The Oil and Gas Addendum

Superior Court Breathes New Life Into Guaranteed Minimum Royalty Act

As the debate in Harrisburg heats up this winter regarding the practice of deducting post-production costs from oil and gas royalties, the Pennsylvania Superior Court has made clear that the Guaranteed Minimum Royalty Act, or GMRA, remains a viable component of Pennsylvania oil and gas law.

In Southwestern Energy Production v. Forest Resources, 2013 PA Super. 307 (Nov. 27, 2013), the Superior Court held that an “assignment back” clause negotiated by the parties, which resulted in the lessor’s royalty being less than the statutory minimum of 12.5 percent, violated the GMRA.

The opinion breathes new life into the GMRA, which had been relegated to the proverbial sidelines after the Supreme Court’s 2010 decision in Kilmer v. Elexco Land Services, 990 A.2d 1147 (Pa. 2010). The Southwestern Energy decision should serve as a reminder to both landowners and gas drillers that the GMRA can and will be enforced and that the Pennsylvania Superior Court will closely scrutinize all royalty clauses. In light of the renewed debate in Harrisburg regarding Pennsylvania’s minimum royalty requirement, the Southwestern Energy decision is both timely and instructive.

At issue in Southwestern Energy was a 2002 oil and gas lease that provided for a 12.5 percent production royalty. The 2002 lease was subsequently amended and modified by two letter agreements executed by the same parties in 2002 and 2005. The letter agreement executed in 2005 modified the royalty clause by assigning 50 percent of all production royalties to the lessee.

Although separate documents, both the 2002 lease and the letter agreements referenced and incorporated each other. In response to a quiet title action commenced by Southwestern Energy in 2011, the lessor filed a counterclaim seeking to invalidate the 2002 lease on the grounds that the “assignment back” clause in the 2005 letter agreement violated the GMRA.

Southwestern Energy moved to dismiss the lessor’s counterclaim on the basis that the 2002 lease and the 2005 letter agreement were separate, distinct agreements. Since the 2005 letter agreement was independent from the 2002 lease, Southwestern Energy argued that the “assignment back” clause did not violate the GMRA. The trial court agreed and dismissed the lessor’s counterclaim, noting that “the royalty to be paid remains one-eighth; the assignment back to [lessor] simply divided that royalty.” The trial court concluded that the 2005 letter agreement was “distinct and collateral” from the original 2002 lease and, therefore, the GMRA was not implicated.

The trial court’s narrow reading of the 2002 lease and the 2005 letter agreement was rejected by the Superior Court. The panel concluded that both documents “must be construed together” as a single, integrated agreement between the parties. Since the parties’ agreement failed to guarantee a royalty of at least 12.5 percent, the 2002 lease violated the GMRA and was invalid, the court held.

In its opinion, the Southwestern Energy panel made two striking statements regarding the GMRA.

First, the court said that the “assignment back” clause violated the GMRA because it resulted in the lessor’s net royalty being less than the statutory minimum. Specifically, the court said “a provision in a lease couched in the guise of an assignment back of a portion of a defined royalty that results in a lessor’s net royalty being less than one-eighth fails to guarantee the minimum royalty mandated by the GMRA.”

The use of the term net royalty, as opposed to gross royalty, introduces a new analytical framework in assessing compliance under the GMRA. Under this new analysis, it appears that the GMRA may be violated if the landowner’s net royalty falls below 12.5 percent. This is a remarkable departure from Kilmer and its progeny. In Kilmer, the Pennsylvania Supreme Court held that the net-back method of calculating royalties does not violate the GMRA, even if the net royalty after deductions is less than 12.5 percent. The Southwestern Energy opinion suggests otherwise.

Second, the panel suggested that when reviewing a royalty clause under the GMRA, the reviewing court must look beyond the literal text of the clause and assess whether the effect of entire lease will result in a royalty being less than 12.5 percent. The Southwestern Energy court warned that “a lease that contains a clause, which, when read alone, facially provides the lessor with at least the minimum royalty is nonetheless noncompliant with the GMRA, if, when read as a whole, it fails to guarantee that minimum royalty.”

This language implies a different approach than espoused by the Supreme Court in Kilmer. Under this new test, a royalty clause that provides for a 12.5 percent royalty but nonetheless authorizes the deduction of certain post-production costs may violate the GMRA because when read as a whole, the lease fails to guarantee the minimum statutory royalty of 12.5 percent.

When read in conjunction with the court’s emphasis on the term net royalty, the Southwestern Energy decision could represent a significant change in Pennsylvania oil and gas jurisprudence. Both statements may reflect an emerging judicial preference toward re-establishing, and perhaps expanding, the protective sphere of the GMRA.

Such a preference, however, is at odds with Kilmer. As such, both landowners and gas drillers alike should carefully monitor the aftermath of Southwestern Energy, as well as the ongoing political debate in Harrisburg. Only time will tell if Southwestern Energy was the beginning of a new and dramatic judicial trend or simply a bump in the road.