On October 24, 2016, in Pollock v. Energy Corp. of Am., Nos. 15-2648 & 15-2649, 2016 WL 6156313 (3d Cir. Oct. 24, 2016), a panel of the United States Court of Appeals for the Third Circuit denied Energy Corporation of America’s (ECA) attempt to overturn a jury verdict of over $1.1 million in favor of a class of landowners who claimed that ECA improperly deducted post-production costs from their royalty checks.
Key takeaways from the litigation are:
- Post-production costs, such as costs for marketing and transportation, are properly deductible from royalty payments using the “netback method,” provided they are incurred by the lessee.
- The point at which gas is sold is crucial in determining whether post-production costs may be assessed. If post-production costs are incurred after gas is sold to a separate entity, such costs may not be deductible.
- Producers should take considerable care when selling gas to affiliate marketing and transportation companies if they intend to pass post-production costs back to royalty owners.
Pennsylvania Royalty Litigation Background
Kilmer v. Elexco Land Servs., Inc., 990 A.2d 1147 (Pa. 2010) is the seminal royalty calculation case in Pennsylvania. There , the Pennsylvania Supreme Court held that, absent a specific lease provision to the contrary, transportation and marketing costs may be properly deducted from the gross proceeds of gas sales prior to the disbursement of royalties, a process commonly called the “netback method.” The netback method permits royalties to be computed at the wellhead, the same as if the gas was taken in kind, rather than at the ultimate point of sale. The Kilmer decision is in line with the majority of states which have considered the issue.
The ECA Royalty Litigation
Under ECA’s business model, it sold all of the gas it produced exclusively to its affiliate company, Eastern Marking Corporation (EMCO). After the gas was sold to EMCO, EMCO then marketed, shipped, and sold the gas to third-party buyers. The gross proceeds for the gas were credited to EMCO’s books, which then paid to ECA “the net proceeds of gas sales” by check each month. ECA then paid one-eighth of the money it received from EMCO to the royalty owners. Therefore, the royalty payments from ECA to the royalty owners were reduced to include the post-production costs incurred by EMCO.
Pursuant to this arrangement, the jury found that the gas had been sold to EMCO and that ECA had improperly deducted marketing and transportation costs. The District Court found sufficient evidence to uphold the jury’s decision, holding that the decision was reasonable because EMCO, not ECA, incurred marketing costs when it sold the gas to third party purchasers. Moreover, transportation deductions could also be considered improper because the plaintiff’s expert testified that title passed to EMCO before any interstate transportation costs were incurred.
The Third Circuit panel agreed, denying ECA’s motion for judgment as a matter of law, or in the alternative, a new trial. It first held that the jury could reasonably find that transportation costs had been improperly deducted because third-party buyers had paid EMCO a surcharge of fifty cents per each unit of gas sold for the purpose of “having the gas delivered at the point on the interstate system” that the buyers wanted it delivered to. “If the third-party buyer paid the transportation costs, the jury could reasonably find that it was a breach of the leases to require Appellees to contribute to costs of transportation that had already been paid.” Id. at p.4.
The Third Circuit also held that there was sufficient evidence to support the jury’s conclusion that marketing costs were improperly deducted from the royalties. The court stated that, by its own admission, ECA sold all of its gas exclusively to EMCO, its affiliate. There were no marketing costs involved in the first transaction between EMC and EMCO, rather, marketing later played a part “only in establishing a transaction between EMCO and its third-party buyers.” Id. Therefore, because EMCO incurred the marketing costs after it purchased the gas from ECA, the Third Circuit upheld the jury’s finding that the costs could not properly be passed by ECA back to the royalty owners.
This litigation demonstrates the care that producers must take when dealing with affiliate marketing companies, and the impact that the producer/affiliate relationship may have with respect to the deduction of post-production costs. Deals should be structured so that there is no question that post-production costs which are to be deducted are incurred by the producer before gas is sold to a third party.