RECENT LITIGATION IN KENTUCKY REGARDING POST-PRODUCTION COSTS

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1 RECENT LITIGATION IN KENTUCKY REGARDING POST-PRODUCTION COSTS Harry D. Callicotte, P.E., J.D. Harry D. Callicotte, PLLC KOGA 2015 Annual Meeting Lexington, Kentucky July 15, 2015

2 What are Post Production Costs? Gathering Separating Storing Dehydration Compression Transportation Processing Treating Marketing Delivering Or any other costs and expenses incurred between the wellhead and Lessee s point of delivery or sale of such share to a third party

3 Calculation of Royalties Royalty Calculation issue is created upon the sale of Gas Actual Sale of Gas is almost always away from the Well Common Lease Terms Market Price at the Well Proceeds at the Well Produced and Marketed from the Leasehold Market Value at the Well Amount realized at the Well How do you determine the Price or Proceeds at the Well?

4 Marketable Product Rule v. At-the-Well Rule Producer is obligated to make the Product (Natural Gas) marketable at its own expense Gather/Treat/Process to make Product marketable Transport to Market Issue is whether post-production costs can be deducted from the sales price to Net-Back to Market Price or Proceeds at the Well

5 States that currently follow the California Montana North Dakota New Mexico Louisiana Mississippi Michigan Pennsylvania Texas At-the-Well Rule Chesapeake Exploration, LLC v. Hyder (Texas Supreme Court affirmed (5-4) the Fourth District Court of Appeals decision in favor of lessors regarding language stating that royalty be free and clear of all production and post production costs and expenses )

6 Colorado States that currently follow the Oklahoma Arkansas Kansas Marketable Product Rule Fawcett v. Oil Producers Inc. of Kansas (on July 2, 2015, State Supreme Court held that when calculating royalty, the postproduction, post-sale processing expenses deducted by thirdparty purchasers are shared) Virginia Federal Court only (compare to Attorney General s Opinion with regard to allowing deduction from leases that are force pooled) West Virginia

7 Map of Interstate Pipeline System

8 Utah Wyoming Alabama Tennessee Ohio Undecided? Lutz v. Chesapeake Appalachia, LLC (U.S. District Court for the Northern District of Ohio certified the question of whether Ohio follows the at-the-well rule or the marketable product theory to the Ohio Supreme Court on April 1, 2015)

9 Post-Production Costs Litigation West Virginia Tawney v. Columbia Natural Resources (2006) Radical minority view ($405 million Judgment) At the well language is ambiguous Kentucky Poplar Creek Dev. Company v. Chesapeake Appalachia Appalachian Land Company v. EQT Production Company Baker v. NGAS (n/k/a Magnum Hunter Production, Inc.) Asher Land & Mineral v. Nami Resources Company, LLC

10 Poplar Creek case First Tawney copycat case in Kentucky Federal Court (Eastern District of Kentucky) At issue: Gathering Treatment Transportation/Compression But NOT Severance Taxes

11 Poplar Creek case (continued) Trial Court July 2, 2009 Kentucky Courts would interpret at the Well to mean that producer pays on the value of Gas before it has been gathered, treated or compressed Appellate Court (6 th Circuit Court of Appeals) Affirmed the lower Court s ruling (E.D. Ky.) We hold that Kentucky follows the at-the-well rule, which allows for the deduction of post-production costs before paying the appropriate Royalties.

12 Baker case State Court case (filed in Harlan Circuit Court) Same Plaintiffs attorneys as Poplar Creek case At issue: Deductibility of Post-Production Costs to arrive at Price at-the-well (Net back or Work back) Severance Taxes NOT an issue Motion to Dismiss (Counts I and IV of Complaint) Kentucky follows the at-the-well rule that permits a Lessee to deduct its post-production costs before the Royalty payment to the Lessor is calculated. (Order Entered by Circuit Clerk on March 29,2012)

13 Baker case (continued) Plaintiff appealed to the Kentucky Court of Appeals Defendant/Appellee relied on the Poplar Creek decision KOGA filed an amicus curiae brief in support of Appellee Appellate Court agreed that Gathering, Compression and Treatment costs were all deductible Affirmed in an unpublished Opinion on June 28, 2013 Motion for Discretionary Reviewed granted Oral arguments took place before the Kentucky Supreme Court on February 6, 2015 Decision expected later this Summer (6 Justice Panel)

14 Asher case Also a State Court case (filed in Bell Circuit Court) At issue: Deductibility of Post-Production Costs Including Severance Taxes Bell Circuit Court decided: Gathering, Treatment, Transportation Costs all Deductible Severance Taxes NOT Deductible Appealed to the Kentucky Court of Appeals Severance Tax is only issue before the Appellate Court KOGA also filed an amicus curiae brief in support also

15 Appalachian Land case Federal Court case (Eastern District of Kentucky) At issue: Deductibility of Post-Prod. Costs and Severance Taxes Case was held in abeyance until the 6 th Circuit of Appeals could rule in the Poplar Creek case Trial Court adopted 6 th Circuit s ruling in Poplar Creek that Post-Production costs are deductible Also Ruled that Severance Taxes are deductible Case Appealed to the 6 th Circuit Court of Appeals Certified Question of Law regarding the Deductibility of Severance Taxes to the Kentucky Supreme Court

16 Way Forward Perhaps discontinue use of at the well language Same with respect to use of gross proceeds Transparent and Unambiguous Draft lease to clarify post production costs (what are they, how are they calculated, net royalty, etc.) Clarify third party versus Affiliate Lessor engagement Negotiate other parts of the lease / increase royalty Stay current on developments (not settled yet) Recommend use of counsel in drafting leases

17 Questions?

By: Michael J. Gartland (Copyright 2016 ) THIS IS AN ADVERTISEMENT.

By: Michael J. Gartland (Copyright 2016 ) THIS IS AN ADVERTISEMENT. KENTUCKY S AT-THE-WELL RULE PROHIBITS A LESSEE UNDER AN OIL AND GAS LEASE FROM DEDUCTING ANY SEVERANCE TAXES PRIOR TO CALCULATING A ROYALTY VALUE ABSENT A SPECIFIC LEASE PROVISION APPORTIONING SUCH TAXES.