2011 AAPL ANNUAL MEETING SPONSORS
PLATINUM
GOLD
SILVER
BOSTON SEMINAR
A wholly owned subsidiary of ExxonMobil
GOLF
BOSTON 2011
OIL AND GAS LEASING IN THE
MARCELLUS SHALE REGION:
“POST-PRODUCTION COSTS”
Presented by
Kevin C. Abbott
Reed Smith LLP
AAPL’s 57th Annual Meeting – June 8-11 in Boston, MA
Copyright © 2011 by AAPL
2
What are “post-production costs”?

Typical oil and gas leases provide that the lessee’s royalty
on gas shall be a specified proportion of “the market
value at the well” or of the “amount realized at the well.”

Gas is not typically sold at wellhead.

Between the point of production and the point of sale,
various costs can be incurred (transportation, processing,
dehydration, storage, marketing).

These costs are called “post-production costs.”
The question is:

Between the lessor and lessee, who is
responsible for post-production costs?
Two different approaches:
“At the well” rule
 “Marketable product” rule

“At the Well” Rule
Majority approach.
 Texas, Louisiana, California, New Mexico,
Michigan, Mississippi, Pennsylvania.
 Courts in these jurisdictions interpret
lease phrases such as “net proceeds” and
“market value” to allow deductions for
post-production expenses.
 “Net-back” method of calculating royalty.

Some ambiguity still arises under
the “at the well” rule…
If the lease includes a reference to
“proceeds” or “gross proceeds.”
 Texas: the phrase “gross proceeds at the
well” is not the same as “net proceeds”
and does not permit deduction of postproduction costs.
 Other courts: the phrase “gross proceeds
at the well” authorizes deduction of postproduction expenses.

“Marketable Product” Rule





Minority Rule.
Colorado, Oklahoma, Arkansas, Kansas.
Lessee bears all of the costs associated with production
and transforming into a marketable product.
Only after gas has reached “marketable condition” can
post-production costs be deducted.
View that leases are silent as to allocation of postproduction costs and “at the well” is ambiguous.
Other features of minority view:
When lease refers to “gross proceeds” or
“proceeds” at the well, sharing of postproduction costs is not permitted.
 Once gas reaches a “marketable
condition,” additional costs to improve or
transport the product may be shared.

 Burden on lessee to demonstrate “marketable
condition.”
 What about “gathering costs” where there is no
market for the gas within lease boundaries?
The West Virginia “Point of Sale”
Rule:
Most extreme approach.
 Historically followed “marketable product” rule.
 Tawney case (2006) – most hostile view of postproduction cost deductions.
◦ “at the well” language is ambiguous.
◦ No post-production costs could be deducted from
the royalty absent express language in the lease
identifying specific deductions AND providing a
method for calculating those deductions.
◦ $405 million judgment.

Post-Production Costs and Affiliate
Producers:
Courts have indicated a close scrutiny of
transactions involving affiliates of the
lessee.
 Case law in “at the well” jurisdictions
does not specifically address this issue.
 Many “marketable product” jurisdictions
already require the lessee to establish
that deducted costs are “reasonable.”

A Closer Look:
Royalty Litigation in Pennsylvania

Pennsylvania’s minimum royalty statute, 58 P.S.§ 33,
provides that:
A lease or other such agreement conveying
the right to remove or recover… natural
gas…shall not be valid if such lease does not
guarantee the lessor at least one-eighth
royalty of all… natural gas…removed or
recovered from the subject real property.
Before last year, only 1 reported Court
decision since Guaranteed Minimum
Royalty Act passed in 1979.
 Exploration of Marcellus brought issue to
a boil – billions of dollars riding on
meaning of obscure and largely ignored
statute.

Current State of Royalty Litigation
in Pennsylvania



Over 70 cases pending in state and federal courts.
Issue as to whether lease provision for sharing of postproduction costs (compression, dehydration, gathering,
and transportation) violates Act.
Lessors argued that deduction of these costs reduces
their royalty below the statutory minimum of 1/8 of gas
recovered or removed.
Pennsylvania Issue Different
Not construing just “at the well” leases.
 Statute interpretation issue.
 Not seeking damages – seeking
declaration that thousands of post-1979
leases providing for sharing of postproduction costs are “invalid.”
 Would throw industry into chaos.

Two Federal Decisions –
Round 1 to Lessors But No
Knockout
Two opinions – Kropa and Stone.
 Same federal judge in Middle District.
 Favored lessors’ interpretation of Act but
didn’t decide issue.
 No final decision.

One State Court Decision –
Round 2 to Lessees
Kilmer case.
 Judge Vanston rules in favor of
Southwestern Energy.
 Lessors appeal to Superior Court.

Straight to Supreme Court
PA Supreme Court exercised
extraordinary jurisdiction to decide issue.
 Issue to be decided:

Whether 58 P.S. § 33 precludes parties from
contracting that post-production costs be factored
into the determination of the amount of royalty
payable under an oil or natural gas lease.
Owner’s Arguments




Act intended to be remedial statute to protect simple
landowners from unscrupulous producers.
Act requires that lease “guarantee” at least one-eighth
royalty of proceeds of sale of gas.
Any deductions for post-production expenses violates
Act.
Only remedy is to find lease “not valid.” Frees lessor to
negotiate new lease.
Industry’s Arguments
Plain language of Act requires royalty “of
all natural gas . . . removed or recovered
from subject real property.”
 Act has nothing to do with postproduction activities.
 “Net-back” method is proper.
 Only intent of Legislature was to ban flat
rate leases, not create leverage for lessors
to get out of contracts.

Pennsylvania Supreme Court’s decision in Kilmer v.
Elexco Land Services, Inc., 990 A.2d 1147 (Pa. 2010).
Minimum royalty measured at the well.
 Net-back method is appropriate way to calculate wellhead value.
 Producers bear all production costs, but can allocate pro
rata share of post-production costs to royalty owners.
 Same treatment for royalty owners taking in-kind.
 Royalty owners can seek accounting to challenge costs,
but leases valid under Act.

Post-Kilmer issues
Royalty owners seek to limit Kilmer to
lease at issue there.
 Several federal courts have applied Kilmer
broadly.
 Battle over equitable extension of leases.
 No reported cases holding oil and gas
lease void under Minimum Royalty Act.

What Comes Next?

Now that the Supreme Court has made
its decision in Kilmer, what is the next big
area for litigation regarding leases?
◦ Royalty payment claims.
Class Actions Over Royalty
Payments
One already settled.
 At least 3 more filed.

What Will Be the Impact of this
Litigation?
Will decide if class action is proper
vehicle for claims.
 Impact on royalties and leasing practices.
 Help develop the law of Pennsylvania
regarding royalty payments.

Thank you