Now, with a few new wells coming online (mostly in Carroll County and other counties to the south), the first Ohio horizontal well royalty checks are starting to trickle in. When some recipients see the statements — and particularly amounts being deducted for lessee costs for marketing, transportation or processing — they might feel like they have been duped.

Many horizontal well royalty recipients are asking:

• “How can I be certain that my royalty was correctly calculated?”
• “Why am I seeing all of these deductions?” and
• “What can I do about this?”

Unfortunately, there are few simple answers. Every dollar deducted from royalties for “costs” is a dollar in the lessee's pocket. So lessees might not have much incentive to be responsive to these questions from their royalty recipients. Unanswered calls and letters seem all too common.

State laws and royalty payments

Some states have laws designed to protect royalty recipients. Pennsylvania recently passed a statute setting a minimum royalty amount (though the courts have since interpreted it to be a “net” amount, allowing some costs).

Texas has a standard required format for royalty statements, so details cannot be as easily obfuscated by the payor.

Ohio has little protection: only Ohio Revised Code Section 1509.30, titled, “Reports to Holder of Royalty Interest.” This section does require upon request of the recipient that the owner (the payor) timely report volumes of gas produced and the price per thousand cubic feet that the producer received.

The producer is to keep records for at least two years. The producer is to provide the information within fifteen days, or the end of the current payment period in the lease, whichever is later.

ORC Section 1509.04 indicates that the Chief of the Division of Oil and Gas of Ohio Department of Natural Resources is to enforce this section, and Section 1509.99 indicates a possible penalty of between $100 to $1,000 per day for failure to comply, and that the law is to be enforced by the county prosecutor.

I am unaware of any successful enforcement efforts along these lines, but this is in Ohio's statutes.

Royalty payments and lease language

The royalty recipients' rights are based on contract. There is no Ohio law requiring royalty payments of any certain level or addressing cost deductions. These issues often were not considered a “big deal” with lower-producing conventional gas wells, usually based on a “wellhead price” where post-production costs were relatively minor.

But, those same leases can cause great concern with higher-producing horizontal wells, and greater production and transportation costs (and any other post-production costs that the companies might think up). Cost deductions in horizontal well royalty statements have amounted to over 10% of the royalty.

If the lease language explicitly allows deduction of these costs (as many do, including the so-called “royalty enhancement” clauses), the recipient is likely stuck with the deal that they made.

But it is particularly frustrating when costs are unilaterally deducted from royalties under leases that explicitly prohibit deduction of such costs. Unfortunately, it appears that when some companies were in a race to sign leases on as much property as possible, they agreed to these clauses.

Now that production is starting, they want to pay the royalties as though these leases read the same as their “standard company” leases that allow cost deduction. It is as though they are deducting the costs, assuming that they can get away with it, recognizing the difficulty individual lessors would have contesting the issue, likely involving hiring costly attorneys, accountants and petroleum engineers.

Taking action over underpaid royalties

If you believe your royalties are less than they should be, consider the following actions:

• Thoroughly know what your lease says regarding royalty payments and deduction of costs. Also try to learn if such language has been interpreted by the courts.  Look for clauses in your lease allowing audits of the lessee.

• Be the very loud squeaking wheel. Be relentless. Call and write (certified mail) the company with your questions. If you cannot get response, contact the Ohio Department of Natural Resources, the Ohio Attorney General, and your county prosecutor.

• Organize for action. Likely others have similar leases and are dealing with the same company. Contact the landowner groups with which you were affiliated during the lease-up process to determine whether some collective action might be undertaken. Contact others in your drilling unit to determine whether this is a common problem with this lessee.

It is important that lessors not “rest on their rights,” and allow precedent to develop that would indicate that their valuable leases do not mean what they say regarding cost deduction.

Though action now might seem costly, those costs might pale in comparison to the benefit of receiving the royalty to which you are entitled from the production of the valuable resources under your property.

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Alan D. Wenger is an oil & gas lawyer in Youngstown, Ohio, and chair of the Oil & Gas Law Practice Group at HHM.