GREENE, C.J.
EOG Resources, Inc. (EOG) appeals a decision of the Kansas Court of Tax Appeals (COTA) establishing the value for ad valorem tax purposes of six oil and gas leasehold interests located in Seward County (County) for tax years 2007 and 2008. EOG argues that COTA erred as a matter of law or acted in a manner that was arbitrary, capricious, and unreasonable by failing to exclude the
In 2005, EOG acquired several new oil and gas leases in Seward County, and production was obtained through new wells on five of these properties subsequent to July 1, 2006, and on a sixth property in late 2007. For tax years 2007 and 2008, EOG and the County argued about the proper methodology to calculate valuation for purposes of ad valorem taxation, and they principally argued about the correct manner to exclude for purposes of that valuation the distorting effect of flush production apparent on each lease. The dispute ultimately reached COTA, which heard evidence before issuing an order that redetermined the valuation of each leasehold interest for each of the tax years at issue. For purposes of our opinion on appeal, we reserve a more detailed discussion of applicable evidence and COTA's ultimate valuation of the leasehold interests for more specific treatment hereafter.
Procedurally, we note at the outset that EOG did not initially contest the extent to which flush production distorted the production rate utilized in the County's valuation calculation; instead, EOG's initial position focused exclusively on decline rate. In fact, COTA ultimately accepted EOG's proposed production rates in its initial order and decision. In EOG's motion for reconsideration, however, EOG clearly raised this issue, suggesting that "new calculations must be performed to factor out the influence of flush production in the annualized production rate," citing Helmerich & Payne, Inc. v. Board of Seward County Comm'rs, 34 Kan.App.2d 53, 115 P.3d 149, rev. denied, 280 Kan. 982 (2005). This issue has now become one of the primary arguments of EOG on appeal. The County has asserted no procedural bar to our consideration of this argument, nor do we recognize any such bar given the clear preservation of the issue before COTA in the motion for reconsideration. See In re Tax Exemption Application of Strother Field Airport, 46 Kan.App.2d 316, ___, 263 P.3d 182 (2011); In re Tax Appeal of Dillon Real Estate Co., 43 Kan.App.2d 581, 589, 228 P.3d 1080 (2010).
Judicial review of orders of COTA is governed by K.S.A. 2010 Supp. 77-621. For purposes of this appeal, application of this statute requires the appellate court to grant relief (i) if the agency has erroneously interpreted or applied the law, K.S.A. 2010 Supp. 77-621(c)(4); or (ii) if the agency failed to follow prescribed procedure, K.S.A. 2010 Supp. 77-621(c)(5); or (iii) if the agency's action is arbitrary, capricious, or unreasonable, K.S.A. 2010 Supp. 77-621(c)(8). We do not perceive that EOG has challenged any of the factual findings of COTA, but it has challenged exclusively COTA's application of legal principles—appraisal principles—to the undisputed facts.
On appeal of COTA's decision, the party complaining bears the burden of demonstrating that the agency erred. K.S.A. 2010 Supp. 77-621(a)(1).
Interpretation of a statute is a question of law over which this court has unlimited review. Unruh v. Purina Mills, 289 Kan. 1185, 1193, 221 P.3d 1130 (2009). Kansas appellate courts no longer give deference to agency statutory interpretations. See Kansas Dept. of Revenue v. Powell, 290 Kan. 564, 567, 232 P.3d 856 (2010); In re Tax Exemption Application of Kouri Place, 44 Kan.App.2d 467, 471-72, 239 P.3d 96 (2010).
In Helmerich, 34 Kan.App.2d at 53, 115 P.3d 149, a panel of this court noted the statutory guidelines and theory of oil and gas leasehold valuation for ad valorem taxation in Kansas:
The theory and practice for appraising such properties was endorsed by our Supreme Court in Board of Ness County Comm'rs v. Bankoff Oil Co., 265 Kan. 525, 529, 960 P.2d 1279 (1998). The court quoted with approval an expert who noted that the goal is to value the reserves that are in the ground by discounting income over a period of time to reflect the production capabilities of those reserves. The essential mathematical formula to achieve that goal is: annual production rate times net price on valuation date equals estimated gross income times present worth factor associated with decline rate equals estimated gross reserve value. The court recognized that the decline rate is "the most critical factor in establishing its valuation." 265 Kan. at 529-30, 960 P.2d 1279. The decline rate is the annual percentage by which a well has or is expected to decrease in production as the recoverable mineral reserves are depleted. The decline rate is then correlated to the associated present worth factor from a table in the Oil and Gas Appraisal Guide prepared annually by the Division of Property Valuation of the Kansas Department of Revenue (PVD Appraisal Guide).
Of particular consideration here is that the legislature has specifically mandated special treatment of new wells with initial production achieved after July 1 of the year preceding valuation in K.S.A. 2010 Supp. 79-331(b) as follows:
This special treatment was adopted in 1979 to address the problematic influence of flush production on the methodology for valuation of new oil or gas production. As noted by our Supreme Court in State ex rel. Stephan v. Martin, 230 Kan. 747, 749, 641 P.2d 1011 (1982):
Critical to our analysis here, however, is that our Supreme Court found K.S.A. 79-331(b) to be constitutional only because it was assumed that subsection (b) would be applied with due consideration of the factors set forth in subsection (a) of the same statute, with the view that the objective "is to arrive at the actual fair market value of the property appraised" "as opposed to a fictional, unrealistic, or arbitrary determination." 230 Kan. at 755, 756, 641 P.2d 1011. In fact, the court admonished that if subsection (b) was applied in a vacuum, the result might be found arbitrary.
The pernicious influence of flush production was elegantly explained by our Supreme Court in Bankoff:
In Helmerich, we had occasion to address the impact and proper treatment of flush
Finally, we acknowledge the most essential holding of Bankoff: "Production data pertaining to periods after January 1 is relevant to a determination of an oil and gas lease's future productivity and earning potential as of January 1, particularly when there have been significant changes in production late in the year prior to assessment." 265 Kan. 525, Syl. ¶ 7, 960 P.2d 1279.
Against this legal background, we examine the record evidence and apply these principles to the properties in question.
EOG's Hatcher 8# 1 lease first produced oil on December 8, 2006. During the 24 productive days of that month alone, 3,688 barrels were produced; within 12 months, the lease was producing only 315 barrels per month. The complete production history of this lease through the appraisal date for 2008 was as follows:
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Production
Month (Barrels)
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December 2006 3,688
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January 2007 2,113
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February 1,436
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March 1,326
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April 941
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May 1,315
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June 815
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July 727
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August 542
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September 388
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October 371
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November 332
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December 315
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January 2008 428
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February 366
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March 307
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April 343
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The County conceded that flush production was apparent from December 2006 through May 2007, but annualized production based only on the 24 days in December 2006 and assumed a decline rate of 30% prior to a K.S.A. 2010 Supp. 79-331(b) statutory 40% reduction. EOG argues that the County's annualization "included flush production" and that the evidence supported a decline rate in excess of 50%. EOG's contentions—if accepted—would reduce the gross reserve value subject to taxation by nearly 75%. COTA agreed with the County that there was insufficient data to support "an actual, normalized decline rate" and found appropriate the County's use of the 30% assumed decline rate.
These facts present the most challenging valuation problems in this case. With only 24 days of actual production before the valuation date (January 1, 2007) and the County's concession that this production was flush production, how should the production and
First, based on Bankoff's mandate to consider postvaluation date production data, we conclude that the production data through March 31, 2007 "is relevant to a determination of the property's future productivity and earning potential." See 265 Kan. at 542, 960 P.2d 1279. Thus, for the first 114 days of production, 8,563 barrels of oil were produced, and the annualization of this production yields an annual production rate of 27,416 barrels. Not only does this calculation minimize the distorting influence of the flush production, this annualization of all available data yields more precisely the production rate "if [the lease] had actually produced said entire year preceding the year in which such property is first assessed" for purposes of K.S.A. 2010 Supp. 79-331(b).
Second, given the Supreme Court's explanation that the statutory reduction should apply to the "`quantity of oil or gas produced'" (Martin, 230 Kan. at 757, 641 P.2d 1011), the resulting annualized production rate for purposes of valuation should be 27,416 times 60%, or 16,449 barrels.
Finally, we agree that—as of the appraisal date—no "stable" or "normalized" rate of decline could be calculated, but it simply cannot be said that no decline was apparent given all available data. The absence of evidence of a stable or normalized rate does not dictate that an assumed declined rate of 30% should be applied. After all, even the applicable PVD Appraisal Guide (2007 & 2008, respectively) states that the assumed rate of 30% should be employed only "if the first few months of production and all data available do not indicate a reasonable rate of decline." (Emphasis added.) The PVD Appraisal Guide further provides that "this [assumed rate] is not automatic and is to be used only when the actual decline rate cannot be established." Here, the consideration of postvaluation date information clearly establishes that the decline already being experienced was far in excess of 50%; i.e.: (1) we know from examining the first 4 months of production that the well production had declined more than 50% between December and February—and this would indicate an annual decline "off the charts"; and (2) the daily production rate for December was 153.7 barrels, whereas the daily rate for the entire first quarter of 2007 was only 54.2 barrels. Thus, from raw production data alone, it is clear that this lease was declining in excess of 50% from its initial production. Thus, gross reserve value for tax year 2007 should have been determined using production of 16,449 barrels declining in excess of 50%. We leave the precise calculations deriving taxable valuation to the working interest and the royalty interest(s) to COTA on remand.
Where the only available production data as of the January 1 valuation date for a new oil or gas well is clearly distorted by flush production, but all such data indicates that the production rate from which a stable decline will commence has not yet been achieved, fair market value is not achieved by application of a 30% decline rate. Instead, the taxpayer is entitled not only to the statutory 40% reduction in annualized rate, but the maximum decline must be assumed in order to avoid overtaxation in the first year of assessment. All such data may include month to month comparisons, initial month to latest month comparison, or comparison with the characteristics of production in the same field or formation. The essential point is that when or if a stable decline develops for the well, that decline will not commence at production levels anywhere near the initial flush production rates. Under these circumstances, to assume a 30% decline rate is to disregard statutory factors of value critical to determination of fair market value, including the age of the wells, their probable life, and the quantity of oil or gas that will be produced from the property. Application of this holding will be demonstrated below to the first lease at issue here.
We pause in our analyses to corroborate these conclusions and our holding. The goal here is to determine fair market value of the remaining mineral reserves, based on production already achieved. For how many years and at what rate might the remaining reserves continue to be produced? We have already utilized an annual production rate known to exceed by multiples of any likely future production. Granted, the 40% statutory
As noted above, there was apparently no dispute at the initial COTA hearing as to actual production for the calendar year, but EOG's motion for reconsideration suggested that this rate merited adjustment to disregard flush production. At the initial hearing, the principal issue was decline rate. The County applied an assumed 30% decline rate "because the production was starting to level off after the flush ended." EOG requested a decline rate of 45% based in part on an "Aries" computer graph and a back-to-back analysis that demonstrated a 38.6% quarterly decline which indicated an annual decline rate in excess of 50%.
COTA conceded that there were two full quarters of postflush production that could be considered in 2007, and one quarter in 2008, but rejected a back-to-back approach because "the use of a singular back-to-back quarter analysis to establish a stable and normalized rate of decline should also be supported by additional evidence in order to show that the decline experienced in such a short period reflects a normalized rate of decline." COTA found that this principle was supported by the 2008 PVD Appraisal Guide, which stated that "more than a single quarter decline should be considered when trying to establish an annual rate" and suggested that "results should be compared with other estimates of decline for the same lease or the typical decline for the area."
We respectfully disagree with COTA in rejecting a singular back-to-back quarter analysis here. Comparison of third and fourth quarter production in 2007 establishes a quarterly decline of 38%, which indicates an annual rate far in excess of 50%. Although production spiked a bit in early 2008 (which was not explained in the record but may have been the result of artificial stimulation), even a comparison of production in January and March 2008 indicates a decline of 28% in only 60 days, and that would also drive an annual rate far in excess of 50%. Monthly declines after the flush production period were often 25%, also indicating an annual rate far in excess of 50%. These clear mathematical conclusions cannot be disregarded; there was ample evidence that EOG was entitled to the maximum decline rate permitted under the PVD Appraisal Guide. Additionally, these indications of the 2008 decline should be examined against the backdrop of our valuation conclusion in 2007; i.e., this lease has since inception indicated a very high rate of decline, both during and after initial flush production. This was simply not a situation justifying a default assumption of a 30% decline rate. We acknowledge that there was not the same precise corroborating evidence as we noted in Helmerich, but there was plenty of corroboration by the raw data.
Additionally, we recognize that this lease may someday achieve a stable decline rate less than 50%. If or when it does so, the rate of production will then necessarily be a fraction of the high flush production rates achieved in its first 4 or 5 months of production. Does this mean that some of the reserves may have forever escaped taxation by reason of our conclusions or holdings? No; the appraisal scheme is virtually self-correcting. To the extent that reserves may be slightly underestimated in the early years of productivity, EOG will ultimately be taxed on those reserves because they are recomputed and taxed every year of each well's productive life. In contrast, if the reserves are overstated and overtaxed in the early years of production, EOG's excessive tax payment
Although EOG's "Aries" computer graph of decline is urged as further support of decline rate, we are not inclined to consider its value on appeal because COTA found the graph unreliable due to lack of foundation, uncertainty as to its data points, and inclusion of "speculative" data points. Such graphical analysis, however, is not necessary to establish decline rates that are apparent from mathematical comparisons of raw production data. As we noted in Helmerich, such engineering curves or gross reserve estimates can indeed support a decline rate analysis achieved by a comparison of singular back-to-back quarters. 34 Kan.App.2d at 64, 115 P.3d 149. Here, they are not necessary because of the additional evidence noted above that supports the 50% decline rate.
EOG's McQuillen 19# 1 gas lease attained initial production on November 21, 2006, and had produced nearly 42,000 million cubic feet of gas (Mcf) before the end of the year, or an average daily production of 900 Mcf. Within a year, daily production had slipped to only 140 Mcf—an 80% decline. Production history through the appraisal date for 2008 was as follows:
----------------------------------------Month Production (Mcf) ---------------------------------------- November 2006 (10 14,903 days) ---------------------------------------- December 2006 27,084 ---------------------------------------- January 2007 19,144 ---------------------------------------- February 13,989 ---------------------------------------- March 12,270 ---------------------------------------- April 11,450 ---------------------------------------- May 9,994 ---------------------------------------- June 8,315 ---------------------------------------- July 7,057 ---------------------------------------- August 7,166 ---------------------------------------- September 5,706 ---------------------------------------- October 5,885 ---------------------------------------- November 4,219 ---------------------------------------- December 4,755 ---------------------------------------- January 2008 4,388 ---------------------------------------- February 4,130 ---------------------------------------- March 3,931 ---------------------------------------- April 3,620 ----------------------------------------
Once again, the County conceded that as of the appraisal date (April 1, 2007), part if not all production from this lease was flush production. Until the motion for reconsideration, EOG does not appear to challenge the production rate, but that motion clearly suggested that the production merited an adjustment for flush production. As in the case of the Hatcher oil lease, the principal dispute at COTA's hearing was not the annual production rate but the decline, with the County assuming a 30% decline and EOG contending the apparent decline was 45%.
COTA rejected EOG's contended decline rate, noting that the PVD Appraisal Guide instructs that the "appraiser should use an assumed 30% decline rate for new wells ... unless an actual rate can be established with supporting documentation." COTA concluded that "a reasonable amount of time had not passed to establish a normalized decline," thus finding appropriate the assumed 30% decline rate.
Again, we respectfully disagree with COTA's application of the law to the facts presented. First, based on Bankoff's mandate to consider postvaluation date production data, we conclude that the production data through March 31, 2007, "is relevant to a determination of the property's future productivity and earning potential." See 265 Kan. at 542, 960 P.2d 1279. Thus, for the first 131 days of production, 87,390 Mcf of gas were produced, and the annualization of this production yields 211,241 Mcf. Second, given the Supreme Court's explanation that the statutory reduction should apply to the
Here, the factual contentions were not unlike those for the 2007 tax year, except EOG contended the apparent decline rate was 50% based on back-to-back quarter comparisons and the "Aries" computer model. COTA rejected this contention, again quoting the PVD Appraisal Guide, but also stating:
As to production rate, we note that the County conceded that flush production was evident thru May 2007. Disregarding such production, a realistic production rate can be calculated by annualizing actual production through the balance of the year, June through December, a total of 43,103 Mcf, for an annualized rate of 73,175 Mcf.
As to decline rate, we must first address COTA's "interesting question" as to the viability of comparing back-to-back quarters in determining the decline of gas production. We see no reason this is not just as valid for gas as it is for oil. The statutory framework for the appraisal of oil and gas leases makes no distinction between oil and gas production, and the gas section of the PVD Appraisal Guide often incorporates or refers to the parallel provisions in the oil section. Back-to-back quarter comparisons provide a valuable vehicle to determining annual decline rate for either type of production, especially where there is substantial distortion in actual data due to flush production.
Analyzing quarterly data, we note that there is actual production data here after the conceded flush production to compare three back-to-back quarters. Comparing quarter three to quarter four of 2007, the quarterly decline rate is 25%, and comparing quarter 4 of 2007 to quarter 1 of 2008, the quarterly decline is 16%, both of which indicate an annual decline rate in excess of 50%. We
We fear that in rejecting a more realistic decline rate for 2008, COTA may have been influenced by the testimony of the Seward County Appraiser, who testified that the assumed decline rate of 30% was corroborated by her calculation of decline after the flush production was no longer apparent. Unfortunately, her calculation used a comparison of an annualized 6-month period in 2007 and compared it to an annualized 3-month period in early 2008. This same mathematically flawed approach was also employed by this appraiser in the Helmerich case, where it was expressly criticized and rejected by this court. 34 Kan.App.2d at 64, 115 P.3d 149.
COTA's Order contains no lease-specific discussion of each of the remaining gas leases involved here, but it notes that "[EOG] made similar arguments and presented similar documents and testimony regarding each lease." By attachments to the Order, however, COTA derived the lease-specific valuation on all properties involved, and it is apparent that the assumed decline rate of 30% was applied to all. Annual production was not contested until the motion for reconsideration, but—as noted above—that motion was denied without further discussion.
We similarly decline to discuss each of the remaining leases other than to say that our rationale and conclusions applicable to the Hatcher 8# 1 and McQuillen 19# 1 are equally applicable to the remaining leases. Thus, the valuation determined by COTA for each such lease for each respective tax year is reversed and vacated, and the entire case is remanded to COTA for precise determination of values in a manner not inconsistent with this opinion.
In summary, we have held that where initial production on an oil or gas well is established after July 1 of the year prior to valuation and reflects several months of flush production, (1) annualization of all available actual production data prior to April 1 of the tax year is required to determine the production rate; (2) the 40% reduction mandated by K.S.A. 2010 Supp. 79-331(b) must be applied to that annualization; (3) the decline rate should not be assumed if there is available data demonstrating a decline that exceeds the assumed rate; (4) back-to-back quarterly comparisons of actual production are permissible for both oil and gas wells, and (5) such quarterly comparisons provide reliable information to calculate the annual rate where flush production no longer distorts any monthly production amount used in the calculations.
We have reversed COTA's valuation determinations for all properties and all respective tax years framed by this appeal, concluding that (1) COTA erroneously interpreted or applied the law in failing to recognize the pernicious influence of flush production on the production and decline rates employed in its final valuation determinations and in failing to consider all data available as of the appraisal date; (2) COTA failed to follow prescribed procedures in endorsing assumption of decline rates that were facially erroneous considering all available data; and (3) COTA's final valuation determinations were unreasonable in utilizing overstated production rates and understated decline rates. See K.S.A. 2010 Supp. 77-621(c)(4), (5), and (8).
We recognize that aspects of our holdings herein may not square with the most recent 2011 edition of the PVD Appraisal Guide. To the extent of any variance, we have relied exclusively on statutory factors and procedures, and any statement or direction in the PVD Appraisal Guide that is inconsistent with our opinion is erroneous as a matter of law. See Garvey Grain, Inc. v. MacDonald, 203 Kan. 1, 12, 453 P.2d 59 (1969).
We remand to COTA with directions to recalculate all valuation determinations in this case in a manner not inconsistent with
Reversed and remanded with directions.
