The Oil and Gas Addendum

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 1/8^th 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 1/8^th of the sale price minus 1/8^th 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).