Oil and Gas Update

Gas Producer Sues WVDEP for Declaration that “Flat Rate Statute” Unconstitutionally Impairs Flat Rate Gas Leases

April 24, 2018

By: Robert G. McLusky

Historically, oil and gas leases have been of two types— those with flat rates and those with production-based royalties. In the “flat rate” leases, the lessees agreed to pay a flat annual fee to lessors for the right to extract oil and gas without regard to whether any mineral was extracted or the amount extracted. In the production-based leases, the lessees agreed to pay a percentage of the price paid for the gas—typically “at the wellhead.”

In 1982, the West Virginia Legislature enacted the so-called “Flat Rate Statute.” See W.Va. Code §22-6-8. Seeking to re-level what it regarded as an uneven playing field resulting from advances in technology, it effectively prohibited the continued use of flat rate leases. But, hoping to avoid a claim that it had unconstitutionally impaired existing contracts, it did not expressly invalidate the leases. Instead, it barred WVDEP from issuing new well permits to oil and gas operators where the operators sought to operate under “flat rate leases.” Rather, WVDEP was authorized to issue new well permits to operators only where the operator executed an affidavit stating that it would tend to the mineral owner “not less than one eighth of the total amount [of the wellhead price] before deducting the [royalty to be paid to the owner].” Thus, the Legislature effectively converted all flat rate leases to production-based leases. Specifically, W.Va. Code § 22-6-8(e) provided that the lessor must be paid “one-eighth of the total amount paid to or received by or allowed to the owner of the working interest at the wellhead.”   

In 2006, the West Virginia Supreme Court limited the ability of producers to deduct “post-production” costs incurred in gathering, processing, compressing and delivering the gas to the point of delivery. See Tawney v Columbia Natural Resources, LLC, 633 S.E. 2d 22 (W.Va. 2006), available at http://www.courtswv.gov/supreme-court/docs/spring2006/32966.htm. There, the Court acknowledged that if an oil and gas lease provides that the lessor shall bear some part of the costs incurred between the wellhead and the point of sale, the lessee was entitled to credit those costs against royalty payments provided the costs were actually incurred and were reasonable. However, the Court ruled that leases providing that the royalty shall be paid “at the wellhead” were ambiguous, and were therefore incapable of altering the “marketable product rule.” That rule creates an implied duty to market and requires the lessee to bear all costs until the product is made “marketable” absent clear lease language to the contrary. (citing Wellman v. Energy Resources, Inc. 557 S.E. 2d 254 (W.Va. 2001)) (available at http://www.courtswv.gov/‌supreme-court/docs/spring2001/28209.pdf). The case was decided after West Virginia adopted the “flat rate statute.” However, the opinion did not discuss the role of the Flat Rate Statute in evaluating the deductibility of post-production expenses where a production-based royalty was based solely on the effect of the 1982 statute to convert a flat rate lease to a production-based one. Rather, both Tawney and Wellman used contract principles to evaluate the term “at the wellhead” in freely negotiated production-based leases

In 2017, the State Supreme Court considered the applicability of Tawney and Wellman to the deductibility of post-production costs where the basis of royalty payments was the “Flat Rate Statute” rather than a production-based lease. Acknowledging that different rules of construction apply to interpreting freely entered production-based contracts and to statutory language which binds a party that had no role in its formulation, the Court ruled that the term “at the wellhead” as used in the Flat Rate Statute was NOT ambiguous and authorized lessees to deduct post-production costs that were actually incurred. See Leggett v. EQT Production Company, ____ S.E. 2d ___ (2017) (available at http://www.courtswv.gov/supreme-court/docs/spring2017/16-0136.pdf ). 

Earlier this year, however, the West Virginia Legislature amended W.Va. Code §22-6-8(e) to again effectively alter the provisions of older flat rate leases. Thus, in addition to the 1982 changes requiring the payment of at least a 1/8 production based royalty “at the wellhead,” the 2018 amendment provides that lessees must pay a royalty on the ultimate sale price to an unaffiliated third party—that is after the lessees have borne the cost of gathering, compressing, processing and transporting the gas. Further, the statute prohibits lessees from deducting any post-production costs. See W.Va. Senate Bill 360 (effective May 31, 2018) (available at http://www.wvlegislature.gov/Bill_Text_HTML/2018_SESSIONS/RS/bills/SB360%20SUB1%20ENR.pdf).

On April 12, 2018, EQT Production Company sued WVDEP in federal court for a declaration that West Virginia’s Flat Rate Statute “as applied to preexisting flat rate leases violates the Contract Clause” of the United States Constitution.” See EQT Production Company v. Austin Caperton, CA No. 1:18-cv-72 (N.D. W.Va.). The Contract Clause provides that “[n]o State shall … pass any … Law impairing the Obligation of Contracts.” U.S. Const. art. I, §10, cl.1. EQT concedes the prohibition of the clause is not absolute, but asserts that it requires states to demonstrate a significant and legitimate public purpose and that the contractual adjustments they make are reasonable and appropriate to serve those ends. EQT asserts that the statute fails this test because it merely “shift[s] the benefits of private parties” and “is not in any way related to any conceivable state interest in effecting the permitting regime.”

The Complaint also squarely addresses the artifice by which the Legislature has sought to withstand a Contracts Clause challenge—by not expressly amending leases and instead by prohibiting WVDEP from issuing necessary permits unless lessees agree to be bound by the statutory terms. EQT contends that states cannot, under the “unconstitutional conditions doctrine,” condition receipt for a government benefit on the waiver of a constitutionally protected right.

The Complaint attacks and seeks relief with respect to three parts of the Flat Rate Act:

1. It seeks to declare the original 1982 statute unconstitutional to the extent it requires flat rate lessees to pay something other than the agreed upon flat rate as a condition of obtaining a well permit.
2. It seeks to declare the 1982 “at the wellhead” royalty provision, which will only be effective until May 31, 2018, unconstitutional as applied to preexisting leases; and
3. It seeks to declare that the new royalty provision—requiring calculation at the point of sale to an unaffiliated third party and prohibiting deduction of post-production expenses—is unconstitutional. 

This article was authored by Robert G. McLusky, Jackson Kelly PLLC.