Preparing for the New Pennsylvania "Oil and Gas Lease Act"

by K&L Gates LLP
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Introduction
Over recent months, the Pennsylvania General Assembly has increased its focus on issues surrounding royalty payments to landowners from oil and natural gas producers; and on June 30, the legislature sent to the Governor Senate Bill 259. Upon approval by the Governor, SB 259 will enact the “Oil and Gas Lease Act,” (the “Act”) requiring further disclosures to royalty owners in the accounting statements that they receive with their checks regarding how those royalties are calculated. The Act would require natural gas producers to include ten different categories of information on periodic financial statements or “check stubs” sent to royalty owners.

In addition to the increased disclosure requirements, the Act: (i) re-codifies the guaranteed minimum royalty provisions of the prior law, (ii) implements new and significant provisions concerning unitization of contiguous parcels for horizontal drilling, and (iii) effectively eviscerates the use of division orders to amend or alter the oil and gas lease relationship.

The Act—which becomes effective in 60 days from enactment—will impact already busy accounting departments of natural gas producers, and may require quick implementation of new accounting processes and software to address the new disclosure requirements under the Act. And the Act’s provisions concerning unitization and division orders may lead to additional disputes between landowners and producers, which the courts could be called upon to resolve.

But beyond these practical issues, the Act may signal a broader desire by the legislature to become increasingly involved in a relationship traditionally governed by private agreement in Pennsylvania.[1] Accordingly, parties to oil and gas leases should closely watch the potential effect of not only the Act, but also further legislative action that may affect their contractual relationships.

Background
The Act amends the 1979 Guaranteed Minimum Royalty Act (“GMRA”). The GMRA provides that “[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 1/8th royalty of all oil, natural gas or gas of other designations removed or recovered from the subject real property.”

As interpreted by the Pennsylvania Supreme Court in Kilmer v. Elexco Land Services, Inc., 990 A.2d 1147 (Pa. 2010), the GMRA requires at least a 1/8th royalty calculated at the well, and leases that authorize the lessor and lessee to share in “post-production” costs (incurred after the wellhead) may do so as long as the net royalty is at least one-eighth of the wellhead value of the oil or gas. That wellhead value could be calculated based on the “net-back” method—that is, by deducting from the royalty the lessor’s 1/8th share of the post-production costs incurred by the producer in order to deliver the gas to a sales point.

Neither the GMRA nor Kilmer required that production companies itemize post-production costs that they share with the lessor. Recently, however, royalty owners began requesting more detailed accounting information with respect to how their royalties were being calculated, seeking disclosure of the amounts of post-production costs that were being deducted in calculating their royalties. These requests appear to have prompted the Pennsylvania General Assembly to pass the Act, joining several other states that have passed similar laws requiring more detailed royalty reporting, notwithstanding the lack of provisions in the oil and gas leases requiring such reporting.

The Act’s Reporting Obligations
As a threshold matter, the Act does not change the GMRA. The minimum royalty and escalation provisions of the prior law remain and have been re-codified. The Act, however, imposes on producers a new requirement that they provide certain accounting information each time that they make a royalty payment. There are at least three significant aspects of the Act’s reporting requirements, of which producers and royalty owners should be aware.

First, the Act applies to payments to all “Interest Owners.” The Act defines an “Interest Owner” as a “person who is legally entitled to payment from the proceeds derived from the sale of oil or gas from an oil or gas well located in this Commonwealth.” Because of the broad definition of “Interest Owner,” it would appear that the Act potentially applies not only to royalty owner/oil and gas lessors, but also to working-interest owners, overriding royalty owners, joint-venture partners, and any other individual or entity who shares in the proceeds from the sale of oil and gas.

Second, whenever payment is made for oil or gas production to an interest owner, whether pursuant to a division order, lease, servitude, or any other agreement, the Act requires producers to set forth either on a check stub or an attachment to the form of payment, a statement that lists, at a minimum:

“(1) A name, number or combination of name and number that identifies the lease, property, unit or well or wells for which payment is being made; and the county in which the lease, property or well is located.
(2) Month and year of gas production.
(3) Total barrels of crude oil or number of Mcf of gas or volume of natural gas liquids sold.
(4) Price received per barrel, Mcf or gallon.
(5) Total amount of severance and other production taxes and other deductions permitted under the lease, with the exception of windfall profit tax.
(6) Net value of total sales from the property less taxes and deductions from paragraph (5).
(7) Interest owner’s interest, expressed as a decimal or fraction, in production from paragraph (1).
(8) Interest owner’s share of the total value of sales prior to deduction of taxes and deductions from paragraph (1).
(9) Interest owner’s share of the sales value less the interest owner’s share of taxes and deductions from paragraph (5).
(10) Contact information [of producer], including an address and telephone number.”

Third, producers need not provide the foregoing information on a check stub or attachment form if “the information is otherwise provided on a regular basis.” The Act, however, does not set forth how frequently such information must be disclosed in order to be considered being “provided on a regular basis.”

Other Features of the Act
In addition to the royalty reporting requirements, other notable features of the Act include:

  • Unitization/Apportionment. The Act’s new apportionment section is significant in at least two respects. It provides the right to unitization or pooling of contiguous leases and development by horizontal drilling over the contiguous area, so long as the leases do not expressly prohibit such unitization. Thus, if the leases are silent on unitization or utilizing horizontal drilling on unitized premises, the Act provides statutory authority to engage in such development. Additionally, the Act states that, absent agreement, production and royalties over the contiguous unit are to “be allocated to each lease in such proportion as the operator reasonably determines to be attributable to each lease.”
  • Division Orders. The Act includes a new section that provides that where there is a conflict between a division order and an oil and gas lease, the terms of the oil and gas lease shall control. The Act makes clear that a division order may not amend or supplement the terms and conditions of an oil and gas lease. Accordingly, the Act appears to have precluded parties to an oil and gas lease from utilizing division orders to amend the terms of their agreements.
  • De Minimus Payments. The Act has a provision that permits producers to accumulate and remit royalty payments annually for those amounts totaling less than $100. Thus, this provision would permit producers to dispense with issuing monthly royalty payments for small payment amounts, and may ease the administrative burden and costs associated with issuing monthly checks as production in a well nears completion.
  • Effective Date. The Act’s proposed effective date is 60 days from enactment.

Conclusion
The Oil and Gas Lease Act may have a significant effect on how producers account for and report royalty payment information. With only a 60-day window before the Act becomes effective, this may require producers to re-configure their accounting systems or create new software to generate the type of information required under the Act.

Additionally, as the Act is being applied, additional disputes may arise. For example, the provision of the Act permitting producers to disclose the royalty accounting information in an alternate manner on a “regular basis” is not entirely clear. Further, the new provisions of the Act concerning unitization and division orders may lead to additional disputes between producers and royalty owners.

Beyond this legislation, a variety of additional legislative initiatives have been proposed that would regulate, modify, or otherwise affect the terms of parties’ oil and gas leases. Those initiatives should be closely watched by the industry given the potential effect of legislation on the relationship between production companies and landowners.

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K&L Gates LLP
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