Fourth Circuit Decides West Virginia Royalty Case

Takeaways

• West Virginia’s marketable product rule applies through the point of sale, not just to the point the product becomes marketable. Thus, lessees must bear all costs through sale unless the lease specifically provides otherwise. Lessees without specific lease language permitting deductions should review their marketing agreements and payment methodologies to ensure no costs are deducted prior to sale.
• Parties to oil and gas leases are free to agree to share the burden of post-production costs, so long as the lease meets the Tawney requirements, although the lease need not spell out every deduction to be taken.
• The Fourth Circuit, like other courts in marketable product states, refrained from defining when gas becomes marketable. In interpreting the specific language of the leases, the court implied that the term “marketable” required the gas be “processed.” In other words, the gas must be processed in order to be considered marketable, and therefore Antero must bear all costs prior to processing. While this may be true in some contexts, it ignores the fact that Antero, at times, sold unprocessed gas directly to the ETC Bobcat Pipeline, implying that the gas was lean enough for direct sales to interstate pipelines without the need for processing. Under those circumstances, the gas was in a marketable form without the need for processing. Nevertheless, the Fourth Circuit left to the fact-finder the question of when gas becomes marketable.

On Jan. 5, 2023, the Fourth Circuit Court of Appeals issued an opinion interpreting the royalty payment obligation of a producer under various lease provisions in West Virginia. In Corder v. Antero Resources Corp., No. 21-1716, 2023 WL 105712 (4th Cir. Jan. 5, 2023), the court affirmed in part and reversed in part the district court’s summary judgment order in favor of the lessors. In doing so, it gave both operators and royalty owners partial victories in royalty payment litigation. The Fourth Circuit held:

1. The Tawney analysis for determining whether post-production deductions are appropriate is not limited to “proceeds” leases. Specifically, the Tawney requirements apply to “market value” leases, and all requirements must be met for the lessee to take deductions from the lessor’s royalties.
2. The presumption that the lessee bears all post-production costs applies through the point of sale, not just to the point of marketability.
3. The lease need not identify every specific deduction to satisfy Tawney’s “particularity” requirement. The court confirmed there is no “hard and fast” rule for determining whether a lease meets Tawney’s second prong, finding the market enhancement clauses at issue in Corder were plain and unambiguous, permitting Antero to deduct actual and reasonable costs incurred to enhance the value of an already marketable product even though the clause did not specify each deduction to be taken.
4. Lessors failed to plead their fraud with particularity, affirming the district court’s dismissal of the plaintiffs’ fraud and punitive damage claims.

Background Facts

Corder concerned a dispute between Antero Resources Corporation (Antero) and a group of royalty owners (lessors) over the payment of natural gas royalties under several leases in West Virginia. The leases at issue fell into three general categories:

1. Leases with a “market value” royalty clause, requiring Antero to pay royalties on the “value” of gas, the “net amount realized” or the “gross proceeds received from the sale,” all of which were calculated “at the well” or “at the wellhead.”
2. Leases expressly prohibiting any deductions from royalties.
3. Leases containing a “Market Enhancement Clause” requiring Antero to bear costs to “transform the product into marketable form” but permitting deductions from royalties for costs that “result in enhancing the value of the marketable oil, gas or other products to receive a better price.”

The parties disputed whether these leases allowed Antero to deduct two types of post-production costs: (1) processing, fractionating and transporting natural gas liquids and (2) transportation of residue gas. The lessors sued Antero for breach of contract, breach of fiduciary duty and fraud, seeking actual and punitive damages. The district court dismissed the lessors’ fraud, fiduciary duty and punitive damage claims. After discovery, the parties filed cross motions for summary judgment. The district court ruled in favor of the lessors, finding the leases did not satisfy Tawney’s requirements for deduction of post-production costs. Antero appealed.

The Fourth Circuit’s Opinion

West Virginia has historically followed the marketable product rule. Unless the lease provides otherwise, there is a presumption that “the lessee must bear all costs incurred in exploring for, producing, marketing, and transporting the product to the point of sale.” Wellman v. Energy Resources, Inc., 557 S.E.2d 254, 256 (W. Va. 2001) (see also Estate of Tawney v. Columbia Natural Resources, LLC, 633 S.E.2d 22, 27 (W. Va. 2006)). In Tawney, the West Virginia Supreme Court set forth three specific requirements that must be contained in a lease for the lessee to deduct post-production costs. In particular, the lease must (1) “expressly provide that the lessor shall bear some part of the costs incurred between the wellhead and the point of sale”; (2) “identify with particularity the specific deductions the lessee intends to take from the lessor’s royalty”; and (3) “indicate the method of calculating the amount to be deducted from the royalty for such post-production costs.” Tawney, 633 S.E.2d at 24.

Antero argued the first category of leases, “market value” leases, did not need to satisfy Tawney for Antero to deduct post-production costs from royalties. Antero reasoned Tawney applied only to leases that calculate royalties based on “proceeds” received from the sale of gas, and therefore Antero could deduct post-production costs on market value leases by using the work-back method to calculate the “value,” “net amount” or “gross proceeds” of gas sold “at the well.”

The court rejected Antero’s argument, finding Tawney was not limited to “proceeds” leases but also applied to market value leases. Corder at *8. As a result, Antero could deduct post-production costs from royalties only if it met Tawney’s three requirements.

The court then analyzed the three categories of leases against the Tawney requirements. As to the first category, the court found none of the leases satisfied “even one” requirement. Id. Antero was therefore not authorized to deduct post-production costs from Lessor’s royalties for category No. 1 leases. Id. At 9.

The court also rejected Antero’s argument that the lessee’s burden to bear all post-production costs does not apply after the product becomes marketable. The court confirmed the prohibition against post-production deductions applies through the point of sale, not just to the point of marketability. Id. At 9. In so holding, the court was not persuaded by the West Virginia Supreme Court’s recent criticism of the point-of-sale approach in Leggett v. EQT Production Co., 800 S.E.2d 850 (W. Va. 2017), or the characterization of the marketable product rule as narrower than the point-of-sale approach in SWN Prod. Co. v. Kellam, 875 S.E.2d 216 (W. Va. 2022). Rather, the court found references to “point of sale” in Wellman, Tawney and Kellam too strong to overcome, and therefore it held the Tawney requirements “apply through the point of sale.” Corder at *9. In other words, absent express language in the lease to the contrary, a lessee is required to bear all post-production costs, even after the product is rendered marketable. While technically the court did not create any new law, it certainly dashed the hopes of West Virginia lessees that the courts may narrow the marketable product rule in West Virginia.

The court then found Antero was prohibited from deducting any post-production costs from leases in category No. 2. However, as to category No. 3, the court found Antero could deduct costs that enhanced the value of the product after it became marketable, holding Tawney’s second prong – which requires a lease to “identify with particularity the specific deductions the lessee intends to take” – does not require the lease to clearly identify the specific deductions to be taken. The court found it sufficient that the market enhancement clause in the leases had a “plain, unambiguous meaning: when Antero pays royalties from the sale of a particular product, it may deduct actual and reasonable costs it incurred after that product became fit for sale, as long as those costs enhanced the value of the product.” Corder at *12.

Finally, the court affirmed the district court’s dismissal of the lessors’ claims for fraud and punitive damages. Even under a more-relaxed pleading standard, the court held the lessors failed to plead their fraud allegations adequately. Id. at 14.