Royalty Rip-off

In some cases, questionable deductions from royalty checks represented just a few hundred dollars on thousands of dollars in royalties, but the amounts added up over time. That was the case with the Hyder family’s suit against Chesapeake. Last month, a San Antonio appellate court ruled that Chesapeake had wrongfully taken $700,000 by charging post-production costs against royalties. But that was on a big property — 948 acres straddling the Tarrant-Johnson county line — with 22 wells drilled between 2006 and 2010. The court ordered that money to be repaid and ordered Chesapeake to pay the Hyders’ legal costs as well, bringing the total judgment to about $1 million.

On royalty checks for a typical homeowner with a small lot — and likely no accountants on the payroll to watch — the deductions might not have been noticed. But that’s not been the case recently for some Pennsylvania mineral rights owners. The radical reductions in royalty money there — to the point that some people got negative-value “checks” — have people up in arms.

Carolyn Knapp and her husband own land in Bradford County in northern Pennsylvania, where they leased minerals to Chesapeake.

“Over a year ago, the money we were being charged for post-production costs began to skyrocket,” Knapp said. “I mean just skyrocketed. And it’s all lumped as ‘post-production’ or ‘market enhancement,’ but we have no idea what those words really mean in terms of what’s involved.

“For instance, the gas companies are rebuilding some roads they ruined — is that included in what they’re taking from our royalties? What about the houses they’ve had to buy after some bad spills? Are we paying for those as well? Technically, those expenses occurred post-production, so they might be, but who knows? To try to get to see the business records of those companies is just too costly and time-consuming for regular folks.”

Even if Knapp had money to hire someone to do that, there is little chance she’d have the legal right to force the issue. According to NARO’s Simmons, in order to get to look at a company’s books to determine what they are being charged for, royalty owners would have had to make sure an audit clause was included in their mineral leases.

“Most people just get so excited about the money that they sign the lease without taking it to a specialist,” he said. “Later they think something isn’t right and want to look at the books. But if you didn’t put a clause in the lease giving you the right to audit, you can’t.”

Simmons lays some of the blame for the problem on the royalty owners themselves. “You wouldn’t buy a house without an inspection, yet a lot of people don’t bother to inspect what they’re signing when they sign that lease,” he said. “And that often leaves them out in the cold, because the gas companies are not going to change that to suit you.”

On the other hand, Simmons said, “It’s flabbergasting what these companies are doing to people. It’s unbelievable. They’ll write down that you get a 12 and a half percent share of the leasing unit’s production in royalties and add that no monies can be taken from that except for the purpose of enhancing the gas to bring a better price. Which sounds good, but isn’t.”

It isn’t enough, he said, because the gas companies can claim that any costs incurred are enhancing the gas value. And this is where the issue gets very tricky.

In other areas and other years, when drillers were producing “sweet” oil, not gas, a well’s output was sold immediately to pipeline companies, and royalties were figured based on oil value at the wellhead. But natural gas must be put through several processes before it is marketable; therefore, it has little or no value at the wellhead. That leaves lots of room for interpretation of what should be included in the cost of getting the gas ready to sell.

“You put it in separator tanks to separate out the water and any other gases that might come up with the methane you want. That costs. Then you’ve got to move it through pipe. That costs. Then you’ve got to dehydrate and compress it — another cost. Then you have to sell it,” Moyer explained. “All of those are enhancements, and the gas companies are claiming that the royalty owners have to pay a share of all of that. Which is not how they [royalty owners] read the lease at all.”

In Colorado and Oklahoma, McFarland said, post-production costs cannot legally be deducted from royalty payments. “It’s the oil or gas company’s sole responsibility to get that gas into marketable condition.

“In Texas, they go by the specific language of the lease — which is why the airport and Hyder suits were lost by Chesapeake,” he said. “Both of those had leases that were very specific about no costs being taken from the royalties. Unfortunately, not everyone has a lease like that in Texas. Very few do, actually.”

The standard lease in Pennsylvania calls for royalty owners to receive a minimum share of 12.5 percent, and courts had allowed nominal deductions that brought that slightly lower. But a case decided by the Pennsylvania Supreme Court in 2010 changed the situation drastically.

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That case, Kilmer v. Elexco, pitted several landowners against the company that gathered lease agreements that were then sold to Chesapeake and other gas companies. The landowners were challenging the landman company over the minimum royalty figure, claiming that if post-production costs were allowed to be deducted, gas companies would inflate those costs to the point where royalties would all but disappear.

The Pennsylvania Supreme Court ruled that while landowners had a legitimate concern about gas companies inflating supposed post-production costs, that probably wouldn’t happen because “gas companies have a strong incentive to keep their costs down … .”

Not so much, as it turned out. “The court ruled that deductions that dropped royalties below the state minimum of 12.5 percent were allowable,” said Root, “and that opened the floodgates to the gas companies doing exactly what the landowners thought they would and which the court said they wouldn’t. … That’s when these problems started. That’s when some people started seeing half or nearly all of their royalty checks disappear.”

A bill now moving through the Pennsylvania legislature could change that in the future, if it passes. But a new law wouldn’t help royalty owners who have already signed leases.

“The odd thing is that not all companies are doing it,” Moyer said. When the state high court ruling was announced, Chesapeake and a number of other companies “all raised the amount they held from royalty checks,” he said. “As did Statoil and Talisman — but then last September, both of those companies paid back all of those post-production and enhancement monies to their royalty owners and don’t charge them anymore.”

Most of the companies instituted post-production charges that topped out at about 15 percent, Moyer said. But Chesapeake went much further, raising deductions to 30 or 40 percent of the royalty amount and in some cases to more than 90 percent.

“In March 2013, when Chesapeake was reeling financially, that’s when they started taking most of the royalties in several parts of the state,” he said.

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