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PO Box 1070, Frankfort, KY 40602  Phone 502.875.2428, Fax 502.875.2845

House Bill 543 Bad News For Gas Lessors  Posted: February 26, 2007
February 26, 2007

To: House Leadership
Rep. Hubert Collins

From: Tom FitzGerald

Re: House Bill 543

I am writing to express my serious reservations concerning the adverse effects that adoption of House Bill 543 would have on the rights of the thousands of Kentuckians who have leased natural gas reserves for production and who receive royalties on a percentage basis under a lease that does not specifically address deductions. HB 543, while purporting to be “consistent with Kentucky common law” in fact dramatically changes existing common law in a manner that is quite favorable to the lessee gas companies and will dramatically lower royalty payments to lessors below the amounts to which they are entitled under current Kentucky law.

The bill appears to depart from Kentucky common law in these ways:

1. The bill shifts to the lessor postproduction costs that currently are the responsibility of the lessee, and in so doing retroactively and impermissibly impairs the lessee’s obligations under existing leases.

Current Kentucky law provides that where a lease of natural gas provides a percentage (typically 1/8) of the proceeds to the lessor and is silent as to whether deductions can be taken for marketing and transmission of the gas, those expenses are to be borne by the lessee rather than being charged to the lessor. Warfield Natural Gas Co. v. Allen, 261 Ky. 840, 88 S.W. 2d 989 (1935). As the Court explained, “[I]t must be presumed that the payment by the defendant of its expenses in [producing and marketing the gas] is the consideration it is to pay for its seven-eighths of the proceeds, for it pays no other and it certainly gets the lion’s share.” The Warfield Court stated clearly that proceeds means total proceeds.

The bill would, contrary to the Warfield line of cases, allow the lessee to deduct “reasonable and necessary costs” for postproduction activities, including the “gathering, processing, dehydration, blending, treating, compressing, marketing, and transporting” gas to the point of first sale. None of these costs are currently chargeable against the lessor’s royalty interest under Kentucky common law, and the effect of the adoption of this bill would be to lower royalty payments and to retroactively alter and impair the obligations of the lessees under these existing contracts.

2. The bill replaces the current legal obligation of the lessee to pay market value for the gas measured at the wellhead, with actual sale price at the point of sale. Kentucky common law is clear that “if a lease is silent on the question, royalty should be based upon the market value of the gas at the well.” Reed v. Hackworth, 287 S.W. 2d 912 (1956); Warfield, supra.

Under HB 543, if the producing company enters into a contract for sale of the natural gas at below the market value, the lessor would suffer a lower royalty since the actual sale price rather than market value would be used for valuation. Additionally, since the bill shifts the point of determining value from the well to the point of sale (which may be in another state or several states away), the line losses of the transported gas would be charged back to the lessor proportionally.

In conclusion, HB 543 does not codify existing common law concerning valuation of natural gas, the point of determining value, nor the ability to charge expenses against the royalty paid to the lessor. I urge you to recommit the bill to either the Judiciary or Natural Resources and Environment Committee for further review, particularly in light of the significant detrimental impact the bill will have on the reasonable expectations of lessors under existing leases, and the substantial impairment of those lease agreements that this bill would effect.

Cordially,
Tom FitzGerald
Director

[Note: A floor amendment was filed by the sponsor removing Section 1(3) of the bill. Section 1(3) would shorten the statute of limitations for suits on such leases from 15 to 5 years, and would preclude any argument that the right to sue (the "cause of action") starts on discovery of the breach rather than when it occurs. Also, the terms "existing and future" were included as modifiers of the leases affected by the bill in a committee substitute, but even if the original bill language for Section 1(2) is used, the language of the bill would still appear broad enough to apply to, and thus impair, existing leases.]


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