In an earlier post on this blog I had expressed confidence that the Pennsylvania legislature would enact a Marcellus drilling impact fee. Although the legislative negotiations have taken longer than I had anticipated, the Pennsylvania House and Senate have now passed House Bill 1950 and the bill was signed by Governor Tom Corbett last week. The legislation imposes an annual impact fee on each natural gas well drilled into an unconventional formation such as the Marcellus or Utica shale, and also significantly updates the existing Oil and Gas Law.

Reaction to the bill that was passed has been mixed. Some organizations with an environmental agenda have labeled the legislation a gift to the oil and gas industry. Other commentators have suggested that the new fee structure, coupled with current low natural gas prices, will drive oil and gas development elsewhere. Aside from the actual impact fee, perhaps the most controversial aspect of the new law is a limitation on the ability of local municipalities to regulate drilling activity and enact zoning ordinances.

An interesting twist added by the legislature is tying the revenue that will be generated to the current price of natural gas. For instance, if the price of natural gas averages less than $2.25, the impact fee will be $40,000 for the first year of the well. On the other hand, if the annual average price of natural gas is $6.00 or more, the first year impact fee will be $60,000. With the recent rock-bottom prices for natural gas, it seems likely that the revenue from the impact fee will be on the lower end of the scale. Sixty percent of the revenues will be distributed to counties and municipalities where wells are located, with the remainder going to the state.

One of the more divisive issues regarding the legislation was who would have the authority to levy the fee. The final version of the legislation requires that the fee be adopted by individual counties, rather than the state government. If a county should choose to not enact the fee, an affirmative vote by fifty percent of the municipalities in the county will override the decision. The legislators’ efforts notwithstanding, Grover Norquist still calls the fee a tax.

Viewed from the perspective of the local landowner, some of the more important provisions in the new legislation are as follows:

Setbacks

The previous regulations require that oil and gas wells be located at a minimum distance of 200 feet from an existing building or water source. Section 3215 of H.B. 1950 increases the minimum setback to 500 feet for an unconventional well, unless the owner of the property consents to a reduced distance. Unconventional wells must also be located at least 300 feet from any spring or other body of water.

H.B. 1950 does, however, provide an exception to the minimum distance requirement when the owner of the building or water well does not give consent and the distance restriction would deprive the owner of the oil and gas underneath the property of the right to share in production. A similar exception appeared in the previous version of the Oil and Gas Law, which provided that a well operator may be granted a variance from the distance requirement upon submission of a plan with additional measures to protect the property. But while the previous regulation states that the well operator may be granted a variance, H.B. 1950 provides that the operator shall be granted a variance. Time will tell whether the change from the permissive “may” to the mandatory “shall” will prove to be significant.

Water Testing

As anyone who even casually scans the news is aware, there have been ongoing concerns about the potential impact on water supplies from Marcellus drilling. Pennsylvania has provided an important protection for landowners with a presumption that a well operator is responsible for water pollution if the water well is within one thousand feet of drilling and the pollution occurred within six months of the completion of operations.

H.B. 1950 significantly adds to this protection by extending the presumption to water wells within 2,500 feet of unconventional drilling operations and increasing the period in which the presumption applies from six months to one year.

Hydrofracturing Disclosure

In an effort to allay concerns about hydraulic fracturing some operators in the oil and gas industry have moved to voluntarily disclose the contents of fracking fluids. H.B. 1950 now requires that a well operator disclose the identity of the chemicals used in hydraulic fracturing on a public chemical disclosure registry. This legislative mandate that the industry disclose the details of fracturing fluids is one of the provisions in the new law that has received the most positive media attention.

But the legislature has also provided the industry with an exception to the rule requiring disclosure if “the specific identity of a chemical or the concentration of a chemical, or both, are a trade secret or confidential proprietary information.” In that case, the operator need only disclose the chemical family or similar description associated with the chemical.

It may be hoped that the oil and gas operators in Pennsylvania will see the public relations benefit from transparency in hydraulic fracturing operations and will not take advantage of the exception to the disclosure rule generously provided to the industry by the Pennsylvania legislature.

Local Municipal Regulation

As discussed above, the restriction on the ability of local municipalities to enact zoning ordinances that regulate where oil and gas drilling activities may occur is probably the most controversial aspect of H.B. 1950. The bill explicitly preempts all local ordinances regulating oil and gas operations and requires that all such ordinances allow for reasonable development of oil and gas resources.

The oil and gas industry has consistently argued that it needs uniformity in terms of regulation across the state; adapting to a patchwork of varying regulations from different municipalities would significantly add to the cost of operations and may drive the industry to shift development to areas with lower operating costs. Governor Corbett and the legislature clearly take this concern seriously and the result is that Section 3304 of H.B. 1950 requires that local ordinances allow oil and gas activities, other than activities at impoundment areas, compressor stations and processing plants, as a permitted use in all zoning districts.

Section 3304 also provides that a municipality may not impose requirements or limitations on oil and gas operations that are more restrictive than those placed on other industrial activities.

The final version of this legislation appoints the state Public Utility Commission as the arbiter of disputes between local governments and operators as to whether an ordinance violates the requirements of Section 3304.

The bill appears to be designed to discourage such disputes. Section 3307 provides that a court can award attorney fees and costs if it finds that a municipality enacted an ordinance with willful disregard for the requirements in H.B. 1950. The municipality will also be ineligible to receive funds collected under the impact fee until it amends or repeals the ordinance.

Conclusion

Pennsylvania has been considering some form of a severance tax or impact fee since the Marcellus boom began. H.B. 1950 is the product of extensive negotiations and reflects a compromise between the various competing interests. Though the legislation leaves room for improvement, in the opinion of this Commentator it is nevertheless a significant step in the right direction.

I have met Dr. Sterngold and respect his opinion.

With natural-gas drilling booming in Pennsylvania's Marcellus Shale region, state lawmakers might seem to have chosen the perfect time to impose an impact fee on gas producers. The new fee has been projected to generate $191 million in retroactive 2011 fees, $220 million in 2012, and larger amounts over time.

Unfortunately, though, the legislature may have procrastinated for too long. Natural-gas prices have plummeted from their lofty levels of a few years ago, squeezing industry profits and forcing producers to start scaling back their activity. As a result, the impact fees may generate less revenue than expected and induce some cash-strapped drillers to shift resources to other states.

After years of avid promotion of natural-gas development by the Marcellus Shale Coalition, the industry's chief lobby, it's hard to imagine a slowdown in drilling. As part of its campaign to win public approval, the coalition funded a series of economic impact studies by Penn State researchers. The three studies, released in 2009, 2010, and 2011, forecast increasingly larger jumps in employment, incomes, and tax revenues as a result of shale exploitation. In the most recent study, released last summer, the authors concluded that "the outlook for Marcellus production is remarkable."

While the Penn State researchers were preparing their reports, however, evidence was mounting that the industry was in trouble. From an average of $8.85 per million British thermal units in 2008, natural-gas prices fell sharply to $4.39 in 2010, and $3.94 in 2011. Last month, prices dropped below $2.50, and they are expected to stay under $5 for another decade.

Signs of a slump

Lower gas prices mean smaller profit margins. So it's no surprise that gas producers are scaling back their Marcellus Shale drilling, putting growth on hold, or moving resources to states with lower costs and more deposits rich in oil and other liquid fuels. The companies doing so include Talisman Energy, EQT Corp., Consol Energy, and Occidental Petroleum Corp. Chesapeake Energy, which has the largest Marcellus Shale holdings in the state, has announced the most drastic cutbacks in Pennsylvania and elsewhere.

In a recent Inquirer op-ed, Louis D. D'Amico, president of the Pennsylvania Independent Oil & Gas Association, explained that "low natural-gas prices are bad for producers, many of whom can't continue to spend money on wells that aren't profitable under current and foreseeable conditions. In the coming months, Pennsylvanians can expect to see fewer ... wells drilled."

There have been signs of a coming correction for years. In May 2010, energy consultant Andrew Weissman observed in the American Oil and Gas Reporter that falling natural-gas prices had already caused markets to tumble, warning: "Current price levels will inevitably lead to further cutbacks in drilling." A year later, the Wall Street Journal reported, "With natural-gas profit margins all but disappearing, companies are cutting back on new gas drilling."

The 2009 Penn State study noted that "a prolonged slump in prices could dampen" Marcellus Shale activity. By the time last year's report was released, the slump was obviously in progress, but the researchers made their most optimistic forecast to date. They should have made the possibility of a lull clearer - even if that's not what the Marcellus Shale Coalition wanted to hear.

Boom and bust

It's too early to say how long a gas slowdown could last or how it will affect drilling impact fees. But even if natural-gas development grows at a slower rate than anticipated, people may suffer from having overinvested. Rural residents who decided to fix up family farms rather than move to smaller homes may be hard-pressed if their gas leases aren't renewed. Small-business owners who expanded their operations to serve gas companies may find they can't pay their bills. Let's hope the Marcellus Shale Coalition's relentless boosterism didn't exacerbate a climate of overspeculation and make the pain worse.

In the long run, natural-gas development may be good for Pennsylvania, especially compared with the economic stagnation we lived through before the drilling started. But industries that grow too quickly and then pull back painfully create a toxic boom-and-bust cycle. Pennsylvania needs an energy industry that is economically and environmentally sustainable, guided by academics who provide prudent advice and careful analysis. That would do more to safeguard our communities and natural resources than any amount of impact fees.

A link to a video recording of the panel discussion can be found here.

PAR recognizes that Marcellus development is having a significant impact on the business practices of its members. Working with property subject to an oil and gas lease raises concerns for both the buyers and sellers of real estate and PAR is committed to educating its members about the issues that realtors in the Marcellus region need to have on the radar.

Ensuring that a buyer of real estate is fully informed about the property being purchased is critical and today that clearly includes knowing the status of the gas rights and any oil and gas lease covering the property. Buyers will need to know about the specific rights granted to the gas company in the gas lease, which means that buyers must have a copy of the signed lease available for review. However, buyers of real estate cannot in most cases obtain a copy of the lease from the county recorder of deeds because the gas companies don’t typically record the actual lease; instead, the industry practice is to  record an abbreviated memorandum of lease that doesn’t included all of the information necessary for a buyer to review. Mr. Evenhuis has extensively researched the legality of this practice and discussed his concerns at the PAR meeting.

The primary focus of my discussion was the impact of various terms in a lease on a buyer’s ability to use and enjoy the property, and the property value. The gas lease will in most cases give a very broad grant of rights to the gas company, including the rights to drill wells, construct roads, place pipelines and related facilities, to use the property for underground gas storage and to drill wells for disposal of waste fluids. In many cases the seller will have worked with a qualified attorney to restrict this broad grant of rights, but a buyer of property will obviously need to know these details before entering into an agreement of sale.

There was also a discussion of the general trends that we see in Marcellus development today.

It was a pleasure presenting with Hank Lerner and David Evenhuis and I commend the Pennsylvania Association of Realtors^®  for its educational efforts on behalf of its members.

@NY1weather: Hot in the city? Since 1996, we've broken only 1 record low at Central Park while setting 48 record highs.

Though it’s not my intention to jump into the climate change debate, this struck me as interesting fact which highlights the importance of reducing greenhouse gas emissions. And this naturally leads an oil and gas attorney to reflect upon the advantages of using natural gas for energy production, rather than coal.

Those who follow issues related to Marcellus development are probably familiar with the conventional wisdom that use of natural gas for electricity production results in about fifty percent less greenhouse gas emissions than the use of coal. Aside from the reduction in emissions of mercury, sulfides and soot from coal, the substantial improvement in terms of climate impact has been touted as one of the important benefits resulting from development of domestic natural gas resources.

Or so we thought, until the release of a study by Robert Howarth from Cornell University which reached the surprising conclusion that unconventional natural gas had a larger greenhouse gas footprint than coal. This study looked at the lifetime emissions resulting from a hydraulically fractured gas well and was based on a series of assumptions, including a projection that up to eight percent of the methane from an unconventional gas well leaks into the atmosphere. That would be a very significant factor in the analysis because methane is a more potent greenhouse gas than carbon dioxide.

The Howarth study was widely reported in the news media. Robert F. Kennedy Jr., a prominent environmental activist, has cited the study as a reason for backtracking on his previous endorsement of natural gas development. The study may even form the basis for policy decisions as Howarth has provided testimony for the European Parliament and the New York state legislature.

Now it appears that the Howarth study may have missed the mark. A number of subsequent reports refute the conclusions of the Howarth study and affirm that natural gas is a cleaner fuel than coal. This includes studies by Carnegie Mellon University, the National Energy Technology Laboratory, IHS-CERA and the University of Maryland. The former Secretary of the Pennsylvania Department of Environmental Protection, John Hanger, has summarized these studies nicely on his blog.

The final nail in the coffin may have been driven home by a different team of Cornell researchers in a paper that was recently published online. Characterizing the Howarth study as “misleading,” these researchers conclude that shale gas has a greenhouse gas footprint that is half and perhaps even a third that of coal.

These studies refuting the Howarth report are encouraging for those of us who are concerned about climate change and see hope in the development of domestic shale gas that can reduce dependence on foreign energy supplies while substantially reducing greenhouse gas emissions.

As anyone who even casually scans the news is aware, there are other potential environmental concerns associated with Marcellus development besides green house gas emissions. For landowners who have not yet signed an oil and gas lease, the ideal way to address many of those concerns is by working with a qualified attorney who can negotiate protections for the landowner in the lease. This may include provisions such as an environmental indemnity clause and restrictions on the right to use the property for drilling or disposal of wastewater. The gas planning team at Marshall, Parker & Associates is always committed to helping landowners protect their family and their property in the gas leasing process and also in dealing with the various issues that may arise after signing the lease.

A related issue that has received less attention, but is nevertheless significant, has been regulation of the network of natural gas pipelines that is being constructed to transport natural gas from the Marcellus to the market. The Philadelphia Inquirer has published an excellent series of articles, drawing public attention to the notable lack of regulatory oversight of pipeline construction in the Commonwealth. A link to the series of articles can be found here.

Pipeline regulation is one area where the Governor and our state legislators have recently made progress: Act 127, introduced by State Representative Matthew Baker, was signed by Governor Corbett on December 22, 2011. The Act remedies a significant shortfall in pipeline regulation by giving the state Public Utility Commission (PUC) authority over pipeline regulation that matches the current oversight by the federal Pipeline and Hazardous Materials Safety Administration (PHMSA). An article discussing this pipeline measure can be found here.

PUC involvement with pipeline regulation is nothing new, but prior to Act 127 the PUC only regulated those pipelines also subject to regulation by the Federal Energy Regulatory Commission. These are generally the large, interstate transmission lines that are regulated as public utilities and have eminent domain powers. The only entity that had any regulatory control over the many miles of gathering lines that transport the gas from the wells to the transmission lines in Pennsylvania was the PHMSA. Unfortunately, that oversight has been less than complete as the PHMSA has lacked the resources to fully regulate those many miles of pipelines.

This missing piece of the regulatory puzzle is what was fixed with Act 127; now, the PUC will have the authority to regulate gathering lines in the Commonwealth. To meet its new responsibilities under the Act, the PUC plans to hire 12-15 new pipeline inspectors – good news for the residents of those areas where pipeline construction is taking place.

But one very large piece of the puzzle is still missing. As discussed above, the PUC now has authority over those pipelines currently regulated by the PHMSA. However, the federal regulations break down the locations where pipelines are placed into four classes, from Class 4 high-population areas to the rural areas with low-density population categorized as Class 1. And the federal regulators apparently made the decision that the risks posed by pipelines in the low population areas didn’t justify the added costs of regulation. So, pipelines in Class 1 areas are not subject to regulation by the PHMSA and will thus not fall under the new regulatory requirements of Act 127.

A significant percentage of the new pipelines being constructed to transport Marcellus shale gas are being placed in the rural Class 1 areas. For that reason, the oil and gas industry in Pennsylvania may view Act 127 as more bark than bite. Representative Baker predicts that the federal regulations could be strengthened in two to three years, placing pipelines in Class 1 areas under federal oversight. Pennsylvania could also choose to extend PUC authority, but uncertainty about expanded regulation remains.

The natural gas industry naturally views additional regulation as unnecessary, suggesting that self-policing is adequate. Certainly, the industry has every incentive to ensure that pipelines are constructed in a safe manner. Nevertheless, it’s safe to say that the landowners in rural areas where these gathering lines are placed would prefer to see expansion of PUC regulatory oversight to include Class 1 areas sooner, rather than later.

There are a number of issues that will need to be addressed in reconciling the competing versions of the bills. For instance, the amounts that will be collected by the impact fee vary considerably. Here is a link to an article which includes a chart that nicely summarizes the key differences in the amounts collected and the allocation of the proceeds.

The more critical difference may be regarding who is responsible for collecting the fee; while Governor Corbett and the House agree that the individual counties should asses the fee, the Senate version of the bill gives that duty to the state Public Utility Commission.  

Discussing the Marcellus Shale legislation, the Pittsburgh Post Gazette concludes that “large question marks still loom regarding whether that measure will find its way to the governor's desk by the end of the year”.

The Pennsylvania legislature has been considering some type of severance tax or impact fee since the Marcellus boom began. Whether or not it will happen this year remains to be seen – with only three session days left for the Senate in 2011, our legislators are certainly taking it down to the wire.

One area in which the House and Senate bills agree is in placing restrictions on the ability of local municipalities to regulate where in the municipal boundaries oil and gas development activities may occur. Despite the opposition of municipal officials  to language in the proposed bills that would place limits on local zoning control over gas drilling, both bills include significant limitations on municipal regulation of oil and gas operations and it seems very likely that these restrictions will appear in the final version of the impact fee bill.

Pennsylvania Supreme Court Decisions

Disputes over municipal regulation of oil and gas development are nothing new. There has been considerable litigation over the attempts by municipalities to regulate drilling activity, with two cases decided by the Pennsylvania Supreme Court in 2009 setting forth the current state of Pennsylvania law on these issues. In Range Resources v. Salem Township the Court reviewed an ordinance that attempted to enact a comprehensive regulatory scheme relating to oil and gas development, including specific regulations governing drilling operations. The Court noted that the regulations paralleled and in some cases conflicted with the state regulations in the Oil and Gas Act, and concluded that the local regulations were invalid because they were preempted by state law.

In contrast, in Huntley & Huntley v. Borough of Oakmont the Court held that a zoning ordinance which restricted oil and gas drilling in residential districts was not preempted. The Court noted that municipalities have unique expertise in designating where different uses should be permitted in a manner that accounts for the community's development objectives and character.

As a result of these decisions, it seemed clear that although a municipality could not regulate how drilling operations were conducted, it could enact zoning rules restricting where drilling activities could occur, at least in residential districts. That may soon no longer be the case.

Impact Fee Bills

The Pennsylvania Senate passed SB 1100 on November 15, 2011. Section 3303 of the bill provides that a local ordinance shall provide for the reasonable development of minerals within the local government. The bill then lays out the provisions that must be included in a local ordinance to allow for reasonable development:

§ 3309.  Provisions of local ordinances

In order to allow for the reasonable development of oil and gas resources, a local ordinance must, in addition to complying with this chapter, Chapter 32 (relating to regulations) the Oil and Gas Act, the MPC and judicial decisions of the Commonwealth:

(5)  Authorize oil and gas operations, other than activities in or at impoundment areas, compressor stations and processing plants, as a permitted use in all zoning districts.

(6)  Authorize impoundment areas used for oil and gas operations as a permitted use in all zoning districts, provided that the edge of any impoundment area shall not be located closer than 300 feet from an existing building.

As indicated in the areas underlined (by the author) above, in order to allow for reasonable development, a local ordinance must allow oil and gas operations and construction of impoundments in all zoning districts. It should be noted that the bill would allow municipalities to regulate limits on lighting and noise relating to oil and gas operations as long as the restrictions are no more stringent than existing rules for industrial operations. The bill also specifies setbacks for well pads, impoundments and compressors.

What if there is a dispute as to what constitutes reasonable development? Section 3304 appoints the state Attorney General as the arbiter of such disputes:

§ 3304.  Review by Attorney General.

(a)  Request of owner or operator.‑‑ An owner or operator of an oil and gas operation, or any person having the right to royalty payments under a lease of oil or gas mineral rights, may request the Attorney General to review a local ordinance to determine whether it allows for the reasonable development of oil and gas resources in accordance with the provisions specifically addressed in this chapter, Chapter 32 (relating to regulation), the MPC and judicial decisions of the Commonwealth.

If the Attorney General determines that the ordinance does not allow for reasonable development of oil and gas resources, the local government will be immediately ineligible to receive any funds collected under the impact fee. With the standard as to what constitutes reasonable development stated right in the statute, there might not be much room for argument.  The Attorney General is also authorized to bring an action against a local government to invalidate a local ordinance that does not allow for the reasonable development of oil and gas resources.

What’s Next?

The House version of the bill, HB 1950, includes provisions regarding local ordinances that substantially mirror those in SB 1100. This iteration of the House bill is considered a significant improvement over a previous version that completely preempted all local ordinances. While there is agreement on the zoning provisions, there are still considerable differences between the bills in terms of the amounts that will be collected by the impact fee. It may be assumed that there are closed-door negotiations proceeding now in an attempt to reconcile the bills.

The zoning restrictions in these bills may be understood as an attempt to strike a compromise that will allow limited municipal regulation of drilling activities while facilitating development of oil and gas resources. Landowners who favor reasonable development and look forward to royalties will appreciate this legislation. Local municipalities may find, however, that there isn’t much practical distinction between a bill that completely preempts local zoning and one that requires authorization of drilling operations as a permitted use in all zoning districts.

Oil and gas leasing and Marcellus development are often perceived as controversial and divisive issues in Pennsylvania. While the large majority of landowners in the Marcellus fairway have been amenable to leasing their property for gas drilling, there is a vocal minority of landowners who vehemently oppose Marcellus development and have refused to proceed with an oil and gas lease for their property.

Readers of the PENNROAR (or this blog) are by now familiar with the operation of the pooling provision found in the gas leases used by Marcellus operators. It is readily apparent that these holdout landowners will make it difficult or impossible for the gas companies to proceed with development of a production unit in the area where the un-leased land is located. For the gas companies, the solution to this problem has been forced pooling – also sometimes referred to as “statutory pooling” or compulsory integration.

Pennsylvania has previously enacted a forced pooling law known as the Oil and Gas Conservation Law, but the current law does not apply to the Marcellus shale. As a result, there has been an ongoing, heated discussion among the various stakeholders about the possibility of drafting a new version of the Conservation Law that would allow compulsory integration of the Marcellus. At this time, it appears that forced pooling may be such a hot topic that legislators will refuse to touch it, but the issue is likely to resurface in future legislative sessions.

It is not the purpose of this article to advocate for adoption of a new forced pooling law in the Commonwealth. Rather, the discussion below highlights a number of issues that should be addressed in the legislative discussion about a forced pooling law, in the event that such legislation is introduced in Pennsylvania.

Good Faith Offer

Texas has enacted a forced pooling law. However, the law requires that the oil and gas company first make a good faith lease offer to a holdout landowner before proceeding with a forced pooling proceeding. As a result, the forced pooling law has been rarely used in Texas. Pennsylvania legislators may consider including such a requirement in any forced pooling proposal.

Minimum Leased Acreage

Some states with forced pooling laws have included a requirement that the operator have a certain minimum amount of acreage leased in the area of the proposed pooled unit. This type of requirement forces the gas company to lease some percentage of the landowners in the area intended for drilling before proceeding with compulsory integration. The percentage of land required to be leased may vary anywhere from 51% to 95%. Obviously, as the minimum percentage required increases, it will be increasingly difficult for the gas company to utilize forced pooling.

Risk Penalty

When an oil and gas company drills a well, there is always some risk that the well will be unproductive and the operator will be unable to recoup its drilling costs. The amount of risk will vary from well to well and will also vary depending on the target formation being drilled.

The concept of the “risk penalty” recognizes that the non-participating landowner who is being forced-pooled should share in the risks involved in drilling. Forced pooling laws accomplish this risk sharing by providing that the non-participating landowner will not receive gas production payments until the gas company has recouped the landowner’s proportional share of the costs to drill the well, plus some additional percentage of the costs as compensation to the operator for undertaking the risk of drilling.

Pennsylvania’s current Conservation Law sets the risk penalty at 200% of the landowner’s proportional share of the drilling costs. Until the gas company recoups double the landowner’s share of the costs, the un-leased landowner will receive a royalty payment of 1/8 (12.5%) of his or her proportional share of production. After 200% of the landowner’s share of costs is recovered by the gas company, the non-participating landowner is then entitled to his or her entire proportional share of the total gas production.

Legislators may also address the specific types of drilling costs that may be charged against the landowner’s share.

The most recent forced pooling proposal discussed here in Pennsylvania set the risk penalty at 400%. It may be questioned whether the risks involved in Marcellus drilling justify a risk penalty in that range.

Landowner Surface Protection

A forced pooling law should explicitly provide that the surface of the land of a non-participating landowner may not be used for drilling operations. Legislators may also consider a provision requiring that the operator provide compensation to the landowner in the event that there is some inadvertent impact on the un-leased landowner’s property or water supply.

Conclusion

This commentator does not intend to suggest that forced pooling is either good or bad for Pennsylvania landowners. But clearly, Pennsylvania royalty owners must understand that when evaluating any future forced pooling proposal, the devil is in the details.

This has been a well-settled rule of law in Pennsylvania for many years.

Last week, the Pennsylvania Superior Court issued a decision that now questions whether Dunham’s rule applies to the Marcellus shale. This is an important decision that will be followed closely by oil and gas attorneys, real estate attorneys and title companies. The decision may prove to be most significant, however, for the oil and gas companies that have signed gas leases based on the presumption that an exception and reservation of minerals in a deed does not include oil and gas – and for the landowners subject to those leases.

In Butler v. Powers the Superior Court reversed a decision by the lower court that had applied Dunham’s rule in an action for declaratory judgment asking the court to interpret a deed that included an exception and reservation of one half of the minerals to the grantor. The text of the decision can be found here.

The Superior Court focused on the distinction between free-flowing gas - “fere naturae” - and natural gas trapped in an unconventional reservoir such as the Marcellus shale. The court analogized the process to obtain gas from an unconventional reservoir to that used to produce gas from a coal vein, noting that the owner of the coal also owns the coal bed gas contained in the coal. The court stated that application of Dunham’s rule did not end the analysis in this case, “absent a more sufficient understanding” of the following issues:

1. Whether Marcellus shale constitutes a mineral;

2. Whether Marcellus shale gas constitutes the type of conventional natural gas contemplated in the  Dunham case and following decisions; and

3. Whether Marcellus shale is similar to coal in that whoever owns the shale, owns the shale gas.

The court concluded that the “parties should have the opportunity to obtain appropriate experts on whether Marcellus shale constitutes a type of mineral such that the gas in it falls within the deed’s reservation.” The case was reversed and remanded for further proceedings.

We will continue to follow the developments in this case as it proceeds - stay tuned.

There seems to be particular confusion about the tax risks for Marcellus landowners. While minimizing taxes is an almost universal goal, landowners are unsure what the tax risks may be and are even more uncertain about how and when to plan. Although they may be hearing mixed messages, the plain facts are abundantly clear.

Just the facts.

Production estimates for the Marcellus continue to increase. For instance, Range Resources reports that the estimated ultimate recovery for wells drilled in 2009 and 2010 averages 5.7 billion cubic feet of gas per well – two to three times greater than the lifetime production from wells drilled in the Barnett Shale of Texas, which has been the most prolific natural gas field in the nation.

These production numbers have attracted the attention of the major oil and gas companies. We have seen investment in the Marcellus from Exxon, Chevron, Shell, Hess, Norway’s Statoil and India’s Reliance Industries, among others.

An earlier post on this Blog further notes the potential for a “triple play” for many Pennsylvania landowners as the drillers may produce gas not just from the Marcellus, but also from the Utica and Upper Devonian shales. With more target formations available to the operators, the production potential must increase.

The gas reserves in the Marcellus have recently received a great deal of attention in the national news. The U.S. Geological Survey has dramatically increased its estimate of recoverable natural gas from the Marcellus to 84 trillion cubic feet – 42 times higher than the previous estimate from 2002. While this estimate is lower than the most recent projection from the Energy Information Administration, the amount of recoverable gas is still tremendous.

Dramatically more natural gas means dramatically more wealth for landowners with Marcellus acreage.

The future of the Federal Estate Tax?

Further complicating matters is the uncertainty about the future of the estate tax. Today, individuals can transfer up to $5 million tax free to their children, whether as a lifetime gift or upon their passing. However, the government’s generosity is schedule to end in 2013, when the estate tax exclusion will return to $1 million – unless congress and the president agree to raise the exclusion.  With concerns about the budget deficit and cries for fiscal austerity, it’s beyond the ability of this Commentator’s crystal ball to predict the actions of our polarized and paralyzed government over the next year.

What we do know is that the estate tax is based upon the value of the landowner’s assets as of the date of death, including the value of Marcellus gas rights. An appraisal will be required to determine the value of the gas rights. The most generally accepted appraisal methodology for proven gas reserves projects the stream of royalty income over the lifetime of a well, reduced to its present value. For non-producing properties, the royalty stream is calculated based on the production estimates that are accepted as of the date of the appraisal. This means that as production data improves and the estimates of natural gas reserves increase, the appraised values will also increase.

Because of the uncertainty about future Marcellus development, non-producing gas rights may have a low value today. But as the wells are drilled, gas is produced and production reports are filed with the PA Department of Environmental Protection, the uncertainty disappears and the appraised value of the gas rights is likely to skyrocket.

What does this mean for landowners?

What landowners with substantial Marcellus acreage need to understand is that when maximum gas production is obtained, there is tremendous potential that the value of the gas rights could exceed the federal estate tax exclusion. This means that if a landowner with large acreage dies when the gas rights reach peak value, the estate may well be subject to federal estate tax. If the landowner’s children are unable to produce the cash necessary to satisfy the IRS within nine months of the date of death, the unfortunate result may be that the children will be forced to sell some portion of the gas rights for pennies on the dollar to pay the estate tax that is due.

This is the nightmare scenario that keeps estate planning attorneys in the Marcellus awake at night.

The key takeaway here is that this nightmare can be avoided with proper planning done at the right time. The time to accomplish effective planning is when we have a favorable transfer tax regime and the value of the gas rights is low. In other words, the time to plan is now.