A Pennsylvania class action alleging that gas producer Energy Corporation of America (ECA) had improperly calculated royalty payments experienced a major setback last week when a Pennsylvania federal judge eliminated most of the claims brought by the class. (See Pollock v. Energy Corporation of America Opinion.) ECA’s motion for summary judgment was partially granted by U.S. District Judge Joy Flowers Conti, adopting Magistrate Judge Robert Mitchell’s October 2012 Report and Recommendation.

Interpreting the landmark Kilmer decision, the court rejected the class plaintiffs’ claim that marketing costs were not acceptable post-production deductions. The court concluded that the list of post-production costs detailed in Kilmer “should not be interpreted as comprehensive and that deduction of marketing costs, generally, is not contrary to law.” (See Opinion at p.9). The court also found that under the leases between ECA and the class plaintiffs, ECA was permitted to use an allocation methodology to assign each well its pro rata share of aggregate volumes from a total field volume, as well as a pro rata share of post-production costs. In so doing, the court found that Kilmer did not mandate that ECA could deduct only costs that it could demonstrate were actually sustained by a particular well.

The court also eliminated the claim that the class plaintiffs should have been paid royalties on the upside of hedges that benefited a publicly traded trust that owned the right to receive a portion of ECA’s proceeds from the sale of gas from the class plaintiffs’ wells, concluding that ECA’s relationship with the trust was unconnected to ECA’s lease obligations with the class plaintiffs.

Finally, the court rejected ECA’s challenge to the Report and Recommendation’s finding that ECA improperly deducted charges for interstate transportation costs.The court did, however, allow ECA the opportunity to revisit the issue at trial depending on the evidence presented.

The court’s ruling evidences Pennsylvania courts’ willingness to give Kilmer a practical constructionin allowing deductions for post-production costs as well as computing those costs. Further, the court refused to connect unrelated hedging transactions (utilized to mitigate market risk) with the specific lease obligations between lessor and lessee. As such, this decision is a helpful development for Pennsylvania oil and gas producers, in that it reasonably enables lease obligations to coexist with commercial realities.