royalty on sweet gas or sour gas? the supreme court...

273

ROYALTY ON SWEET GAS OR SOUR GAS? THE

SUPREME COURT OF PENNSYLVANIA‘S

INTERPRETATION OF THE GUARANTEED

MINIMUM ROYALTY ACT TO PERMIT GAS

COMPANIES TO DEDUCT POST-PRODUCTION

COSTS FROM ROYALTY PAYMENTS MADE TO

LANDOWNERS: KILMER V. ELEXCO LAND

SERVICES, INC.

Benjamin F. Hantz*

ENVIRONMENTAL LAW—GUARANTEED MINIMUM ROYALTY ACT—

ROYALTY—THE SUPREME COURT OF PENNSYLVANIA HELD THAT THE

GUARANTEED MINIMUM ROYALTY ACT DOES NOT PRECLUDE GAS

COMPANIES FROM CONTRACTING TO DEDUCT POST-PRODUCTION COSTS

FROM ROYALTY PAYMENTS MADE TO LANDOWNERS UNDER

PENNSYLVANIA OIL AND GAS LEASES.—KILMER V. ELEXCO LAND

SERVICES, INC., 990 A.2D 1147 (PA. 2010).

INTRODUCTION ....................................................................... 273

A. Kilmer v. Elexco Land Services, Inc. ................ 274

B. History ............................................................... 284

C. Analysis .............................................................. 286

CONCLUSION ........................................................................... 294

INTRODUCTION

The exponential growth in interest in Pennsylvania‘s Marcellus

Shale deposits caused many landowners to challenge the validity of

their leases under Pennsylvania‘s Guaranteed Minimum Royalty Act.1

The central issue in deciding whether the leases were valid was

whether gas companies were permitted to deduct certain post-

production costs from royalty payments made to landowners. By de-

ciding that such deductions are permissible, the Pennsylvania Su-

* J.D. Candidate Spring 2013, Duquesne University School of Law; B.A.,

Economics, University of Pittsburgh, 2006.

1. 58 PA.STAT. ANN. § 33 (West 1996).

274 Duquesne Business Law Journal Vol. 13:2

preme Court in Kilmer v. Elexco Land Services, Inc. validated the

challenged leases and quieted a litany of disputes.2

This case note reviews the Supreme Court of Pennsylvania‘s deci-

sion to permit the calculation of royalty in a way that benefits the oil

and gas industry. First, the case note presents the facts and procedural

history of Kilmer, including the various arguments made on behalf of

both sides and the Pennsylvania Supreme Court‘s decision. Second,

the case note examines the recent history of Marcellus Shale gas leas-

es in Pennsylvania and the history of the oil and gas industry and its

relevance to the Guaranteed Minimum Royalty Act. Third and final-

ly, the case note analyzes the Kilmer decision and examines how the

decision comports with the established framework of oil and gas ju-

risprudence.

A. Kilmer v. Elexco Land Services, Inc.

1. Facts and Procedural History

The validity of hundreds of Pennsylvania natural gas leases that

provide for the payment of royalties to owners of land under which sit

Marcellus Shale reserves were in jeopardy prior to the decision in this

case.3 Pennsylvania‘s Guaranteed Minimum Royalty Act

4 (the

―GMRA‖) requires that leases guarantee the landowner a minimum

one-eighth royalty of all gas recovered from the landowner‘s proper-

ty.5 The GMRA, however, does not define the term ―royalty‖ or spec-

ify how royalties should be calculated.6

Industry leases routinely provide for royalties to be calculated at

one of two points of production – ―at the point of sale‖ or ―at the

2. Kilmer v. Elexco Land Servs., Inc., 990 A.2d 1147 (Pa. 2010).

3. Kilmer, 990 A.2d at 1149.

4. 58 PA.STAT. ANN. § 33. The GMRA provides:

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, natural gas or gas of other designations removed or recovered from the

subject real property.

Id.

5. Kilmer, 990 A.2d at 1149 (quoting 58 PA. STAT. ANN. § 33). It should be

noted that the GMRA‘s, and thus Kilmer’s, application is not limited to royalties

payable under natural gas leases, but instead extends to royalties payable under oil

leases as well. Id. at 1158.

6. Id.

2011 Royalty on Sweet Gas or Sour Gas? 275

wellhead.‖7 In order to calculate royalty at the wellhead, the gas

company subtracts post-production costs, i.e., those costs incurred by

the gas company between the point when the gas reaches the wellhead

and the point of sale, from the sale price.8 This calculation is known

as the ―net-back method‖ and it results in the payment of royalties

which are lesser than if the royalty was calculated at the point of sale.9

In Kilmer, the October 15, 2007 lease (the ―Lease‖) between

Kilmer, et al.10

(the ―Landowners‖) and Elexco Land Services, Inc.,11

(the ―Gas Companies‖), along with many other leases within the

Commonwealth, contains a provision for calculating royalty at the

wellhead by using the net-back method.12

The Landowners argued

7. Id. at 1149, 1152.

8. Id. at 1149.

9. Id. See also 30 C.F.R. § 206.151 (2010) (defining the net-back method as ―a

method for calculating market value of gas at the lease‖).

Under this method, costs of transportation, processing, or manufacturing are

deducted from the proceeds received for the gas, residue gas or gas plant prod-

ucts, and any extracted, processed, or manufactured products, or from the val-

ue of the gas, residue gas or gas plant products, and any extracted, processed,

or manufactured products, at the first point of which reasonable values for any

such products may be determined by a sale pursuant to an arm‘s-length con-

tract or comparison to other sales of such products, to ascertain value at the

lease.

30 C.F.R. § 206.151.

10. Herbert Kilmer, Elsie Kilmer, Jacqueline Frantz, Jeffrey Kilmer, Diane

Kilmer, Kenneth Kilmer, and Thomas Kilmer. Kilmer, 990 A.2d at 1147.

11. See Brief of Appellees, Kilmer, 990 A.2d 1147 (No. 63 MAP 2009), 2009

WL 6346619, at *2 n.2. (explaining that Elexco Land Services, Inc. assigned its

rights in the Lease to Southwestern Energy Production Company).

12. Kilmer, 990 A.2d at 1150. The Lease provides:

Lessor shall receive as its royalty one eighth (1/8th) of the sales proceeds actu-

ally received by Lessee from the sale of such production, less this same per-

centage share of all Post Production Costs, as defined below, and this same

percentage of all production, severance and ad valorem taxes. As used in this

provision, Post Production Costs shall mean (i) all losses of produced volumes

(whether by use as fuel, line loss, flaring, venting or otherwise) and (ii) all

costs actually incurred by Lessee from and after the wellhead to the point of

sale, including, without limitation, all gathering, dehydration, compression,

treatment, processing, marketing and transportation costs incurred in connec-

tion with the sale of such production. For royalty calculation purposes, Lessee

shall never be required to adjust the sale proceeds to account for the purchas-

er‘s costs or charges downstream from the point of sale.

Id. See also id. at 1149 n.2 (stating that ―[i]n industry parlance, ‗production costs‘

refer to the expenses of getting gas to the point it exits the ground, and ‗post-


that the net-back method of calculating royalty, and thus the Lease,

violated the GMRA by failing to guarantee them royalties which are at

least one-eighth of the value of the natural gas removed from their

land.13

In January 2008, the Landowners filed a complaint in the Court of

Common Pleas of Susquehanna County seeking declaratory judgment

to invalidate the Lease.14

After both parties filed motions for sum-

mary judgment, the trial court granted summary judgment in favor of

the Gas Companies in March 2009, concluding that the GMRA did

not preclude the parties from using the net-back method in calculating

royalty.15

The Landowners timely appealed to the Superior Court of

Pennsylvania.16

The Gas Companies, however, filed a petition with

the Pennsylvania Supreme Court asking it to exercise extraordinary

jurisdiction to assume plenary jurisdiction17

over the case which pre-

sented a pure legal question of first impression.18

Ultimately, the

Pennsylvania Supreme Court granted the Gas Companies‘ petition in

order to hasten resolution of the question: does the GMRA preclude

parties from using the net-back method to calculate royalty under a

natural gas lease?19

production costs‘ refer to expenditures from when the gas exits the ground until it is

sold‖).

13. Id. at 1149-50.

14. Id. at 1150.

15. Id. at 1151. Specifically, the trial court ―held that the lease did not violate

the GMRA because ‗[t]he statute in question does not prohibit the inclusion of ‗post-

production‘ costs to calculate the one-eighth royalty. The parties are, therefore, free

to negotiate how that royalty shall be calculated, so long as the net result is not less

than one-eighth.‘‖ Id. (quoting Kilmer v. Elexco Land Servs., Inc., No. 2008-57, slip

op. at 6 (Susquehanna Co. C.P., March 3, 2009)).

16. Id. at 1151.

17. 42 PA. CONS. STAT. ANN. § 726 (West 2004). This statutory provision pro-

vides:

Notwithstanding any other provision of law, the Supreme Court may, on its

own motion or upon petition of any party, in any matter pending before any

court or magisterial district judge of this Commonwealth involving an issue of

immediate public importance, assume plenary jurisdiction of such matter at

any stage thereof and enter a final order or otherwise cause right and justice to

be done.

Id.

18. Kilmer, 990 A.2d at 1151.

19. Id.


2. Arguments Presented

The Landowners argued that the Lease, which calculates royalty at

the wellhead instead of at the point of sale violated the GMRA by

guaranteeing them royalties less than one-eighth of the value of the

natural gas removed from their land.20

The Gas Companies, to the

contrary, argued that the Lease did not violate the GMRA and that the

Landowners were merely attempting to find a way to invalidate the

Lease in hopes of renegotiating its terms to exploit industry-wide ex-

pansion of drilling natural gas wells into Pennsylvania‘s Marcellus

Shale reserves.21

a. Arguments Concerning the Plain Language of the GMRA

The Landowners argued that the plain language of the GMRA

simply does not provide for use of the net-back method to calculate

royalty, and therefore, the Gas Companies violated the GMRA by us-

ing it, i.e., by subtracting post-production costs from the final sale

price.22

The Gas Companies countered by contending that the perti-

nent language of the GMRA is the phrase ―removed or recovered.‖23

They argued that natural gas cannot be ―removed or recovered‖ at any

point after it exits the ground, and therefore, the GMRA must have

intended for royalty to be calculated at the wellhead.24

Additionally,

the Gas Companies argued that the GMRA does not restrict parties

from contracting to use different methods to calculate royalty, so long

as the contracted-for method guarantees at least one-eighth royalty.25

b. Arguments Concerning In-Kind and In-Money Royalty

There are two basic ways for a gas company to pay royalties to a

landowner – either as a portion of the actual product (―in-kind‖) or as

a monetary payment (―in-money‖).26

20. Id. at 1150-53.

21. Id. at 1154-56.

22. Id. at 1151.

23. Kilmer, 990 A.2d at 1154. Specifically, the GMRA provides that a landown-

er shall receive ―at least one-eighth royalty of all oil, natural gas or gas of other

designations removed or recovered from the subject real property.‖ 58 PA. STAT.

ANN. § 33 (emphasis added).

24. Kilmer, 990 A.2d at 1154.

25. Id.

26. Id.


The Gas Companies, while acknowledging its impracticability, ar-

gued that it is possible for a landowner to take royalties in-kind.27

Choosing this alterative would require the landowner, to turn the raw

gas into a marketable product, to incur expensive post-production

costs.28

Accordingly, the Legislature could not possibly have intended

for landowners to receive different total royalties depending on

whether they chose to receive royalties in-kind or in-money.29

To

avoid such a conundrum and to remain consistent with the language of

the GMRA, the Gas Companies use the net-back method to standard-

ize royalty payments.30

The Landowners contended that the term ―royalty‖ does not con-

template a portion of the actual product; only the monetary equivalent

thereof.31

In addition, because natural gas is not usable until it under-

goes post-production activities to render it marketable, they argued

that the idea of taking natural gas royalties in-kind is absurd.32

Thus,

following rules of statutory construction, the logical conclusion is that

the GMRA did not intend for royalties be taken in-kind.33

c. Arguments Concerning Pennsylvania Precedent

The Landowners next argued that the Pennsylvania Supreme

Court‘s adoption of the ―implied duty to market‖ more than a century

ago in Iams v. Carnegie Natural Gas Co. 34

formed the legal basis for

the First Marketable Product Doctrine.35

They claimed the First Mar-

ketable Product Doctrine provides that because the gas company has

an implied duty to market the natural gas, the gas company must bear

all of the costs necessary to get the extracted natural gas to the point

27. Id.

28. Id.

29. Kilmer, 990 A.2d at 1156.

30. Id.

31. Id. at 1154 n.12.

32. Id.

33. Id.

34. Kilmer, 990 A.2d at 1152. ―Under the implied duty to market theory, if suf-

ficient quantities of gas can be obtained to justify marketing the gas, then the . . . gas

company has ‗an obligation to operate for the common good of both parties.‘‖ Id.

(quoting Iams v. Carnegie Natural Gas Co., 45 A. 54, 55 (Pa. 1899)).

35. Id. at 1152. It should be noted that the Landowners acknowledged that Penn-

sylvania has not adopted the First Marketable Product Doctrine. Id.


of sale, i.e., the post-production costs.36

And given that Pennsylvania

common law had recognized the implied duty to market since 1899,

the Landowners contended the Pennsylvania Legislature was aware of

such duty when it enacted the GMRA in 1979.37

Therefore, it must be

assumed the Legislature intended the GMRA to reflect the implied

duty, thereby requiring gas companies to bear all of the costs neces-

sary to get the extracted natural gas to the point of sale.38

The Gas Companies disagreed with the Landowners‘ contention

that the Pennsylvania Supreme Court‘s adoption of the implied duty to

market in Iams amounted to an adoption of the First Marketable Prod-

uct Doctrine.39

They contended that Iams did not address at what

point royalty should be calculated or which party should bear the post-

production costs.40

They interpreted Iamsto only impose upon a gas

company an implied duty to market natural gas if it could be extracted

in sufficient quantities.41

d. Arguments Concerning the Legislative History of the GMRA

The Landowners focused their legislative history argument on the

relatedness of the GMRA to the 1961 Pennsylvania Oil and Gas Con-

servation Law.4243

The Oil and Gas Conservation Law regulated the

drilling of natural gas wells more than 3,800 feet below the surface

and defined the term ―royalty owner‖44

but not the term ―royalty.‖

36. Id. The United States District Court for the Middle District of Pennsylvania

acknowledged that the Pennsylvania Supreme Court recognized the theory behind

the ―First Marketable Product Doctrine‖ in Iams, and that it is ―evidently still good

law.‖ Kropa v. Cabot Oil & Gas Corp., 609 F. Supp. 2d 372, 379-82 (M.D. Pa.

2009), reconsidered in part by, 716 F. Supp. 2d 375 (M.D. Pa. 2010). Accord Stone

v. Elexco Land Servs., Inc., No. 3:09cv264, slip op. at 2-4 (M.D. Pa. June 1, 2009).

37. Kilmer, 990 A.2d at 1152.

38. Id. See also infra Analysis of ―Royalty‖ and the First Marketable Product

Doctrine for further discussion of this issue.

39. Id. at 1155.

40. Id.

41. Id. at 1155-56.

42. 58 PA.STAT. ANN. § 402 (West 1996).

43. Kilmer, 990 A.2d at 1154. As the court pointed out, the Landowners

―[e]ssentially acknowledg[ed] that there is no legislative history regarding the

GMRA that is directly supportive of their claim.‖ Id.

44. Under the Oil and Gas Conservation Law, ―royalty owner‖ is defined 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 costs under such lease.‖ Id. (emphasis in original).


The Landowners argued that, because both statutes deal with natural

gas leases, they are inpari material.45,46

As such, the Landowners

would be entitled to one-eighth of all natural gas removed from the

land without obligating them to pay any costs under the Lease.47

The Gas Companies argued that the Landowners‘ contention that

the GMRA and the Oil and Gas Conservation Law are in parimateria

was erroneous.48

They argued that the subject matter of the two stat-

utes differs – the Oil and Gas Conservation Law established a regula-

tory program designed to prevent potentially wasteful development of

wells more than 3,800 feet below the surface (i.e., its purpose was not

to impose royalty requirements) while the GMRA established a par-

ticular requirement related to gas lease royalties.49

Moreover, the Gas

Companies noted that the Oil and Gas Conservation Law only defines

―royalty owner,‖ not ―royalty.‖50

And, they argued, ―royalty owner‖

was defined in the Oil and Gas Conservation Law to include as many

landowners/lessors as possible; it was not so defined as a way to ad-

dress the calculation of royalties.51

Additionally, the Gas Companies cited the little available legislative

history of the GMRA to support their position.52

They argued that,

45. See 1 PA. CONS. STAT. ANN. § 1932 (West 2008). See also BLACK‘S LAW

DICTIONARY 862 (9th ed. 2009) (defining in parimateria as ―in the same matter‖

and explaining that it ―is a canon of statutory construction that statutes that are in

parimateria may be construed together, so that inconsistencies in one statute may be

resolved by looking at another statute on the same subject‖).

46. Kilmer, 990 A.2d at 1153.

47. Id. (quoting Brief of Appellants at 7, Kilmer, 990 A.2d 1147 (No. 63 MAP

2009)).

48. Id. at 1156.

49. Id.

50. Id.

51. Kilmer, 990 A.2d at 1156.

52. As cited in the Brief of Appellees:

The Pennsylvania Senate passed Senate Bill 568 (which became the [GMRA])

on June 20, 1979, and sent it to the House of Representatives for final consid-

eration. The House considered the bill the following day. During the brief dis-

cussion on the floor of the House, Representative Thomas J. Murphy of Alle-

gheny County questioned Representative L. Eugene Smith of Jefferson Coun-

ty, the legislative sponsor of the bill in the House:

Mr. MURPHY. Mr. Speaker, my concern on this bill is that when you set 12

1/2 percent as the price you are going to pay, based on the wellhead price, that

very often the small farmer in signing with a gas company on that 12 1/2 per-

cent will be giving away a great deal more than he is getting. And let me ex-

plain how it can work: If a gas company comes to a farmer and asks to drill on


although the legislative history is rather sparse, what is available sup-

ports their position.53

e. Arguments Concerning Legislative Intent and Statutory Con-

struction

The Landowners argued that the GMRA is a remedial statute and,

as such, should be construed broadly to achieve its remedial pur-

pose.54

They claimed that because the GMRA is the only statute in

the country to provide for a minimum royalty to be paid to a landown-

er, it should be construed to prevent deception and exploitation of

landowners by gas companies.55

And the only way to achieve the goal

of preventing deception and exploitation, the Landowners claimed, is

to use the sale price of the natural gas as the base for calculating roy-

alty.56

By using the point of sale as the base for calculating royalty, as

opposed to using the value of the gas at the wellhead, royalty would

not be subjected to corporate manipulation and inflation of costs by

the Gas Companies.57

The Gas Companies did not refute the Landowners‘ claim regarding

the GMRA‘s remedial purpose. They instead focused their argument

on the technical meaning that ―royalty‖ has developed in the oil and

his property, the gas company will say, we will give you 12 1/2 percent of the

well-head price. Often the gas company then will contract that drilling out to a

drilling company -- we will say ABC Drilling Company -- ABC Drilling

Company will drill for the gas and then will sell it to BC Transmission Com-

pany, we will say. Those two companies determine the price of that gas. And

on the basis of that, the 12 1/2 percent that goes to the small farmer or the

landowner is set.

My concern is that that is not a fair way of determining the value of the gas,

particularly with the increases that have been taking place at the consumer lev-

els. I would much prefer to see the amount of money going back to the land-

holder be set on a percentage of the consumer price of gas. I do not think it is

a fair way of doing it, I think it leaves it open to some fraud and would vote

against it. Thank you.

Legislative Journal -- House, at 1373 (June 21, 1979) (remarks of Rep. Mur-

phy) (emphasis added).

Brief of Appellees at 31-32, Kilmer, 990 A.2d 1147 (No. 63 MAP 2009).

53. Id. at 31.

54. Kilmer, 990 A.2d at 1153.

55. Id.

56. Id.

57. Id.


gas industry.58

Because royalty was historically calculated at the

wellhead, the term ―royalty‖ means the value of the unprocessed gas

at the point of removal.59

Therefore, the Gas Companies argued, the

Legislature intended the one-eighth royalty provision of the GMRA to

mean one-eighth of the value of the unprocessed gas at the point of

removal, i.e., at the wellhead.60

Today, the net-back method is used to

recreate the situation that existed when the GMRA was enacted, when

royalty was calculated based on the value of the unprocessed gas at

the wellhead.61

3. The Supreme Court of Pennsylvania’s Opinion

The unanimous opinion of the Pennsylvania Supreme Court, deliv-

ered by Justice Max Baer, affirmed the decision of the trial court by

focusing on three arguments.62

First, Justice Baer discussed the rele-

vance and application of the Pennsylvania Statutory Construction

Act.63

He explained that technical words are to be construed accord-

ing to their technical meaning,64

and that the object of statutory inter-

58. Id. at 1155. The Court explained that prior to the 1980‘s, the producer ex-

plored for the gas, maintained the wells, and, when the gas came out of the well,

sold it to the pipeline company at the wellhead for a federally regulated price. Id.

The Court continued:

The pipeline company would then assume all the responsibilities of transform-

ing the raw product (sour gas) into marketable natural gas (sweet gas) and

transporting it to the market place, where the gas was sold . . . for a higher

price, given the value added in the process of transforming and transporting it

from sour to sweet gas. The producer, however, was paid a price for the natu-

ral product . . . at the wellhead, and royalties for the landowner were calculated

based on that ―at the wellhead‖ price.

Id. See also infra History of The Guaranteed Minimum Royalty Act for further

discussion of this issue.

59. Kilmer, 990 A.2d at 1155.

60. Id. The Gas Companies also noted ―that in 1979 almost all jurisdictions

presumed that royalties were calculated at the wellhead.‖ Id. at 1155.

61. Id. The Gas Companies ―argue that [the] Landowners‘ construction [of the

GMRA] would result in a substantial increase in the royalties paid to . . . landowners

without any indication that the legislature intended that result, or even foresaw the

dramatic changes from deregulation.‖ Id. at n.13.

62. Id. at 1156-59. Justice Baer also noted that ―[w]e are unconvinced by the

Landowner‘s argument regarding the Oil and Gas Conservation Law‘s definition of

‗royalty owner‘ because it does not define ‗royalty.‘‖ Id. at 1158 n.15.

63. Id. at 1156-59.

64. 1 PA.CONS. STAT. ANN. § 1903(a) (West 2008). This section of the Statutory

Construction Act provides:


pretation is to ascertain the Legislature‘s intent behind enacting the

statute.65,66

With regard to the Legislature‘s intent, Justice Baer con-

cluded that, because in 1979 the price at the wellhead and the price at

the point of sale were the same, it could be assumed that both parties‘

interpretation of ―royalty‖ was correct.67

To accomplish the goal of

ascertaining whether the term ―royalty‖ had developed a technical

meaning in the oil and gas industry, and to determine what that mean-

ing was, Justice Baer undertook a review of various industry

sources.68

He concluded that ―royalty,‖ as that term is used in the oil

Words and phrases shall be construed according to rules of grammar and ac-

cording to their common and approved usage; but technical words and phrases

and such others as have acquired a peculiar and appropriate meaning or are de-

fined in this part, shall be construed according to such peculiar and appropriate

meaning or definition.

Id.

65. Id. § 1921(a). Section 1921 of the Statutory Construction Act provides:

(a) The object of all interpretation and construction of statutes is to ascertain

and effectuate the intention of the General Assembly. Every statute shall be

construed, if possible, to give effect to all its provisions.

(b) When the words of a statute are clear and free from all ambiguity, the letter

of it is not to be disregarded under the pretext of pursuing its spirit.

(c) When the words of the statute are not explicit, the intention of the General

Assembly may be ascertained by considering, among other matters:

(1) The occasion and necessity for the statute.

(2) The circumstances under which it was enacted.

(3) The mischief to be remedied.

(4) The object to be attained.

(5) The former law, if any, including other statutes upon the same or sim-

ilar subjects.

(6) The consequences of a particular interpretation.

(7) The contemporaneous legislative history.

(8) Legislative and administrative interpretations of such statute.

Id. § 1921.

66. Kilmer, 990 A.2d at 1156-57.

67. Id. at 1157. See infra History of The Guaranteed Minimum Royalty Act for a

discussion of this issue.

68. Kilmer, 990 A.2d at 1157-58. Justice Baer found that ―[t]he term royalty has

been defined in the oil and gas industry as ‗[t]he landowner‘s share of production,

free of expenses of production.‘‖ Id. at 1157 (quoting Howard R. Williams &

Charles J. Meyers, MANUAL OF OIL AND GAS TERMS § R (Patrick H. Martin &

Bruce M. Kramer eds., 2009)). He continued by stating that

[i]n the industry, as referenced above, 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 termed ―post-production costs.‖ ―Although the royalty


and gas industry, is subject to post-production costs, thus its calcula-

tion is based on net profits as opposed to gross profits.69

The Lease,

therefore, did not violate the GMRA by using the net-back method to

calculate royalty.70

Second, Justice Baer noted the importance of royalties being capa-

ble of being taken in-kind.71

He concluded the Legislature would not

have intended to create a situation whereby a landowner who chose to

receive royalties in-kind would receive a dramatically lesser royalty

compared with a landowner who chose to receive royalties in-money

based on the value of the gas at the point of sale.72

Third, Justice Baer discussed the Landowners‘ argument that royal-

ty should be calculated at the point of sale to avoid corporate manipu-

lation and inflation of costs by the Gas Companies.73

He found this

contention meritless because the Gas Companies have a strong incen-

tive to keep their post-production costs as low as possible since they

are responsible for paying seven-eighths of such costs, as opposed to

one-eighth paid by the Landowners.74

In addition, he noted that the

Landowners, if they suspect corporate wrongdoing, can seek a court

ordered accounting to determine such.75

B. History

1. Marcellus Shale Natural Gas Leases

is not subject to costs of production, usually it is subject to costs incurred after

production, e.g., production or gather taxes, costs of treatment of the product

to render it marketable, costs of transportation to market.‖

Id. (quoting Howard R. Williams & Charles J. Meyers, MANUAL OF OIL AND GAS

TERMS § R (Patrick H. Martin & Bruce M. Kramer eds., 2009)). Justice Baer pro-

ceeded to examine a second treatise which stated that, ―[w]hile a lease may make the

amount of the royalty dependent on the proceeds, generally the royalty is not paya-

ble from gross profit but from the net amount remaining after deduction of certain

production and development costs.‖ Id. at 1157-58 (quoting 17 WILLISTON ON

CONTRACTS § 50:60 (4th ed. 2009) (footnote omitted)).

69. Kilmer, 990 A.2d at 1157-58.

70. Id. at 1158.

71. Id.

72. Id.

73. Id. at 1159.

74. Kilmer, 990 A.2d at 1159.

75. Id.


Due to developments in recovery techniques over the past few

years, the Marcellus Formation76

has become increasingly economi-

cally accessible to gas companies.77

With the potential to recover

dramatically larger quantities of natural gas at lower costs, a greater

number of gas companies are vying for the right to drill across the

Commonwealth of Pennsylvania.78

Increased competition for drilling

rights has resulted in landowners receiving more lucrative lease terms

today than did their neighbors a few years ago.79

Feeling as though

they were not receiving an adequate portion of the revenues from the

gas being removed from their lands, hundreds of landowners sought to

invalidate their leases under the theory that their leases do not comply

with the GMRA.80

2. The Guaranteed Minimum Royalty Act

When the GMRA was enacted in 1979, essentially all royalties were

calculated at the wellhead, which, conveniently, was also the point of

sale.81

Until the late 1980‘s, there were essentially four groups of par-

ties involved in the natural gas industry: landowners, production

companies, pipeline companies, and distribution companies.82

The production company would enter into a lease with a landowner,

and would begin the process by extracting gas from the property.83

The gas, in its natural state, was then sold to the pipeline company at

the wellhead for a price set by the federal government.84

The pipeline

company would then transform the natural product85

into marketable

natural gas,86

assuming all of the costs associated therewith.87

There-

76. ―The Marcellus Formation is a region of natural gas-rich shale extending

from New York to West Virginia, including large portions of Pennsylvania.‖ Id. at

1150 (citing generally TIMOTHY CONSIDINE ET AL., AN EMERGING GIANT:

PROSPECTS AND ECONOMIC IMPACTS OF DEVELOPING THE MARCELLUS SHALE

NATURAL GAS PLAY (2009), http://www.alleghenyconference.org/PDFs/PELMisc/

PSUStudyMarcellusShale072409.pdf).

77. Kilmer, 990 A.2d at 1150.

78. Id.

79. Id.

80. Id.

81. Id. at 1157.

82. Kilmer, 990 A.2d at 1155.

83. Id.

84. Id.

85. The natural product is also referred to as ―sour gas.‖ Id.

86. The marketable natural gas is also referred to as ―sweet gas.‖ Id.


after, the pipeline company would sell the marketable natural gas to a

local distribution company at a higher price than it paid the production

company for the natural product.88

As noted above, the pipeline company would pay a federally regu-

lated price to the production company.89

Royalties to the landowner

were paid by the production company, not the pipeline company, and

were based on that federally regulated price.90

Therefore, regardless

of whether the landowner‘s royalties were based on the ―at the well-

head‖ price or on the ―at the point of sale‖ price, it was the same

amount.91

C. Analysis

1. The Effect of Kilmer on Pending Pennsylvania Litigation

Prior to Kilmer, the United States District Court for the Middle Dis-

trict of Pennsylvania was left to decide how the GMRA should be in-

terpreted and, specifically, how ―royalty‖ should be defined.92

During

that time, in Kropa and Stone, the district court refused to grant the

gas companies‘ motion to dismiss because, in its opinion, the term

―royalty‖ was subject to two meanings, and the gas companies failed

to show that ―royalty‖ should be defined in accordance with industry

parlance.93

87. Kilmer, 990 A.2d at 1155.

88. Id.

89. Id.

90. Id.

91. Id. This is the case because, as noted above, the landowner would enter a

lease with the production company, which added no value to the gas between the

extraction point, i.e., at the wellhead, and the point of sale to the pipeline company.

Id.

92. See Kropa, 609 F. Supp. 2d at 379-82. See also Stone, No. 3:09cv264, slip

op. at 2-4.

93. Kropa, 609 F. Supp. 2d at 381-82. The District Court in Kropa stated:

We will deny the defendant‘s motion to dismiss. Because two different

schools of thought exist with regard to the term ―royalty‖ we will not conclude

at this early stage in the litigation that the term is subject to a ―peculiar‖ mean-

ing under the rules of statutory construction. . . . It would be premature for the

court to dismiss the case at this point. Defendant has not established that the

term ―royalty‖ should be construed so as to allow for deduction of costs in the

lease and the plaintiff has not established that the term should not be so con-

strued. Although it claims that this is the ―industry practice‖ plaintiff has

pointed out that not all jurisdictions follow this practice. To make a final de-


However, after the Pennsylvania Supreme Court rendered its deci-

sion in Kilmer,94

the district court in Kropa, which had granted the gas

company‘s motion to stay proceedings until Kilmer was decided,95

rendered judgment in the gas company‘s favor on the ―royalty‖ issue,

finding the lease at issue valid under Pennsylvania law.96

Kilmer has had, and will continue to have, the same effect on nu-

merous cases pending in Pennsylvania state and federal courts.97

2. Royalty” and the First Marketable Product Doctrine

Although not analyzed in great detail in Justice Baer‘s opinion in

Kilmer,98

one of the Landowners‘ more important points of conten-

tion, the Pennsylvania Supreme Court‘s adoption of the implied duty

to market in Iams,99

and how that implied duty formed the basis of the

First Marketable Product Doctrine (―Doctrine‖), fails to withstand

close scrutiny.

The Landowners argued that the implied duty to market adopted in

Iams is the legal basis for the Doctrine, which requires the lessee un-

der a gas lease to pay all the costs necessary to get the raw gas to the

point of sale,100

i.e., to turn the unmarketable gas into a marketable

product.101

They argued it can be assumed the Pennsylvania Legisla-

ture was aware of the implied duty to market set forth in Iams when it

enacted the GMRA in 1979 and, therefore, intended the lessee to pay

all the costs necessary to get the raw gas to the point of sale.102

The

Landowners‘ argument, however, falls apart on many levels.

termination on this issue we have to examine documents outside of the plead-

ings, which we will not do on a motion to dismiss.

Id. See also Stone, No. 3:09cv264, slip op. at 2-4 (same analysis).

94. Kilmer, 990 A.2d 1147.

95. Kropa v. Cabot Oil & Gas Corp., 716 F. Supp. 2d 375, 378 (M.D. Pa. 2010).

It should be noted that Stone has yet to succumb to the same certain fate as Kropa.

96. Id. Specifically, the District Court stated, ―[t]here has been an intervening

clarification of the controlling law. The Pennsylvania Supreme Court has concluded

that a lease like that signed between the parties here is valid. Id.

97. See, e.g., Julia v. Elexco Land Servs., Inc., No. 3:09cv590, slip op. at 2-3

(M.D. Pa. May 11, 2010); Puza v. Elexco Land Servs., Inc., No. 3:09cv589, slip op.

at 2-3 (M.D. Pa. May 3, 2010); Carey v. New Penn Exploration, LLC, No.

3:09cv188, slip op. at 2 (M.D. Pa. Apr. 28, 2010).

98. Kilmer, 990 A.2d 1147.

99. Iams v. Carnegie Natural Gas Co., 45 A. 54, 54-55 (Pa. 1899).

100. Kilmer, 990 A.2d at 1152.

101. Bice v. Petro-Hunt, L.L.C., 768 N.W.2d 496, 501-02 (N.D. 2009).

102. Kilmer, 990 A.2d at 1152.


First, while the implied duty to market was indeed adopted by the

Pennsylvania Supreme Court in Iams,103

the Doctrine has never been

recognized by Pennsylvania law.104

Second, while almost every oil or

gas producing jurisdiction has adopted the implied duty to market,105

only four have adopted the Doctrine and thus require royalties to be

calculated at the point of sale.106

Thus, it is common for a jurisdiction

to utilize the implied duty to market while not recognizing the Doc-

trine – the two are not necessarily related concepts.107

103. Id. (holding that if sufficient quantities of gas are found to justify marketing

it, the lessee is under an implied duty to market the gas). See also Bruce M. Kramer

& Chris Pearson, The Implied Marketing Covenant in Oil and Gas Leases: Some

Needed Changes for the 80’s, 46 LA. L. REV. 787 (1986) (stating that ―[t]he basic

principles underlying the implied [duty] to market were elucidated . . . by the Penn-

sylvania Supreme Court in Iams‖).

104. Kilmer, 990 A.2d at 1152 (stating that the Landowners ―acknowledge[e] that

Pennsylvania has not adopted the [Doctrine]‖).

105. See Edward B. Poitevent, II, Post-Production Deductions from Royalty, 44 S.

TEX. L. REV. 709, 713 (2003) (finding that every major oil producing jurisdiction

has adopted the implied duty to market); Brian S. Wheeler, Deducting Post-

Production Costs When Calculating Royalty: What Does the Lease Provide?, 8

APPALACHIAN J. LAW 1, 11 (2008) (stating that the implied duty to market is found

in every oil and gas lease).

106. See Garman v. Conoco, Inc., 886 P.2d 652, 657-59 (Colo. 1994) (stating that

―the implied covenant to market obligates the lessee to incur [the] post-production

costs necessary to place gas in a condition acceptable for market‖); Gilmore v. Su-

perior Oil Co., 388 P.2d 602, 606 (Kan. 1964) (stating that ―Kansas has always rec-

ognized the duty of the lessee . . . to use reasonable diligence in finding a market for

the product‖ and that ―lessee is required to bear the expense [of preparing the gas for

sale]‖); Wood v. TXO Production Corp., 854 P.2d 880, 882 (Okla. 1992) (stating

that ―the lessees‘ duty to market . . . include[s] the cost of preparing the gas for mar-

ket‖); Tawney v. Columbia Natural Res., L.L.C., 633 S.E.2d 22, 27-28 (W. Va.

2006) (stating that ―our generally recognized rule [is] that the lessee must bear all

costs of marketing and transporting the product to the point of sale‖). See also Han-

na Oil & Gas Co. v. Taylor, 759 S.W.2d 563, 564-65 (Ark. 1988) (defaulting to

calculate royalties at the point of sale unless the lease dictates otherwise). See gen-

erally Byron C. Keeling & Karolyn King Gillespie, The First Marketable Product

Doctrine: Just What is the Product?, 37 ST. MARY‘S L.J. 1, 51 (2005) (finding that

only four states have explicitly rejected calculating royalties at the wellhead in favor

of the First Marketable Product Doctrine); Poitevent, supra note 105, at 716-18

(same finding); Wheeler, supra note 105, at 11 (same finding).

107. E.g., Yzaguirre v. KCS Res., Inc., 53 S.W.3d 368, 373 (Tex. 2001) (stating

that ―Texas law has long recognized that an oil and gas lease imposes duties on the

lessee that extend beyond the terms of the lease itself . . . including the duty to mar-

ket the oil and gas reasonably‖); Heritage Res., Inc. v. NationsBank, 939 S.W.2d

118, 121-23 (Tex. 1996) (noting that ―royalty is usually subject to post-production


Third, the Landowners failed to recognize and address the fact that

the Doctrine presents a number of challenges which make its imple-

mentation flawed and difficult.

For instance, there exists an inherent difficulty in determining when

the raw gas has become a marketable product.108

Being a question of

law, calculating royalty at the wellhead provides certainty to gas com-

panies.109

This is a luxury not afforded by the Doctrine, which makes

the valuation point a question of fact – to be decided on a case-by-case

basis.110

As such, the Doctrine invariably results in gas companies

facing seemingly endless litigation by landowners seeking to receive

higher royalties.111

costs‖ and using the net-back method to calculate royalties at the wellhead). See

also Keeling & Gillespie, supra note 106, at 91 (noting that ―the implied [duty] to

market is not a valid analytical framework for the [Doctrine]‖); Poitevent, supra

note 105, at 726 (noting that under Texas law, ―[t]he [implied] duty to market does

not require the lessee to bear alone the cost of post-production or marketing activi-

ties‖).

108. See Bice, 768 N.W.2d at 502 (finding that ―[t]his problem is ‗highlighted by

the fact that even the states which follow the [Doctrine] rule have failed to articulate

a clear standard for determining when a marketable product has been created‘‖

(quoting Wheeler, supra note 105, at 24)). See also Poitevent, supra note 105, at

759 (noting that the Doctrine states have failed to define a standard for marketabil-

ity); Wheeler, supra note 105, at 10 (noting that ―the realities of the marketplace

change, and those costs that are or are not deductible will change accordingly‖).

109. See Wheeler, supra note 105, at 25.

110. See Scott Lansdown, The Marketable Condition Rule, 44 S. TEX. L. REV.

667, 676 (2003) (noting that the [Doctrine] ―change[s] the point of valuation from

one that can usually be identified with little dispute and few complications to a

vaguely defined point that will be determined by a jury using few, if any, defined

criteria‖).

111. See id. at 701-04. Lansdown noted that if the Doctrine is adopted, ―oil and

gas lessees will be faced with an endless wave of expensive, burdensome and waste-

ful litigation.‖ Id. at 701. He continued,

The existence of large numbers of factual questions, and the absence of any

specific criteria for answering those questions, virtually ensures that each dis-

pute over the marketable product rule will dissolve into a battle of experts over

what a market is and when it is available to a lessee. Apart from the fact that

such litigation will be prolonged and expensive, given the virtually certain lack

of expertise on the part of the jury, the verdict will likely go to whichever side

has experts that sound the most persuasive. In addition to the obvious inequity

of this, the results of any particular case will be of virtually no use in determin-

ing the parties' rights and obligations in any other case. Even if the case is ap-

pealed, since marketability is a question of fact, so long as one side or the oth-

er does not introduce evidence that is wildly irrelevant, there will be no basis

for the court to determine whether a verdict was correct, and no reason for the


In addition, the jurisdictions that follow the Doctrine routinely dis-

regard the agreed upon and plain language terms of a lease, e.g., ―at

the well.‖112

This approach produces a result outside the parties‘ rea-

sonable expectations when they entered into the lease and creates un-

certainty in the industry which very well could harm production in the

long run.113

court to state any additional criteria for determining marketability. The result

will be that the litigation is much less likely to yield much guidance for lessees

to use in making future decisions with regard to royalty calculation.

Id. at 703-04.

112. See Poitevent, supra note 105, at 759-60 (noting that the Doctrine states

―manipulate royalty clauses to support their application of the [Doctrine]‖). See also

Keeling & Gillespie, supra note 106, at 85-90 (noting that ―the [Doctrine] invokes

canons of contract construction . . . to rewrite lease terms that courts have long

found to be plain and unambiguous‖); Wheeler, supra note 105, at 9 (noting that the

states which have adopted the Doctrine ―have concluded that royalty provisions

which use ‗at the well‘ language are silent as to the allocation of post-production

costs between a lessor and lessee‖ and ―have held that the term ‗at the well‘ does not

adequately identify [the] post-production costs a lessee may deduct when calculating

royalty‖ even though these costs are well established).

113. See Keeling & Gillespie, supra note 106, at 85-90. Keeling and Gillespie

make the observation that, ―[i]n any case involving a contract, a court must try to

give effect to the expressed intent of the parties before turning to any canons of

contract construction . . . . Canons should never prevail over the language used in

the instrument.‖ Id. at 85-86 (quoting Bruce M. Kramer, The Sisyphean Task of

Interpreting Mineral Deeds and Leases: An Encyclopedia of Canons of Construc-

tion, 24 TEX. TECH L. REV. 1, 61 (1993)). They argued that Doctrine courts,

in at least two key respects . . . invoke[] canons of contract construction . . . to

rewrite lease terms that courts have long found to be plain and unambiguous[:

First,] ―[a]t the well‖ means a location ―at the well,‖ not a downstream market-

ing location. Historically, the words ―at the well‖ establish the point where the

lessee should calculate the value or price of its production. However, in inter-

preting the term ―market value at the well,‖ the [Doctrine] argues that the

proper location for calculating the value of oil and gas production is a com-

mercial market, not the wellhead. Consequently, the [Doctrine] - at least as

described in Rogers and Wellman[, see infra] - purports to give effect to the

word ―market‖ at the expense of the words ―at the well.‖

Keeling & Gillespie, supra note 106, at 86-88 (citing Martin v. Glass, 571 F. Supp.

1406, 1411 (N.D. Tex. 1983) (―noting that the definition of the term ‗at the well‘ is

‗well settled‘‖); Rogers v. Westerman Farm Co., 29 P.3d 887, 897 (Colo. 2001) (en

banc) (―arguing that the term ‗at the well‘ is ‗silent with respect to the allocation of

costs‖); Wellman v. Energy Res., Inc., 557 S.E.2d 254, 257 (W. Va. 2001) (―sug-

gesting that a lease providing for the payment of a share of proceeds at the well

requires that the lessee pay royalties on its gross proceeds, without deducting any

production, marketing, or transportation costs‖)).


Furthermore, the scope and boundaries of the implied duty to mar-

ket are disregarded by those jurisdictions that follow the Doctrine.114

As discussed above,115

the implied duty to market is not a valid ana-

lytical framework for the Doctrine. Jurisdictions which use the im-

plied duty to market as an analytical framework for the Doctrine fail

to work within the duty‘s intended purpose.116

The implied duty to

market should arise only when parties have not expressed their inten-

tions in a lease and should be implied in fact, not in law.117

By construing leases that contain the language, ―market value at the

well,‖ or some other similar express provision indicating the parties‘

intent, in such a way as to require royalties to be calculated at the

point of sale, Doctrine jurisdictions use the implied duty to market in a

[Second,] ―[p]roduction‖ means ―the act of producing oil, gas, and other min-

erals,‖ not the act of transporting, gathering, treating, processing, or marketing

oil or gas . . . Historically, ―production‖ ceases once the lessee extracts oil or

gas from the ground at the wellhead. The historical definition of ―production‖

is consistent with the common understanding of the term; to ―produce‖ is to

make or create a product that did not previously exist, and not to refine or im-

prove a product already in existence. The [Doctrine], however, argues that the

act of ―production‖ does not end until the lessee obtains a first marketable

product - a product that the lessee may have had to refine or improve for mar-

ket . . . . Thus, the [Doctrine] takes a word that formerly had a clear meaning

and twists it into something that may ―vary from area-to-area and perhaps

[even] from well-to-well.‖

Keeling & Gillespie, supra note 106, at 88-90 (quoting Owen L. Anderson, Royalty

Valuation: Should Royalty Obligations be Determined Intrinsically, Theoretically,

or Realistically?, 37 NAT. RESOURCES J. 547, 645 (1997) (citation omitted)).

114. See Keeling & Gillespie, supra note 106, at 91-94. As stated by Lansdown,

[t]he implied [duty] to market only requires that a lessee make reasonable ef-

forts to obtain the best price possible. The [duty] says nothing about the obli-

gation of a lessee to employ a particular mechanism to calculate royalty, and it

certainly does not require that the lessee employ a mechanism that contradicts

the terms of the lease.

Scott Lansdown, The Implied Marketing Covenant in Oil and Gas Leases: The Pro-

ducer’s Prospective, 31 ST. MARY‘S L.J. 297, at 348-49 (2000). Keeling and Gil-

lespie added, ―[b]y seeking to shove a round peg down a square hole, the case law

adopting the [Doctrine] has radically altered the very nature of the implied [duty] to

market.‖ Keeling & Gillespie, supra note 106, at 92. See also Wheeler, supra note

105, at 25.

115. See supra note 107.

116. See Wheeler, supra note 105, at 25.

117. See Keeling & Gillespie, supra note 106, at 91-94.


way it was not intended to be used, i.e., to alter express intentions of

the parties.118

Lastly, jurisdictions that follow the Doctrine often disregard judicial

precedent.119

As a result, a lessee in such a jurisdiction cannot predict

with certainty what rights it has to deduct post-production costs.120

Such a web of unpredictability is the antithesis of a stable jurispruden-

tial system.

The Pennsylvania Supreme Court‘s decision in Kilmer to reject the

Doctrine and calculate royalty at the wellhead was a decision that fits

neatly within the settled modern framework of oil and gas lease juris-

prudence. It provides certainty and consistency to gas companies and

accords Pennsylvania law with that of the majority of oil and gas pro-

ducing jurisdictions.

3. Proposed Amendments to the GMRA

118. Id. at 92-93. See also Schroeder v. Terra Energy, Ltd., 565 N.W.2d 887,

895-96 (Mich Ct. App. 1997) (finding ―no reason to require [lessee] to bear fully the

cost of postproduction marketing under an implied duty to market where the express

royalty clause delineates how such costs are to be apportioned‖).

119. See Keeling & Gillespie, supra note 106, at 81-82 (noting that ―[a]lthough oil

and gas royalty law once recognized that a lessee may calculate its royalty payments

at the wellhead, the [Doctrine] has uprooted jurisprudence and divided oil and gas

states into two categories‖). They continued,

Even in those states that have adopted it, the [Doctrine] lacks consistent rules

to ensure uniform application from state-to-state and lessee-to-lessee. The net

effect of the [Doctrine] is uncertainty, both to lessees in calculating their royal-

ty payments and to the courts in resolving royalty disputes. . . . ―Unfortunate-

ly, given the mix of views encountered in the various states concerning royalty

valuation standards, we may have arrived at the worst possible result, which is

that royalty valuation must be determined on a state-by-state, interest-by-

interest, and clause-by-clause basis. . . . [T]hese various approaches will fuel

litigation in states whose courts have not considered the various royalty valua-

tion issues. The result will be large bodies of case law that offer little guidance

to parties facing a royalty valuation dispute. The end result will serve only to

make domestic exploration and production even less competitive in the world

marketplace.‖

Id. at 82 (quoting Owen L. Anderson, Royalty Valuation: Should Overriding Royal-

ty Interests and Nonparticipating Royalty Interests, Whether Payable In Value or In

Kind, be Subject to the Same Valuation Standards as Lease Royalty?, 35 LAND &

WATER L. REV. 1, 20-21 (2000)).

120. See Poitevent, supra note 105, at 759.


Currently proposed in the Pennsylvania Legislature is a piece of

legislation that would render the Pennsylvania Supreme Court‘s ruling

in Kilmer essentially superfluous.121

The bill would (1) increase the

minimum royalty payment from 12.5% (one-eighth) to 15%, (2) re-

quire the lessee to bear all post-production costs, and (3) set forth a

point of ―royalty‖ computation that comports with the Landowner‘s

position in Kilmer, i.e., at the point of sale.122

In short, the bill would

121. H.R. 2214, 193d Gen. Assemb., Sess. 2010 (Pa. 2010). As of this writing,

the bill has not received final passage. The bill was introduced on January 20, 2010

and was reported as committed on May 25 by a 14-12 vote. It received its first con-

sideration on May 25 but was tabled on May 26, and recommitted to the Appropria-

tions committee that same day. See THE PENNSYLVANIA GENERAL ASSEMBLY, BILL

INFORMATION, HOUSE BILL 2214, http://www.legis.state.pa.us/cfdocs/billinfo/ billin-

fo.cfm?syear=2009&sind=0&body=H&type=B&bn=2214 (last visited March 21,

2011).

122. Pa. H.R. 2214. The proposed bill would amend 58 PA. STAT. ANN. § 33 to

read:

(a) A lease or such other 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 the lease or other agreement does not guarantee the lessor at least a

15% royalty of all oil, natural gas or gas of other designations removed or re-

covered from the subject of real property. The lessee shall compute and pay

oil and gas royalties due under each lease on the gross proceeds received by

the seller based on the fair market value at the point of sale, including

amounts collected to reimburse the seller for severance taxes and production-

related costs. The lessee shall not deduct from royalties any severance taxes

or applicable fees charged by any Commonwealth agency or department, or

any post-production costs. Post-production costs are:

(1) All losses of produced volumes, whether by use as fuel, line loss,

flaring, venting or otherwise.

(2) All costs actually incurred by the lessee from and after the wellhead

to the point of sale, including, without limitation, all gathering, dehydra-

tion, compression, treatment, processing, marketing and transportation

costs incurred in connection with the sale of such production.

(b) For the purpose of computing and paying royalties, the fair market value

shall be presumed to be the gross proceeds received pursuant to a bona fide

contract entered into by nonaffiliated parties of adverse economic interests. If

a contract is not negotiated at arm's length or was between affiliated parties,

the presumption that market value is equal to gross proceeds shall not apply

and the lessee shall have the burden to establish that royalties paid are based

on market value. Parties are affiliated under this subsection if they are related

by blood, marriage or common business enterprise, are members of a corporate

affiliated group or where one party owns a 10% or greater interest in the other.

(c) Royalties are due and payable by the lessee on 100% of each lease's gross

production of oil and gas unless the lease explicitly states otherwise. Royalties

due must be paid within 90 days after the end of the month for gas sales. A


drastically alter the landscape of oil and gas leases in the Common-

wealth.

While the bill cannot retroactively invalidate existing leases due to

constitutional constraints,123

it will, if enacted, alter the way gas com-

panies negotiate with landowners in the future.124

How the gas com-

panies will adapt their leases to cope with these potential changes is

not certain, but what is clear is that the oil and gas industry in Penn-

sylvania will face new obstacles if the bill is passed.

CONCLUSION

The Pennsylvania Supreme Court, for the time being, quieted up-

heaval by hundreds of landowners seeking to invalidate their natural

gas leases by deciding Kilmer in the gas companies‘ favor.125

By de-

termining that royalty can be calculated at the wellhead using the net-

back method, the court logically and rightly joined the majority of oil

and gas producing jurisdictions. The gas companies‘ victory may,

however, be short lived due to the Pennsylvania Legislature‘s appar-

ent desire to uproot the Pennsylvania Supreme Court‘s decision in

Kilmer.

10% monthly interest shall accrue on the unpaid balance. If royalties are not

paid within the required period, the lease may become null and void at the dis-

cretion of the lessor.

Pa. H.R. 2214 (emphasis added).

123. See U.S. CONST. art. I, § 9, cl. 3 (―No Bill of Attainder or ex post facto Law

shall be passed‖); PA.CONST. art. I, § 17 (―No ex post facto law, nor any law impair-

ing the obligation of contracts, or making irrevocable any grant of special privileges

or immunities, shall be passed‖).

124. It is unclear whether existing leases will be affected at all by the proposed

bill.

125. Kilmer, 990 A.2d 1147.

royalty on sweet gas or sour gas? the supreme court...

Documents