Supreme Court of Pennsylvania Construes Statute to Allow Royalty Value Calculation at Wellhead



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In an eagerly anticipated ruling issued yesterday, the Supreme Court of Pennsylvania has construed Pennsylvania's Guaranteed Minimum Royalty Act (GMRA) to allow natural gas producers to calculate the minimum one-eighth royalty required based on the value of gas at the wellhead. The case, Kilmer, et al. v. Elexco Land Services, et al., No. 63 MAP 2009, was one of many brought by Pennsylvania royalty owners seeking to invalidate leases negotiated prior to the recent Marcellus drilling that has resulted in more lucrative lease terms for mineral owners.
The statute at issue, 58 P.S.  33, requires that leases guarantee lessor mineral owners "at least one-eighth royalty of all oil, natural gas or gas of other designations removed or recovered from the subject real property." The statute does not define the term "royalty." The plaintiffs' lease provided for royalty to be calculated as one-eighth of the sale price of the gas minus one-eighth of the post-production expenses incurred in processing and transporting the gas from the wellhead to the point of sale.
The plaintiff mineral owners brought an action in the Court of Common Pleas of Susquehanna County seeking a declaratory judgment that their 2007 lease violated the GMRA by allowing for deduction of post-production expenses before calculation of royalty. The trial judge rejected this argument, granting summary judgment in favor of the gas company defendants. The Plaintiffs timely appealed to the Pennsylvania Superior Court. Because more than seventy cases involving the same issue were pending in Pennsylvania?s state and federal courts, however, the Supreme Court granted the gas companies? motion that it exercise extraordinary jurisdiction to immediately issue a definitive interpretation of the statute.
Among other things, the mineral owners argued that the standard dictionary definition of "royalty" should be applied to define the term, not the meaning of royalty as understood in the oil and gas industry (which contemplates calculation based on the value of gas at the wellhead). They further contended that a century-old case placing an "implied duty to market" upon gas companies requires Pennsylvania to adopt the first "marketable product doctrine" and impose on the gas companies all expenses necessary to get the gas to the point of sale.
The gas companies argued that the plain language of the GMRA, which states that the royalty shall be one-eighth of "natural gas removed or recovered from the subject real property," means that the calculation should be based on the value of the gas when it is ?removed? from the ground ? in other words, its value at the wellhead. Moreover, they pointed out that in 1979, when the GMRA was enacted, gas was typically sold at the wellhead, and the Legislature can be presumed to have acted consistently with that fact. The gas companies also pointed out that measuring the value of gas at the wellhead effectively standardizes royalties; to do otherwise would result in different royalties being paid depending on whether a mineral owner took the one-eighth share-in-kind at the wellhead or one-eighth of the proceeds of the more valuable processed gas downstream at the point of sale.

The Court found it "not surprising" that the GMRA did not specifically use such terms as "at the wellhead," "post production costs," or "point of sale" because in 1979 "virtually all royalties to landowners were based on the sale of unprocessed gas from the producer to the pipeline ompanies at the wellhead." "Given the current state of the industry where the wellhead and the point of sale are not the same," the Court looked to Pennsylvania law on statutory construction, which, it held, required it to adopt the industry's definition of "royalty" providing for calculation at the wellhead. The Court also credited the gas companies' argument that the Legislature would not have intended to create a situation where one royalty owner would receive a "dramatically different" royalty depending on whether the product was valued at the point of sale as opposed to when it was taken in kind at the wellhead. The Court recognized that gas companies have a "strong incentive" to keep post-production expenses low, as they bear seven-eighths of those costs. The Court therefore concluded that "the GMRA should be read to permit the calculation of royalties at the wellhead, as provided by the net-back method in the Lease" and affirmed the trial court?s grant of summary judgment in favor of the gas companies.