Archive for the 'Leasing and Surface Rights' Category

Federal Court Declines to Extend Pennsylvania Leases, by Megan King, Esq, Saul Ewing LLP

            In a March 8, 2011 opinion, the United States District Court for the Middle District of Pennsylvania held that a gas production company was not entitled to an equitable ruling extending the terms of leases for the same period of time that production under the leases was delayed pending resolution of challenges to the leases.  In Lauchle v. Keeton Group, LLC, — F. Supp. 2d —, 2011 WL782024 (M.D.Pa. March 8, 2011), the Plaintiffs/Lessors (landowners) had challenged the validity of gas leases that they had entered into with Defendants/Lessees (gas production companies), arguing noncompliance with the Guaranteed Minimum Royalty Act, 58 P.S. § 33 (“GMRA”).  On October 6, 2010, the District Court issued a Memorandum and Order granting Defendants’ Motion to Dismiss and upholding the leases as valid under the GMRA.  The Defendants then asked the Court to equitably extend the leases to account for the period of time during which the Plaintiffs contested the leases with the Court.

 

            Each lease had a primary term of five years and, if the lessees were producing oil or gas in paying quantities at the end of the five year term, the leases would automatically extend for as long as production continued.  After the Plaintiffs filed the actions to seek a determination of whether the leases were valid under the GMRA, the Defendants voluntarily ceased development and drilling on the Plaintiffs’ properties.  The Defendants argued that the declaratory judgment actions initiated by the Plaintiffs created such uncertainty about the validity of the leases that the Defendants were forced to forego operations on the Plaintiffs’ properties and were thereby deprived of the benefits of the leases’ full terms.  Plaintiffs argument was two fold: (i) the declaratory judgment actions did not prevent the Defendants from conducting drilling operations on the Plaintiffs’ properties during the pendency of those actions; and (ii) it was inequitable to require Plaintiffs to extend the leases merely because the Defendants decided to voluntarily forego operations in the face of litigation over leases that the Defendants themselves had drafted.

 

            The District Court, relying on the Pennsylvania Superior Court decision in Derrickheim Company v. Brown, 305 Pa. Super. 173 (Pa. Super. 1982), found that the Plaintiffs did not repudiate their leases by filing the declaratory judgment action.  The District Court further found that “oil companies … wield significant, if not exclusive, power in the drafting of oil and gas leases” and “a determination that Plaintiffs had repudiated their leases via the filing of [the declaratory judgment actions] further tips the balance of power in favor of the oil companies” and that such would “likely dissuade lessors from bringing potentially meritorious actions.”  Lauchle at *4.  The District Court further went on to say “deeming these leases to have been repudiated under the circumstances of this case is both bad law and even worse public policy, and we decline to accept [Defendants’] invitation to so penalize Plaintiffs.”  Id at *4.

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Cabot Oil & Gas Corp. v Jordan (2010)

Case summary by Ross Bruch, Esquire, Saul Ewing LLP

Cabot Oil & Gas Corp. v Jordan, 698 F. Supp. 2d 474 (M.D. Pa., Feb. 12, 2010) (Conaboy, J.)

 

Summary: Due to a conflict in Pennsylvania law, the United States Court for the Middle District of Pennsylvania refused to consider a declaratory judgment to resolve a dispute between an operator and a landowner over alleged deficiencies in an oil and gas lease and in negotiations.

 

            In November of 2009, Cabot Oil & Gas Corporation (“Cabot”) filed a claim seeking a declaratory judgment with the United States District Court for the Middle District of Pennsylvania following an oil and gas lease dispute between Cabot and Carol Manning Jordan, a Susquehanna County, Pennsylvania landowner.  Ms. Jordan claimed her lease with Cabot was invalid because (1) the individual who notarized the documents was an agent of Cabot whose fee was contingent on the Lease being entered into, (2) Cabot’s representatives made false representations to Ms. Jordan which induced her to enter into the agreement, and (3) the lease’s bonus payment was not timely and was not in the proper amount.  Ms. Cabot conceded that the notarization was not invalid; therefore the false representation and bonus payment issues went before the court.

 

            Ms. Jordan claimed that Cabot stated it would not pay any more than a 1/8th royalty to Susquehanna County landowners, that no landowner would be offered more than $500 per acre signing bonus, and that if Ms. Jordan did not enter into the lease, the gas under her property could be captured and removed via activity on neighboring properties.  Cabot assumed these arguments to be true for the purposes of argument and asserted they do not render the lease invalid for two reasons.  First, Cabot claims, any evidence of the alleged misrepresentations are barred by the parol evidence rule and the integration clause contained in the lease documents.  Second, the alleged statement regarding the “rule of “capture” would not have been misrepresentation under Pennsylvania law.

 

            The court declined jurisdiction over this declaratory judgment action.  In doing so, the Court refused to engage in discussions of Pennsylvania law on the parol evidence rule, the integration clause contained in the lease documents, and the rule of capture because it found the applicable law to be unclear and unsettled.  The court  held that “any decision about corporate practices and/or landowner responsibility has potential broad impact on the matters of state law presented and the state courts should make such vital determinations.”  Cabot Oil & Gas Corp. v Jordan, 698 F. Supp. 2d at 479.

 

            The court noted that federal district courts have discretion to determine when they will entertain an action under the Declaratory Judgment Act, “even when the suit otherwise satisfies subject matter jurisdiction prerequisites.”  Id. at 476.  One of the bases for denying jurisdiction is when a matter comes before the court that must be decided under state law and “when the state law involved is close or unsettled.”  At 476, quoting State Auto Ins. Co., v. Summy, 234 F.3d 131, 135 (3d Cir. 2001).  In this instance the court found that there are “important issues raised in this action [that] are matters which have not been settled under Pennsylvania law.”  Cabot Oil & Gas Corp. v Jordan, 698 F. Supp. 2d at 476.  The court found that “[w]hile Pennsylvania courts have extensively discussed the operation of the parol evidence rule related to such claims, their pronouncements on the matter are far from clear.”  Id.

 

            The court examined a number of cases dealing with fraud in the inducement and the parol evidence rule.  It found instances where the Pennsylvania Supreme Court ignored its own precedent (citing Berger v. Pittsburgh Auto Equip. Co., 387 Pa. 61, 127 A.2d 334 (1956)) and instances where Pennsylvania courts cited one Supreme Court determination discussing the parol evidence rule but not the other.  More recently, the court found that the Pennsylvania Supreme Court “provides some clarification of the apparent conflict.”  Cabot Oil & Gas Corp. v Jordan, 698 F. Supp. 2d at 477.  This clarification, however “does not resolve the question of whether claims of fraudulent inducement based on misrepresentation not related to subjects specifically addressed in the written contract are barred by the parol evidence rule.”  Id.

 

Many Pennsylvania and Federal courts have examined the question of the applicability of the parol evidence rule and have found a way to issue a determination.  In this instance, however, the District Court was sending a message to the courts of Pennsylvania that there is substantial conflicting state authority regarding important issues like fraud in the inducement and the parol evidence.  The court’s ruling reinforces the fact that these conflicting Pennsylvania rulings need to be clarified by the state courts and not left to the Federal courts for a resolution.

 

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Pennsylvania Supreme Court Upholds Leases with Certain Net-Back Provisions

By Megan E. King, Esquire

Saul Ewing LLP

 

In the Kilmer case, the Supreme Court addressed, in extraordinary jurisdiction to speed the resolution of a pure legal question of first impression, whether the Guaranteed Minimum Royalty Act (“GMRA”), 58 P.S. 33 precludes parties from contracting to use the net-back method to determine the royalties payable under an oil or natural gas lease. 

 

The Court held that the GMRA should be read to permit the calculation of royalties at the wellhead, as provided by the net-back method in the lease and affirmed the trial court’s grant of summary judgment to the gas companies.

 

The GMRA governs leases between Pennsylvania landowners and gas companies seeking to drill natural gas wells into Pennsylvania‘s Marcellus Shale deposits.  It requires that “at least one-eighth of all oil, natural gas or gas of other designations removed or recovered from the subject real property” be guaranteed to the lessor.  However, it has been the practice in some Pennsylvania leases to calculate the royalties as “net back” or one-eighth of the sale price of the gas minus one-eighth of the post-production costs of bringing the gas to market.  Essentially the net-back method determines the value of the gas when it leaves the ground at the wellhead by deducting from the sales price the costs of getting the natural gas from the wellhead to market.

 

The landowner’s argument was that the net-back method of calculating royalties violates the GMRA.  The landowners argued that the calculation should be made at the point of sale rather than the wellhead because gas companies have an implied duty to market the natural gas.  Included in this is the inherent responsibility of the gas company to bear all the costs necessary to market the gas, including the post-production costs at issue in this case.

 

The landowners also argued that the legislature intended for the one-eighth royalty to be calculated at the point of sale because the Pennsylvania Oil and Gas Conservation Law, 58 P.S. 402 defined royalty owner as “any owner of an interest in oil or gas lease which entitles him to share in the production of the oil or gas under such lease or the proceeds therefrom without obligating him to pay any costs under such lease.  The landowners argued that, when read together, the GMRA and the Oil and Gas Conservation Law provide that the landowners are entitled to the payment of a one-eighth royalty without the deduction of any post-production costs.

 

The gas companies asserted that the landowners were trying to invalidate the lease in hopes of renegotiating, given the recent developments in the arena of the Marcellus Shale natural gas deposits and that the lease’s net-back calculation of royalties did not violate the GMRA.  The gas companies argued that the gas is removed from the ground at the well head and that nothing in the GMRA restricts the parties from contracting for a different point of measurement downstream of the wellhead so long as it provides at a minimum for a royalty of one-eighth at the point of removal – the wellhead.

 

The gas companies further argued that gas producers sell their product at various points downstream from the wellhead in various states of production and that the further downstream the sale, the higher the price.  Therefore, by deducting the expenses of production and transportation from the final sales price, the price for the unprocessed gas at the moment of removal is fairly calculated.  The lease did not involve post-production deductions from the royalty but, rather, calculations that enable a determination of the royalty at the time of removal.  The gas companies further argued that the lease’s net-back calculation of royalties recreates the allocations that existed at the time of enactment of the GMRA, before deregulation, when royalties were calculated based upon the price of the raw gas at the wellhead and not based on the price of the value-added gas at the destination point.

 

The gas companies rejected the landowner’s notion that Pennsylvania is a “First Marketable Product” jurisdiction and pointed out that the landowner’s argument would result in internal inconsistencies depending on whether the landowner takes the one-eighth share in-kind at the wellhead or takes the one-eighth share of the processed gas at the market.  Valuation of the gas at the wellhead standardizes the royalties consistent with the statutory language.  The gas companies’ argument, further, distinguished the Oil and Gas Conservation Law and the GMRA.

 

The Court took into account the state of the industry (regulated) at the time that the GMRA was enacted when all royalties to landowners were based on the sale of unprocessed gas from the producer to the pipeline companies at the wellhead.

 

The Court noted that royalty has been defined in the oil and gas industry as “the landowner’s share of production free of expenses of production” and that the “expenses of production” relate to the costs of drilling the well and getting the product to the surface but do not encompass the costs of getting the product from the wellhead to the point of sale as those costs are “post-production costs.”  Moreover generally, royalties are not payable from gross profit but from the net remaining after deduction of certain production and development costs.

 

The Court concluded that the General Assembly would not intend to create a situation where one landowner would receive a dramatically increased royalty where the product is valued at the point of sale when the neighbor who took the royalty in-kind would have a reduced royalty base on the wellhead value.  The Court was also wary of the fact that natural gas can be sold at different degrees of processing for different prices and at different prices based upon the proximity of the market to high demand cities and such would give one landowner dramatically different royalties than a neighbor’s whose gas is sold after it is fully processed.  Finally, the Court was unconvinced that gas companies would inflate their costs to drive down royalties paid as gas companies have a strong incentive to keep costs down as they are paying seven-eights of the costs.

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PENNSYLVANIA MINIMUM ROYALTY ACT LITIGATION

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 1/8th 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 1/8th minimum royalty should be resolved in Pennsylvania.  This could have a huge impact on many leases (those that provide the Lessor with the bare 1/8th 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 1/8th 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 1/8th 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.

    When the Supreme Court finally issues its ruling on the Minimum Royalty Act, it may have a profound effect on existing leases for Marcellus gas as well as other oil and gas interests.  A strong possibility exists that the Supreme Court will issue a ruling to preserve the status quo, which will have no impact on existing Marcellus gas leases.  Any interpretation that production and other costs may not be deducted from a 1/8th minimum royalty, however, will have an impact on literally thousands of Marcellus and other leases.  This will require both lessors and lessees to revisit all of their 1/8th minimum royalty Marcellus (and other oil and gas) leases to make sure they are in compliance with the Court’s requirements.  Stay tuned.

 

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House Committee Considering Expansive Surface Owner’s Protection Act

On March 31st the Pennsylvania House Committee on Environmental Resources and Energy began consideration of an expansive piece of legislation imposing new requirements on gas drilling operators in relation to the rights of land surface owners.  The Bill proposes:

  • prior notice to surface owners prior to entry upon land for certain pre-drilling activities, 
  • notice to surface owners within one half mile of a proposed well prior to submission of a Well Permit application, 
  • plan and notice content requirements,
  • a mandatory offer to enter into a “surface use and compensation agreement”,
  • required contents of a surface use and compensation agreement,
  • a definition of required compensation to surface owners,
  • provisions for enforcing compensation obligations, 
  • a requirement to post security for compensation,
  • obligations for the restoration or replacement of polluted water supplies and a presumption of operator responsibility for pollution of water supplies within 2,500 feet of a well occuring within six months after completion of drilling or alteration,
  • a provision for recovery of attorneys fees and for treble damages in certain instances of failure to comply with the Act.

The PaDEP would be prohibited from issuing a Well Permit or renewing an existing permit if the operator is not in compliance with with the Act, placing DEP squarely into a role of protecting surface owner rights established by the bill, if enacted.

The full text of HB1155 can be viewed by clicking here.

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