Author: Brad Dunkle, Associate Member, University of Cincinnati Law Review
Last year, a Pennsylvania Superior Court ruled that including a provision in an oil and gas lease assigning a portion of the royalty back to the company violated the Guaranteed Minimum Royalty Act (GMRA). In Southwestern Energy Prod. Co. v. Forest Res., LLC, an oil and gas company attempted to have a lessor “assign-back” half of its royalty for marketing purposes. Pennsylvania’s GMRA guarantees that mineral owners leasing their land for oil and gas production receive a minimum of one-eighth royalty on oil and gas produced from property. Although the court held that its ruling in no way affects a lessor from assigning or conveying its royalty independent of the lease, this holding alters the way oil and gas leases are constructed in Pennsylvania and may have an impact on current leases assigning royalties.
Leases, “Assignment-Back” Clauses, and Royalties
At issue in Southwestern v. Forest Resources was an amendment to an oil and gas lease that assigned half of the lessor’s one-eighth royalty back to the lessee. In the original agreement, executed on June 17, 2002, the owners of oil, gas, and mineral rights to a piece of property in Lycoming County, Pennsylvania, leased their oil and gas rights to Lancaster Exploration & Development Co. The agreement granted the oil and gas owners an industry standard one-eighth royalty from gross production.
The amendment was executed about three years later on February 17, 2005. It extended the lease and assigned half of the royalty back to Lancaster in exchange for Lancaster’s marketing services. Lancaster argued this action did not violate the GMRA because Lancaster would only be providing marketing services and not producing any oil and gas.
The trial court agreed with Lancaster and Southwestern, concluding that the original lease agreement and the “assignment-back” amendment were distinct and separate contracts. Because the original lease guaranteed the statutory minimum amount, the agreements were valid under the GMRA. The amendment was then a division of the guaranteed minimum royalty. The mineral rights owners appealed arguing that the GMRA does not allow for a reduction of the minimum royalty amount through an “assignment-back” to the lessee. In the first tier review, the Superior Court agreed.
The Superior Court found that a lease is a contract and is subject to normal contract interpretation; therefore, the original lease must be read along with the amendment in order to establish the entire intent of the parties. The amendment directly noted the previous agreement; in fact, the amendment both referenced and incorporated the previous agreement. With this understanding, the court found that the record did not support Lancaster’s claim that under the amendment it would not be producing any oil or gas, but only providing marketing services. The court wanted to make clear that the mandates of the GMRA cannot be circumvented by establishing a one-eighth royalty by requiring that the lessor assign half back.
Questioning the Clarity of the GMRA
The Superior Court found that the terms of the GMRA were “clear and unambiguous and the provision’s intent to protect Lessors plain.” The GMRA provides the following:
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.
The intent of the legislature to protect the interest of mineral owners by assuring they receive at least the industry standard one-eighth royalty certainly appears clear. However, the language is not as “clear and unambiguous” as the Superior Court stated.
Seemingly, all the GMRA guarantees is an untouched one-eighth royalty in the pre-production costs of the well. This is consistent with both the general industry understanding, and the traditional view of the Pennsylvania courts. However, the GMRA does not mention how post-production costs are affected. Therefore, although it protects a lessor from costs associated with activities such as initial drilling and exploration, it does not guarantee a lessor’s royalty will not be affected by costs such as transportation or marketing.
The term “royalty” had already faced challenges in Pennsylvania courts because the statute lacks guidance concerning the method of calculating the value of the gas recovered. In calculating the value of the recovered gas, energy companies needed to know whether they could factor in the pre or post-production costs incurred by the company. In Kilmer v. Elexco Land Services, the Supreme Court of Pennsylvania ruled that pre-production costs could not be deducted from a lessor royalty; however, post-production costs could. The language of the “assignment back” provision in Southwestern was intended to create that transaction where the lessors would cover a portion of the marketing costs—a post-production cost.
The issues with interpreting aspects of the GMRA, such as “royalty,” makes some within the industry extremely cautious when leasing in Pennsylvania, especially because of the great risk created by failure to comply with the provisions of the act in drafting and implementing leases. Although Southwestern was remanded for determination on a number of issues, the lease could still be invalidated.
Effects on the Industry Going Forward
Pennsylvania courts allow oil and gas companies to subtract some post-production costs from the lessor’s royalty. Following Kilmer, this was understood by many in the industry to mean subtraction of post-production expenses like marketing would be a standard deduction. Oil and gas companies were given deference in their determination of the post-production costs; courts generally accepted companies’ formulas for royalty calculations provided that a one-eighth royalty reservation was in place pre-production. Southwestern seems to shift the power back to landowners. Now post-production costs may be examined more closely to determine if the lease violates the GMRA by reducing the mandatory royalty through disguised post-production costs.
Going forward, energy companies, landowners, and their attorneys must continue to be cautious of the penalty for violating the GMRA. If an energy company and landowner desire to split the costs of marketing natural gas in an attempt to increase both of their profits, they must be sure to draft separate conveyances, independent of the initial lease. The court’s indication that lessors can freely transfer or assign the royalty they receive indicates that the intent of the “assignment-back” amendment from Southwestern can be achieved, albeit by other means. However, attorneys must be cautious and assure both that their language is clear and that all parties involved understand the risks of the agreement.
Pennsylvania’s GMRA is an oddity in oil and gas producing states. Most states that have large production of natural resources, like Texas and West Virginia, do not bother to mandate a minimum royalty. Most states and producers allow the market to determine royalties, with an industry understanding that one-eighth is the minimum. In fact, royalties can often amount to more than one-eighth, sometimes up to one-fifth or more with additional bonuses to be paid per acre. Producers understand making an agreement to include a royalty less than the standard industry royalty would be harmful to business, especially during a gas boom like the one we are experiencing now.
The agreement made in Southwestern v. Forest Resources exhibited the intent of both parties to increase the potential profits from the acreage, which they believed could be best achieved by increasing the funds held by the marketing company. The GMRA was created to protect lessors, but today the market provides more than adequate protection. Pennsylvania should revisit the statute and determine what protection it feels lessors need outside the market. Currently, the statute is interpreted to only protecting the same rights as those protected through common law decisions. If the legislature feels lessors should not have to pay pre-production or post-production costs, then the statute should be adjusted to say as much. Without those changes, the legislature might consider repealing the statute and allowing the common law to govern royalties.
Otherwise, going forward, lessees and lessors may conclude that the best course of dealing would be having additional funds in the hands of a marketing company, and the ruling in Southwestern v. Forest Resources will not stop these individuals from effectively reducing the royalty to less than one-eighth. The only thing difference going forward will be the manner in which they reduce the royalty.
 Southwestern Energy Prod. Co.v. Forest Resources, LLC, 2013 Pa. Super. LEXIS 3184.
 58 P.S. § 33.3 (2013).
 Southwestern Energy Production Company succeeded to Lancaster’s interests in the property. Southwestern v. Forest Resources, 2013 Pa. Super. LEXIS 3184 at *2-3. Southwestern subsequently succeeded to Lancaster’s interests in the subject property.
 See Id.
 Id. at 19-20.
 Id. at 22-24.
 Lease Amendment Assigning Portion of Lessor’s Royalty Interest to Lessee Violates Pennsylvania’s Guaranteed Minimum Royalty Act, December 2, 2013, http://www.mcguirewoods.com/Client-Resources/Alerts/2013/12/Lease-Amendment-Assigning-Portion-of-Lessors-Royalty-Interest.aspx.
 Southwestern v. Forest Resources, 2013 Pa. Super. LEXIS 3184 at *31.
 58 P.S. § 33.3 (2013).
 George A. Bibikos & Jeffrey C. King, A Primer on Oil and Gas Law in the Marcellus Shale States, 4 Tex. J. Oil and Gas & Energy L. 155, 181 (2008-2009).
 See Kilmer v. Elexco Land Services, Inc., 605 Pa. 413, 990 A.2d 1147 (Pa. 2010). The court found that the post-recovery costs, such as refinement and transportation, could be subtracted from the royalty to be paid; however, pre-recovery costs incurred were the sole responsibility of the lessee.
 Russell L. Schetroma, Oil and Gas Law: Nationwide Comparison of Laws on Leasing, Exploration and Production (Pennsylvania) 262 (George A. Snell & Richard A. Rosprim eds., 2011)
 Michael Morris, 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, 48 (2012).
 See Id.
 E.g. Bradshaw v. Steadfact Fin., L.L.C., 395 S.W.3d 348 (Tex. App. Fort Worth, February 14, 2013).
 See John S. Lowe, Oil and Gas Law in a nut shell 278-287 (2009).