On March 24, 2010, the Pennsylvania Supreme Court issued a unanimous opinion in Kilmer v. Elexco Land Services, No. 63 MAP 2009, holding that the Pennsylvania Minimum Royalty Act ("MRA") shall be interpreted to permit the deduction of post-production expenses in the calculation of royalty payments.  The Pennsylvania Supreme Court clarified that the MRA should be read to permit calculation of royalties at the wellhead.  The case was initiated by landowners seeking to void a lease based on the argument that the provision in their lease for the deduction post-production expenses from the royalty calculation violated the MRA.  The opinion will have widespread affect on the emerging Marcellus Shale gas development as more than 70 lawsuits were stayed pending the Pennsylvania Supreme Court's resolution of the appropriate method to calculate royalty payments in the Commonwealth.  

The MRA requires that leases guarantee the landowner-lessee "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 lease at issue provided for royalty calculation based on one-eighth the sales price of the gas minus one-eighth of the post-production costs of bringing the gas to market.  Post-production costs were defined in the lease as all costs incurred getting the gas from the wellhead to the point of sale, including gathering, dehydration, compression, treatment, processing, marketing and transportation costs.  

Landowners claimed that deduction of post-production costs  resulted in a royalty less than one-eighth the value of the gas.  Gas Producers sought clarification that royalties would be defined as the value of the gas at the wellhead based on the value of the gas sold less post-production costs, including but not limited to, gathering, compression,  transportation and whether performed by the producer or a third person to deliver the gas to the location at which the gas is sold.  Deduction of post-production expenses by a producer in calculating royalty is authorized by controlling law in the majority of gas-producing states.  

Gas producers maintained that the valuation of the gas at the wellhead standardizes the royalties consistent with the MRA.  Gas producers argued that landowners were simply seeking an opportunity to renegotiate leases for a better price.  The Pennsylvania Supreme Court agreed with the gas producers that the royalty calculation should be determined based on one-eighth of the unprocessed value of the gas at the point of removal.   

Now that Pennsylvania's highest Court has ruled, the battleground will move to the General Assembly where two bills propose amendments to the MRA.  HB 977 would prohibit the deduction of post-production expenses from the MRA.  HB 2214 would also prohibit the deduction of post-production expenses and increase the minimum royalty to 15 percent of the fair market value at the point of sale.  Both bills have been referred to the House Environmental Resources and Energy Committee.