Big Win for Gas Companies in Pennsylvania Marcellus Shale Royalties Case

April 2, 2010

On March 24, 2010, the Pennsylvania Supreme Court issued a decision that is seen as a big success (and a big relief) for oil and gas companies involved in Marcellus Shale and other natural gas and coalbed methane exploration and production within the Commonwealth.

After exercising its extraordinary jurisdiction (also known as King’s Bench jurisdiction or King’s Bench power) in order to hear the case, the Pennsylvania Supreme Court held that Pennsylvania’s Guaranteed Minimum Royalty Act, 58 P.S. § 33, which governs, inter alia, post-Sept. 18, 1979, oil and gas leases between landowners and gas companies, including leases for Marcellus Shale production, permits the calculation of royalties at the wellhead by the net-back method in natural gas leases. Kilmer v. Elexco Land Svcs., No. 63 MAP 2009. The bottom line is that oil and gas lessees in the Commonwealth may calculate the royalties as 1/8 of the sale price of the gas after deduction of 1/8 of the post-production costs of bringing the gas to market.

The Supreme Court decision upheld the validity of many thousands of leases that have already been signed within the Commonwealth that specifically authorized the lessee to pay a royalty of 1/8 after the deduction for post-production costs. An opposite conclusion by the court would have been “catastrophic” according to counsel for the gas companies that were parties to the case. The decision also effectively ratified a common method of royalty calculation that has been in continuous use for decades.

The Pennsylvania Supreme Court, which affirmed the trial court’s earlier grant of summary judgment to the gas companies, relied on the rules of statutory interpretation in making its determination and credited the industry’s argument that the Guaranteed Minimum Royalty Act should be read in historical context (i.e., it was enacted at a time when the industry was still regulated and when producers sold raw gas to regulated buyers).

Basically, the net-back method (or work-back method) is a method for calculating the market value of natural gas “at the wellhead” by recognizing a deduction for post-production costs such as transportation, processing, or manufacturing costs to get the gas to market. The plaintiffs were early stage Marcellus Shale lessors who had granted leases with then-standard 1/8 royalty provisions, and who received little signing bonus. These lessors were disappointed when subsequent lessors received thousands of dollars pre acre as a Marcellus Shale signing bonus. The plaintiffs filed the complaint as a means to invalidate their leases in the hope that they could re-lease their Marcellus Shale property, and receive a higher royalty and a mature market signing bonus.

The court’s unanimous opinion resolved dozens of cases that had been pending in state and federal courts, which challenged the validity of natural gas leases signed during early Marcellus Shale exploration in the Commonwealth. The lease in question in the case specifically authorized the lessee to deduct 1/8 of the post-production costs from the lessor’s royalty. Although the decision does not specifically address the leases which are silent on whether post-production costs may be deducted, the court’s ruling should apply with equal force to any oil and gas lease that authorizes payment of the lessor’s royalty “at the wellhead.”

Additionally, although not specifically addressed by the decision, it also can be read as extending to 58 P.S. § 34 which requires the payment of a 1/8 royalty for (i) any existing well first drilled on leases that did not require payment of a 1/8 royalty (Pre-Act Leases), but which are reworked, deepened or stimulated after Sept. 18, 1979, and (ii) new wells drilled on Pre-Act Leases after Sept. 18, 1979.