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“At the Wellhead” Language and Use of the Net-Back Method in Pennsylvania

By Paul R.Yagelski, Esquire

Is Kilmer to be construed broadly or narrowly?

In Coastal Forest Res. Co. v. Chevron U.S.A., No. 2:20-cv-1119, 2021 U.S. Dist. LEXIS 89675 (W.D. Pa. May 11, 2021), the United States District Court for the Western District of Pennsylvania had before it the issue of whether the Pennsylvania Supreme Court’s decision in Kilmer v. Elexco Land Servs., Inc., 605 Pa. 413, 990 A.2d 1147 (Pa. 2010) should be read as providing an industry wide interpretation of the term “at the wellhead” as permitting the use of the net-back method to recoup post-production expenses, or whether it is limited to the context of whether the method violates Pennsylvania’s Guaranteed Minimum Royalty Act (“GMRA”), 58 P.S. § 33, repealed by Oil and Gas Lease Act, 58 P.S. § 33.3 (2013).  To put it another way, in Coastal Forest Res., the district court addressed the question of whether Kilmer should be given broad construction, covering all instances where the term, “at the wellhead,” is used or whether Kilmer was narrowly focused on whether leases using that term run afoul of the GMRA.

In Coastal Forest Res., Coastal Forest Resources Company (“Coastal Forest”) asserted claims for breach of contract and accounting against Defendants, Chevron U.S.A., Inc.; Chevron Appalachia, L.L.C.; and Atlas America, L.L.C. (collectively “Chevron”), contending that Chevron’s use of the net-back method to recover post-production costs violated the terms of its oil and gas lease (“Lease”).  Chevron filed a Motion to Dismiss the Complaint under Federal Rule of Civil Procedure 12(b)(6), arguing that Coastal Forest’s claims failed as a matter of law because the Lease’s language governing royalties incorporates the “at the wellhead” term that the Pennsylvania Supreme Court held in Kilmer permits the recovery of post-production costs.  The district court granted Chevron’s Motion to Dismiss, holding that the Kilmer decision must be read broadly.  As such, Coastal Forest could not prevail on its breach of contract and accounting claims.

Coastal Forest is the owner of a mineral estate of approximately 356.4 acres in Greene Township, Greene County, Pennsylvania.  Coastal Forest’s Lease provided that the lessor would be paid a production royalty on gas and hydrocarbon products as follows:

Gas: To pay Lessor as royalty for all gas and the constituents thereof, including all liquid, solid or gaseous substances produced and saved from any sand or sands on the leases [sic] premises, an amount equal to five-thirty-seconds (5/32) or 15.625% of the gross sales price received by Lessee from the sale of such gas and the constituents thereof at the wellhead. (emphasis added)

Coastal Forest alleged that Chevron took unauthorized deductions from the gross sales price for post-production costs by using the net-back method[1].  Coastal Forest alleged that these deductions were inconsistent with the above-referenced plain language of the Lease.  Specifically, Coastal Forest contended that Chevron unilaterally deducted $53,834.28 for “costs/other adj” from Coastal Forest’s interest in the mineral estate, which was $266,195.99.  When Coastal Forest asked what “costs/other adj” meant, Chevron stated the deductions were for post-production costs.  When Coastal Forest asked Chevron for further details on the post-production costs and the calculations for royalties owed to Coastal Forest from the production of marketable gas, Chevron did not respond to Coastal Forest’s request for production and well information/data.

Coastal Forest argued that Kilmer was not meant to provide an expansive definition that would allow the net-back method to be used in all instances where the “at the wellhead” language is present, but rather, that Kilmer was a case of narrow statutory interpretation limited to the construction of the GMRA.

The district court disagreed.  In undertaking its own interpretation of Kilmer, the district court held that Kilmer should be construed broadly and critically read through the prism that the Pennsylvania Supreme Court used in interpreting the “at the wellhead” language.  As the Pennsylvania Supreme Court reasoned, one of the fundamental methods for statutory interpretation is to examine the industry accepted definition.  The Pennsylvania Supreme Court could not rely upon a GMRA-specific definition of “at the wellhead” or “net-back method” because there was none.  Lacking a statute-specific definition of those terms, the Pennsylvania Supreme Court took a broader view as to how they are treated in the oil and gas industry.  In doing so, it examined several treatises that stand for the proposition that leases using the “at the well” terminology permit the use of the net-back method to recover post-production expenses.  The Pennsylvania Supreme Court applied this industry-accepted usage to the specific issue of whether the net-back method violated the GMRA.  It did not, and in light of its interpretative methodology, it could not limit its interpretation of the “at the wellhead” language to the confines of the GMRA.  Rather, it applied the interpretation of the contractual language that was already well established in the oil and gas industry.

The district court conducted its own review of industry authorities and found that its review only highlighted the fact that the Pennsylvania Supreme Court’s determination was broad and should be afforded broad application whenever the term “at the wellhead” is used.  The district court concluded that the “at the wellhead” language is used to indicate “that any downstream costs incurred by the operator from the well to the place where the leased product is disposed of in an arm’s length transaction are borne pro rata by owners of operating and owners of non-operating interests.”  Coastal Forest Res., 2021 U.S. Dist. LEXIS 89675, at *17 (citing 3 Patrick H. Martin & Bruce M. Kramer, Williams & Meyers, Manual of Oil and Gas Terms § 645.2, § A (17th ed. 2018)).

In short, under the district court’s holding, and despite the wording in the Lease of a gas royalty of 15.625% of the gross sales price received by Lessee, the Lease, because it uses the term “at the wellhead,” calls for the calculation of royalties using the net-back method.  As the Lease provisions expressly and unequivocally call for the calculation of royalties “at the wellhead,” the Lease must be interpreted as permitting the net-back method.  As such, and although the district court’s decision is not binding on Pennsylvania’s state courts, in negotiating an oil and gas lease for a landowner or a royalty owner, the words “at the wellhead” should be deleted from the lease’s royalty provision if a gross lease is contemplated.

If you have questions about your oil and gas lease language, contact us online or call (412) 338-1124.

[1] The net-back method allows deductions for certain post-production expenses associated with bringing the oil or gas to market from the royalty paid to the lessor.  Royalties are paid subject to the right of the operator to recoup its post-production expenses.  To do so, they are calculated as “one-eighth of the sale price of the gas minus one-eighth of the post-production costs of bringing the gas to the market.”  Kilmer, 990 A.2d at 1149.

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