Post-production costs deducted from gas royalties, such as interstate transportation charges and marketing costs, must be incurred while a producer still holds title to the gas.

On June 18, the US District Court for the Western District of Pennsylvania confirmed that Energy Corporation of America (ECA), a natural gas producer, was liable to a class of landowners for deducting certain post-production costs—interstate pipeline transportation charges and marketing costs—from their royalties. The court distinguished that ECA incurred these post-production costs after title to the natural gas had transferred from ECA to third-party purchasers. Deduction of those expenses from the landowners’ royalties therefore was improper, even though ECA in fact incurred those costs.[1]

The district court in Pollock v. Energy Corporation of America applied precedent from the Supreme Court of Pennsylvania explained in Kilmer v. Elexco Land Services, Inc., the leading case in Pennsylvania concerning royalty calculations. The Pollock court confirmed that a royalty (unless defined otherwise by the parties) means the landowner’s share of the produced gas free from production costs (costs associated with drilling the well, removing the gas from an underground formation, and getting it to the wellhead). But a gas producer’s post-production costs (those associated with transporting, processing, and marketing the gas from the wellhead to the point of sale) generally are deductible from the landowner’s royalty, so long as certain conditions are met. As in Kilmer, the Pollock court endorsed the “net-back” method of royalty calculation under which a landowner’s royalty is one-eighth of the sale price of the gas minus one-eighth of the post-production costs actually incurred in bringing the gas from the wellhead to market.

In Pollock, a class of landowners sued ECA, alleging that it improperly deducted interstate transportation charges and marketing costs from their royalties because those costs were incurred after ECA sold the gas. The applicable lease provision stated that “Lessee agrees to pay . . . as a royalty for all gas produced and marketed . . . one-eighth (1/8th) of the net proceeds received by Lessee from the sale of all gas produced, saved and sold from said premises” and that the royalty would be based on “an amount equal to one-eighth (1/8th) of the price received by the Lessee from the sale of such gas and the constituents at the well head.” The court found that this royalty provision called for application of the net-back method of royalty calculation. The primary issue was when post-production costs may be nondeductible, even when the lease at issue provides for the deduction of such costs from royalties and the costs are actually incurred by the producer.

The case was tried to a jury, which found that the transportation and marketing costs deducted from ECA’s royalty payments were incurred by ECA, but not until after title to the gas transferred from ECA to third-party buyers. The court confirmed these findings by refusing to grant ECA’s post-trial motions seeking to overturn the jury’s verdict.

The key highlights from the court’s ruling are as follows:

  • Expenses for interstate pipeline transportation of gas and marketing costs are properly deductible as post-production expenses when royalties are based on “net proceeds” and  the price received by the operator from the sale of gas is “at the well head.”
  • The date title to gas transfers from a producer to third-party buyers is critical in determining which post-production expenses may be deducted from royalties, because costs incurred before title transfers are deductible, but costs incurred after are not, even if they are actually incurred by the producer.
  • A court may permit use of expert testimony to determine when title to gas transfers from a producer to third parties.