In a recent decision, the federal court in Pittsburgh held that the definition of “royalty” adopted by the Pennsylvania Supreme Court in Kilmer v. Elexco Land Services, Inc. was not applicable to the plaintiff’s breach of contract claim.1 The decision is significant and compelling because it erodes the long-standing myth that Kilmer authorizes the deduction of post-production costs in all cases. Since it was decided in 2010, Kilmer has been relied upon by industry as providing justification for the controversial practice of deducting post-production costs. However, the court in Marburger v. XTO Energy (Civil No. 15-910, February 17, 2016) correctly observed that the actual scope of the Kilmer decision is quite narrow and that it cannot be read as foreclosing each and every landowner challenge.
In Marburger, the plaintiff brought suit contending that the parties’ lease did not allow or authorize the deduction of post-production costs. The royalty clause in the lease provided that Mr. Marburger was entitled to receive a royalty of 1/8th of the “proceeds received” for all gas sold “less lessor’s pro-rata share of any severance or excise tax imposed by any governmental agency.” Despite this language, XTO began to deduct post-production costs from Mr. Marburger’s royalties after it assumed the lease in 2011. In his suit, Mr. Marburger argued that, unlike the leases at issue in Kilmer, his lease did not expressly allow or authorize the deduction of post-production costs. As such, he contended that XTO breached the lease by taking unauthorized deductions. It is important to note that Mr. Marburger did not seek to invalidate the lease under Pennsylvania’s Guaranteed Minimum Royalty Act (GMRA).
In response, XTO filed a motion to dismiss under the auspices of Kilmer. XTO argued that Kilmer explicitly allows gas companies to “net out” post-production costs when calculating a lessor’s royalty. Specifically, XTO asserted that Kilmer held that the term “royalty” as used in oil and gas leases implicitly permits the net-back method of calculating royalties. Given the definition adopted by Kilmer, XTO argued that it was permitted to deduct post-production costs from Mr. Marburger’s royalty, even though the lease itself was silent on this issue.
The federal court disagreed and noted Kilmer was inapplicable for several reasons:
First, the issue in Kilmer was whether deductions could be taken under the GMRA. The specific issue decided by the Kilmer panel was whether the GMRA permitted contracting parties to determine the amount of royalties by “utilizing the net-back method”. The Kilmer court held that it was not a violation of the GMRA “for the driller to calculate royalties as 1/8th of the sale price minus 1/8th of the post-production costs.” The Marburger court pointed out that these issues were not implicated in the instant suit. Mr. Marburger’s claim was not brought under the GMRA and he was not arguing that the deductions themselves violated the GMRA. As such, the Marburger court determined that the Kilmer analysis was not germane to Mr. Marburger’s breach of contract claim.
Second, the Marburger court observed that the leases at issue in the Kilmer litigation explicitly permitted the deduction of post-production costs. Since deductions were authorized, the issue before the Kilmer court was really one of statutory construction and not contract interpretation. In the instant case, the Marburger court noted that the parties’ lease did not allow or authorize deductions and that the sole issue was whether XTO breached the lease by taking such deductions. Given this distinction, the holding of Kilmer was simply inapplicable.
While the Marburger decision is certainly good news for landowners, it must be noted that the opinion was simply a ruling on a motion to dismiss. By denying XTO’s motion, the case will move forward. XTO will have the opportunity to again challenge the legal sufficiency of the plaintiff’s claim at the summary judgment stage. Nonetheless, the rationale and logic of the Marburger opinion is significant. The Marburger court correctly observed that the Kilmer opinion cannot be blindly asserted as justification for deducting post-production costs in all cases. For too long, Kilmer has been wrongly cited and read for this proposition. The Marburger court dispelled this notion and this long overdue clarity will benefit all landowners in Pennsylvania.
1Kilmer v. Elexco Land Services, Inc., 990 a.2d 1147 (Pa. 2010).
Oil and gas development can present unique and complex issues that can be intimidating and challenging. At Houston Harbaugh, P.C., our oil and gas practice is dedicated to protecting the interests of landowners and royalty owners. From new lease negotiations to title disputes to royalty litigation, we can help. Whether you have two acres in Washington County or 5,000 acres in Lycoming County, our dedication and commitment remains the same.
We Represent Landowners in All Aspects of Oil and Gas Law
The oil and gas attorneys at Houston Harbaugh have broad experience in a wide array of oil and gas matters, and they have made it their mission to protect and preserve the landowner’s interests in matters that include:
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Robert Burnett - Practice Chair
Robert’s practice is exclusively devoted to the representation of landowners and royalty owners in oil and gas matters. Robert is the Chair of the Houston Harbaugh’s Oil & Gas Practice Group and represents landowners and royalty owners in a wide array of oil and gas matters throughout the Commonwealth of Pennsylvania. Robert assists landowners and royalty owners in the negotiation of new oil and gas leases as well as modifications to existing leases. Robert also negotiates surface use agreements and pipeline right-of-way agreements on behalf of landowners. Robert also advises and counsels clients on complex lease development and expiration issues, including the impact and effect of delay rental and shut-in clauses, as well as the implied covenants to develop and market oil and gas. Robert also represents landowners and royalty owners in disputes arising out of the calculation of production royalties and the deduction of post-production costs. Robert also assists landowners with oil and gas title issues and develops strategies to resolve and cure such title deficiencies. Robert also advises clients on the interplay between oil and gas leases and solar leases and assists clients throughout Pennsylvania in negotiating solar leases.
Brendan A. O'Donnell
Brendan O’Donnell is a highly qualified and experienced attorney in the Oil and Gas Law practice. He also practices in our Environmental and Energy Practice. Brendan represents landowners and royalty owners in a wide variety of matters, including litigation and trial work, and in the preparation and negotiation of:
- Pipeline right of way agreements
- Surface use agreements
- Oil, gas and mineral conveyances