In a case of first impression, the Pennsylvania Superior Court held that a lease amendment that requires the lessor to assign 50 percent of its royalty under an oil and gas lease violates Pennsylvania’s Guaranteed Minimum Royalty Act (GMRA). See Southwestern Energy Production Company, et al. v. Forest Resources, LLC, et al., 2013 PA Super 307 (Nov. 27, 2013).

The initial oil and gas lease at issue guaranteed the lessor a one-eighth royalty of all oil “produced and saved from said land” and a one-eighth royalty of the “market value at the well” of all gas sold or used off the premises. The lease was amended and modified by two separate letter agreements and one extension of lease. The last letter agreement noted that the initial lease, as modified, provided “for the industry standard twelve and one-half (12.5%) percent royalty.” However, the letter agreement modified the royalty provision, stating that the lessor would retain 50 percent of such royalty, and assign the remaining 50 percent of the royalty interest to the lessee. The letter agreement explicitly referred to the lessor’s royalty as “a 6.25% royalty interest.”

In the trial court, the lessor argued that the lease, as amended, violated the GMRA, which 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 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.

The trial court adopted the lessee’s argument that the letter agreement was a separate, collateral agreement, distinct from the lease, and thus the letter agreement’s assignment of one-half of the royalty interest received under the lease did not violate the terms of the GMRA.

The Superior Court reversed this finding, relying on the language of the agreements at issue and well-established case law to conclude that the various agreements must be construed together as one agreement. Accordingly, the Superior Court concluded that the assignment back provision of the letter agreement violated the GMRA.

The court made clear that a lessee cannot try to circumvent the mandates of the GMRA, which requires that the lessor receive at least a one-eighth royalty on all production, by structuring an arrangement pursuant to which the lessor nominally receives a one-eighth royalty, but is required to assign back 50 percent of same to the lessee. The court explained that “[t]o allow such provisions in a lease, where a trick of drafting permits the left hand to remove what the right has given, would render the GMRA meaningless and run contrary to the plain language and intent of the legislation.” The court noted that a lessor remains free to assign or convey its royalty interests under the lease in other circumstances.

The Superior Court’s holding counsels that parties to an oil and gas lease that wish to share the risks and rewards of exploration must structure their arrangements through mechanisms other than a royalty assignment.