Due to changes in the relationship between the producer and the transmission pipeline companies arising out of the deregulation and decoupling of pipelines from the producing companies, some of the producers changed the manner in which they calculated royalties, using the point of sale price and deducting expenses associated with transmission and marketing. A West Virginia lawsuit questioned the consistency of that point and manner of royalty calculation, resulting in concern among Kentucky producers (heightened by a class-action suit that has been filed in Kentucky) that they may be found to have the same degree of liability for royalty underpayment.
In an attempt to limit the liability, KOGA has proposed HB 543, which purports to codify common law and would (in the absence of lease provisions to the contrary) calculate the royalty on net proceeds on the sale at the point of sale after deductions for a range of “postproduction activities.”
Unfortunately, HB 543 is not a workable solution to the potential liability since it departs from Kentucky common law in several critical areas:
* Kentucky case law is uniform in holding that a percentage (1/8) royalty is calculated at the well and based on fair market value in the area where the well is located, and is to be based on the gross value with no deductions nor enhancements of the value due to post-production activities.
The Warfield Natural Gas v. Allen case, 88 S.W.2d 989 (1935) involved a gas lease that provided a royalty based on 1/8 of the “proceeds of the sale” of the gas. Nothing was said in the lease about the market nor the sale price. The Court held unambiguously that:
this lease must be held to mean one-eighth of the gross proceeds of a sale of the gas at the well side, and that is all for which defendant must account even though it may market the gas elsewhere and get a much greater sum for it.
Concerning whether expenses could be deducted from the proceeds due the royalty owner, the Court held that those expenses had to be borne by the producer, for
It 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. Proceeds of a sale, unless there is something in the context showing to the contrary, means total proceeds.
Id. at 845.
The shifting to the lessor of postproduction costs retroactively for existing leases, would certainly be struck by the courts as an impermissible impairment of the lessee’s obligations under existing leases. 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 second issue is where and what is to be paid. 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 (which could be in another state under the post-1992 reorganization of the relationship of producers to pipelines).
The case of Reed v. Hackworth, 287 S.W.2d 912 (1956) twice reiterates that if “the lease is silent concerning the place of market and the price, the royalty should be applied to the fair market value of gas at the well.” Reed v. Hackworth, 287 S.W. 2d 912, 914 (1956); Warfield, supra. The Reed court reaffirmed the Warfield holding that “if a lease is silent on the question, royalty should be based upon the market value of the gas at the well.” In Reed, the court specifically rejected two concepts that HB 543 seeks to interject – that the lessor was entitled to a share of any appreciated value for activities occurring after the extraction of the gas, and that evidence of one actual sale in the area could trump other evidence of the prevailing value in the vicinity for the gas at the wellhead. Reed closes the door to an argument that postproduction value or costs are chargeable to the lessor, and to an actual sale price trumping market value as determined by a more broad review of the typical value of gas derived from sales in the area.
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.
I’ve attached the Warfield and Reed decisions. Let me know if you need anything further. I understand the concern that you have with the potential impact on small producers, and I wish that I could be more encouraging regarding the range of actions that the General Assembly can take at this point. There is a potential liability for some of these companies that is significant, but consistent with Kentucky’s constitutional protection against impairment of contracts I don’t believe that HB 543 or any other legislative measure can restrike the bargain made in those leases.
As I mentioned earlier, I believe the best course of action for the industry is to seek a mediated settlement with a plaintiff class representing all royalty owners that would provide for a payout over a period comparable to the alleged period of underpayment, similar to how utilities rebate overearnings in electric utility cases.
PS: Please feel free to share this memo and the case law as you believe appropriate.