CHAPTER 10 LEASING AND DEVELOPMENT IN THE MARCELLUS SHALE REGION: AVOIDING THE PITFALLS
| Jurisdiction | United States |
(Dec 2010)
LEASING AND DEVELOPMENT IN THE MARCELLUS SHALE REGION: AVOIDING THE PITFALLS
Ariel E. Nieland
Reed Smith LLP
Pittsburgh, Pennsylvania
KEVIN C. ABBOTT is a partner in Reed Smith's Pittsburgh office. He has been recognized in Pennsylvania Super Lawyers in the energy field each year from 2004 through 2010 and is also listed in Super Lawyers Corporate Counsel Edition in the area of energy and natural resources. Kevin has represented companies in all facets of the natural gas business for 25 years. He represents exploration and development companies on various issues related to the exploration of the Marcellus Shale, including royalty disputes, lease issues and other litigation. Kevin graduated from Indiana University of Pennsylvania magna cum laude in 1978 and the University of Pittsburgh School of Law magna cum laude in 1981. He clerked in the United States District Court for the Northern District of Ohio and the United States Court of Appeals for the Sixth Circuit. He is admitted to practice in Pennsylvania and West Virginia and all federal courts in Pennsylvania, West Virginia and Ohio.
The Marcellus Shale boom in natural gas exploration in Pennsylvania has brought with it a predictable wave of litigation as leasing activity and development progress. This paper will address the major areas of litigation, the results thus far and what likely lies ahead.
As with most litigation, the activity thus far has been largely motivated by the parties' economic interests. This paper will look at the flood of cases in Pennsylvania brought by lessors seeking to void their leases in order to try to benefit from the change in market conditions resulting from the intense competition to acquire Marcellus Shale leases, royalty calculation issues, disputes with surface owners, and other issues that are, or will be, faced by exploration and production companies as the Marcellus Shale is developed.1
I. ROYALTY ISSUES
The first wave of litigation has focused on claims by plaintiffs that their existing leases should be considered void or not binding upon them in order to allow them to negotiate new leases as free agents under the current Marcellus Shale market conditions. As discussed below, many of those claims have been resolved. The next wave of royalty litigation will likely focus on the calculation of royalties, particularly the type and amount of post-production costs that may be charged to lessors.
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A. Post-Production Costs
Most of the litigation on royalty issues relates to the issue of whether post-production costs can be charged to lessors, and, if so, what costs can be charged.
It is undisputed that the lessee/producer bears all of the costs of producing gas.2 Those costs include preparing the site for the well, buying the materials for the well, drilling the well, fracturing or stimulating the underground formations from which the gas is produced, and restoring the well site. These costs are substantial, especially for horizontal wells designed to produce gas from the Marcellus Shale formation. In addition to bearing 100% of the costs of production, the lessee/producer also bears 100% of the risk that the well will not produce gas.
If a well is successfully drilled, the natural gas is produced at the wellhead. Although the gas theoretically could be sold at the wellhead, in the current structure of the industry, it is more typically sold downstream. Between the point of production and the point of sale, various costs can be incurred that improve the condition and value of the gas. The gas can be processed or dehydrated in order to improve its quality, it can be compressed in order to allow it to flow into higher pressure pipelines, and it can be transported to a delivery point for sale.
B. Pennsylvania Guaranteed Minimum Royalty Act Claims
Whereas the issue of the deductibility of post-production costs has arisen in other states in the form of declaratory judgment or damages claims brought by royalty owners against exploration and production companies, the issue was first raised in Pennsylvania in the form of a
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flood of claims brought to declare existing leases void under Pennsylvania's Guaranteed Minimum Royalty Act ("GMRA").3
1. The Pennsylvania Act
In 1979, with no fanfare and virtually no legislative history, the Pennsylvania legislature passed the GMRA, which states as follows:
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 lease does not guarantee the lessor at lease 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.
An oil, natural gas or other designation gas well or oil, natural gas or other designation gas lease which does not provide a one-eighth metered royalty shall be subject to such an escalation when its original state is altered by new drilling, deeper drilling, redrilling, artificial well stimulation, hydraulic fracturing or any other procedure for increased production. A lease shall not be affected when the well is altered through routine maintenance or cleaning.
58 P.S. § 34.
Whenever such increased production procedure has been completed prior to the effective date of this act, metering and the above royalty shall commence within 90 days after the effective date of this act.
58 P.S. § 35.
From 1979 until recently, the GMRA was little noted or discussed by the courts of Pennsylvania or by lessors and lessees. In the sole published opinion concerning the GMRA, the Pennsylvania Supreme Court held in 1992 that the statute could not be applied retroactively so as
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to reform a pre-Act flat-rate lease to provide for a one-eighth royalty.4 A "flat-rate" lease is a lease that provides for a stated annual royalty (e.g. $200 per year) that is not tied to the volume of the oil or gas produced. Such provisions were fairly typical in natural gas leases prior to the enactment of the 1979 act. In contrast, the vast majority of leases executed after the GMRA provided for a royalty of one-eighth of production and many allowed for the deduction of certain expenses incurred after production.
2. Marcellus Shale Development Brings Flood of Claims
As a result of the prospect of the development of the Marcellus Shale, over 70 different lawsuits, involving hundreds of leases, were filed in state and federal courts in Pennsylvania. Although the claims varied, the central claim common to all of the cases was the royalty owners' contention that any lease clause that explicitly or implicitly permits the deduction of post-production costs in the calculation of a royalty violates the GMRA and, as a result, rendered the lease void because the GMRA requires a guarantee of a minimum royalty of one-eighth. The royalty owners contend that they are entitled to at least one-eighth of the proceeds of the sale of the gas, without any deductions at all.
A few of the cases were short-circuited before the merits could be heard. In some cases, the producers sought to shift the cases to arbitration because the leases contained provisions that called for the arbitration of all disputes. Several courts, rejecting the royalty owners' arguments that the arbitration provisions did not apply because the leases containing the arbitration provisions were void.5 The perceived value of arbitration to the producers was that it seemed
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less likely that an arbitrator would declare the leases void and, even if they did, that decision would be private (and therefore, a bad decision would not create precedent). Some federal judges simply refused to entertain the claims, invoking their discretionary power to decline to hear a declaratory judgment claim because the dispute involved a declaration of the meaning of a state statute that had never been interpreted by the state courts.6
A few cases did address the issue on the merits. In two cases decided by the same federal judge, the court denied the producer's motion to dismiss the royalty owners' claims in language that, while dicta, favored the plaintiffs' view.7 The court stated that "[a]lthough the lease technically does provide for a one-eighth royalty, it then proceeds to explain that costs will be deducted from that amount. The royalty then becomes less than one-eighth and a violation of the plain language of the statute."8 The federal court, however, did not deny the motions to dismiss on that basis. Instead, the court found that the term "royalty" was ambiguous because some jurisdictions permit deduction of post-production expenses while others, relying on the implied covenant of marketability, do not allow such deductions unless they are expressly agreed to in the lease. Because the court found the term "royalty" to be ambiguous, it denied the motion to dismiss.9
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In a state court case, however, the trial court granted the producer's motion for summary judgment.10 The royalty owners appealed to the state's intermediate appellate court, the Pennsylvania Superior Court, but the producer asked the Pennsylvania Supreme Court to exercise its extraordinary jurisdiction and take the issue itself (thus bypassing the Superior Court).11 The producer's motion, supported by the state's largest oil and gas trade associations, contended that with the large number of cases in various state and federal courts, there was a risk of inconsistent interpretations of the GMRA, which would lead to chaos in the industry. Because the meaning of the GMRA (and the resulting validity or invalidity of thousands of leases) was critical to the state's oil and gas industry, the producer and the trade associations argued that the state's highest court needed to decide the issue definitively. The Pennsylvania Supreme Court agreed and...
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