The Pennsylvania Supreme Court in an expedited case last week rejected an attempt by Marcellus Shale landowners to receive higher royalty payments from natural gas operators.

The court, in a unanimous opinion, upheld the validity of the original leases signed by property owners, who had claimed the transactions violated state law (J-78-2009, Supreme Court of Pennsylvania, Middle District, on appeal from the Order of the Susquehanna County Court of Common Pleas, Civil Division, No. 2008-57, in Herbert Kilmer, Elsie Kilmer, Jacqueline Frantz, Jeffrey Kilmer, Diane Kilmer, Kenneth Kilmer and Thomas Kilmer vs. Elexco Land Services Inc. and Southwestern Energy Production Co.).

“The court could have invalidated tens of thousands of leases,” said attorney David R. Fine, who represented Elexco and Southwestern Energy. “It would have been catastrophic, really.”

Attorney Patricia Proctor of Steptoe & Johnson PLLC noted that the state’s high court granted the gas companies’ motion to exercise extraordinary jurisdiction and immediately issue a definitive interpretation of the Pennsylvania statute.

“Among other things, the mineral owners argued that the standard dictionary definition of ‘royalty’ should be applied to define the term, not the meaning of royalty as understood in the oil and gas industry (which contemplates calculation based on the value of gas at the wellhead),” Proctor noted. “They further contended that a century-old case placing an ‘implied duty to market’ upon gas companies requires Pennsylvania to adopt the ‘first marketable product doctrine’ and impose on the gas companies all expenses necessary to get the gas to the point of sale.”

The gas companies, however, said “measuring the value of gas at the wellhead effectively standardizes royalties; to do otherwise would result in different royalties being paid depending on whether a mineral owner took the one-eighth share-in-kind at the wellhead or one-eighth of the proceeds of the more valuable processed gas downstream at the point of sale,” said Proctor.

Justice Max Baer wrote the court’s opinion, which resolved more than 70 cases pending in state and federal courts in Pennsylvania that challenged the leases signed in the early stages of Marcellus exploration. The landowners then received smaller payments compared with some of the more recent lucrative agreements.

The plaintiffs had argued that the original leases violated Pennsylvania’s 1979 royalty law, which provides that landowners receive at least one-eighth shares of natural gas recovered from their properties. They had claimed that the energy industry’s practice to charge landowners for a share of the post-production costs had reduced their royalty payments below the state minimum.

However, the state’s high court agreed with the operators that the netback method to calculate royalties did not violate Pennsylvania law.

Baer noted that the “critical term ‘royalty’ is not defined by the statute” as it is used in the Pennsylvania’s Guaranteed Minimum Royalty Act (GMRA), but “many leases in the Commonwealth, including the lease at issue before this Court, calculate the royalties as one-eighth of the sale price of the gas minus one-eighth of the post-production costs of bringing the gas to market.

“This calculation is called the ‘netback method,’ as its goal is to determine the value of the gas when it leaves the ground (hereinafter ‘at the wellhead’) by deducting from the sales price the costs of getting the natural gas from the wellhead to the market. The landowners in this case filed for declaratory judgment seeking to void their leases, arguing that the netback method of calculating royalties violates the GMRA. The trial court rejected this argument and granted summary judgment to the gas companies.”

Proctor noted in her summary that “the court found it ‘not surprising’ that the GMRA did not specifically use such terms as ‘at the wellhead,’ ‘post production costs’ or ‘point of sale’ because in 1979 ‘virtually all royalties to landowners were based on the sale of unprocessed gas from the producer to the pipeline companies at the wellhead…Given the current state of the industry where the wellhead and the point of sale are not the same,’ the court looked to Pennsylvania law on statutory construction, which, it held, required it to adopt the industry’s definition of ‘royalty’ providing for calculation at the wellhead.”

The high court, said Proctor, “also credited the gas companies’ argument that the legislature would not have intended to create a situation where one royalty owner would receive a ‘dramatically different’ royalty depending on whether the product was valued at the point of sale as opposed to when it was taken in kind at the wellhead. The court recognized that gas companies have a ‘strong incentive’ to keep post-production expenses low, as they bear seven-eighths of those costs…”

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