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, assume that you sign an oil and gas lease in 2020 with a prominent driller regarding the 100 acre family farm in Greene County.  You spend countless hours negotiating the lease and insist on a 18% royalty clause.  In November, you receive your first royalty statement but the royalty is not calculated on 18% but rather 9%.  You are shocked, confused and angry.  The driller informs you that back in 1905, your great-grandfather conveyed a “royalty interest” to Mr. Crosby, a person you have never heard of.  The driller tells you it is paying one half (1/2)  of your current royalty to Mr. Crosby’s grandchildren.

To support its royalty payment, the driller provides you with a copy of the 1905 Deed and it says that your great-grandfather conveyed to Mr. Crosby “one half of Grantor’s 1/8th interest of the oil and gas royalty produced from the land.”  You do some additional research and discover that your great-grandfather had entered into an oil and gas lease with XYZ Oil in 1903. But that lease expired years ago.  How is this possible?  How can a transaction in 1905 reduce the royalty you specifically negotiated in 2020?  This “royalty” vs. “royalty interest” dilemma is rather common and unfortunately affects many landowners each year in Pennsylvania.  Recently, the Federal District Court in Pittsburgh addressed this unique and confusing aspect of oil and gas law in JJK Mineral Co. v. Morris.

At issue in Morris was June 14, 1897 deed between Miles Meek and George Swingle (the “1897 Deed”).  Pursuant to the 1897 Deed, Meek conveyed to George Swingle “all of his oil and gas rite [sic] being the full half of his eighth interest, one sixteenth royalty to have and hold forever all of the undivided (1/16) one sixteenth royalty and gas rite [sic]…” At the time of the 1897 Deed, Miles Meek owned a fee simple interest in a 236 acre parcel located in Greene County, Pennsylvania (the “Subject Parcel”).  Prior to executing the 1897 Deed, Mr. Meek leased the oil and gas rights underlying the Subject Parcel to South Penn Oil Co. (the “South Penn Lease”).  The South Penn Lease had a primary term of ten (10)  years and provided for a royalty of 1/8th on all oil produced from the Subject Parcel.

Years later, the South Penn Lease expired.  According to court records, in the 1940’s, the heirs of George Swingle and the heirs of Miles Meek each apparently leased their ½ interest in the oil and gas rights underlying the Subject Parel to third parties.  And in the 1980’s, the respective heirs of each family again allegedly leased their ½ interest in the oil and gas rights underlying the Subject Parcel to the Philadelphia Oil Company.  These oil and gas leases eventually expired and the oil and gas formations underlying the Subject Parcel remained unleased until 2014.

In April 2014, EQT Production Company (“EQT”) entered into new oil and gas leases with the members of the Morris family, who traced their oil and gas title to Miles Meek and the 1897 Deed.  EQT asserted that the Morris family owned 100% of the oil and gas rights underlying the Subject Parcel.  In EQT’s view, George Swingle only acquired a royalty interest in the South Penn Lease and nothing more.  When the South Penn Lease expired, so did George Swingle’s royalty interest.

In 2019 and 2020, JJK Mineral Company LLC (“JJK”) acquired oil and gas rights from the heirs of George Swingle. By virtue of these mineral deeds, JJK acquired approximately 46.235% of the original ½ interest conveyed to George Swingle in the 1897 Deed. JJK notified EQT that it now owned 46.235% of the oil and gas rights underlying the Subject Parcel and that it was entitled to a royalty on any and all hydrocarbons removed from the Subject Parcel.  In addition, JJK argued that as a co-tenant, a separate oil and gas lease was required for its 46.235% interest. EQT refused to recognize JJK’s interest and refused to tender any royalties or negotiate a new lease.  In June 2021, JJK filed suit in the Western District of Pennsylvania.

JJK’s complaint sought, inter alia, a declaration from the District Court that, as a successor in title to George Swingle, it owned 46.235% of the oil and gas underlying the Subject Parcel.  Specifically, JJK argued that Miles Meek  intended to convey one-half (1/2) of his oil and gas fee interest to George Swingle by operation of the 1897 Deed.  In essence, JJK contended that George Swingle acquired a one-half (1/2) “mineral” interest in the oil and gas estate, not merely an interest in the production royalty under the South Penn Lease.  JJK emphasized that the 1897 Deed itself stipulated that Miles Meek was conveying “[a]ll of his oil and gas rite [sic]” in the Subject Parcel and that the reference to his ownership as being “his eighth interest” was an error.  In support of this interpretation, JJK relied on a peculiar nuance of oil and gas law known as the “Estate Misconception Theory”.

Under this theory, JJK postulated that Miles Meek mistakenly believed he only owned a 1/8th interest in the oil and gas formations given his execution of the South Penn Lease.  In actuality, he still retained a fee ownership interest in the underlying oil and gas.  Nonetheless, this confusion over what interest was retained by the lessor was common around the turn of the century.  As a result, modern courts have developed the so-called Estate Misconception Theory to aid in the interpretation of ambiguous oil and gas deeds. The Texas Supreme Court summarized the theory as follows:

This theory refers to a once-common misunderstanding (perpetuated by antiquated judicial authority) that a landowner retained only 1/8 of the minerals in place after executing a mineral lease instead of a fee simple determinable with the possibility of reverter in the entirety.  “For example, a lessor who has leased the entire mineral estate, but desires to sell-one half [sic] of the minerals, would assume that he owned 1/8 of the minerals due to the existing lease…[and] would use the fraction 1/16, or a double fraction ½ of 1/8, to convey ½ of what he perceived he owned.”

See, Hysan v. Dawkins, 483 S.W.3d 1 (Tex. 2016): see also, Heyer v. Hartnett, 679 P.2d 1152 (Kan. 1984) (“[A]s the most common leasing arrangement provides for a one-eighth royalty reserved to the lessor, the confusion of fractional interests stems primarily from the mistaken premise that all the lessor-landowner owns is a 1/8th royalty.”).

In response to the complaint, EQT filed a motion to dismiss.  EQT argued that:  i) the Estate Misconception Theory has never been adopted in Pennsylvania and was therefore inapplicable and ii) the text of the 1897 Deed only reserved a 1/16th royalty under the South Penn Lease.  And once the South Penn Lease expired, the royalty reserved in the 1897 Deed also expired.  The District Court agreed and dismissed JJK’s complaint.

The author respectfully submits that the District Court’s ruling was, and is, incorrect.  The District Court did not appreciate the distinction between a leasehold royalty and a royalty fee interest.  Before we examine the District Court’s ruling, a brief review of the ownership attributes of the oil and gas estate is warranted.

The oil and gas estate generally consists of five separate and distinct components:  i) the right to develop and extract the underlying hydrocarbons, ii) the right to lease (i.e., the executive right), iii) the right to receive the signing bonus payment, iv) the right to receive delay rentals and v) 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 (4) 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 entirety different from a leasehold royalty. The District Court in Morris failed to address whether the 1897 Deed could have created a NPRI in favor of George Swingle.

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 real property.

In Morris the District Court concluded that the purported interest created by the 1897 Deed was merely a partial assignment of the production royalty set forth in the South Penn Lease. In arriving at this conclusion, it is submitted that the District Court made several fundamental errors.

First, the District Court erroneously concluded that after Miles Meeks signed the South Penn Lease, the only interest he retained in the underlying oil and gas was the leasehold royalty interest created by the South Penn Lease and a future interest known as a “possibility of reverter”.[1] That is incorrect. Miles Meeks still owned the other four ownership “sticks” referenced above, including a fee royalty interest which is separate and distinct from the leasehold royalty.

Second, the District Court opined that after the South Penn Lease was signed, the only “rights Meek had to assign to George Swingle were as defined by the terms of the South Penn Lease”.  This is also incorrect. The mere signing of the South Penn Lease did not extinguish or suspend the other four ownership “sticks” held by Miles Meek. He still owned all of these real property interests and he could convey or transfer any of them as he so desired. The District Court then compounded these errors by failing to examine or discuss whether the 1897 Deed may have created a NPRI or, alternatively, transferred and conveyed a ½ mineral interest in the entire oil and gas estate.

Finally, the District Court should have considered the Estate Misconception Theory.  As noted, this theory recognizes that drafting styles and references to property interests were different a century ago than what they are today.  For example, in Duquesne Nat. Gas Co. v. Fefolt, 198 A.2d 608, 609 (Pa. Super. Ct. 1964), the Superior Court examined a reservation clause in a deed stating: “reserving however, to first party, the equal one-eighth (1/8th) part of all oil produced and saved from said premises, to be delivered in the pipe line to the credit of the first party, free of charge.” The court concluded that this reserved a mineral interest in the oil and gas estate, even though it used terms typically associated with a royalty under an oil and gas lease. At this early stage of the litigation, it appears that further factual development was warranted. This is particularly true given the parties’ alleged conduct in the 1940’s and the 1980’s when the respective heirs of both Miles Meek and George Swingle apparently each signed separate oil and gas leases for their ½ interests.  As such, one could argue that sufficient facts were pled in the JJK complaint to survive a motion to dismiss.

There also appears to be a legitimate factual question as to Miles Meek’s intent in connection with the 1897 Deed. Did he mistakenly believe that he only owned a 1/8th leasehold royalty interest in the underlying oil and gas after the South Penn Lease was signed? He did not- he actually retained and owned the other four ownership “sticks”. Under the Estate Misconception Theory, this purported mistake could be disregarded and the 1897 Deed could be construed as actually conveying a ½ mineral interest in the entire oil and gas estate.

Although not the result in the Morris 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 18% royalty you negotiated may actually only be 9% 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.

[1] When a landowner executes an oil and gas lease, the developmental rights are transferred to the lessee.  The lessor’s interest in the transferred developmental rights is known as a “possibility of reverter”.  If the oil and gas lease expires, the developmental rights automatically revert back to the lessor-landowner.  See, Appeal of Baird, 1 A.2d 485 (Pa. Super. 1938).