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Are Your Royalties Going Up In Flames?

March 30, 2022

Let’s assume you own 114 acres in Tioga County Pennsylvania. In 2012, you signed an oil and gas lease with XYZ Drilling. Two years later they drill and complete the MUSKIE #1H Well. The royalty clause in the 2012 lease requires XYZ Drilling to pay you a royalty of 1/8th on all “oil, gas, and liquids” produced from the leasehold. In January, you observe a large flame erupting from the MUSKIE #1H Well. The XYZ Drilling workers at the well-pad inform you that they are simply “flaring” the well in order to perform some well pad maintenance. The flaring goes on for hours. The same thing happens the next two days. In February, you notice that the monthly production royalty from the MUSKIE #1H Well is much less than previous months. You contact XYZ Drilling and they inform you that no royalty is due on the volume of flared gas. How can that be? The gas was brought to the surface but XYZ Drilling alone decided to burn the gas instead of selling it. Doesn’t your 2012 Lease require a royalty on all gas “produced” from the leasehold? The authors believe that a royalty would be owed under the 2012 Lease and that XYZ Drilling’s flaring operations may implicate Pennsylvania’s Guaranteed Minimum Royalty Act.

There are tens of thousands of oil and gas leases in effect across Pennsylvania. Each of these leases contains a royalty provision. Royalty provisions can differ and often contain different royalty valuation points. But all of those leases are subject to the Pennsylvania Guaranteed Minimum Royalty Act (the “GMRA”), which imposes a minimum royalty on all hydrocarbon production:

A lease or other such agreement conveying the right to remove or recover oil, natural gas or gas of any other designation from the lessor to the lessee shall not be valid if the lease does not guarantee the lessor at least one-eighth royalty of all oil, natural gas or gas of other designations removed or recovered from the subject real property.

58 P.S. § 33.3. So, to be clear, no oil and gas lease is valid under the GMRA if it does not “guarantee” that the lessor will receive a 1/8th royalty on all oil or gas “removed or recovered” from the leasehold. These authors believe that drillers may be violating the GMRA by failing to pay royalties on flared gas volumes.

The GMRA was addressed a decade ago by the Pennsylvania Supreme Court in Kilmer v. Elexco Land Services, Inc., 990 A.2d 1147 (Pa. 2010) which reviewed a guaranteed royalty provision functionally identical to the present statute. In Kilmer, the Pennsylvania Supreme Court believed it was required to construe the term “royalty” as the term was used in the GMRA.

A key factor influencing the Pennsylvania Supreme Court’s decision in Kilmer was the gas companies’ argument that the GMRA is triggered once the gas is produced and reaches the surface:

The Gas Companies maintain that the plain language of the GMRA provides that a landowner shall receive one-eighth of “all oil, natural gas or gas of other designations removed or recovered from the subject real property.” 58 P.S. § 33. From this language, the Gas Companies contend that the relevant point of reference is the moment the gas is “removed” from the ground, or in other words “at the wellhead.” They assert that natural gas cannot be “removed or recovered” downstream from the point it exits the ground at the wellhead. They also argue that nothing in the GMRA restricts the parties from contracting for a different point of measurement downstream of the wellhead so long as it provides at a minimum for a royalty of one-eighth at the point of removal—the wellhead.”

Kilmer, 990 A.2d at 1154. The Kilmer court agreed and implicitly recognized that gas is “produced” once it come to the surface:

The term royalty has been defined in the oil and gas industry as “[t]he landowner’s share of production, free of expenses of production.” Howard R. Williams & Charles J. Meyers, Manual of Oil and Gas Terms § R (Patrick H. Martin & Bruce M. Kramer eds., 2009). In the industry, as referenced above, the “expenses of production” relate to the costs of drilling the well and getting the product to the surface, but do not encompass the costs of getting the product from the wellhead to the point of sale, as those costs are termed “post-production costs.”

Kilmer, 990 A.2d at 1157. The Kilmer court’s characterization of a production royalty under the GMRA was further influenced by the gas companies’ suggestion that royalties could be taken “in-kind”, rather than being a monetary value, so as to implicate the wellhead itself. Id. at 1158.

The gas companies essentially argued that, under the GMRA, a “royalty” is based on the oil or gas that is actually removed from the ground, at the place of production and removal. It is well-established in most oil and gas jurisdictions that the “production” of oil and gas occurs when the hydrocarbons reach the surface. See, Bluestone Natural Resources II, LLC v. Randle, 620 S.W. 3d 380, 386-87 (Tex. 2021) (“Production is the process of bringing minerals to the surface, and production for raw gas occurs at the wellhead”). The ‘wellhead’ is the “equipment installed at the surface of the wellbore.” A wellhead typically includes such equipment as the “casinghead and tubing head.” Katch Kan Holdings USA, Inc. v. Can-Ok Oil Field Services, Inc., 152 F. Supp. 3d 595, 599 n.7 (N.D. Tex. 2015) (quoting OSHA Glossary of Terms, “wellhead” (July 22, 2015)). The “wellhead” is therefore a distinct and specific piece of equipment on a well pad location. Since the physical “wellhead” is the location where oil and gas is actually “removed or recovered” from the ground, then under Kilmer’s logic, all oil and gas leases in Pennsylvania are invalid if they do not guarantee the lessor one-eighth of all oil or gas at that location (i.e., all gas “removed or recovered”). That is problematic because not “all” of the oil or gas that is “removed or recovered” at the wellhead is actually sold. Some of it may be flared, some of it may be used by the driller to power equipment on the well pad and some of it may be subject to line loss or leakage as it is moved to the point of sale. Regardless, under the GMRA, the lease must guarantee a 1/8th royalty on all gas “removed or recovered.” Kilmer made no exception for flared or used gas.

Unfortunately for royalty owners, courts have neglected or ignored the central rationale of Kilmer: the royalty obligation under the GMRA is triggered at the point of “removal.” In Kilmer, the royalty provision in the underlying lease provided as follows:

Royalty Payment. For all Oil and Gas Substances that are produced and sold from the leased premises. Lessor shall receive as its royalty one eighth (1/8th) of the sales proceeds actually received by Lessee from the sale of such production, less this same percentage share of all Post Production Costs, as defined below, and this same percentage share of all production, severance and ad valorem taxes. As used in this provision, Post Production Costs shall mean (i) all losses of produced volumes (whether by use as fuel, line loss, flaring, venting or otherwise) and (ii) all costs actually incurred by Lessee from and after the wellhead to the point of sale, including, without limitation, all gathering, dehydration, compression, treatment, processing, marketing and transportation costs incurred in connection with the sale of such production. For royalty calculation purposes, Lessee shall never be required to adjust the sales proceeds to account for the purchaser’s costs or charges downstream from the point of sale.

Quite clearly, this provision excused the driller from paying a royalty on “(i) all losses of produced volumes (whether by use as fuel, line loss, flaring, venting or otherwise)”. So, if volumes of gas were “removed or recovered”, but lost due to flaring or line loss, no royalty would be owed on those volumes under the Kilmer lease. It is unclear how the Kilmer lease, and its methodology, could have been found consistent with the GMRA because the lease language itself directly contradicts the Pennsylvania Supreme Court’s interpretation of the minimum royalty obligation.

The Kilmer lease contained the minimum royalty rate (1/8th) and it expressly contemplated that volumes of gas would be produced (i.e., “removed or recovered”) for which no royalty was contractually due. In other words, the lease at-issue in Kilmer violated the GMRA based on the Kilmer court’s own logic. The Kilmer opinion never addressed this inconsistency.

The confusion regarding this aspect of the Kilmer opinion was then amplified a few years later by the Pennsylvania Superior Court. In Hall v. CNX Gas Co., LLC, 137 A.3d 597 (Pa. Super. Ct. 2016), the Pennsylvania Superior Court examined a royalty clause which provided as follows:

(b) on gas, including casinghead gas or other gaseous substance, produced from said land and sold or used beyond the well or for the extraction of gasoline or other product, an amount equal to one-eighth of the net amount realized by Lessee computed at the wellhead from the sale of such substances. On gas sold at the well, the royalty shall be one-eighth of the amount realized by Lessee from such sale.

 Id. at 597-98. The Halls claimed that “CNX’s allocation of the lost and used gas among the lessors was unauthorized under the lease. Lost gas is a reduction in the volume of gas due to evaporation or leakage as it is transported through a pipeline. Used gas refers to volumes of gas that are used along the pipeline for compression, flaring, venting, and other operations associated with processing raw gas into a marketable gas and transporting it to the point of sale.” Id. at 600.

The Superior Court stated that “[w]e observe preliminarily that the Halls’ position is predicated on the assumption that lost and used gas is part of the royalty, a premise that CNX disputes and the trial court rejected. . . According to CNX, there is no volume of lost and used gas at the point of sale to allocate.” Id. at 604. The Superior Court agreed with CNX and opined that “[g]as lost or used on the way to the point of sale is simply not a part of the royalty computation”. Id.

So, in Hall, the lease provided for the state-minimum royalty rate (1/8th) but CNX did not pay any royalty on the flared or used gas volumes. As such, the Halls’ royalty was less than the state minimum of 1/8th on those volumes. The Pennsylvania Superior Court summarily concluded that royalties were not due on gas that was produced, but not sold. This appears inconsistent with Kilmer’s observation that the GMRA is triggered on all oil and gas “removed or recovered”. Gas that is flared or used downstream from the wellhead is gas that was nonetheless “removed or recovered” from the leasehold. As such, it is unclear how to reconcile the Hall holding with Kilmer. This aspect of the Kilmer holding will need to be clarified by the Supreme Court in the near future.

In the meantime, returning to our example, the authors believe that the volume of flared gas from the MUSKIE #1H well constitutes gas that is “removed or recovered” from the leasehold. As such, the 2012 Lease is arguably invalid unless it guarantees a royalty of 1/8th on such volumes. If XYZ Drilling neglects to pay a royalty on the volume of flared gas, an argument could be made that XYZ Drilling is in breach of the GMRA.

“Flaring” is the controlled combustion of natural gas at the wellhead for operational, safety or economic reasons. It is often used to divert and dispose of produced gas during well testing or flowback gas during well completion. It is also done to relieve wellhead pressure during an emergency or if associated well infrastructure such as gathering pipelines or processing facilities are temporary off-line.

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