On Nov. 14, 2024, the Supreme Court of Appeals of West Virginia issued a 3-2 opinion that answered two certified questions in Romeo v. Antero Resources Corp. The court found that oil and gas operators must bear postproduction expenses associated with producing, transporting, and marketing residual gas and natural gas liquids (NGLs) up to the point of sale unless the lease expressly provides otherwise. In doing so, the court placed West Virginia in a “minority of one” and recognized that West Virginia law obligates operators to bear postproduction costs further downstream than other jurisdictions. As a result, West Virginia operators must carefully consider increased postproduction expenses and larger royalty payments associated with selling residual gas and NGLs beyond the first available interstate pipeline connection.
Romeo is the latest liberalization of West Virginia’s marketable product rule, which the Supreme Court of Appeals first adopted in its 2001 Wellman v. Energy Resources, Inc. opinion and later refined in Estate of Tawney v. Columbia Natural Resources, L.L.C. (2006). The marketable product rule applies to all leases that do not expressly permit the operator to deduct postproduction expenses. Under this rule, operators owe lessors an implied duty to get the gas they produce to market and pay the postproduction expenses incurred to get the gas to market. Romeo answered two critical questions related to the scope of the marketable product rule: (1) whether operators could deduct postproduction expenses associated with transporting gas beyond the first available market to a downstream “point of sale” in a more lucrative market, and (2) whether the operator must bear postproduction expenses associated with processing and marketing NGLs.
First, Romeo held that, under West Virginia’s version of the marketable product rule, operators are responsible for all postproduction expenses related to getting residual gas to the ultimate “point of sale.” This holding broke with other oil- and gas-producing states that apply the “first marketable product rule,” which permits operators to deduct postproduction expenses incurred after the residual gas becomes marketable or up to the first available market. The cost-sharing permitted under the first marketable product rule incentivizes operators to get their gas to the market with the highest gas prices by allowing operators to deduct expenses associated with getting the gas to the more profitable market from their increased royalty obligations. Under West Virginia’s marketable product rule, operators have less of an incentive to transport gas to more lucrative markets because doing so will increase the operators’ costs and its royalty obligations. The Romeo court acknowledged the “economic repercussions of [its] ‘point of sale’ rule,” but indicated that the West Virginia Legislature should address those repercussions.
Second, Romeo held that operators’ implied duty to market gas extended to NGLs and, under the marketable product rule, operators could not deduct postproduction expenses associated with processing, fractionation, transporting and marketing NGLs up to the point of sale. Again, this holding broke with other oil- and gas-producing states’ first marketable product rule that only obligates operators to bear postproduction expenses associated with getting residual gas — but not NGLs — into a marketable form. “Wet” gas reaches its marketable form when NGLs are separated out to leave residual (dry) gas. The separated NGLs (known as Y-Grade NGLs) must go through additional processing (factorization) before they become a marketable product, such as ethane, butane, isobutane, propane and other forms of hydrocarbons. The first marketable product rule applies only to residual gas and, by exclusion, permits operators to deduct the expenses associated with the additional postproduction expenses associated with processing the Y-Grade NGLs into marketable products. West Virginia’s marketable product rule, however, applies to residual gas and NGLs. Thus, unless the lease expressly permits operators to deduct postproduction expenses, operators will be unable to deduct postproduction expenses from royalties paid on both residual gas and NGLs.
Going forward, operators must evaluate whether their current West Virginia leases are subject to the marketable product rule, and if so, ensure that their royalty calculations are consistent with Romeo’s holdings. Although the marketable product rule is the default rule in West Virginia, lessors and lessees may agree to reallocate postproduction expenses in their leases by strictly complying with the requirements set forth in Tawney. Operators looking to reduce the “economic repercussions” of Romeo can do so by negotiating for lease modifications that satisfy the Tawney requirements and permit postproduction deductions, updating lease forms to expressly permit specific postproduction deductions in accordance with the Tawney requirements, accounting for additional postproduction and royalty expenses in downstream sales, and encouraging the West Virginia Legislature to adopt legislation more in line with other oil- and gas-producing states.