The Oil and Gas Addendum

Throughout Pennsylvania, landowners are continuing to experience “sticker shock” when they open their royalty statements related to gas drilling. The practice of deducting post-production costs from the royalty has become widespread as more and more gas drillers elect to pass these costs on to the landowner. Although the landowner negotiated an 18 percent royalty, the actual payment is nowhere close to that. Instead, the royalty is reduced by operational costs that the gas driller allegedly incurs after the gas is extracted from the ground. These so-called post-production costs can include expenses for dehydrating, compressing, gathering and transporting the gas as it moves downstream. In some cases, the post-production costs have reduced the landowner’s gross royalty by 50 percent or more.

The outrage and anger does not stop there. Many landowners signed leases with the statutory minimum royalty of 12.5 percent. This minimum royalty is guaranteed by Pennsylvania’s Guaranteed Minimum Royalty Act (GMRA). Pursuant to the GMRA, an oil and gas lease is invalid unless it guarantees the landowner a production royalty of at least 12.5 percent. At the time they signed the lease, these landowners were told by the landman working for the gas driller that their royalty would never be less than this statutory minimum. However, because of the practice of deducting post-production costs, the net royalty received by these same landowners is actually closer to 7.5 percent or less. To these frustrated and disillusioned landowners, 12.5 percent apparently does not really mean 12.5 percent. As a result, these landowners believe that the GMRA has become a hollow and impotent statute that guarantees nothing.

The outrage and anger does not stop there. Many landowners signed leases with the statutory minimum royalty of 12.5 percent. This minimum royalty is guaranteed by Pennsylvania’s Guaranteed Minimum Royalty Act (GMRA). Pursuant to the GMRA, an oil and gas lease is invalid unless it guarantees the landowner a production royalty of at least 12.5 percent. At the time they signed the lease, these landowners were told by the landman working for the gas driller that their royalty would never be less than this statutory minimum. However, because of the practice of deducting post-production costs, the net royalty received by these same landowners is actually closer to 7.5 percent or less. To these frustrated and disillusioned landowners, 12.5 percent apparently does not really mean 12.5 percent. As a result, these landowners believe that the GMRA has become a hollow and impotent statute that guarantees nothing.

The public uproar over the practice of deducting post-production costs has sparked a lively political debate in Harrisburg. At the center of this debate is HB 1391, introduced on June 29, 2015 by state Rep. Garth Everett, R-Lycoming County. This bill is a more narrowly focused version of HB 1684, which Rep. Everett introduced in June 2013. The bill seeks to limit these deductions and restore the viability of the GMRA. The bill provides, with respect to deep Marcellus or Utica Shale wells, that “no deductions of any costs shall result in a royalty payment less than 1/8th as provided in this section.” This language puts teeth back in the GMRA and prevents a gas driller from taking deductions that reduce the net royalty below the statutory minimum of 12.5 percent.

It is important to note that HB 1391 would not ban or prohibit the practice of deducting post-production costs. It simply would prevent those deductions from reducing the landowner’s net royalty below 12.5 percent. Although grounded in common sense and simplicity, HB 1391 has generated significant and vocal opposition from the gas industry.

One of the primary arguments advanced by the gas industry is that the regulatory framework espoused by HB 1391 is unprecedented and simply goes too far. Opponents further contend that, if enacted, HB 1391 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 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 1391, Wyoming has prohibited the deduction of certain post-production costs for more than 30 years.

In 1982, Wyoming enacted the Royalty Payment Act. Under the Royalty Act, 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 Act was enacted “to stop oil producers from retaining other peoples’ money for their own use.” The cornerstone of the Royalty 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 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 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.

In Cabot Oil & Gas v. Followill, 2004 WY 80, 93 P3d 238, the Wyoming Supreme Court was asked to decide whether certain costs deducted by the gas driller were nondeductible gathering expenses or permissible transportation expenses. The royalty owners in Cabot argued that the cost of collecting and moving gas from the leased premises to a downstream processing plant was a cost of production under the Royalty Act. Specifically, they argued that the expense of transporting the gas from the leased premises to the plant should be considered a nondeductible gathering cost. The gas driller, on the other hand, argued that the term gathering is limited to transportation taking place on or about the leased premises and since the gas was being moved off the leased premises, the transportation exception applied. Cabot contended that once the gas exited the leased premises, the gathering function ceased and all costs incurred after this demarcation point could be lawfully deducted under the Royalty Act as transportation costs.

The Wyoming Supreme Court rejected Cabot’s geographic-based definition of gathering. The court opined that the term gathering “means to collect gas and move it to a point where it can be processed or transported to the user.” As such, all costs incurred moving the gas from the leased premises to the downstream processing plant were nondeductible gathering 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.

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.

Opponents of HB 1391 also contend that the bill is unconstitutional. As support for this argument, they rely on Article I, Section 17 of the Pennsylvania Constitution. This section states that the General Assembly shall pass no law “impairing the obligation of contracts…” Because HB 1391 would prohibit an operator from taking deductions that reduce the net royalty below the statutory minimum, opponents mistakenly claim that the bill unilaterally impairs or changes existing oil/gas leases. This argument is nothing more than a scare tactic and has no legal basis.

Let’s get the record straight – HB 1391 does not change, alter or modify any contractual obligation. Every oil and gas lease executed after 1979 must provide for a minimum royalty of 12.5 percent or it is unenforceable and invalid. HB 1391 simply clarifies the existing law by making sure the net royalty is not less than 12.5 percent. The original 1979 law overlooked this nuance and HB 1391 merely removes this ambiguity from the statute.

A new law violates Article I, Section 17 only if it impairs an existing contractual right or obligation. See, South Union Township v. Commonwealth of Pa., 839 A.2d 1179 (Pa. Comm. 2003). The author is unaware of any oil/gas lease that gives the driller the express contractual right to avoid the GMRA and pay a net royalty below 12.5 percent. That is what the opponents of HB 1391 are essentially arguing – the bill is unconstitutional because it “impairs” their practice of taking deductions that reduce the net royalty below the statutory minimum. There is no contractual right to avoid the GMRA. As such, the opponents’ argument is simply factually and legally suspect.

Pennsylvania should enact HB 1391. As noted, HB 1391 would not prohibit a gas driller from deducting the costs of gathering, dehydrating or even transporting the gas. Unlike Wyoming, those costs would still be deductible in Pennsylvania. HB 1391 would simply prevent those deductions from reducing the landowner’s net royalty below the statutory minimum of 12.5 percent. This makes sense and is consistent with the original intent of the GMRA. Given the legislation adopted by Wyoming, Nevada and Michigan, HB 1391 is neither unprecedented nor anti-competitive and, as such, it should be considered by the General Assembly, as it would bring much needed clarity and certainty to Pennsylvania oil and gas law.

This article is an update of “Pa. Should Clarify its Approach to Post-Production Costs” originally published in the June 17, 2014 issue of Pennsylvania Law Weekly.