Unfair Share: How oil and gas drillers avoid paying royalties to landowners (ProPublica)

A farm in Pennsylvania with a natural gas well. (AP file photo)
ProPublica By ProPublica The Post-Standard
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on August 13, 2013 at 12:30 PM, updated February 24, 2014 at 8:52 AM
Every penny that a corporation can save on royalties is a penny of profit for shareholders.

By Abrahm Lustgarten, ProPublica


It seemed promising. Two wells drilled on his lease hit as sweet a spot as the Marcellus shale could offer - tens of millions of cubic feet of natural gas gushed forth. Last December, he received a check for $8,506 for a month's share of the gas.


Chesapeake Energy, the company that drilled his wells, was withholding almost 90 percent of Feusner's share of the income to cover unspecified "gathering" expenses and it wasn't explaining why.

"They said you're going to be a millionaire in a couple of years, but none of that has happened," Feusner said. "I guess we're expected to just take whatever they want to give us."



From Pennsylvania to North Dakota, a powerful argument for allowing extensive new drilling has been that royalty payments would enrich local landowners, lifting the economies of heartland and rural America. The boom was also supposed to fill the government's coffers, since roughly 30 percent of the nation's drilling takes place on federal land.







Significant amounts of fuel are never sold at all - companies use it themselves to power equipment that processes gas, sometimes at facilities far away from the land on which it was drilled. In Oklahoma, Chesapeake deducted marketing fees from payments to a landowner - a joint owner in the well - even though the fees went to its own subsidiary, a pipeline company called Chesapeake Energy Marketing. The landowner alleged the fees had been disguised in the form of lower sales prices. A court ruled that the company was entitled to charge the fees.


"To find out how the calculation is done, you may well have to file a lawsuit and get it through discovery," said Owen Anderson, the Eugene Kuntz Chair in Oil, Gas & Natural Resources at the University of Oklahoma College of Law, and an expert on royalty disputes. "I'm not aware of any state that requires that level of disclosure."


In other cases, companies have bartered for services off the books, hiding the full value of resources from landowners. In a 2003 case in Louisiana, for example, Kerr McGee, now owned by Anadarko Petroleum, sold its oil for a fraction of its value - and paid royalties to the government on the discounted amount - in a trade arrangement for marketing services that were never accounted for on its cash flow statements. The federal government sued, and won.

The government has an arsenal of tools to combat royalty underpayment. The Department of Interior has rules governing what deductions are allowable. It also employs an auditing agency that, while far from perfect, has uncovered more than a dozen instances in which drillers were "willful" in deceiving the government on royalty payments just since 2011. A spokesman for the Department of Interior's Office of Natural Resources Revenue says that over the last three decades, the government has recouped more than $4 billion in unpaid fees from such cases.


ProPublica made several attempts to contact Chesapeake Energy for this article. The company declined, via email, to answer any questions regarding royalties, and then did not respond to detailed sets of questions submitted afterward. The leading industry trade group, the American Petroleum Institute, also declined to comment on landowners' allegations of underpayments, saying that individual companies would need to respond to specific claims.


"The duty of the corporation is to make money for shareholders," Anderson said. "Every penny that a corporation can save on royalties is a penny of profit for shareholders, so why shouldn't they try to save every penny that they can on payments to royalty owners?"

* * *

Gas flows up through a well head on Feusner's property, makes a couple of turns and passes a meter that measures its volume. Then it flows into larger pipes fed by multiple pipelines in a process the industry calls "gathering." Together, the mixed gases might get compressed or processed to improve the gas quality for final sale, before feeding into a larger network of pipelines that extends for hundreds of miles to an end point, where the gas is sold and ultimately distributed to consumers.


As in many royalty disputes, it is not clear exactly which point of sale is the one on which Feusner's payments should be based - the last sale onto the open market or earlier changes in custody. It's equally unclear whether the expenses being charged to Feusner are incurred before or after that point of sale, or what processes, exactly, fall under the term "gathering." Definitions of that term vary, depending on who is asked. In an email, a spokesperson for Chesapeake declined to say how the company defines gathering.


Chesapeake and Statoil pay him royalties and account for expenses separately. Statoil does not deduct any expenses in calculating Feusner's royalty payments, possibly because it has a different interpretation of what's allowed.

"Statoil's policy is to carefully look at each individual lease, and to take post-production deductions only where the lease and the law allow for it," a company spokesman wrote in an email. "We take our production in kind from Chesapeake and we have no input into how they interpret the leases."

Once the gas is produced, a host of opaque transactions influence how sales are accounted for and proceeds are allocated to everyone entitled to a slice. The chain of custody and division of shares is so complex that even the country's best forensic accountants struggle to make sense of energy companies' books.

Feusner's lease does not give him the right to review Chesapeake's contracts with its partners, or to verify the sales figures that the company reports to him. Pennsylvania - though it recently passed a law requiring that the total amount of deductions be listed on royalty statements - has no laws dictating at what point a sale price needs to be set, and what expenses are legitimate.


"If you have a system that is not transparent from wellhead to burner tip and you hide behind confidentiality, then you have something to hide," Jerry Simmons, executive director of the National Association of Royalty Owners (NARO), the premier organization representing private landowners in the U.S., told ProPublica in a 2009 interview. Simmons said recently that his views had not changed, but declined to be interviewed again. "The idea that regulatory agencies don't know the volume of gas being produced in this country is absurd."


Since then, Pennsylvania landowners say, Chesapeake has been making larger deductions from their checks. (The company did not respond to questions about this.) In April, Feusner's effective royalty rate on the gas sold by Chesapeake was less than 1 percent.

Paul Sidorek is an accountant representing some 60 northeastern Pennsylvania landowners who receive royalty income from drilling. He's also a landowner himself - in 2009, he leased 145 acres, and that lease was eventually sold to Chesapeake. Well aware of the troubles encountered by others, Sidorek negotiated a 20 percent royalty and made sure his lease said explicitly that no expenses could be deducted from the sale of the gas produced on his property.

Yet now, Sidorek says, Chesapeake is deducting as much as 30 percent from his royalties, attributing it to "gathering" and "third party" expenses, an amount that adds up to some $40,000 a year.

"Now that the royalties are flowing, some people just count it as a blessing and say we don't care what Chesapeake does, it's money we wouldn't have had before," Sidorek said. But he's filed a lawsuit. "I figure I could give my grandson a first-class education for what Chesapeake is deducting that they are not entitled to, so I'm taking it on."

Landowners, lawyers, legislators and even some energy industry groups say Chesapeake stands out for its confusing accounting and tendency to deduct the most expenses from landowners' royalty checks in Pennsylvania.

"They've had a culture of doing cutthroat business," said Jackie Root, president of Pennsylvania's chapter of the National Association of Royalty Owners.


Root and others report good working relationships with other companies operating wells in Pennsylvania, and say that deductions - if they occur at all - are modest. Statoil, which has an interest in a number of Chesapeake wells, does not deduct any expenses on its share of many of the same leases. In an email from a spokesperson, the company said "We always seek to deal with our lease holders in a fair manner."

Several landowners said that not only do deductions vary between companies using the same gas "gathering" network - sales prices do as well.


"If Statoil can consistently sell the gas for $.25 more, and Chesapeake claims it's the premier producer in the country, then why the hell can't they get the same price Statoil does for the same gas on the same day?" Sidorek wondered.









Pennsylvania attorneys say many of their clients' leases do not allow landowners to audit gas companies to verify their accounting. Even landowners allowed to conduct such audits could have to shell out tens of thousands of dollars to do so.

When audits turn up discrepancies, attorneys say, many Pennsylvania leases require landowners to submit to arbitration - another exhaustive process that can cost tens of thousands of dollars. Arbitration clauses can also make it more difficult for landowners to join class action suits in which individuals can pool their resources and gain enough leverage to take on the industry.

"They basically are daring you to sue them," said Aaron Hovan, an attorney in Tunkhannock, Pa., representing landowners who have royalty concerns. "And you need to have a really good case to go through all of that, and then you could definitely lose."

All of these hurdles have to be cleared within Pennsylvania's four-year statute of limitations. Landowners who realize too late that they have been underpaid for years - or who inherit a lease from an ailing parent who never bothered to check their statements - are simply out of luck.


"They just wait to see who challenges them, they keep what they keep, they give up what they lose," said Root, the NARO chapter president. "It may just be part of their business decision to do it this way."