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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