Marcellus Shale Watch

By:  Joel R. Burcat, Esquire, Saul Ewing LLP, Harrisburg, PA

The hottest legal issue right now affecting Marcellus gas exploration is Pennsylvania’s Minimum Royalty Act litigation.  This is the subject of numerous cases that have been filed in state and Federal courts, several judicial opinions and, most importantly, one case pending before the Pennsylvania Supreme Court.  The 1/8^th minimum royalty provision has been ruled upon by a number of state and Federal Courts.  More importantly, the Pennsylvania Supreme Court has a case before it that is ripe for a determination.  When that case is decided, we believe the question of whether certain costs may be deducted from the 1/8^th minimum royalty should be resolved in Pennsylvania.  This could have a huge impact on many leases (those that provide the Lessor with the bare 1/8^th royalty) as the law seems to imply that if the Act’s provision is violated the lease is invalidated.  Many landowners and exploration companies are anxiously awaiting the ruling of the Supreme Court.

Pennsylvania’s minimum Royalty Act provision provides as follows:

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 or natural gas recovered or removed.

58 P.S. § 33.

Pennsylvania and Federal Courts have gone in a variety of directions on whether or not the provision of the Minimum Royalty Act mandates that costs cannot be deducted from the 1/8^th royalty.

Case permitting the deduction:

Kilmer v. Elexco Land Servs., Inc., No. 2008-57 (Susquehanna Co. C.P., March 3, 2009), appeal granted, No. 63 MAP 2009 (Pa.).

In Kilmer, the Susquehanna County Court of Common Pleas ruled in favor of the gas company that had deducted the post-production costs from the royalty.  The court ruled that, “58 P.S. Sec. 33 does not preclude parties from contracting that ‘post-production’ costs be factored into the determination of the amount of royalty payable under and [sic] oil or gas lease.” 

Cases not allowing any deduction:

Kropa v. Cabot Oil & Gas Corp., 609 F. Supp.2d 372 (M.D. Pa. 2009).

Gas rights lessor brought action against lessee, alleging that he was fraudulently induced to enter into an oil and gas lease, and seeking a declaratory judgment that the lease was invalid.  Lessee moved to dismiss.  The court granted the motion in part and denied it in part.

The defendant paid a bonus of $25 per acre to the plaintiff for 521 acres, amounting to a total bonus payment of $1,275.  Plaintiff claimed the defendant’s representative told him, it would “never pay any more than $25 per acre so he better take the $25 per acre.”  After learning that others received more money, plaintiff sued seeking to void the contract claiming fraudulent inducement and also sought a declaration that the royalty provision, which pays 1/8^th less certain expenses, violates Pennsylvania law.

The court examined the integration clause of the lease but also examined three writings that were all a part of the contract at the time it was signed.  One did not contain an integration clause.  The court refused to dismiss that portion of the claim dealing with the statement that plaintiff would never be offered more than $25, since that part of the claim was not covered by an integration clause.  609 F. Supp.2d at 378.  The court did dismiss that part of the claim that there was fraud regarding the statements having to do with the amount of royalty, since that was covered by an integration clause.  Id.

As to the royalty issue, the court held that “a plain reading of 58 P.S.§ 33 guarantees one-eighth royalty and does not provide for the subtraction of any costs.”  Id. at 379.  This court disagreed with the holding of the Pennsylvania Court of Common Pleas in Kilmer.

Cases leaving the door open on the validity of the deduction:

Stone v. Elexco Land Servs., Inc., 2009 U.S. Dist. LEXIS 45897 (M.D. Pa. June 1, 2009).

Plaintiff landowners sought a declaration that the oil and gas lease the parties signed was invalid under Pennsylvania law because it did not provide a minimum royalty payment as required by statute.  Id. at *4.  The lease provided for a royalty of one-eighth of the amount realized from the sale of gas produced from the well, less one-eighth of the post-production costs and one-eighth of the taxes incurred on the gas.  Id. at *6.  Plaintiff argued that because the lease called for the subtraction of costs from the royalty, it did not comply with Pennsylvania law.  Id.

The court noted that “a plain reading” of the statute supported the Plaintiff’s position because it does not provide for subtraction of any costs.

Defendants argued that reduction of costs is standard in the industry and the court noted that the question would turn on how “royalty” should be interpreted.  Plaintiffs pointed to other jurisdictions’ definitions of “royalty” and to the “First Marketable Product Doctrine,” which provides that post-production costs should not be deducted from a royalty.  Id. at *10.  The court noted that Pennsylvania recognized this theory over 100 years ago, and that it is apparently still good law.  Id. 

The court declined to dismiss the case because two schools of thought exist as to what the term “royalty” means, id. at *12, and because the court would be required to look to materials outside of the pleadings to determine “industry practice,” which the court could not do at the motion to dismiss stage of the litigation, id. at *13. 

See also, Price v. Elexco Land Servs., Inc., 2009 WL 2045135 (M.D. Pa., July 9, 2009) (same result).

Pennsylvania Supreme Court Appeal:

Kilmer v. Elexco Land Servs., Inc., No. 63 MAP 2009 (Pa.).

On June 16, 2009, the Pennsylvania Supreme Court asserted its extraordinary jurisdiction to bypass the Superior Court and take a case directly from the Court of Common Pleas of Susquehanna County explicitly on the question of whether a lease violated the Minimum Royalty Act because post-production costs were to be deducted from the royalty.  The Court identified the question before it as:

Whether 58 P.S. § 33 precludes parties from contracting that post-production costs be factored into the determination of the amount of royalty payable under an oil or natural gas lease.”

Seven amicus curiae briefs were filed.  The case was argued before the Supreme Court on September 16, 2009.  No ruling has yet been handed down by the Court.  We expect that a ruling will be issued in the next several months.

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