The Royalty Rub

When Mary Jane Foelster and her husband, Richard, retired five years ago and left Philadelphia for a secluded 50-acre tract of land in Bradford County, they never figured they’d get rich.

In fact, until they were about to close on the property, they didn’t even know that the previous owners had signed a lease with Chesapeake Energy. That lease guaranteed the Foelsters a 12.5 percent cut of proceeds of the gas that the company and its partners planned to siphon out from underneath their land—the rock-bottom minimum allowed by law in Pennsylvania.

They didn’t object. The extra income probably wouldn’t be much, but it would be welcome.

But that income has been considerably less than they believed it would be. In the 18 months or so since they received their first royalty check from Chesapeake for their portion of the square-mile drilling unit they’re in, they’ve seen steep drops in the amount of money they receive. Some months, Mary Jane Foelster said, fully 90 percent of their 12.5 percent royalty was eaten up by deductions taken by the company. Even more puzzling, she said, was the fact that Chesapeake’s partner in the well, Statoil Hydro, was taking no deductions at all.

“I think the last check was for $126. And that’s for 50 acres from Chesapeake,” she said. “The other company… is actually taking out a great deal less (gas), they have a smaller percentage of the unit (about 25 percent), and they’re paying two and three times as much to us as Chesapeake.”

The Foelsters are not alone. Over the past two years, many landowners—most of them in the northern tier, but some in Greene and Washington counties as well—have found that their monthly royalty checks were often far less than the one-eighth share they had been expecting.

They have accused drillers—Chesapeake in particular, though not exclusively—of unfairly withholding significant amounts of money and of charging them for post-production costs, processing the gas, developing infrastructure and the like, that they never expected to bear.

The issue, at least in the northern tier, has become contentious enough that a group of about 5,000 disgruntled landowners filed a class-action suit against the gas industry giant. Last September, Chesapeake agreed to a settlement that required the company to pay $7.9 million to the landowners, in essence returning 55 percent of most of the deductions taken from the landowners, excluding transportation costs, up until Sept. 1, 2013, said Michelle O’Brien, one of the lawyers representing the landowners. Going forward, the landowners and the companies will split the post-production costs—though not evenly. Chesapeake will pay 23.5 percent of the costs while the landowners will pay the remaining 72.5 percent.

Chesapeake, which has faced similar allegations across the country, did not respond to requests for an interview for this story. But in a statement released after the settlement was announced, Chesapeake spokesman Jim Gipson described the settlement as “fair and reasonable.”

While that settlement may have pleased the landowners and the company, it does not address the underlying issue, the complicated and confusing issue of just how much a company can deduct and still meet its legal obligation to pay the landowner a guaranteed one-eighth minimum royalty. The question at the heart of the issue is this: At what point in the chain of events that carry the gas from the wellhead to the pipeline to the marketplace should royalties be calculated?

As it turns out, that’s not an easy question to answer.

Most analysts agree that drillers have the right to take certain deductions from royalty payments, unless the language of a landowner’s lease specifically prohibits them from doing so. (In the interest of full disclosure, my own family’s lease with Chesapeake on our 100 acres in Wyoming County defines the types of deductions the company may take, and we have not faced unexpected deductions). Their right to take the deductions was affirmed in 2010 by the Pennsylvania Supreme Court in its decision in Kilmer v. Elexco Land Services, Inc.

But the court also opened the door to further controversy when it declared in its unanimous opinion that the state legislature, in its 1979 law establishing the 12.5 percent minimum royalty, failed to define the word “royalty.” More precisely, the law failed to declare at what point in the process royalties should be calculated.

If the royalty was calculated at the wellhead, before it was processed and sent to market, then the royalty amount could be calculated on the price of the raw gas, and the cost of turning that gas into a marketable product could be passed along, at least in part, to the landowner. If, on the other hand, royalties are calculated on the price the producer receives for the gas at the point that it enters the marketplace—an interstate pipeline—a landowner would expect to receive a larger royalty check.

In effect, the Supreme Court left that question for the legislature to resolve. “The General Assembly is the branch of government best suited to weigh the public policies underlying the determination of the proper point of royalty valuation,” the court wrote.

Now, after three years of legal wrangling over the issue, some in the legislature are taking on the issue. In September, state Rep. Garth Everett, a Republican from Lycoming County, together with a handful of representatives from the northern tier, drafted a bill that would amend the 1979 Guaranteed Minimum Royalty Act to require that royalties be calculated at the point where the gas enters the pipeline. The bill would effectively guarantee that the promised minimum royalty of 12.5 percent is one-eighth of the higher-priced marketable product and that the drillers would bear most of the cost of getting the gas to that point.

“The basic idea of our legislation is… no matter what you want to say about post-production costs or deductions or gathering costs, no matter what, you can’t pay less than 12.5 percent,” Everett told Pittsburgh Quarterly.

The bottom line, Everett said, is that landowners signed leases believing that they were going to get at least a 12.5 percent royalty, and the bill he’s introduced would make sure that happens. “When many of my constituents were signing leases they were told by the land people who were at their kitchen tables or on the phone with them, ‘You don’t have to worry about what this lease says about these deductions and all that stuff. Pennsylvania is a minimum royalty state and you’re going to get one-eighth—12.5 percent—no matter what this says.’ I know for sure that many people were told that,” he said. “What I am saying, and what my legislation is saying is at the end of the day, it’s 12.5 percent. You can’t—through deductions and deductions and this deduction and that deduction—take somebody below 12.5 percent. Or in some cases… end up paying no royalties using deductions.”

Predictably, he says, the industry has thus far been less than enthusiastic about the measure. In fact, in an interview a week before the bill was formally introduced, Everett noted that representatives of the industry had “already been in touch with me. They said they’re willing to work with me on it, but they’re generally not supportive.”

Publicly, the industry and the Marcellus Shale Coalition have remained mum on Everett’s bill. The coalition did not respond to a request for an interview for this story.

But the industry is not the only group that has reservations about Everett’s measure. While the Pennsylvania chapter of the National Association of Royalty Owners is generally supportive of the measure, the group at this point argues that Everett’s bill does not go far enough. “We think defining royalty at the point of valuation is the key,” said Jackie Root, the group’s Pennsylvania president. “We don’t think the legislation adequately addresses it.”

“We are having a dialogue with Everett’s office,” Root said.

Even if the landowners and Everett and his fellow Republican co-sponsors from the affected areas can reach agreement on language that all of them are happy with, they may still find it hard to drum up widespread support for it among other Republicans in areas that have not yet seen many problems with deductions, both Root and Everett acknowledged.

Thus far, the issue has largely been confined to a few drillers in a comparatively small portion of the larger Marcellus drilling area, they said. As a result, both are concerned that lawmakers, many of them fellow Republicans who are generally seen as supportive of the industry, may not rally behind the measure.

That, says Bradford County Commissioner Daryl Miller, would be shortsighted. “Even if it is isolated here, I’m afraid that if it’s not addressed here shortly, it will spread, because there are other companies that are talking about doing it to various degrees [and are] starting to take out post-production costs,” Miller said.

National Association of Royalty Owners board member Bill Wilson agreed. The way he sees it, if the legislature and the association don’t draw a line in the sand, and prevent the handful of companies that are currently taking deep deductions from doing so, other drillers in the rest of the state will follow suit. “If Chesapeake gets away with it, then everybody’s going to want to do it,” Wilson said. “It’s just in the nature of the beast. How can you go to your stockholders and say, ‘Well, they’re doing it, and… everybody’s letting them, and we’re not doing it?’ And the stockholders would be saying, ‘What are we, stupid?'”