A Fluid Interpretation: Pennsylvania Courts’ Conflicting Interpretations of the Legislature’s Intent for the Guaranty Minimum Royalty Act

I. Introduction 

            Pennsylvania has always maintained a role as an energy producing state.  In recent years, technological advancements and increased energy prices have made energy production in Pennsylvania even more lucrative.  This is especially true with natural gas, which has seen a dramatic increase in exploration and drilling.  Of course, along with any economic opportunity come disputes over rights to profits.  Pennsylvania citizens have recently been faced with seemingly conflicting standards when realizing their share of their profits from natural gas located under their feet.  This Essay will explore that conflict between two recent Pennsylvania opinions that interpret the Guaranty Minimum Royalty Act[2] (hereinafter referred to as “GMRA”).

II. Guaranty Minimum Royalty Act Background

            Given that many private citizens in Pennsylvania own the rights to the minerals[3] beneath their land, companies must first seek the rights to the resource before they can begin to drill and produce the lucrative natural gas.  In most cases, natural gas companies enter into leases with individual landowners.  As compensation for the leases, landowners are typically given both lease signing bonuses and royalties.  Signing bonuses vary widely, however many experts suggest that the real benefit for landowners is in the royalty payments.[4]  Yet, there is still concern that natural gas companies have not provided adequate compensation for landowners when negotiating and executing natural gas leases.

            In 1979, the Pennsylvania Legislature responded to these concerns by passing the GMRA: a law guaranteeing landowners a 12.5% royalty on any natural gas drilled on their property.[5]  While the law defines the percentage of the royalty, “it is silent regarding the definition of royalty and the method for calculating the royalty.”[6]

            At its most basic, there are two methods for calculating the amount of royalties owed to a landowner: either factoring in the post-production costs or not including them in the calculation.[7] It is common in the oil and gas industry to include those costs in royalty allocations, thus taking into account the cost of processing the natural gas.[8]  However, landowners have advanced arguments that royalty calculations should be simply based on the net sale price, which would not take into account production cost.[9]  Obviously landowners would prefer increased profits that do not bear the production costs.  Pennsylvania courts have been called upon to interpret the intent of the Pennsylvania Legislature in passing the GMRA, with potentially mixed results.

A. Kilmer and the Technical Net-Back Method

            In Kilmer v. Elexco Land Services, Inc.,  the Pennsylvania Supreme Court was asked to determine whether the “net-back” method of calculating royalties was appropriate under the GRMA.[10]  The net-back method calculates the “value-added price received at the point of sale,” which includes post-production costs in the final royalty payment.[11]  The Kilmer court, while conducting its analysis, noted that when the GRMA was first passed, “virtually all royalties to landowners were based on the sale of unprocessed gas from the producer to the pipeline companies at the wellhead,” that is, production costs were not included.[12] Yet, the court suggested that in 1979, the year that the GMRA was passed, the natural gas company actually drilling the gas did not engage in refining post-drilling.  Therefore, the Kilmer court suggested, in 1979, a statutory distinction was unnecessary for royalty purposes.

            Furthermore, the Kilmer court looked to the technical definition of “royalty” to determine whether post-production costs may be included, explicitly rejecting the standard dictionary definition.[13]  According to the court, by passing the GRMA and remaining silent regarding the definition of “royalty,” the Pennsylvania Legislature intended to allow post-production costs to be shared between landowners and natural gas companies.

            The Kilmer decision does require that post-production costs be included in a royalty calculation, only that they may be permissibly included in the calculation under Pennsylvania law.  Of course, the natural gas companies—that actually draft the leases—prefer the net-back method as it defrays some of the production cost and results in higher profits for the natural gas companies.  So, while either method may be legally permissible under the GRMA, following the Kilmer decision, it would be surprising to see many leases that do not use the net back method to calculate royalties.[14]

B.  Forest Resources and the Assignment Back

            In Southwestern Energy Production Co. v. Forest Resource, LLC, the Pennsylvania Superior Court examined a mineral lease that contained an assignment back provision.[15]  The assignment back provision assigned fifty percent of the landowner’s royalty payment back to the natural gas producer.  In practical terms, it was a contractual means to circumvent the statutory requirements of the GRMA.

            The Forest Resources court decided that the assignment was invalid, stating that “[t]o allow such provisions in a lease, where a trick of drafting permits the left hand to remove what the right hand has given, would render the GMRA meaningless and run contrary to the plain language and intent of the legislation.”[16]  That intent was “plain[ly]” to “protect [l]essor[s]” of mineral rights.[17]  The court also noted the relationship of its holding to the Kilmer decision, stating in a footnote that, in its opinion, the matter at hand did not “implicate the definition of ‘royalty’ or the value of the gas removed . . . . It merely has the effect of reducing the net royalty . . . .”[18]  The Superior Court’s decision in this matter appears to be final  as the Pennsylvania Supreme Court has recently denied a Petition for Allowance of Appeal in the matter.[19]

III. The Conflicting Interpretations of Legislative Intent in Kilmer and Forest Resources

            This Essay does not comment on whether the courts in Kilmer or Forest Resources came to the correct or incorrect decision.  However, it does suggest that there is tension between the two decisions.

            First, when interpreting the exact same law, Pennsylvania courts have applied differing interpretive methods.  On one hand, the Kilmer court said that the GMRA was interpreted in accordance with the industry standard.  On the other, the Forest Resources court interpreted the GRMA in accordance with the plain meaning of the statute.  It is interesting and troubling that the same statute, which is merely one sentence long, is interpreted under two conflicting methods.

            Second, the Pennsylvania Legislature, in passing the GMRA, intended to provide Pennsylvania landowners with a minimum royalty on natural gas production.[20]  That is, the Pennsylvania Legislature created the GMRA with the intent to provide landowners with a floor on their natural gas royalties.  If the legislature’s intent was to create that floor—as discussed and asserted in Forest Resources—it seems contradictory that the Kilmer court came to a decision that effectively decreased the royalties received by Pennsylvania landowners.  In this way, the Kilmer and Forest Resources opinions appear at odds.

            One way to reconcile the conflict is that the two courts were interpreting different intents of the legislature.  In Kilmer, the question surrounded whether the legislature intended production costs to be included, whereas in Forest Resources, the question was effectively about the ability to contract around the GMRA.  It is understandable that the courts could come to differing opinions: one allowing an effective decrease in royalties for landowners and the other maintaining the minimum royalty paid to landowners.  However, this micro-analysis ignores the macro picture.  While the Kilmer court analyzed the intent of the legislature with regard to a particular phrase, the Forest Resources court analyzed the intent of the legislature with regard to the entire GMRA.  Nevertheless, given that the entire section at issue is, one sentence long, one may reasonably question why the two courts did not analyze the same intent ostensibly to protect Pennsylvania landowners and provide them with a minimum royalty.

            The second way to reconcile the apparent conflict is that the Forest Resources was an effort by the Pennsylvania courts to shift the interpretive balance of the statute.  Kilmer provided natural gas producers with a win – granting them increased profits from their production of natural gas.  Forest Resources pulled back from that position, ensuring that landowners actually received their minimum royalties under the GRMA.  While there is little explicit support for this interpretation in the actual text of Forest Resources, it is a reasonable conclusion given the seemingly conflicting views of the GRMA.

IV. Conclusion

            In the wake of Kilmer, there have been calls for the Pennsylvania Legislature to clarify the GRMA not to include post-production costs in the definition of royalty.[21]  The Pennsylvania Legislature has responded to those calls with a bill to amend the GMRA to effectively overrule Kilmer.[22]  While the outcome of that bill is yet to be determined, there does appear to be some popular push back on the Kilmer decision as well as further action that appears to undercut the intent behind the GMRA.

[1]J.D. Candidate, 2015, Villanova University School of Law; B.A. 2012, University of Michigan; Executive Editor, Vol. 60, Villanova Law Review.  He may be contacted by email at marktwilhelm@gmail.com.

[2] See 58 PA. STAT. § 33.3 (2014).

[3] In Pennsylvania the blanket term “minerals” does not include oil and natural gas due to the Dunham Rule.  SeeMark T. Wilhelm, Note, “All” Is Not Everything: The Pennsylvania Supreme Court’s Restriction of Natural Gas Conveyances in Butler v. Charles Powers Estate ex. rel. Warren, 59 VILL. L. REV. 375 (2014).  However, for the purposes of this Essay, the general use of the word “minerals” includes oil and natural gas.

[4] See D. ROBERT DAVIDSON, PA. DEP’T OF AGRICULTURE, NEGOTIATING OIL AND GAS LEASES ON PENNSYLVANIA FARMLAND 14 (July 2008), http://www.agriculture.state.pa.us/portal/server.pt/gateway/PTARGS_6_2_7….

[5] See 58  PA. STAT. § 33.3 (“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.”)

[6] Kilmer v. Elexco Land Servs., Inc., 990 A.2d 1147, 1157 (Pa. 2010).

[7] See Stone v. Elexco Land Servs., Inc., No. 3:09cv264, 2009 WL 1515251, at *2-4 (M.D. Pa. June 1, 2009) (discussing how to interpret “royalty” under GMRA and ultimately calling decision on issue “premature”).

[8] See Kilmer, 990 A.2d at 1157.

[9] See id. at 1151.  For example, assume that x units of natural gas were drilled from a landowner’s property and that the x units could be subsequently sold after refinement for $100. Further assume that the 12.5% minimum applies, and the production cost for the x units is $20. Calculations for royalties are as follows:

 With production cost: ($100 – $20) * 12.5% = $10.00

Without production cost: $100 * 12.5 = $12.50

The above calculations are not based on any actual lease and do not represent actual proportions of cost. They are meant only as a mathematical example.

The concern with the above calculations is that by including production costs in the royalty calculations, landowners would receive less than statutorily mandated 12.5%.  Of course, whether that statement is true depends on the method of calculating the royalty, which was at issue in Kilmer.

[10] For a general discussion of Kilmer, see Michael Morris, Note, Buyer’s Remorse over Your Pennsylvania Gas Lease? The Pennsylvania Supreme Court Upholds Meager Royalty Payments and Protects the Profitability of Marcellus Gas Drilling in Kilmer v. Elexco Land Services, Inc., 23 VILL. ENVTL. L.J. 25 (2012).

[11] Kilmer, 990 A.2d at 1155.

[12] Id. at 1157.

[13] See id. at 1156-57 (citing 1 Pa. C.S. § 1903, 1921(a), 1921(c)(2)).  But see Brief of Appellants at 19-21, Kilmer v. Elexco Land Servs., Inc., 990 A.2d 1147 (Pa. 2010) (63 MAP 2009), 2009 WL 6346618.

[14] For an examination of production costs that could potentially be deducted from royalty payments following the Kilmer decision, see Pollack v. Energy Corp. of Am., No. 10-1553, 2012 WL 6929174 (W.D. Pa. Oct. 24, 2012).  Addressing landowners’ concerns about improper billing, the Kilmer court stated that those concerns could be resolved through a court ordered accounting or lawsuit.  Kilmer, 990 A.2d at 1158; see also Alex Horowitz, Rico Suit: Chesapeake Bilked Marcellus Shale Leaseholders of Billions, 34 No. 26 WESTLAW J. ENVTL. 8 (2014), available at 2014 WL 3625907, at *2 (discussing recent lawsuit alleging racketeering on the part of major natural gas producer related to artificial inflation of costs relating to royalty payments).

[15] See Sw. Energy Prod. Co. v. Forest Res., LLC, 83 A.3d 177 (Pa. Super. Ct. 2013).

[16] Id. at 190 (emphasis added).

[17] Id.

[18] Id. at 189 n.11.

[19] See Order of July 30, 2014, 139 MAL 2014, available athttp://www.pacourts.us/assets/opinions/Supreme/out/139and141MAL2014.pdf.

[20] See Forest Resources, 83 A.3d at 190.

[21] See, e.g., Res. 2013-04, Comm’rs Office (Bradford Cnty. Pa. 2013), available athttp://www.bradfordcountypa.org/images/PDFS/Resolutions/2013-r_minimumro….

[22] See H.B. 1684, 2013 Gen. Assemb., Reg. Sess. (Pa. 2013).