Giving the Pennsylvania Supreme Court’s Kilmer decision broad construction, Judge William Stickman of the District Court for the Western District of Pennsylvania granted the lessees’ motion to dismiss and issued a decision affirming that royalty language containing the phrase “at the wellhead” permits the lessee to use the net-back method and deduct post-production expenses. Rejecting the lessor’s argument that Kilmer should be limited to cases involving Pennsylvania’s Guaranteed Minimum Royalty Act, the court concluded that “Kilmer cannot be read so narrowly as to ignore the fact that it interpreted ‘at the wellhead’ language in leases as providing for the use of the net-back method.”
In this case, the lessors sued, claiming the deduction of post-production expenses from the royalty was not permitted and constituted a breach of the lease and entitled them to an accounting. The lessees moved to dismiss, relying upon the Pennsylvania Supreme Court’s Kilmer decision and the language of the royalty provision. The royalty language at issue states:
Gas: To pay Lessor as royalty for all gas and the constituents thereof, including all liquid, solid or gaseous substances produced and saved from any sand or sands on the leases premises, an amount equal to five-thirty-seconds (5/32) or 15.625% of the gross sales price received by Lessee from the sale of such gas and the constituents thereof at the wellhead.
The court aptly summarized the issue before it and concluded:
[The] breach of contract claim hinges on whether the Pennsylvania Supreme Court’s decision in Kilmer can be read as providing an industry wide interpretation of the term “at the wellhead” as permitting the use of the net-back method to recoup post-production expenses, or whether it is limited to the context of whether the method violates the GMRA. The Court holds that application of the net-back method to “at the wellhead” language must have broad application to all leases using that terminology.
To reach that conclusion, the court easily distinguished the plaintiffs’ reliance on another Western District decision, Marburger v. XTO Energy from 2016. The lease at issue in Marburger did not use “at the wellhead” language in the royalty provision. Thus, that case was inapposite to the question before the court. Instead, the court looked to the authoritative treatises on oil and gas law (cited in Kilmer), cited two other federal decisions that interpreted Kilmer, and relied upon the Pennsylvania Supreme Court’s uses of its King’s Bench authority in deciding Kilmer to conclude that Kilmer’s definition of “at the wellhead” must be given a broad application.
“In undertaking its own interpretation of Kilmer, this court holds that it should be construed broadly and critically, read through the prism that the Pennsylvania Supreme Court used in interpreting the ‘at the wellhead’ language.” Thus, the fact that the royalty provision at issue called for the calculation to be “at the wellhead” meant that the net-back method may be used for that calculation.
Additionally, the court rejected the lessor’s argument that other lessees’ payments of royalties without deducting post-production expenses meant that the lease did not permit such deductions. “The choice of [the other lessees] does not establish an authoritative definition of the lease terminology. They are free to pay more than they are obligated under the royalty provision of the lease. Although one company has been benevolent in its deductions, it does not follow that another company must also do so.”
Finally, the court dismissed the accounting claim as well, finding that it failed because the breach of contract claim failed.
This cogent, textual decision, supported both by the rationale in the Pennsylvania Supreme Court’s Kilmer decision and by treatises routinely cited by Pennsylvania state courts as authoritative, follows Pennsylvania’s view that contracts are to interpreted in accordance with their terms. It also adds, in a straightforward manner, to the development of Pennsylvania oil and gas law on when post-production costs can be deducted.