Act is game changer for oil and gas leases

David Evenhuis, Esq.

The recently signed Pennsylvania Oil and Gas Lease Act (the "Act") amends and expands the 1979 Guaranteed Minimum Royalty Act ("GMRA"), which established that all leases must provide at least a one-eighth royalty (12.5 percent) on production sales. The GMRA also guaranteed a rate escalation up to one-eighth for older leases not paying the minimum rate, upon any new or deeper drilling. The Act, effective 60 days from enactment on July 9, 2013, preserves these minimums and adds important new rights for both landowners and industry.

Increased transparency for royalty payments

One of the benefits to landowners is that the Act requires producers to provide much information about the sale of oil and gas from their properties. It must be provided directly on the stubs of royalty checks or otherwise provided on a regular basis. New requirements include well identification, dates and amounts of well production, taxes and deductions, and significant information about the percentage of a well's production allocated to individual interest owners and their shares of sales after taxes and deductions.

Right to drill horizontally between multiple properties

Perhaps the most controversial part of the Act has been the expansion of industry rights to drill horizontally beneath multiple leased properties:

Where an operator has the right to develop multiple contiguous leases separately, the operator may develop those leases jointly by horizontal drilling unless expressly prohibited by a lease.

It is important to note that the Act does not grant producers a right to drill beneath non-leased properties (forced pooling), nor does it permit drilling through properties leased by others. But where leases don't prohibit horizontal drilling, producers will have a clear right to drill between their own adjacent leased properties. At this point, however, it's not clear whether such drilling automatically pools leases into traditional production units, or whether the provision applies to wells on a "one-off" basis without changing the terms of other drilling on the affected properties.

Apportionment of royalties: the real new power

While horizontal drilling rights have attracted the public's attention, the natural gas industry was given an even more significant power over the allocation of royalties:

In determining the royalty where multiple contiguous leases are developed, in the absence of an agreement by all affected royalty owners, the production shall be allocated to each lease in such proportion as the operator reasonably determines to be attributable to each lease.

That means where there's no unit or other landowner royalty agreement in place, this provision grants producers the subjective right to determine which affected lease will receive a greater share of the royalties. Recent opinions from the Pennsylvania Supreme Court have allowed producers great latitude when empowered to make such judgment calls.

Consider when a producer drills a well into one property, then turns and drills horizontally beneath another. Where the leases are not in a unit or under another agreement, the Act would permit the producer to reasonably determine the percentage of gas drawn from each property. Thus, if one lease pays 18 percent royalties and the other 12.5 percent, how is the production likely to be divided? The producer could determine that 90 percent of the gas came from the "bargain" property leased for a 12.5 percent royalty and allocate only 10 percent to land subject to the higher rate.

Few modern leases may be affected by the apportionment provision, since most consent to unitization. Moreover, inclusion in a unit likely constitutes "an agreement by all affected royalty owners" which would control the allocation of a well's production. The danger is that most leases also give producers rights to re-draw and terminate units at any time. But even if leases are taken out of a unit, producers will now have the power to drill horizontally through their properties and say how much gas came from each one.

David Evenhuis is an attorney with Caldwell & Kearns, which serves as general counsel to PAR. His practice focuses on oil and gas law, civil litigation and representing the interests of real estate licensees. He may be contacted at [email protected]