1. MARCELLUSCOALITION.ORG | @MARCELLUSGAS Royalties on Oil and Gas Leases – Treatment of Post-Production Costs

2. MARCELLUSCOALITION.ORG | @MARCELLUSGAS About Royalties What is a royalty? How is it calculated? The term “royalty” in an oil and gas lease means a share of production (1/8 th was a historical standard), free of the costs of production. Kilmer v. Elexco Land Services, Inc. 990 A.2d 1147 (Pa Sup. 2010) Production costs generally are all costs to extract the gas out of the ground, including well pad development, drilling, hydraulic fracturing, production equipment, and well operating expense. Production costs are borne solely by the producer (lessee). Post-production costs are the costs incurred after the gas is produced and include the cost to move gas and natural gas liquids to downstream markets.

3. MARCELLUSCOALITION.ORG | @MARCELLUSGAS What is a royalty? How is it calculated? Netback = Price at a downstream Point of Sale – Post-Production Cost When the point of sale is the wellhead, the producer’s post production cost is zero. However, the sale price is less, reflecting the purchaser’s post-production costs. When the point of sale is downstream of the wellhead, the greater revenue as well as the post-production costs (PPCs) would normally be shared by the producer and the mineral owner (lessor) in proportion to their interests. About Royalties

4. MARCELLUSCOALITION.ORG | @MARCELLUSGAS Post-Production Costs Gathering: Sometimes a well is many miles from an existing transmission gas pipeline and extensive gathering lines are required. Compression: Many of the larger interstate pipelines operate at pressures of 1,000 psig or more; wells frequently operate at much lower pressures, so gas must be compressed to enter the pipeline. Dehydration: Removal of moisture. Processing/Treating: Separation of liquids from the gas (ethane, propane, butane, etc.). May also include removal of hydrogen sulfide, carbon dioxide, nitrogen or other constituents. Firm Transportation Fee: Fee to reserve space in the pipeline (generally an interstate transmission pipeline).

5. MARCELLUSCOALITION.ORG | @MARCELLUSGAS Point of Sale and Wellhead Value of Gas: Sample Case 1 C Interstate Transmission P/L Gathering P/L Production Company A Point of sale Compression and gathering either owned by a producer or by third party who charges a fee for gathering Point of sale is delivery point into first interstate pipeline PPCs for gathering and compression are deducted from sale price to compute royalty based on the percentage royalty contracted with the landowner (i.e. a 1/8 royalty owner shares in 1/8 PPCs)

6. MARCELLUSCOALITION.ORG | @MARCELLUSGAS Point of Sale and Wellhead Value of Gas: Sample Case 2 C Interstate Transmission P/L Gathering P/L Production Company A 300 miles Point of sale Compression and gathering either owned by producer or by third party who charges a fee for gathering Point of sale is downstream of delivery point into first interstate pipeline PPCs for gathering, compression and transportation on interstate pipeline are deducted from sale price to compute royalty

7. MARCELLUSCOALITION.ORG | @MARCELLUSGAS Structure Costs for gathering, compression, processing and firm transportation frequently include: A fee component that is fixed, regardless of flow volume (sometimes referred to as a demand, reservation or capacity fee) A fee component that is variable, based on throughput volume Some arrangements may include minimum volume penalties If gathering, compression or processing is performed by a 3rd party, rates are determined by negotiated contract If a producer operates its own gathering, compression or processing facilities, rates may be determined internally using a calculation that allows recovery of capital and operating cost Rates for transportation on interstate pipelines are regulated by FERC Rate structures for gathering, compression and processing can vary widely depending on many factors

8. MARCELLUSCOALITION.ORG | @MARCELLUSGAS Lease Negotiation Allocation of post production costs is usually an agreed to lease term. The lease terms vary widely as to what PPCs, if any, are deducted. Some leases are clearer than others on these terms. Both the producer and mineral owner benefit from being able to negotiate how PPCs are handled. The level of bonus payment and the royalty share is often related to how post production costs are shared. Mineral owner may prefer the freedom to negotiate terms.

9. MARCELLUSCOALITION.ORG | @MARCELLUSGAS A Lease is a Contract A lease is a contract between private parties setting forth their rights and obligations. Both the Pennsylvania and U.S. constitutions prohibit a state from passing a law that impairs the obligation of contract. Attempting to alter the terms of an existing lease would violate the constitutional ban on laws impairing contracts. Attempting to dictate the terms of future contracts will deprive the parties of the flexibility to negotiate terms that suit the circumstances.