The Oil and Gas Addendum

An Oil and Gas Blog for Landowners. The law of oil and gas here in Pennsylvania and throughout the Marcellus Shale region is complex and continues to evolve and change. If you own oil and gas rights, keeping up to date on these changes and trends is critical. The Oil and Gas Addendum is your resource for timely and informational articles on the latest developments in oil and gas law. Our oil and gas practice here at Houston Harbaugh is dedicated to protecting the interests of landowners and royalty owners. From new lease negotiations, to title disputes, to royalty litigation, we can help. We know oil and gas.

Why the New Minimum Royalty Bill is Constitutional and Good for Pennsylvania

On February 17, 2017, Rep. Garth Everett (R-Lycoming County) introduced HB 557. The bill seeks to put teeth back into Pennsylvania’s Guaranteed Minimum Royalty Act (“GMRA”) by prohibiting a driller from taking deductions that reduce the landowner’s net royalty below 12.5%. It is important to emphasize that HB 557 does not ban or outlaw the practice of deducting post-production costs. The bill simply says that the deductions cannot reduce the net royalty below 12.5%. Opponents of HB 557 argue that the bill is unconstitutional and that it is inherently anti-competitive. These arguments lack merit and operate merely as a distraction to the fundamental purpose of the legislation which is to restore and strengthen the viability of the GMRA.

HB 557 is Constitutional

Many opponents of HB 557 seek to avoid a legitimate debate on the merits of the bill by simply arguing that the bill is unconstitutional. They contend that the bill violates Article I, Section 17 of the Pennsylvania State Constitution. Because HB 557 would prohibit a driller from taking deductions that reduce the net royalty below the statutory minimum, opponents argue that the bill unilaterally “impairs” existing oil and gas leases. As detailed below, this argument is a complete red-herring.

First and foremost, HB 557 does not change, alter or negate any contractual right. Every oil and gas lease executed after 1979 must provide for a minimum royalty of 12.5 percent or it is unenforceable and invalid. There is no contractual “right” to avoid or ignore the GMRA. Opponents disingenuously suggest that there are thousands of oil/gas leases in Pennsylvania which granted the driller the express “right” to ignore the GMRA and pay royalties below the statutory minimum. This is simply untrue. No driller has a contractual “right” to pay a net royalty which violates the GMRA. Since the opponents of HB 557 cannot identify an actual contractual “right” that is impaired by HB 557, it is respectfully submitted that the constitutional analysis begins and ends here. There is simply no contractual “right” that is being impaired.

Even if the opponents could identify a specific and legitimate contractual “right” that is impacted by HB 557, their constitutional argument nonetheless fails as a matter of law. In order to demonstrate that a new law violates Article I, Section 17 of the Pennsylvania Constitution, the moving party must establish and prove two elements: i) the law operates as a substantial impairment of a contractual relationship and ii) the lack of a significant and legitimate public purpose behind the law. See, South Union Township v. Commonwealth, 839 A.2d 1179 (Pa. Cmwlth. 2003). It must be noted that Article I, Section 17 does not prohibit the General Assembly from exercising its police power, even if contractual relationships are altered. As the United States Supreme Court once observed, there are limits to the contracts clause:

“It is the settled law of this court that the interdiction of statutes impairing the obligation of contracts does not prevent the State from exercising such powers as are vested in it for the promotion of the common weal, or are necessary for the general good of the public, though contracts previously entered into between individuals may thereby be affected. This power, which in its various ramifications is known as the police power, is an exercise of the sovereign right of the Government to protect the lives, health, morals, comfort and general welfare of the people, and is paramount to any rights under contracts between individuals.”

See, Allied Structural Steel v. Spannaus, 438 U.S. 234, 241 (1978).

Applying these principles to HB 557, it is clear that the bill will pass constitutional muster. Putting aside the question of whether the drillers have a contractual right to avoid the GMRA, it is submitted that HB 557 does not operate as a substantial impairment of the lessor-lessee relationship. The rights and obligations embodied in the parties’ underlying oil and gas lease remain intact – HB 557 does not impose new obligations on the parties nor does it remove or extinguish existing contractual obligations. The driller retains the right to develop and extract hydrocarbons and the lessor retains his right to receive production royalties from said development. More importantly, the performance of contractual duties as set forth in the parties’ lease is not hindered or prevented by HB 557. See, Beaver County Building & Loan v. Winowich, 187 A. 481 (Pa. 1936) (observing that a new law “imposing conditions not expressed or dispensing with the performance of those which are part of it” unlawfully impairs the relationship). The essence of the lessor-lessee relationship remains unaltered. Moreover, the practice of deducting post-production costs is not prohibited or banned by HB 557 – drillers remain permitted to deduct post-production costs up until the net royalty threshold of 12.5% is reached. Since the lessor-lessee relationship itself remains fundamentally unchanged, opponents of HB 557 cannot satisfy the first element of the constitutional test. In short, the entirety of the contractual relationship between the lessor and the lessee is not “substantially impaired” by HB 557.

Assuming, for sake of argument, that even if HB 557’s opponents could possibly satisfy the first element of the South Union Township test, the General Assembly nonetheless has a significant and legitimate public purpose in restoring fairness to the payment of royalties under Pennsylvania law. The practice of deducting post-production costs below the statutory minimum is not an isolated problem. It is a state-wide and industry-wide problem which affects thousands of farmers, school districts, hospitals and local municipalities across Pennsylvania. When a new law seeks to mitigate and abate a broad problem such as this, reviewing courts “must determine whether the change in the law is based upon reasonable conditions and is a character appropriate to the public purpose justifying adoption.” See, Keystone Bituminous Coal Association, 480 U.S. 470, 505 (1987). If the new law is based upon “reasonable conditions” and is “appropriate to the public purpose”, the law will not violate Article I, Section 17 even if contractual relations are impacted. See, Empire Sanitary Landfill, Inc. v. Department of Environmental Resources, 684 A.2d 1047, 1059 (Pa. 1996) (“[t]he impairment is outweighed by the necessity of the regulation and the benefits to the public good”). Here, even if there was a discernable impairment of an existing contractual right, which is not conceded, the benefit of clarifying the GMRA for all royalty owners in Pennsylvania clearly outweighs any purported impairment. In other words, the mere fact that HB 557 may impact existing leases is not enough. The opponents must also demonstrate the absence of any reasonable and legitimate basis for the law – this they simply cannot do given the widespread practice of avoiding and ignoring the GMRA.

The Original GMRA Was Applied to Existing Oil/Gas Leases

The opponents of HB 557 also point to the original GMRA as support for their argument that HB 557 is constitutionally unsound. They contend that when the GMRA was enacted in 1979 it did not apply to existing leases and that “status quo leases were not changed.” This argument is false and misleading.

The GMRA was enacted on July 20, 1979 and became “effective” 60 days later. Leases executed prior to the effective date were subject to the GMRA but the obligation to pay the new minimum royalty rate (i.e., 12.5%) was suspended until either new drilling took place or if an existing well was stimulated. In other words, existing leases were subject to the GMRA but hydrocarbon production from active wells was exempt from the new royalty rate. If and when those existing wells were deepened or hydraulically stimulated, the lease, whether executed in 1920, 1953 or 1978, became immediately subject to the GMRA.

This interpretation of the GMRA was upheld by the Pennsylvania Supreme Court in Kepple v. Fairman Drilling Company, 615 A.2d 1298 (Pa. 1992). In Kepple, the underlying lease was executed on October 11, 1957 and provided for a flat royalty of $75.00 per year (“1957 Lease”). The lessee drilled a well on May 8, 1978 and subsequently stimulated the well on May 15, 1978. Production, however, did not commence until February 12, 1979. The landowner brought suit claiming he was entitled to the new minimum royalty. The lessee defended the suit on the grounds that since the lease and the well both pre-dated the GMRA, the minimum royalty was inapplicable. The Pennsylvania Supreme Court disagreed and held that the 1957 Lease was subject to the GMRA and that the lessee was required, under Section 3 of the GMRA1, to apply the new royalty rate on all production after December 17, 1979. Although the well was drilled prior to the GMRA, the 1957 Lease was nonetheless subject to the GMRA. It is important to note that the Supreme Court did not strike down Section 3 of the GMRA as being an unconstitutional impairment of contract.

The logic and rationale of Kepple is applicable to HB 557. Hydrocarbon production commencing after the effective date of HB 557 will be subject to a minimum royalty – the actual date of the underlying lease is irrelevant and immaterial. As the Kepple panel correctly observed, the obligation to pay a minimum royalty is not triggered by the date of the lease but upon producing hydrocarbons after the effective date of the act. Here, the HB 557 will become effective and binding on all leases 60 days after enactment. There is nothing unconstitutional about applying the statutory minimum royalty to hydrocarbon production accruing after this date.

Other Oil/Gas Jurisdictions Have Passed Legislation That Limit Or Prohibit Certain Deductions

Another argument advanced by the opponents is that the regulatory framework espoused by HB 557 is unprecedented and simply goes too far. Opponents further contend that, if enacted, HB 557 would have an anti-competitive effect because no other oil and gas jurisdictions regulate or limit post-production costs as proposed in the bill. These contentions are without merit.

Other oil and gas jurisdictions have enacted laws that actually limit or even prohibit the practice of deducting certain post-production costs.

Wyoming is consistently one of the largest producers of natural gas in the United States. In 2015, Wyoming produced 1.7 trillion cubic feet of natural gas. Only Texas, Oklahoma, Louisiana and Pennsylvania produced more. In each of the last five years, Wyoming has produced between 2.3 and 1.7 trillion cubic feet of natural gas each year. Wyoming’s robust natural gas production has not been hindered by the regulation of post-production costs. Contrary to the gloom and doom suggested by opponents of HB 557, Wyoming has prohibited the deduction of certain post-production costs for more than 30 years.

In 1982, Wyoming enacted the Royalty Payment Act, under which the “costs of production” cannot be deducted from the landowners’ royalty. As one court observed, in Independent Producers Marketing Group v. Cobb, 721 P.2d 1106, 1110 (Wyoming 1986), the Royalty Payment Act was enacted “to stop oil producers from retaining other peoples’ money for their own use.” The cornerstone of the Royalty Payment Act is the definition of costs of production. By statute, these costs include not only the costs of exploration and drilling but also the typical post-production costs incurred gathering, compressing, dehydrating and transporting the gas. Pursuant to Section 30-5-304(a)(ii) of the Royalty Payment Act, the landowner is “entitled to payment of a royalty on production, free and clear of the costs of production.” This language prohibits a gas driller in Wyoming from deducting most post-production costs from the landowner’s royalty.

Not all deductions are prohibited by the Royalty Payment Act. Transportation costs incurred after the gas enters a market pipeline are excluded from the “cost of production” definition and may be deducted by the gas driller, as in Wold v. Hunt Oil Company, 52 F.Supp.2d 1330 (D.C. Wyoming 1999), in which the court noted that transportation deductions are permissible “after the gas enters the market pipeline.” This transportation exception, however, has been narrowly construed by the Wyoming courts. See, Cabot Oil & Gas v. Followill, 2004 WY 80, 93 P3d 238 In Cabot, the Wyoming Supreme Court held that all costs incurred moving the gas from the leased premises to the downstream processor plant were non-deductible expenses. This remains the law in Wyoming. Ironically, these same gathering costs are routinely deducted by gas drillers here in Pennsylvania.

Wyoming is not the only jurisdiction that regulates the deduction of post-production costs. Both Nevada and Michigan have enacted similar statutes. Like Wyoming, Nevada excludes the costs of production from the landowner’s royalty. Nevada, likewise, defines the term “costs of production” to include the typical post-production costs associated with gathering, compressing, dehydrating and transporting the gas. See, NRS §522.115. These post-production costs are not deductible from the landowner’s royalty in Nevada.

Michigan’s regulatory framework is slightly different. Michigan allows a gas driller to deduct only two types of post-production costs: processing costs that enhance the value of the gas and transportation costs incurred after the point of entry into an independent pipeline system. Because of these statutes, royalty owners in Wyoming, Nevada and Michigan do not experience the same sticker shock as royalty owners here in Pennsylvania.

In sum, the claim that HB 557 will create “one more competitive disadvantage for Pennsylvania drillers” is simply untrue. Wyoming has regulated post-production deductions for over 30 years and yet that state remains as one of the top producers of natural gas in the United States.

HB 557 Does Not Change How Royalties Are Calculated

Opponents also argue that HB 557 changes Pennsylvania law on the “calculation of royalties” and that the bill itself is inconsistent with the invitation for legislative action made by Pennsylvania Supreme Court in Kilmer v. Elexco Land Services, 990 A.2d 1147 (Pa. 2010). Neither argument is accurate.

First, HB 557 does not change the way royalties are calculated under Pennsylvania law. This is a gross mischaracterization of the bill. Royalties in Pennsylvania will still be subject to post-production costs even after HB 557 is enacted – the bill does not prohibit deductions. The bill merely ensures that the net royalty paid to landowners is consistent with the statutory minimum of 12.5% set forth in the GMRA. The current formula and methodology used to calculate royalties in Pennsylvania is not changed by HB 557.

Second, in Kilmer the Pennsylvania Supreme Court noted that the GMRA does not define the term “royalty”. In footnote 14, the Kilmer court observed that “…the General Assembly is the branch of government best suited to weigh the public policies underlying the determination of the proper point of royalty valuation in the deregulated gas industry…” By this comment, the Pennsylvania Supreme Court invited the General Assembly to craft legislation clarifying this aspect (i.e., definition of royalty) of Pennsylvania oil/gas law. Contrary to the assertion made by HB 557 opponents, Kilmer did not say that existing oil/gas leases will be automatically exempt and forever insulated from any clarification of Pennsylvania law.

In conclusion, HB 557 represents a legitimate and common sense approach to restoring the purpose and effect of the GMRA. When the GMRA was originally enacted, the goal was to provide a minimum royalty of 12.5%, not 8.75% or 10.5%. The practice of deducting post-production costs has eroded and degraded this statutory objective. HB 557 stops this erosion and will bring much needed clarity and fairness back to the GMRA.

1Section 3 of the GMRA provides that “[W]henever such an increased production procedure has been completed prior to the effective date of the act, metering and the above royalty shall commence within 90 days after the effective date of this act.”

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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.

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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.

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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:

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