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Kilmer v. Elexco Land Services

March 24, 2010

HERBERT KILMER, ELSIE KILMER, JACQUELINE FRANTZ, JEFFREY KILMER, DIANE KILMER, KENNETH KILMER, AND THOMAS KILMER, APPELLANTS
v.
ELEXCO LAND SERVICES, INC. AND SOUTHWESTERN ENERGY PRODUCTION COMPANY, APPELLEES



Appeal from the Order of the Susquehanna County Court of Common Pleas, Civil Division, at No. 2008-57 dated March 3, 2009 (Plenary Jurisdiction granted from the Superior Court No. 464 MDA 2009).

The opinion of the court was delivered by: Mr. Justice Baer

CASTILLE, C.J., SAYLOR, EAKIN, BAER, TODD, McCAFFERY, GREENSPAN, JJ.

ARGUED: September 16, 2009

OPINION

The case at bar concerns the proper construction of the term "royalty" as it is used in the Guaranteed Minimum Royalty Act ("GMRA"), 58 P.S. § 33, which governs, inter alia, leases between Pennsylvania landowners and gas companies seeking to drill natural gas wells into Pennsylvania's Marcellus Shale deposits. As developed below, the GMRA requires that leases guarantee the landowner-lessor "at least 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.*fn1 Although the critical term "royalty" is not defined by the statute, many leases in the Commonwealth, including the lease at issue before this Court, calculate the royalties as one-eighth of the sale price of the gas minus one-eighth of the post-production costs of bringing the gas to market.*fn2 This calculation is called the "net-back method," as its goal is to determine the value of the gas when it leaves the ground (hereinafter "at the wellhead") by deducting from the sales price the costs of getting the natural gas from the wellhead to the market.*fn3 The landowners in this case filed for declaratory judgment seeking to void their lease, arguing that the net-back method of calculating royalties violates the GMRA. The trial court rejected this argument and granted summary judgment to the gas companies. After exercising extraordinary jurisdiction, we affirm the decision below.

The Marcellus Formation is a region of natural gas-rich shale extending from New York to West Virginia, including large portions of Pennsylvania. See generally Timothy Considine, et al, Pennsylvania State University, An Emerging Giant: Prospects and Economic Impacts of Developing the Marcellus Shale Natural Gas Play (2009). While the existence of the gas deposits in the area have been known for a long time, recent developments in drilling techniques have allowed for the potential recovery of dramatically larger quantities of natural gas. Estimates suggest that the area could contain over 489 trillion cubic feet of recoverable gas, enough to supply the natural gas needs of the United States for fourteen years. The developments in recovery techniques and the proximity of the formation to the energy markets of the east coast cities has created a surge of interest in drilling in the area. Consequently, gas companies in the past few years have offered landowners much more lucrative lease terms than were present in older leases, given the increased competition for drilling rights. This has caused some landowners to review their older leases and question whether the terms provided therein comply with the GMRA.

In January 2008, Landowners*fn4 in the present case filed a complaint for declaratory judgment in the Court of Common Pleas of Susquehanna County seeking to invalidate their 2007 lease, asserting that the lease violated the one-eighth royalty requirement of the GMRA because the net-back method resulted in a royalty less than one-eighth of the value of the gas. The relevant provision of the lease provided for the calculation of royalties as follows:

3. Royalty Payment. For all Oil and Gas Substances that are produced and sold from the leased premises, Lessor shall receive as its royalty one eighth (1/8th) of the sales proceeds actually received by Lessee from the sale of such production, less this same percentage share of all Post Production Costs, as defined below, and this same percentage share of all production, severance and ad valorem taxes. As used in this provision, Post Production Costs shall mean (i) all losses of produced volumes (whether by use as fuel, line loss, flaring, venting or otherwise) and (ii) all costs actually incurred by Lessee from and after the wellhead to the point of sale, including, without limitation, all gathering, dehydration, compression, treatment, processing, marketing and transportation costs incurred in connection with the sale of such production. For royalty calculation purposes, Lessee shall never be required to adjust the sales proceeds to account for the purchaser's costs or charges downstream from the point of sale.

Lease between Kilmer et. al and Elexco Land Services, Inc, dated October 15, 2007 ("Lease") (emphasis added).*fn5 Similar royalty provisions are present in many other leases across the Commonwealth. According to Landowners, this provision violates the GMRA, which provides in full:

§ 33. Guarantee of minimum royalties

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.

58 P.S. § 33.

As the case presented the trial court with a pure question of law regarding the requirements of the GMRA, both parties filed motions for summary judgment.*fn6 In March 2009, the trial court granted summary judgment in favor of the Gas Companies and denied Landowners' motion for summary judgment. The court concluded that there were no issues of material fact and that the GMRA does not preclude the parties from utilizing the net-back method of royalty calculation. The Gas Companies discontinued their other claims and praeciped for the entry of judgment. Landowners timely appealed to the Superior Court.

In a very brief opinion in support of its decision, the trial court observed that no Pennsylvania appellate court had yet spoken to the question of whether the net-back method of royalty calculation violated the GMRA, despite the numerous cases then pending in Pennsylvania trial courts involving the same question. The trial court acknowledged, but did not rely upon, the Gas Companies' argument that the term "royalty" had acquired a meaning in the industry that was consistent with the use of the net-back method. The court, however, ultimately held that the lease did not violate the GMRA because "[t]he statute in question does not prohibit the inclusion of 'post-production' costs to calculate the ...


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