Marcellus Shale Law Monitor

By Attorney Dale A. Tice, Marshall, Parker & Weber

Over the last five years many landowners in the Marcellus shale region of Pennsylvania have been approached by oil and gas company landmen with gas lease offers. Marcellus leasing activity began in 2006 and 2007, but the gas leasing boom truly took off in 2008 when the cash bonus and royalty offers began to escalate. The majority of the leases that were signed at that time provided for a five year primary term, meaning that if drilling operations aren’t commenced in five years the lease will terminate. Many of those five year leases are now approaching the end of their primary term, raising a variety issues for landowners to consider.

In the hot areas where drilling activity is focused, landowners with expiring leases are now receiving lease extension offers. If the gas company feels confident that the property will be developed without delay, the extension may be for a relatively short term of one to three years. Although the current leasing environment is not as favorable for landowners as it was in 2008, a lease extension offer still creates an opportunity for the property owner to attempt to negotiate an increased cash bonus offer and possibly more beneficial lease terms. Landowners are of course not obligated to sign a lease extension; not signing will force the gas company to either allow the current lease to expire or quickly commence drilling operations to hold the lease.

If a different oil and gas company is interested in leasing property subject to a lease that will likely soon terminate, the landowner may receive a top lease offer. A top lease is a new lease signed by the landowner while the current lease is still in effect; the top lease is drafted so that it will only become effective when and if the current lease expires. Landowners who are approached with a top lease must carefully review their current lease before proceeding with the new offer - many old leases include a right of first refusal that will require the lessor to first allow the gas company holding the current lease an opportunity to match the terms of the top lease before leasing with the new company.

Other landowners with leases approaching the end of the primary term are trying to determine if their leases have been validly extended by the commencement of good-faith drilling operations on their land or property their land has been pooled with in a production unit. In the cases where an oil and gas lease does expire, the landowner may wish to obtain a release of the lease from the oil and gas company that can be placed of record to make clear that the property is not leased and would be available for a new lease offer.

An additional point to keep in mind: oil and gas companies frequently include a lease provision that will grant the company an option to extend the lease for an additional five year term under the same payment terms and conditions. If the option to extend is included, the gas company doesn’t need to obtain the landowner’s agreement to maintain the lease – the landowner may simply receive the extension payment by mail shortly before the expiration of the primary term. Lawyers who represent landowners would typically strike this provision from the lease, but property owners who did not engage a lawyer may find this provision, often buried toward the end, if they carefully review their lease.

In addition to lease extension offers, Marcellus landowners are also being asked to sign pipeline right-of-way agreements, division orders and other documents related to natural gas drilling. These are all important and complex legal documents that should always be reviewed by competent legal counsel to ensure that the landowner avoids the potential pitfalls that are present in the leasing and natural gas development process. 

By Attorney Dale A. Tice, Marshall, Parker & Associates

One of the thorny issues facing estate planners working with clients in the Marcellus shale is the valuation of gas rights for tax purposes. The need for valuation can arise in a number of circumstances including federal estate and gift tax, state realty transfer tax and inheritance tax. The value of gas rights can be approximated using a variety of methods and planners may be uncertain as to the approach favored by the different taxing entities.

At least in regards to Pennsylvania Inheritance Tax, the issue has now become much clearer. On July 10 the Pennsylvania Department of Revenue issued Inheritance Tax Bulletin 2012-01 which lays out the approach to be used for valuation of natural gas rights in the Commonwealth. The Bulletin states that the taxable value is most clearly established by a bona fide sale, so that if the gas rights were sold shortly after the death of the owner the Department would accept the sale price as the value for Inheritance Tax purposes. If the gas rights have not been sold the Department will accept an appraisal or other credible evidence of value. These are the same methods that can be used to value real estate or other personal property, but they won’t always be applicable or ideal for natural gas rights; in many instances the property will not have been sold and appraisals of oil and gas rights can be expensive – a real problem for estates of modest value.

Fortunately the Department has provided taxpayers with a simple solution based on whether the interest is: (1) Leased and producing; (2) Leased and non-producing; (3) Non-leased and non-producing. For estates with gas rights that have not been sold and where there is no appraisal or other credible evidence of value, the Bulletin states as follows:

(i) For leased and producing properties, an estate shall value natural gas rights at an amount equal to any amounts received that were attributable to actual production of the natural gas interests at issue during the twelve months prior to the decedent’s date of death, multiplied by two.

(ii) For leased, non-producing properties, interests shall be reported at a value of zero unless, at the time of death, the properties were part of a contractual arrangement whereby the properties generated fixed future payments, in which case the natural gas rights shall be calculated by reducing the fixed future payments to present value as of the decedent’s date of death using established Internal Revenue Service actuarial tables as found in IRS Publication 1457 Actuarial Values Table B, Section 3 Annuity, Income, and Remainder Interests For a Term Certain.

(iii) For non-leased, non-producing properties, interests shall be reported at a value of zero.

A copy of Pennsylvania Inheritance Tax Bulletin 2012-01 may be downloaded here.

Although this policy clarification hasn’t been out for long, I feel confident in predicting that the valuation approach presented in this Bulletin will be viewed favorably by Pennsylvania landowners in the Marcellus or Utica shale.

By Attorney Dale A. Tice, Marshall, Parker & Associates

Those of us who were working on oil and gas law way back in 2008 remember the heady days of the Marcellus gas leasing boom. Before the major oil and gas companies had shown any interest in the Marcellus, a number of smaller, independent drilling companies were leasing acreage in the core areas as rapidly as possible. The New York Times quoted this Commentator describing the leasing land grab as a “feeding frenzy.”

Thanks to the efforts of the Penn State Cooperative Extension, many landowners were aware of the potential pitfalls in the leasing process and realized that the leasing frenzy created an opportunity to negotiate favorable lease terms. Landowners in the hot spots were often presented with offers to lease from multiple companies, each trying to establish a dominant leasehold position. It was this intense competition for prime Marcellus acreage that placed educated landowners in a fortunate posture from which to negotiate, and those of us working with landowners became accustomed to seeing long lists of landowner-friendly addenda attached to gas leases.

The Times They Are a-Changin’

At this point in 2012 several long-term trends have become apparent that are significantly impacting Marcellus landowners.  The large majority of the land available in the prospective areas of the Marcellus has been acquired by the gas companies; the leasing boom has come and gone. The major oil and gas companies recognize the critical importance of unconventional shale gas for our nation’s energy future and have invested heavily in Pennsylvania Marcellus, with the result that various sections of the core acreage are now held by a handful of dominant players. 

A very significant result of the Penn State educational blitz was that landowners realized the importance of requesting a gas lease with a straight five-year term, with no option to extend the lease for an additional five-year term. In order to keep these leases from terminating, the gas companies need to get the acreage drilled and begin producing natural gas. A key goal of the gas companies now is to keep the acreage that is leased “held by production” so the five-year leases don’t expire.

Residents of the core areas of the Marcellus are living with the results of the race to hold land by production. Drilling activity has taken off in the years following the leasing boom and as wells are completed and go online, natural gas production from unconventional shale has increased significantly. However, as the supply of methane natural gas has increased, the price of natural gas has consequentially dropped. This trend toward lower prices for “dry” natural gas has occurred just as the price of oil and natural gas liquids has spiked.

The Impact on Pennsylvania Landowners

How are these long-term trends impacting Pennsylvania royalty owners? What we see now are strategies from the gas companies to hold more land with less drilling. The standard 640 acre production unit seen in earlier leases has been abandoned for much larger pooled production units, in some cases over 1,200 acres. As the size of the production unit increases, more land is held by production and fewer leases will expire, but each landowner's proportional share of royalties from the unit is diluted.

Landowners with expiring leases who hope to sign a new lease face a vastly different leasing environment. Competition for new leases is no longer the norm. Many landowners will instead be dealing with the one gas company that holds the dominant position in their area. And without competition for leases, landowners will be in a far less advantageous position from which to negotiate. Provisions that landowners and their lawyers have become accustomed to seeing in leases, such as a Pugh clause or royalties paid without deductions for post-production costs, may be difficult to obtain.

Some property owners with land outside the core areas for Marcellus development may find no interest in leasing their acreage. Although the gas companies were willing to lease over a broad area during the height of the leasing frenzy, leasing activity now is much more targeted in the areas where drilling activity is focused.

In fact, Marcellus acreage no longer appears to be the hot commodity. As the market has been flooded with unconventional shale natural gas and the price has plummeted, the gas industry has shifted focus to areas such as Ohio and North Dakota where higher priced oil and “wet” gas with associated liquids such as butane or propane may be found.

A Bright Future

But there may be a silver lining to this dismal cloud of bad news for Pennsylvania royalty owners. Although low-priced natural gas may dim the prospects for Marcellus development in the short-term, the big picture over the long-term looks increasingly bright. We are just beginning to see a huge shift in national policy away from coal and imported oil toward use of domestic natural gas for electricity production and even natural gas vehicles. Energy independence for our nation finally appears within reach. Ultimately, what is driving this shift is cheap natural gas.

Pennsylvania royalty owners need to keep their chin up and look forward to the day when Marcellus natural gas is powering our nation’s energy future.

By Attorney Dale A. Tice, Marshall, Parker & Associates

Jeff Marshall is the founding attorney of the firm where I am employed, Marshall, Parker & Associates. He has long been regarded as one of the preeminent elder law attorneys in Pennsylvania and is well known as a passionate advocate for the rights of the elderly. In addition to his work representing older clients, Jeff has always been active with research and writing and he now maintains a high-profile website, the Marshall Elder & Estate Planning Blog.

In a recent blog post Jeff discussed proposed changes to the Estate and Gift Tax laws in the 2013 Obama Administration budget. These changes include lowering the Federal Estate Tax exclusion to $3.5 million and the Gift Tax exclusion to $1 million. In addition, the proposal would eliminate valuation discounts for family-controlled entities, place limits on the use of intentionally defective grantor trusts and require a minimum ten year term for grantor retained annuity trusts (GRATS). The blog post can be viewed here.

Although it is uncertain if any of these proposals will move forward in light of the gridlock on Capitol Hill, the potential exists that some of these provisions could become law. Jeff concludes that “we could someday look back on 2012 as the last golden year for wealth transfer opportunities.”

The possibility that some these proposals could be enacted is very significant for Marcellus landowners. While we see drilling rigs moving from Pennsylvania to Ohio and rock-bottom low prices for natural gas, landowners may conclude that it is unlikely that they will ever realize royalty wealth. Nevertheless, Marcellus gas rights have value today and that value is very likely to appreciate tremendously over the coming years. Despite the uncertainty about when natural gas development may occur, 2012 still presents a fantastic opportunity to plan for those landowners who own significant Marcellus acreage.

In a previous post I discussed the NARO-PA Convention being held in State College next week. Marshall, Parker & Associates will have an exhibit table at the Convention and Jody Lose, Melissa Bottorf and I will be attending. Please stop by to see us and discuss what your royalty planning options may include.