Appalachian Land Co. v. EQT Prod. Co.
| Decision Date | 20 August 2015 |
| Docket Number | 2013–SC–000598–CL |
| Citation | 468 S.W.3d 841 |
| Parties | In re: Appalachian Land Company v. EQT Production Company |
| Court | United States State Supreme Court — District of Kentucky |
Counsel for Appalachian Land Company: George E. Stigger, III, John C. Whitfield, Madisonville
Counsel for EQT Production Company: Gregory Lee Monge, Kimberly McCann,
Ashland, Keri E. Lucas, Christina Ditty Hajjar, Ashland
Counsel for Kentucky Oil and Gas Association, INC.: Karen J. Greenwell, Gregory Brian Wells, Lexington
United States Court of Appeals for the Sixth Circuit: Deborah S. Hunt
CERTIFYING THE LAW
Today we certify that the producer severing natural gas from the earth is solely responsible for the payment of the severance tax. Of course, this rule can be altered through agreement.
On the first day of December, 1944, widower Robert Williams surrendered the privilege of severing oil and gas from his land in Pike County to West Virginia Gas Company. He leased all oil and gas within his property to the gas company “for the sole and only purpose of operating for, producing and marketing oil, gas and gasoline....”
Appalachian Land Company, (“Appalachian”) is Mr. Williams' successor in interest as the lessor. EQT Production Company, (“EQT”) is a natural gas producer. It is the successor in interest to the original lessee, West Virginia Gas Company. The lease provides that the lessee, now EQT, shall pay the lessor, now Appalachian, a royalty on natural gas extracted from the land “at the rate of one-eighth (1/8) of the market price of gas at the well.” In 2008, Appalachian filed a class action law suit against EQT in the U.S. District Court for the Eastern District of Kentucky. Appalachian claimed that EQT underpaid royalties owed to Appalachian in exchange for natural gas EQT acquired from Appalachian's land.
The disputed issue arises from the fact that natural gas is not sold “at the well.” As such, lessees like EQT must mathematically work back from the price at the point of sale to arrive at the wellhead price. This is the relevant “market price” for purposes of calculating royalties. In the present case, this value was obtained by deducting from the sale price all post-extraction processing costs; transportation costs; and all severance taxes. EQT then paid Appalachian one-eighth of the remainder.
Appalachian argued before the district court that in arriving at a “market price” for royalty purposes, EQT should not have deducted the severance taxes. Appalachian contends that these allegedly improper deductions resulted in an underpayment of royalties. The court disagreed and entered judgment on the pleadings in favor of EQT. Appalachian moved the court to alter or amend that judgment, which was denied. Appalachian appealed those rulings.
Because the issue of apportionment of natural gas severance taxes has not been directly addressed by this Court, the Sixth Circuit Court of Appeals certified the following question pursuant to CR 76.37(1) :
Does Kentucky's “at-the-well” rule allow a natural-gas processor to deduct all severance taxes paid at market prior to calculating a contractual royalty payment based on “the market price of gas at the well,” or does the resource's at-the-well price include a proportionate share of the severance taxes owed such that a processor may deduct only that portion of the severance taxes attributable to the gathering, compression and treatment of the resource prior to calculating the appropriate royalty payment?
While we accept the invitation to clarify this important issue, we reject the two options presented. Instead, we conclude that in the absence of a specific lease provision apportioning severance taxes, lessees may not deduct severance taxes or any portion thereof prior to calculating a royalty value.
The extraction of natural gas is a capital intensive process involving various technologies and extraction methods. After extraction, the gas is cleaned, stored, and subsequently transported to other sites through various pipelines. Often after additional cleaning, refining, and processing, the gas is eventually sold at a hub location. The severance tax is remitted at this point of the operation. KRS 143A.060(2). The sales price at that location constitutes the gross value of the gas for purposes of calculating the severance tax. KRS 143A.010 –020. Royalty payments are calculated based on this sale price.
In Baker v. Magnum Hunter Production, Inc., ––– S.W.3d ––––, 2015 WL 4967131 (Ky. August 20, 2015), we recently held that Kentucky follows the majority “at the well” rule for determining royalty payments. Our decision confirms the Sixth Circuit's interpretation of Kentucky law. Poplar Creek Development Co. v. Chesapeake Appalachia, LLC, 636 F.3d 235 (6th Cir.2011). Under the “at the well” approach, production costs are not deducted from the sale price for royalty calculation purposes. Production costs include bringing the gas to the surface, exploration, drilling, and well-maintenance costs. In other words, production costs are those associated with “severing” the gas from the earth. In contrast, post-production costs are deducted from the sale price when calculating royalty payments. Post-production costs are incurred after the gas is severed and reaches the wellhead. These costs include improving the quality of the gas and transporting it to the point of sale.
Although the “at the well” rule is a critical component of our oil and gas jurisprudence, it is not conclusive of the narrow issue currently before this Court—nor are economic considerations determinative here. Rather, we must decide whether Appalachian's severance tax liability arises under statute or contract. Having reviewed the facts and the law, we conclude that there is no severance tax liability on behalf of Appalachian. We keep in mind that Appalachian is simply the successor to Mr. Williams—the landowner under the 1944 lease—and is not in the business of extracting a profitable mineral from the earth or bringing it to market.
KRS 143A.020(1) states that “[f]or the privilege of severing or processing natural resources in this state, a tax is hereby levied at the rate of four and one-half percent (4.5%) on natural gas ... to apply to the gross value of the natural resource.” This tax applies to “all taxpayers severing and/or processing natural resources in this state....” KRS 143A.020(2). “Severing” is defined as “the physical removal of the natural resource from the earth or waters of this state by any means.” KRS 143A.010(3). “ ‘Processing’ includes but is not limited to breaking, crushing, cleaning, drying, sizing, or loading or unloading for any purpose.” KRS 143A.010(6). With these provisions in mind, we turn to Burbank v. Sinclair Prairie Oil Co., which addressed a nearly identical issue. 304 Ky. 833, 202 S.W.2d 420 (1946).
Burbank involved a dispute between a lessee and lessor concerning the apportionment of the oil severance tax assessed under the original version of what would become KRS 137.120. The consideration provided in the lease at issue in that case was “the equal of 1/8 part of all oil produced and sold from the leased property.” Id. at 421. Similar to the present case, the lease in Burbank did not provide for apportionment of severance taxes.
The Court focused its analysis on the original severance tax statute that provided in pertinent part:
Based on this plain language, the Court held that “the original act as amended cannot be construed as placing any part of the tax in question on one who is simply a royalty owner.”Id. at 425.
The Burbank Court's determination was well-founded. For example, the Court noted that in “States having similar acts ... the courts have held the tax not to extend.” Id. at 424 (). Burbank also relied upon the U.S. Supreme Court's decision in Oliver Iron Mining Co. v. Lord, 262 U.S. 172, 43 S.Ct. 526, 67 L.Ed. 929 (1923). In that case, the Court considered a Minnesota law that taxed “every person engaged in the business of mining or producing iron ore....” Id. In holding that the royalty owner was not liable for the tax or any portion thereof, the Court cogently observed:
Like the royalty owners in Burbank and Oliver, Mr. Williams and his successor, Appalachian, have not engaged in the business of producing natural gas. Burbank, 202 S.W.2d at 423. It is similarly evident that the only party to the lease that engages in severing the gas is EQT. Cf. Cimmaron Coal Corp. v. Dep't of Revenue, 681 S.W.2d 435, 437 (Ky.App.1984) (). EQT is also the only party to the lease involved in bringing the gas to market and, thus, processing the gas. See Burbank, 202 S.W.2d at 423 () (Emphasis added). Therefore, royalty owners are not involved in severing or processing the gas.
Furthermore, it is critical to our analysis that the natural gas tax is assessed for the “privilege of severing or processing” the gas. This...
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