

permit obtained, no production, lease terminated in 1984

• O&G was leased again in 1984. Lease was recorded,

drilling permit was obtained, lease was assigned and assignment was recorded in May 1985. No production

• ccurred, but O&G owner received delay rental

payments in 1985 – 1988. Lease expired January 1989

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Corban v. Chesapeake Exploration, L.L.C. et al.

Supreme Court of Ohio (Certified Questions)

• O&G leased again in 2009, lease recorded,

subsequently assigned, well drilled, and production in June 2011

• Surface owner filed suit in 2013, seeking to quiet title to

the O&G, requesting declaratory judgment, permanent injunction, and damages for conversion – Plaintiff contended that the 2006 amendment to Dormant Mineral Act did not apply because title vested prior to 2006

• Defendants removed the case to federal court, parties

filed for summary judgment, and federal district court identified certified questions

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Corban v. Chesapeake Exploration, L.L.C. et al.

Supreme Court of Ohio (Certified Questions) 1989 Dormant Mineral Act (amendment to Marketable Title Act): “Any mineral interest held by a person [other than the surface owner] shall be deemed abandoned and vested in the owner of the surface” unless (a) the mineral interest was related to coal, (b) the interest was held by the U.S., the state of Ohio, or a political body described in the statute, or (c) a savings event had occurred within the preceding 20 years 1989 Act did not use “extinguish” and did not declare dormant interests “null and void”

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Corban v. Chesapeake Exploration, L.L.C. et al.

Supreme Court of Ohio (Certified Questions) Savings events (generally):

• Recorded title transaction
• Actual production of minerals from the lands or from

lands pooled or unitized with the subject interest, provided that pooling or unitization instrument is recorded

• Use of mineral interest in underground gas storage
• perations
• Issuance of drilling or mining permit and recording of

affidavit regarding the permit

• Recording of a claim to preserve the interest
• Creation of a separate tax parcel number in county

auditor’s tax list and county treasurer’s duplicate tax list

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Corban v. Chesapeake Exploration, L.L.C. et al.

Supreme Court of Ohio (Certified Questions)

• “Deemed” - Conclusive presumption of abandonment, if

the 20-year statutory period passed without a savings event

• Conclusive presumption is an evidentiary device that

applies to a quiet title action, and the Act does not transfer the interest by operation of law

• 2006 Amendment: Mineral interest “shall be deemed

abandoned and vested” in the surface owner if advance notice is provided to mineral owner and the mineral owner fails to timely record (i) a claim to preserve the interest or (ii) an affidavit proving a savings event within the preceding 20 years

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Corban v. Chesapeake Exploration, L.L.C. et al.

Supreme Court of Ohio (Certified Questions)

• “If neither a claim to preserve the interest nor an affidavit

proving that a saving event occurred within the preceding 20 years is timely recorded, then the surface holder may record a notice that the mineral interest has been abandoned, and “the mineral interest shall vest in the owner of the surface . . . And the record of the mineral interest shall cease to be notice to the public

• f the existence of the mineral interest or of any rights

under it.”

• “The statute therefore operates to establish the surface
• wner’s marketable record title in the mineral estate.”

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Disclaimer

These materials are presented with the understanding that the information provided is not legal advice. Due to the rapidly changing nature of the law, information contained in this presentation may become outdated. Anyone using information contained in this presentation should always research original sources of authority and update this information to ensure accuracy when dealing with a specific

• matter. No person should act or rely upon the information

contained in this presentation without seeking the advice of an attorney.

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