Oil and Gas: PA Supreme Court Holds Lease Language is Consistent with Statutory 1/8 Royalty Requirement.

Posted By Cliff Tuttle | March 25, 2010

SUMMARY: PA Supreme Court in Kilmer v. Elexco Land Services, Inc. holds that the “net-back method” of calculating the value of gas at the wellhead (as opposed to the downstream point of sale) is consistent with the Statute requiring payment of a minimum 1/8 royalty to the landowner.

The operation of the Marcellus Shale in Western Pennsylvania has resulted in unheard-of royalties and bonuses being paid to landowners. Using modern hydrofracturing techniques and directional drilling, Marcellus wells can greatly out-produce traditional shallow wells in the same field.

One unanticipated consequence of the Marcellus boom is that landowners who had leased oil and gas (without limitation) to operators of shallow wells in fields where Marcellus plays are now happening started looking for ways to terminate their existing leases.  One popular argument was that the old leases violated the Pennsylvania Guaranteed Minimum Royalty Act (“GMRA”) 58 P.S. § 33. The Supreme Court expedited the appeal of the Kilmer case from the Superior Court because there were 70 common pleas cases on hold, waiting for a decision.

According to the Plaintiff-appellants, the “net-back method” of calculation used to determine value of gas at the wellhead, embodied in the lease at issue and many others, violates the GMRA.  This calculation involves subtracting from the final sales price at the point of sale all of the costs paid for transportation of the gas to the point of sale by pipeline and processing of the raw gas to commercial standards.  According to the Plaintiff-Appellants, the lease calls for payment based upon the “sales price”  and by calculating 1/8 royalties on an amount less than the actual sales price of the gas, the Defendant-appellees are violating the minimum royalty requirements of the GMRA.

The lease between Kilmer et al and Elexco Land Services stated:

“For all Oil and Gas Substances that are produced and sold from the leased premises, Lessor shall receive as its royalty one eighth (1/8th) of the sales proceeds actually received by Lessee from the sale of such production, less this same percentage share of all Post Production Costs, as defined below, and this same percentage share of all production, severance and ad valorem taxes. As used in this provision, Post Production Costs shall mean (i) all losses of produced volumes (whether by use as fuel, line loss, flaring, venting or otherwise) and (ii) all costs actually incurred byLessee from and after the wellhead to the point of sale, including, without limitation, all gathering, dehydration, compression, treatment, processing, marketing and transportation costs incurred in connection with the sale of such production. For royalty calculation purposes, Lessee shall never be required to adjust the sales proceeds to account for the purchaser’s costs or charges downstream from the point of sale.”

This language, said the Plaintiff-appellants, violated the statutory language, since the GMRA did not recognize deductions from the sales price:

“§ 33. Guarantee of minimum royalties. A lease or other such agreement conveying the right to remove or recover oil, natural gas or gas of any other designation from lessor to lessee shall not be valid if such lease does not guarantee the lessor at least one-eighth royalty of all oil, natural gas or gas of other designations removed or recovered from the subject real property.”

After a lengthy recital of the arguments presented under a variety of theories by both sides, the Court noted that at the time the GRMA was adopted in 1979, it was the practice to sell gas to the pipeline owner at the wellhead.  In the 1980’s the federal government required the pipeline companies to grant access to the producers, in effect providing common carrier services of the producer’s gas to market. A small number of states, Colorado, Oklahoma, Kansas and West Virginia have held that the lessee is responsible under the lease for all production expenses until the product arrives at market.  (“First Marketable Product Doctrine”) The Plaintiff-appellants argued that because Pennsylvania had  long held that the lessee has an implied duty to market gas production for the benefit of both parties, the First Marketable Production Doctrine was a natural corollary. See: Iams v. Carnegie Natural Gas, Co., 45 A.2d 54 (Pa. 1899). However, the Court pointed out that the Iams case said nothing about calculation of royalty.  On the contrary, interpretation of the statute, not caselaw, would determine the rule in Pennsylvania. Did the legislature intend that the minimum royalty be calculated free of costs and expenses incurred between the wellhead and the downline point of sale?

Jusice Baer held that the Pennsylvania legislature had not intended such an outcome:

“In 1979, the legislature was not faced with a choice of whether the calculation should be made at the wellhead or the point of sale because they were one and the same. Therefore, we can assume that the General Assembly intended both parties’ interpretation: that the royalty should be calculated at the wellhead and at the point of sale.”

CLT

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CLIFF TUTTLE has been a Pennsylvania lawyer for over 45 years and (inter alia) is a real estate litigator and legal writer. The posts in this blog are intended to provide general information about legal topics of interest to lawyers and consumers with a Pittsburgh and Western Pennsylvania focus. However, this information does not constitute legal advice and there is no lawyer-client relationship created when you read this blog. You are encouraged to leave comments but be aware that posted comments can be read by others. If you wish to contact me in privacy, please use the Contact Form located immediately below this message. I will reply promptly and in strict confidence.

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