ROYALTY TRICKS 

THE INFORMATION BELOW APPLIES TO ROYALTY PAYMENTS AND POST PRODUCTION COST BEING DEDUCTED FROM YOUR ROYALTY PAYMENT. THE NET-BACK METHOD REFERED TO BELOW IS SOMETIMES CALLED REVENUE RENDERED, MODIFIED GROSS, OR JUST TALKS ABOUT POST PRODUCTION PROCESSING AND SEPARATION COSTS. WE INSIST ON A GROSS ROYALTY PAYMENT WITHOUT TRICKS FOR OUR CUSTOMERS. CLICK HERE TO CONTACT US ABOUT A LANDOWNER FRIENDLY LEASE.

 [J-78-2009]
IN THE SUPREME COURT OF PENNSYLVANIA
MIDDLE DISTRICT
CASTILLE, C.J., SAYLOR, EAKIN, BAER, TODD, McCAFFERY, GREENSPAN, JJ.
HERBERT KILMER, ELSIE KILMER,  : No. 63 MAP 2009
JACQUELINE FRANTZ, JEFFREY  :
KILMER, DIANE KILMER, KENNETH  : Appeal from the Order of the
KILMER, and THOMAS KILMER, : Susquehanna County Court of Common
: Pleas, Civil Division, at No. 2008-57 dated
Appellants : March 3, 2009 (Plenary Jurisdiction
: granted from the Superior Court No. 464
v. : MDA 2009)
:
ELEXCO LAND SERVICES, INC. and  :
SOUTHWESTERN ENERGY  :
PRODUCTION COMPANY, :
:
Appellees : ARGUED:  September 16, 2009
OPINION
MR. JUSTICE BAER                DECIDED:  March 24, 2010
The case at bar concerns the proper construction of the term “royalty” as it is used in
the Guaranteed Minimum Royalty Act (“GMRA”), 58 P.S. § 33, which governs, inter alia,
leases between Pennsylvania landowners and gas companies seeking to drill natural gas
wells into Pennsylvania’s Marcellus Shale deposits.  As developed below, the GMRA
requires that leases guarantee the landowner-lessor “at least one-eighth royalty of all oil,
natural gas or gas of other designations removed or recovered from the subject real 1property.”  58 P.S. § 33. Although the critical term “royalty” is not defined by the statute,
many leases in the Commonwealth, including the lease at issue before this Court, calculate
the royalties as one-eighth of the sale price of the gas minus one-eighth of the post-
2production costs of bringing the gas to market. This calculation is called the “net-back
method,” as its goal is to determine the value of the gas when it leaves the ground
(hereinafter “at the wellhead”) by deducting from the sales price the costs of getting the
3natural gas from the wellhead to the market. The landowners in this case filed for
declaratory judgment seeking to void their lease, arguing that the net-back method of
calculating royalties violates the GMRA.  The trial court rejected this argument and granted
   
1 The parties occasionally refer to a required royalty of 12.5 percent, which is equal to
one eighth. 
2  In industry parlance, “production costs” refer to the expenses of getting gas to the
point it exits the ground, and “post-production costs” refer to expenditures from when the
gas exits the ground until it is sold.  We will adhere to these definitions throughout this
opinion.
3 The Code of Federal Regulations defines the net-back method:
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.
30 C.F.R. § 206.151; see also Howard R. Williams & Charles J. Meyers, Manual of Oil and
Gas Terms § N (Patrick H. Martin & Bruce M. Kramer eds., 2009).  The Code uses the term
“lease” to mean both the contractual document and the land covered by the document,
such that it has the same meaning as wellhead.  30 C.F.R. § 206.151.
[J-78-2009] - 2

summary judgment to the gas companies.  After exercising extraordinary jurisdiction, we
affirm the decision below.
The Marcellus Formation is a region of natural gas-rich shale extending from New
York to West Virginia, including large portions of Pennsylvania.  See generally Timothy
Considine, et al, Pennsylvania State University, An Emerging Giant: Prospects and
Economic Impacts of Developing the Marcellus Shale Natural Gas Play (2009).  While the
existence of the gas deposits in the area have been known for a long time, recent
developments in drilling techniques have allowed for the potential recovery of dramatically
larger quantities of natural gas.  Estimates suggest that the area could contain over 489
trillion cubic feet of recoverable gas, enough to supply the natural gas needs of the United
States for fourteen years.  The developments in recovery techniques and the proximity of
the formation to the energy markets of the east coast cities has created a surge of interest
in drilling in the area.  Consequently, gas companies in the past few years have offered
landowners much more lucrative lease terms than were present in older leases, given the
increased competition for drilling rights.  This has caused some landowners to review their
older leases and question whether the terms provided therein comply with the GMRA.
4In January 2008, Landowners in the present case filed a complaint for declaratory
judgment in the Court of Common Pleas of Susquehanna County seeking to invalidate their
2007 lease, asserting that the lease violated the one-eighth royalty requirement of the
GMRA because the net-back method resulted in a royalty less than one-eighth of the value
of the gas.  The relevant provision of the lease provided for the calculation of royalties as
follows:
    
4 We will refer to the appellants listed in the caption as the “Landowners” and
recognize that they are also the plaintiff-lessors.  In contrast, we will refer to the named
appellees as the Gas Companies, who are the defendant-lessees.
[J-78-2009] - 3

3.  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.
Lease between Kilmer et. al and Elexco Land Services, Inc, dated October 15, 2007
5(“Lease”) (emphasis added). Similar royalty provisions are present in many other leases
across the Commonwealth.  According to Landowners, this provision violates the GMRA,
which provides in full:
§ 33.  Guarantee of minimum royalties
A lease or other such agreement conveying the right to remove or recover oil,
natural gas or gas of any other designation from lessor to lessee shall not be
valid if such 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.
As the case presented the trial court with a pure question of law regarding the
6requirements of the GMRA, both parties filed motions for summary judgment. In March
2009, the trial court granted summary judgment in favor of the Gas Companies and denied
   
5 Landowners also acknowledge that they received a signing bonus of $100 per acre.  
Reply Brief for Appellant at 20.  At the time of filing the brief, Landowners asserted that the
gas companies were willing to pay new lessors a signing bonus of $2,800 per acre.  Reply
Brief at 21.
6 The Gas Companies filed counterclaims.  As indicated below, these have been
discontinued and need not be discussed herein.
[J-78-2009] - 4

Landowners’ motion for summary judgment.  The court concluded that there were no issues
of material fact and that the GMRA does not preclude the parties from utilizing the net-back
method of royalty calculation.  The Gas Companies discontinued their other claims and
praeciped for the entry of judgment.  Landowners timely appealed to the Superior Court.
In a very brief opinion in support of its decision, the trial court observed that no
Pennsylvania appellate court had yet spoken to the question of whether the net-back
method of royalty calculation violated the GMRA, despite the numerous cases then pending
in Pennsylvania trial courts involving the same question.  The trial court acknowledged, but
did not rely upon, the Gas Companies’ argument that the term “royalty” had acquired a
meaning in the industry that was consistent with the use of the net-back method.  The
court, however, ultimately held that the lease did not violate the GMRA because “[t]he
statute in question does not prohibit the inclusion of ‘post-production’ costs to calculate the
one-eighth royalty.  The parties are, therefore, free to negotiate how that royalty shall be
calculated, so long as the net result is not less than one-eighth.”  Tr. Ct. Op. at 3. 
Recognizing that more than seventy suits were currently on hold pending the
appellate litigation in this case and fearing that uncertainty would stymie economic
development, the Gas Companies filed a petition asking this Court to exercise
extraordinary jurisdiction to speed the resolution of this pure legal question of first
impression.  The Landowners did not oppose the petition.  We granted extraordinary
7jurisdiction pursuant to 42 Pa.C.S.  § 726 to consider whether the GMRA precludes parties
   
7 § 726.  Extraordinary jurisdiction
Notwithstanding any other provision of law, the Supreme Court may, on its
own motion or upon petition of any party, in any matter pending before any
court or magisterial district judge of this Commonwealth involving an issue of
immediate public importance, assume plenary jurisdiction of such matter at
any stage thereof and enter a final order or otherwise cause right and justice
to be done.
(continued…)
 [J-78-2009] - 5

from contracting to use the net-back method to determine the royalties payable under an oil
or natural gas lease.  As the question presented involves a pure question of law, our scope
of review is plenary and our standard of review is de novo.  See Merlini ex rel. Merlini v.
Gallitzin Water Authority, 980 A.2d 502, 506 (Pa. 2009).
Before this Court, Landowners seek to invalidate their leases, claiming that the Gas
Companies are attempting to evade the GMRA’s requirement of a one-eighth royalty. 
Landowners argue that the plain language of the statute does not provide for the net-back
method through which post-production costs are subtracted from the sale price at market. 
Likewise, Landowners assert that the plain language does not state that royalties should be
calculated at the wellhead as argued by the Gas Companies.  Landowners reject the Gas
Companies’ contention that the word “royalty” has developed a technical meaning in the oil
and gas industry.  Instead, they maintain that the ordinary meaning of the term royalty
should be binding in this case.  Relying upon standard dictionary definitions, Landowners
argue that the term “royalty” is ordinarily defined as “a compensation or portion of the
proceeds paid to the owner of a right, as a patent or oil or mineral right.”  Landowners’ Brief
at 19 (emphasis in original).  They note that “proceeds” are defined as the “total amount
derived from a sale or other transaction.”  Landowners’ Brief at 20.  Thus, they argue that
the relevant question is what was the price at the point of sale, regardless of where the sale
is made or the costs of getting the raw product from the wellhead to the point of sale. 
Landowners additionally argue that Pennsylvania precedent accords with their
interpretation of the term “royalty.”  To support their argument that the calculation should be
made at the point of sale rather than the wellhead, Landowners rely upon a century-old
theory in oil and gas law placing an “ implied duty to market” upon gas companies, which
   
(…continued)
42 Pa.C.S. § 726.
 [J-78-2009] - 6

they claim derives from this Court’s decision in Iams v. Carnegie Natural Gas, Co., 45 A.2d
54 (Pa. 1899).  Under the implied duty to market theory, if sufficient quantities of gas can
be obtained to justify marketing the gas, then the lessee-gas company has “an obligation to
operate for the common good of both parties” and to market the gas, rather than allowing
the well to remain idle.  Id. at 55. 
Landowners assert that the implied “duty to market” is the legal basis for the “First
Marketable Product Doctrine,” which Landowners claimrequires the lessee/gas company to
bear all the costs necessary to get the natural gas to the point of sale.  Citing cases from
Colorado, Oklahoma, and Kansas, they claim that the First Marketable Product Doctrine
provides that because the lessee-gas company has a duty to market the natural gas, it is
inherent that the lessee gas-company be responsible for all costs necessary to satisfy that
duty.  Although acknowledging that Pennsylvania has not adopted the First Marketable
Product Doctrine, Landowners argue that it can be assumed that the legislature was aware
of the century-old duty to market doctrine when it enacted the GMRA in 1979, and thus,
intended the GMRA to reflect the doctrine by requiring lessees to bear all the costs
necessary to market the gas, which would include the post-production costs at issue in this
8case. 
Landowners further note that the federal district court in Stone v. Elexco, No. 3:09-
9cv-264 (M. D. Pa. June 1, 2009), refused to accept, for purposes of a motion to dismiss
filed by the gas companies in that case, the claim that the term “royalty” has developed a
   
8 Landowners cite works of former professor and noted scholar in natural gas law,
Bruce Kramer, in support of their duty to market argument.  Professor Kramer, however,
has filed an amicus curiae brief in favor of Gas Companies, rejecting Landowners’
interpretation of his work.
9 The trial judge in Stone also presided over the published case of Kropa v. Cabot Oil
& Gas Corp., 609 F.Supp.2d 372 (M.D. Pa. 2009), which contains a similar analysis. 
[J-78-2009] - 7

technical meaning in the gas industry, which is that the royalty should be calculated at the
wellhead.  The federal court relied upon a Colorado Supreme Court opinion that identified
two lines of precedent nationwide regarding the calculation of an oil and gas royalty. 
Garman v. Conoco, Inc. 886 P.2d 652, 657-58 (Colo. 1994) (collecting cases).  The
Colorado court observed that Texas and Louisiana calculated royalties at the wellhead,
whereas Kansas, Oklahoma, Wyoming, and the federal government calculated the price at
the point of sale.  Apparently, Arkansas and North Dakota defaulted to use of the point of
10sale to calculate royalties unless the lease specified otherwise.  Id. The court in Stone
also observed that Pennsylvania had utilized the duty to market doctrine in the Iams case. 
Given the divergence in precedent regarding the point of calculation of royalties, the federal
court refused to decide the issue in a motion to dismiss and instead required further
argument. 
Landowners next look to legislative history to support their claim that the legislature
intended for the one-eighth royalty to be calculated at the point of sale.  Essentially
acknowledging that there is no legislative history regarding the GMRA that is directly
supportive of their claim, Landowners look to the Pennsylvania Oil and Gas Conservation
Law, 58 P.S. § 402, enacted  in 1961, which regulated the drilling of natural gas wells more
than 3,800 feet below the surface (specifically, below the so-called Onondaga Horizon).  In
that act, the legislature defined a “royalty owner” as “any owner of an interest in oil or gas
lease which entitles him to share in the production of the oil or gas under such lease or the
proceeds therefrom without obligating him to pay any costs under such lease.”  Id.
(emphasis added).  The Landowners contend that the Oil and Gas Conservation Law and
   
10 We note that, since the decision in Garman, North Dakota now defaults to the
calculation of royalties at the wellhead.  See Bice v. Petro-Hunt, LLC, 768 N.W. 2d 496,
502 (N.D. 2009) (adopting the “at the well rule” and rejecting the First Marketable Product
Doctrine).  Moreover, some of the states detailed in Garman allowed leases to provide for
the sharing of the costs of transportation and processing.  Garman, 886 P.2d at 658.
[J-78-2009] - 8

the GMRA should be read in pari materia as they both relate to natural gas leases. 
Accordingly, they assert that when read together the two statutes provide that landowners
“are entitled to the payment of one-eighth royalty of all oil, natural gas, or gas of other
designations removed or recovered from the subject real property without obligating them
to pay any costs under such lease.”  Landowners’ Brief at 7.  Landowners contend that
“any costs” includes production and post-production costs.
Landowners also rely upon the Pennsylvania rules of statutory construction for
remedial statutes, which require that such statutes must be interpreted to achieve an act’s
purpose of remedying the perceived mischief addressed therein.  They note that the GMRA
is the only statute in the country that provides for a minimum percentage royalty to be paid
to a landowner.  Landowners contend that the GMRA is a remedial statute intended to
prevent deception and exploitation of Pennsylvania property owners by developers. 
Therefore, Landowners assert that the statute must be interpreted in their favor, and the
only way to guarantee the landowner a one-eighth royalty is to base the payment on the
amount of money received by the gas company when it sells the gas at the prevailing
market price, and not the illusory value of the gas “at the wellhead.”  They argue that the
market price is an easily determined amount that is not subject to corporate manipulation
and inflation of costs.  They emphasize that the definition of post-production costs as used
in the net-back calculation in the current lease is “without limitation.”  Moreover, they assert
that use of post-production deductions will merely generate more litigation over the
legitimacy of the deductions claimed by the Gas Companies.  They contend that it satisfies
the remedial purpose of the GMRA to read the statute to prevent the potential exaggeration
of post-production costs, which would result in a diminished royalty. 
In sum, Landowners assert that the Lease is not valid because it does not comply
with the GMRA, given that royalties under the Lease are calculated after deducting post-
[J-78-2009] - 9

production costs, which Landowners claim does not satisfy the one-eighth royalty required
11by the GMRA.
In contrast, the Gas Companies essentially contend that Landowners are attempting
to find a way to invalidate the Lease in hopes of renegotiating, given the newdevelopments
regarding the Marcellus Shale natural gas deposits.  The Gas Companies, however, reject
Landowners’ contention that the Lease’s net-back calculation of royalties violates the
GMRA.
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.  
The Gas Companies note that there are two basic ways to receive a royalty - either
12as a portion of the actual product (“in-kind”) or the monetary equivalent. While
   
11 Weacknowledge that several other landowners have filed amici briefs in this case, in
part, because their individual suits against their lessees have been stayed pending this
decision.  In addition to the arguments raised by Landowners, amici also suggest there is
debate regarding how to classify some costs, like compression, which they claim occurs
during both production and post-production.  This variability in calculation, they claim,
threatens the guarantee of the eight percent royalty mandated by the GMRA.   
12 Landowners contend that the term royalty does not encompass a share of the actual
product but only “money to be paid,” and thus suggest that the GMRA did not contemplate
that a landowner would receive natural gas in-kind as the royalty.  They also suggest that
the concept of taking natural gas royalties in-kind is absurd, and thus against the rules of
(continued…)
 [J-78-2009] - 10

READ MORE OR DOWNLOAD ENTIRE OPINION CLICK HERE

 The Code of Federal Regulations defines the net-back method:


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.

 

 

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