Sharing of Post-Production Costs is the Default in PA

There continues to be a great deal of confusion in Pennsylvania surrounding what constitutes a post-production cost and who should properly bear those costs.  Disputes can and do arise between landowners, mineral buyers, and oil and gas producers as to the correct categorization and allocation of post-production costs, especially in leases that predate the Marcellus Shale boom.  

In Pennsylvania, the Guaranteed Minimum Royalty Act ("GMRA"), 58 P.S. § 33, requires "at least one-eighth royalty of all oil, natural gas or gas of other designations removed or recovered from the subject real property."  Any lease that does not meet this minimum shall not be valid. The GMRA, however, does not define the term royalty.

Under a traditional oil and gas lease, the royalty paid to the Lessor of the lease (i.e. the owner of the oil or gas or a royalty interest in oil or gas) does not bear any production costs, meaning those costs that occur before the moment oil or gas comes out of the ground.  These costs include the costs of leasing, drilling, completing, producing and maintaining a well.

However, the treatment of post-production costs has not always been so clear.  The genesis of the dispute begins because historically, until the late 1980s, gas was sold “at the wellhead” and, as such, post-production costs were not typically considered in royalty calculation. The point of sale moved downstream in the 1990’s, and producers incurred the processing, gathering, compression, transportation, etc. costs, referred to as post-production costs, prior to sale of oil or gas.  Therefore, the royalty calculation has become more difficult over time because the gas valuation point is no longer at the wellhead.

In Kilmer v. Elexco Land Services, 990 A.2d 1147 (Pa. 2010), the Pennsylvania Supreme Court adopted the “at the wellhead” theory and the “net‐back” method for oil and gas leases in Pennsylvania.  The “at the wellhead” theory simply means that the point at which royalty is defined and the guaranteed minimums of the GMRA are calculated are at the wellhead, that is before post-production costs are incurred.  The Court’s rationale is that post-production costs add value to the gas, so the royalty holder should bear a proportionate share of those costs. This method of calculating the royalty owners share of post-production expenses is called the “net-back” method.

In the Kilmer, the Pennsylvania Supreme Court applied the federal definition of “net-back”, which is defined in the Code of Federal Regulations, 30 C.F.R. § 206.151, as:

“Net-back method (or work-back method) means a method for calculating market value of gas at the lease. Under this method, costs of transportation, processing, or manufacturing are deducted from the proceeds received for the gas, residue gas or gas plant products, and any extracted, processed, or manufactured products, or from the value of the gas, residue gas or gas plant products, and any extracted, processed, or manufactured products, at the first point at which reasonable values for any such products may be determined by a sale pursuant to an arm's-length contract or comparison to other sales of such products, to ascertain value at the lease.”

In practice, if you are an owner of oil and gas interests and have a lease with a one-eighth (1/8) royalty determined “at the wellhead”, you will be responsible for one-eighth (1/8) of the costs between extraction from the ground until the first point at which there may reasonably be an arm’s length transaction.  

However, a Lessor and Lessee are also free to enter into an oil and gas lease wherein the Lessee agrees to pay royalty free of any deductions of post-production costs. Potential Lessors and mineral buyers should be aware that there are instances of deceptive language in leases, be it intentional or not, that have the effect of giving the Lessor the false belief that they are entitled to royalty free of post-production costs. 

Finally, the Court in Kilmer reasoned that, since the Lessee would bear 7/8 of the post-production cost, there is sufficient incentive to minimize the costs in the most efficient manner available.  There are, however, issues surrounding the reasonableness of post-production costs, including issues of self-dealing with related or affiliate downstream partners, that undermine this proposition and may require the attention of an attorney.

If you are a landowner, a mineral buyer, or a producer, and would like to discuss the language of a particular lease, please contact our office to consult with one of our Pennsylvania attorneys.