The Oil and Gas Addendum

The calculation of production royalties and the deduction of post-production costs is a hot topic for landowners across Pennsylvania. But there is another frustrating and often confusing royalty-related issue which can, and does, impact the value of the landowner’s royalty.

For example, imagine that you sign an oil and gas lease in 2015 with a prominent driller regarding the 100-acre family farm in Washington County. You spend countless hours negotiating the lease and insist on a 17.5% royalty clause. In November, you receive your first royalty statement but the royalty is not calculated on 17.5% but rather 10.5%. You are shocked, confused and angry. The driller informs you that back in 1937, your grandfather conveyed a 7% “royalty interest” to Mr. Smith, a person you have never heard of. The driller tells you it is paying 7% of your royalty to Mr. Smith. How is this possible? How can a transaction in 1937 reduce the royalty you specifically negotiated in 2015? This “royalty” vs. “royalty interest” dilemma is rather common and unfortunately affects many landowners each year in Pennsylvania. Recently, the Pennsylvania Superior Court addressed this unique and confusing aspect of oil/gas law in Rohe v. Meehan.

At issue in Rohe was an assignment that was made in 1954 between the Rohe Family and the Meehan Trust (the “1954 Assignment”). The 1954 Assignment granted the Meehan Trust “an undivided one-half interest” in an existing oil and gas lease between the Rohe Family and H.R. Hirzel (the “1949 Lease”). The 1949 Lease contained a ten-year primary term, which was set to expire in 1959. Several years later, The California Company acquired Hirzel’s working interest under the 1949 Lease. In 1955, The California Company recorded a lease surrender relinquishing all of its rights, title and interest under the 1949 lease.

Some sixty years later, the Rohe Family heirs signed an oil and gas lease with Chesapeake Appalachia, LLC (“Chesapeake”) concerning the same 62 acres formerly encumbered by the 1949 Lease. After the new lease was signed, Chesapeake drilled several horizontal wells. Once production commenced from the wells, Chesapeake began withholding one-half of the Rohe Family’s royalties pursuant to the 1954 Assignment. Chesapeake contended that the 1954 Assignment, which granted the Meehan Trust a fifty percent interest, was still applicable. The Rohe Family contested and disputed the withholding and argued that the Meehan Trust’s purported royalty interest expired and terminated when the 1949 Lease was surrendered. The Meehan Trust, on the other hand, argued that the royalty interest created in the 1954 Assignment was “perpetual” and its duration was not limited to the 1949 Lease. The trial court in Sullivan County agreed with the Rohe Family and entered summary judgment in January 2016.

The issue on appeal was whether the 1954 Assignment created a perpetual royalty interest in the hydrocarbons underlying the 62 acres or merely a fifty percent interest in the production royalties generated in connection with the 1949 Lease. This distinction is significant.

The mineral estate generally consists of five separate and distinct components:

1. the right to develop and extract the underlying hydrocarbons
2. the right to lease (i.e., the executive right)
3. the right to receive the signing bonus payment
4. the right to receive delay rentals
5. the right to receive production royalties

These attributes, when taken together, are often referred to as a “bundle of sticks”. Each individual “stick” can be separately sold and conveyed by the landowner. See, French v. Chevron, 896 S.W.2d 795, 797 (Tex. 1995) (“[A] conveyance of a mineral estate need not dispose of all interests; individual interests can be held back, or reserved, by the grantor”); Extraction Resources, Inc. v. Freeman, 555 S.W.2d 156 (Tex. Civ. App. 1971) (“[T]he owner of a mineral estate possesses a bundle of interests which can be separately conveyed or reserved…”). When a landowner signs an oil and gas lease, the exclusive right to develop and extract the hydrocarbons is effectively “transferred” to the driller – the other four components are retained and reserved by the landowner. In exchange for transferring the developmental rights, the driller agrees to pay the landowner a “royalty” on the production generated from the lease. This “leasehold” royalty is separate and distinct from the royalty “stick” referenced above – it is created when the oil/gas lease is negotiated and signed. Conversely, when the “mineral” royalty interest (i.e., item #5 above) is transferred by the landowner to a third person, it is commonly referred to as a non-participating royalty interest (“NPRI”). Typically, NPRIs are created by an express grant or reservation in a deed and are entirely different from a “leasehold” royalty.

The holder of a NPRI has no power to negotiate or execute an oil and gas lease and has no power to enter upon the land to extract the hydrocarbons. Likewise, if an oil and gas lease is executed, the holder of the NPRI will not share in the payment of the signing bonus or any delay rentals. The holder does, however, have a vested and perpetual right to a stated percentage of production from any hydrocarbons produced from the premises. In other words, the NPRI essentially lies dormant until there is actual production. Once production commences, the holder of the NPRI automatically receives his share of the production royalty, regardless if he signed any oil and gas lease. Since a NPRI is a real property interest, it is perpetual in nature and can be conveyed or assigned like any other piece of property.

In Rohe, the Pennsylvania Superior Court concluded that the purported interest created by the 1954 Assignment did not rise to the level of a NPRI. Since the language of the 1954 Assignment expressly stated that the fifty percent interest was limited to the existing 1949 Lease (or any other lease with H.R. Hirzel), the court opined that there was no intent to grant a perpetual royalty interest in the underlying 62 acres. The court observed that the 1954 Assignment was merely “a transfer, rather than a grant of interest.” As such, when the 1949 Lease was surrendered in 1955, the purported royalty interest assigned to the Meehan Trust automatically expired and reverted back to the Rohe Family.

Although not the result in the Rohe matter, NPRIs are perpetual and do not expire. Unlike a “leasehold” royalty, which expires when the underlying lease ends, the NPRI is attached to the particular real estate referenced in the original grant or reservation. This can be a source of frustration for landowners and can complicate lease negotiations. The 17.5% royalty you negotiated may actually only be 10.5% due to the pre-existing NPRI. When a landowner discovers the existence of a potential NPRI in his chain-of-title, it is worth having an experienced oil and gas attorney review the original instrument to determine whether the NPRI is, in fact, valid and binding.