M E M O R A N D U M Email to: C. Baird Brown   Harry Weiss    From Michael D. Fabius    RE: Pa Rule of CApture / Oil and GAs Conservation Law

Introduction

Our client, Northern Wayne Property Owners Alliance (“NWPOA”), has asked us to determine the rights of landowners to royalties when leasing the gas rights beneath their property.  Specifically, NWPOA presents a hypothetical where a gas company leases gas rights from one landowner (“Landowner A”) and extracts gas from a common pool stretching underneath the landowner’s property and adjacent properties (“Landowner B”).  Furthermore, we understand that the potential drilling well penetrates the Marcellus Shale horizon but not the Onondaga horizon.  For the purposes of this memorandum, it is assumed that Landowner B has not leased her gas rights.
NWPOA presents two questions in the context of this hypothetical.  It wants to know (i) whether Landowner A has the right to receive royalties on the entire production from the drilling well on her land or a lesser proportion of the well’s production and (ii) whether the Landowner B can be forced into a pooling unit.

Short Answer

The rights of Landowner A and Landowner B as well as the gas company are affected by the General Assembly’s consideration of House Bill 2453 (“HB 2453”).  Presently, Pennsylvania’s existing Oil and Gas Conservation Law, 58 P.S. §§ 401, et seq.,  (“OGCL”) does not apply to wells that the Marcellus Shale horizon but not the Onondaga horizon.  HB 2453, however, will apply the OGCL to such wells if it is enacted by the General Assembly.  Consequently, this memorandum addresses NWPOA’s questions under the current law and proposed law.

Royalties

Under the current law, Landowner A has the right to receive the royalties paid on the entire production of the drilling well placed on her land.  She may extract as much gas from beneath her land as she may be able to, regardless of whether the gas migrated from beneath the surface of her neighbor’s land.  Once she has extracted the gas from the surface of her own property, the gas is her personal property.  Alternatively, Landowner A may lease her right to extract natural gas from beneath her land and thus the gas company may do what she would have done.  In such a case, the entire production is pursuant to the lease and Landowner A will receive royalties on the entire production.
Under the proposed law, Landowner A likely would only receive the royalties on a portion of the entire production from a drilling well on her land.  The OGCL permits owners of neighboring properties directly affected by the drilling (or the owner of oil and gas rights on the neighboring property) to obtain a unitization order that would require that they be pooled together such as in this hypothetical where the drilling well extracts gas from their neighboring property.  Once pooled together, the production from the drilling well would be attributed to Landowner A and her neighbors in accordance with the unitization order.  Landowner A would then receive royalties pursuant to her lease only on the amount of production attributed to her land under the unitization order.

Forced Pooling

Under the current law, forced pooling can only occur under the rare circumstances where Landowner A and Landowner B acquired their rights by the same instrument, such as a will, and they share the obligations under an existing lease.  There may be only a single instance where a Pennsylvania court issued a forced pooling order under common law.
Under the proposed law, Landowner B’s property would be subject to the OGCL that provides for the efficient development of mineral interests.  As landowners in the same pool, Landowner A and Landowner B should be placed in the same pooling unit.  Landowner B would then still have options to obtain the value of her gas rights.  She could lease the gas rights directly.  She could request that the integration order include a reasonable basis and reasonable consideration for the lease of the gas rights to the gas company operating on Landowner A’s property.  Landowner B could also act as if she is a partner of the well operator, in which case she could pay her share of the costs of operations directly or they could be paid out of her share of the production.  If Landowner B pays her share of the costs out of her share of the production, she would retain a right to 1/8 of her share of the production until the value of the remainder of her share was equal to double what she would otherwise be required to pay.  After such a time, she would have the right to 100% of her share of production.

Analysis

Gas drilling in Pennsylvania is governed both by statutory law enacted by the legislature and common law developed through a series of court opinions.  The OGCL applies to all drilling wells in the Commonwealth except those wells that are either shallower than the Onondaga Horizon or shallower than 3800 feet.  58 P.S. § 403(b)(1).  The Marcellus Shale horizon is almost universally shallower than the Onondaga horizon.  Therefore, provisions in the OGCL pertaining to spacing and unitization are presently inapplicable to the hypothetical posed by NWPOA.  HB 2453, however, would amend the OGCL to broaden its application  HB 2453, § 2.  If enacted, the OGCL would also apply to “any oil or gas well that penetrates the Marcellus Shale horizon.”  Id.  Consequently, this memorandum proceeds by addressing NWPOA’s hypothetical under current law and under the proposed amendment to the OGCL.

Royalties

Under the Current Law

Pennsylvania common law, colloquially known in this context as the “rule of capture,” governs the hypothetical described above because the spacing and unitization provisions in the OGCL presently are inapplicable.  Pennsylvania courts treat natural gas as “mineral ferae naturae,” meaning a mineral of a wild nature, because gas has the ability and tendency to escape delineated property boundaries.  Westmoreland etc. N. Gas Co. v. Ira DeWitt, 130 Pa 235, 249-50 (1889).  So long as gas is part of the land, the owner of the land owns the gas contained in the land; when gas migrates from beneath the surface of one property to beneath the surface of another, ownership passes from the first landowner to the second.  Id.  When a landowner or lessee removes the gas from the land, she “perfects” ownership of the natural gas so that ownership only passes through the sale of the gas.  Id.
In extracting the gas, the landowner may drill anywhere on her land even in close proximity to neighboring property.  Barnard v. Monongahela Natural Gas Company, 216 Pa. 362, 1907 Pa. Lexis 820 at *6 (1907) (opinion of lower court affirmed and reported with the approval of Supreme Court of Pennsylvania).  In Barnard, the gas company leased the mineral rights from two adjacent landowners in separate leases.  Id., at *1-3.  The company located a drill near the border of one landowner’s property that was estimated to extract gas from an area seventy-five percent underneath the land of the other landowner.  Id.  In this arrangement, the court held that the landowner had and could lease the right to locate drills anywhere on her land and that the neighbor has no claim against such an operation even though it decreases the production on the neighbor’s land.  Id., at *6.
A court may only order a forced pooling arrangement if the landowners share a common lease.  In Barnard, the neighbor’s only remedy was to erect her own drill and extract the natural gas from the land first.  Id.  In contrast, three landowners in Wettengel v. Gormley, 160 Pa. 559 (1894), inherited their adjacent properties from their father who had leased the entirety of the three properties to a gas company.  Id. at 565.  By the terms of the lease, the obligations continued to the heirs of the lessor; all three landowners were thus obligated to grant the company access over the surface to the minerals below.  Id. at 566-67.  Similarly, the company could have located its drilling wells on any of the properties.  Id.  Being obligated to the terms of the lease, the adjacent landowners must also be entitled to the royalties pursuant to the lease and the court forced the three landowners to share the royalties paid by the company.  Id. at 568.
In the hypothetical posed by NWPOA, Landowner A has the right to extract as much gas from her own land as possible.  She may do so by placing drills anywhere on her land, although the natural gas may migrate from beneath neighboring property before coming to the surface on her own.  When the natural gas crosses the subsurface property line, the gas becomes part of her land and when the natural gas comes to the surface, the gas belongs to her. 
If Landowner A leases this right to a gas company, the company only has the rights to the natural gas that Landowner A provides in the lease even if the company also leases mineral estates from adjacent properties.  Therefore, Landowner A would be entitled to royalties paid on the entire production from the drilling on her land.  The only exception is when the landowners share a common lease, which is inapplicable in this hypothetical.

Under the Proposed Law

The OGCL empowers the Oil and Gas Conservation Commission (the “Commission”) to protect landowners’ “correlative rights.” 58 P.S. § 405.  Correlative rights refer to the right shared by neighbors with oil and gas interests in a common pool of oil or gas to a fair and reasonable opportunity to obtain and produce a just and equitable share of oil and gas.  58 P.S. § 402(2).
Specifically, the OGCL provides a procedure through which the Commission may issue unitization and spacing orders with respect to certain, applicable drilling wells to protect the correlative rights of neighbors (or the owner of oil and gas rights on the neighboring property).  58 P.S. § 407 (hereinafter, the “unitization procedure”).  A unitization order groups properties or parts thereof into a single unit.  Royalties on oil or gas production from the unit would be shared by the property owners within that unit in accordance with the order.  Spacing orders restrict where drills may be placed in proximity to property or unit boundaries to restrict a drill from being able to extract oil or gas from another property or unit.
Upon the application of the owner or operator of “any lands directly and immediately affected by the drilling of the discovery well, or subsequent wells in said pool,” the Commission will hold a public hearing to determine (a) the area to be included in the order; (b) the acreage to be embraced within each unit; (c) the shape thereof; and (d) the area within which wells may be drilled on such units.  58 P.S. § 407. When reaching its determination, the Commission may consider evidence of:
the surface topography and property lines of the lands underlaid by the pool;
the plan of well spacing then being employed or proposed in such pool;
the depth at which production from said pool has been found;
the nature and character of the producing formation or formations and whether the substances produced or sought to be produced are gas or oil;
the maximum area which may be drained efficiently and economically by one well; and
any other available geological or scientific data pertaining to said pool, which may be of probative value to said commission in determining the proper spacing and well drilling unit therefore, with due and relative allowance for the correlative rights and obligations of the producers and royalty owners’ interest therein.
4 P.S. § 407 (quotation marks omitted).
If enacted, HB 2453 would also amend the OGCL to provide an additional protection from horizontal drilling for neighboring properties.  Before drilling any applicable well, the operator would have to demonstrate and assure “that any anticipated horizontal drilling shall not be conducted under or through any lands where an oil and gas lease does not exist between a landowner and an operator.”  HB 2453, § 2 (“Horizontal Drilling Provision”).  Applicable wells are any well that will penetrate the Marcellus Shale horizon or a depth of 3800 feet, whichever is deeper.
In the NWPOA hypothetical, the drilling well extracts natural gas from a common pool stretching across both landowners’ properties.  Landowner B who is not party to the lease but whose gas is or can be extracted from the drilling well on the leased property is directly and immediately affected by the drilling.  She consequently has standing to apply for a unitization order from the Commission.  Although the precise unitization arrangement would depend on the Commission’s evaluation of the evidence (of the types described above), the order should place Landowner A in a unit with Landowner B.  The production on the Landowner A’s property would then be attributed to Landowner A and Landowner B in accordance with the unitization order.  Consequently, Landowner A would receive royalties only on the amount of production attributed to her land under the unitization order. 
It is valuable to note that another consequence of HB 2453 is the proposed Horizontal Drilling Provision.  This provision is intended to make it less likely that the drilling well would be able to extract gas (or as much gas) from neighboring properties.

Forced Pooling

Under the Current Law

The circumstances under which a forced pooling order may be issued by a Pennsylvania court are limited.  When all the landowners acquired their rights to the land by the same instrument and the lease applies collectively to the land of each landowner, then the court may be able to issue a forced pooling order.  Wettengel, 160 Pa. 559.    In the Wettengel case described above, the court could only force the three landowners into a single pool because they all inherited their adjacent properties from their father; their father had leased the entirety of the three properties to a gas company; and the lease provided that its obligations continued to the heirs of the lessor.  Id. at 565-67.  Furthermore, our research has indicated that Wettengel may be the only instance when a Pennsylvania issued a forced pooling order under Pennsylvania common law.  Wettengel, 160 Pa. 559. 
In NWPOA’s hypothetical, Landowner B does not share a common lease with Landowner A.  In the absence of a common lease, the common pool is not sufficient for a court to force the landowners into a pooling unit.  A court could not then force Landowner A and Landowner B into a pooling unit.

Under the Proposed Law

Even if neighboring landowners do not apply to the Commission, the OGCL also permits well operators to initiate the unitization procedure described in section ‎III.A.2 above.  58 P.S. § 407.  Before acting upon any application, the Commission must publish notice for two successive weeks in a newspaper of general circulation and directly mail notice to persons who have specified an address to the Commission.  Id. 
The scope of the Commission’s unitization order is the full extent of the “pool;” except that each application to the Commission may pertain to no more than 10 square miles.  Id.  The OGCL defines “pool” as an “underground reservoir containing a common accumulation of oil [or] gas, or both, not in communication laterally or vertically with any other accumulation of oil and gas.”  58 P.S. § 402(10). 
The Commission must enter the unitization order which will “result in the efficient and economic development of the pool as a whole.” 58 P.S. § 407.  The Commission may vary the size and shape of any unit to conform to property lines.  Id.  Nonetheless, the Commission is guided primarily by an interest in efficient development.
When a spacing unit consists of two or more owners, the Commission may also order the integration of the interests for development, operation and the sharing of production from drilling operations unless the owners voluntarily integrate.  58 P.S. § 408(a).  The integration order will specify just and reasonable terms upon which the royalty interests in the unit shall be shared.  Id.  Any such order must be preceded by notice to all owners in the spacing unit and a public hearing.  Id. 
As part of the unitization and integration orders, all operations upon any portion of a unit for which an integration order has been entered “shall be deemed for all purposes the conduct of such operations upon each separately owned tract in the spacing unit.”  58 P.S. § 408(b).  A portion of production shall be allocated to each separately owned tract; that portion shall be deemed to have been actually produced from such tract by a well drilled thereon. Id.  If more than one operator pursues operations in the pooling unit, the integration order will authorize the drilling, equipping and operations of a well in the unit.  58 P.S. § 408(c).   
Owners of gas rights in the pooling unit may elect whether to participate in the risks and costs of operations.  58 P.S. § 408(c).  The integration order will make provisions for payment among those owners who elect to participate in the risks and costs of operations (“participating owners”) for the reasonable costs of operations and supervision of operations.  Id. 
Owners who elect not to participate in the risks and costs of operations (a “nonparticipating owner”) may elect to sell their leasehold interest to the well operator(s).  Id.  If requested, the Commission may determine a reasonable basis and reasonable consideration for the sale of the leasehold interest.  Id.   Absent such an arrangement, the operator of the well is entitled to seven-eighths (7/8) of the share of production otherwise attributable to the nonparticipating owner until the market value of this entitlement is double the share of such costs otherwise due from the nonparticipating owner.  Id.  After the operator of the well receives this sum, the nonparticipating owner is entitled to 100% of her share of the production.  Id.
In NWPOA’s hypothetical, Landowner A and Landowner B should be included in the same unitization order because the pool stretches beneath both of their properties; provided that an eligible person or company first applies to the Commission for such an order.  The eligible person or company could be Landowner B, another neighboring landowner or the gas company that leased gas rights from Landowner A. 
If forced into the same pooling unit, Landowner B is entitled to decide whether to participate in the costs and risks of operations.  If she chooses to participate, then the Commission will make provision in the integration order for payments of the costs of operations and supervision of operations reasonable act.
If Landowner B chooses not to participate, then (i) she may lease her gas rights to the well operator or another gas company under mutually agreed upon terms, (ii) she may request (or the well operator may request) that the Commission determine a reasonable basis and reasonable consideration for the sale of the leasehold interest, or (iii) double her share of the costs of operations and supervisions of operations may be deducted from her share of the production.  In the third alternative, Landowner B retains a 1/8 interest in her share of production until the value of the deductions equal double her share of the costs.  At such a time, Landowner B will be entitled to 100% of her share of production.

MDMF/

Chesapeake Appalachia is having a site prepared for natural gas drilling, on the Robson property off Fox Hill Road, Oregon Township. A “drill and operate well” permit was issued by Pa. DEP on February 26th. This is the second gas well site in Wayne County started during the current wave of gas prospecting in the region.