No Fracking Way

Royally Fracking Ripped Off

by Chip Northrup on April 17, 2014

By frackers. Who fracking else ? Chesapeake, Range, you name it  – they make as much money fracking landowners as shale. Where do you think all those creative accountants and lawyers went when ENRON imploded ? Into fracking.

Royalty Rip-off

Around the country, landowners are suing Chesapeake and other drillers for massive deductions from royalty checks.

Posted April 16, 2014 by PETER GORMAN in News

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Donald Feusner used to be a dairy farmer. His 370 acres of land in northeast Pennsylvania border New York state in a gloriously lush area. In 2011, when his farm was no longer profitable, he sold off his herd and retired to what he thought would be the life of a gentleman farmer, living off the proceeds of the gas wells Chesapeake Energy had drilled on his land. And in December 2012, when the wells came in, it looked as though he’d made a safe bet: Royalty income from the first month’s production alone totaled more than $8,500.

But five months later, with the wells still producing the same amount of gas, his royalty check suddenly shrank by more than 80 percent, to just under $1,700, eaten away by what Chesapeake called “post-production costs.” In the following months, his checks dwindled even further, to almost nothing.

“In October 2013, I got a check that said my royalty was $6,000,” said Feusner, “but after one set of deductions it was reduced to $115; after another adjustment it dropped further. They wound up taking 99.3 percent of my royalty. I got $46.”

Harold Moyer, an accountant with the Pennsylvania Farm Bureau who represents Feusner and 150 other royalty owners in northern Pennsylvania, said that Feusner’s lease agreement was bad from top to bottom: It not only let Chesapeake put a large well pad on the property for no extra money, but it allowed the company to deduct post-production costs.

Chesapeake declined to comment on Feusner’s royalties or any other aspect of this story.

a style=”color: #1155cc;” href=”http://www.fwweekly.com/wp-content/uploads/2014/04/FEATURE_12.jpg” target=”_blank” rel=”nofollow”>Knapp, with son Nate: “The money we were being charged for post-production costs began to skyrocket.” Courtesy Carolyn Knapp

Knapp, with son Nate: “The money we were being charged for post-production costs began to skyrocket.” Courtesy Carolyn Knapp

Those costs covered every aspect of getting the gas from the well to market: separating out water moisture and other gases, compressing it, sending it through gathering lines, even a fee for selling it. And the deductions weren’t made just from Feusner’s checks. Across Pennsylvania tens of thousands of people who leased their mineral rights saw their post-production costs — which are legal under the terms of most leases — jump from pennies on the dollar to most of that dollar in the beginning of 2013.

Jerry Simmonsexecutive director of the National Association of Royalty Owners, said the situation in Pennsylvania is the worst case of royalty rip-off he’s ever seen. It’s so bad there, he said, that Gov. Tom Corbett recently asked his attorney general to start an investigation.

Rules vary from state to state on post-production costs and other methods that drillers use to reduce the amount of royalties they pay. But one version or another of the problem seems to be happening all over the country, from shale drilling plays in Ohio to South Texas to the Rockies.

The worst offender is Chesapeake, by several accounts. “There is no question that Chesapeake is the bad actor all over the country, and its actions are being imitated,” said Jackie Root, president of the Pennsylvania NARO chapter. “They’re taking deductions from leases that have ‘no deduction’ clauses, and then they sometimes take deductions that are not legal at all.”

In North Texas, Fort Worth’s wealthy Hyder family won almost $1 million from Chesapeake for what were deemed improper deductions from their royalties on a thousand-acre tract. Two years ago, Dallas/Fort Worth International Airport won $5 million from Chesapeake to settle the airport’s claims of similar malfeasance. Last year, the cities of Fort Worth and Arlington, the Arlington school district, and the Bass family filed similar suits against the company, each for millions of dollars. Those lawsuits could come to trial later this year

“And what is that to Chesapeake?” asked John McFarland, an Austin oil and gas attorney, referring to the amounts of settlements and judgments, compared to what Chesapeake and other companies bring in. “They just repay what they took plus attorney’s fees. Cost of doing business.”

He wouldn’t hazard a guess about the total value that Chesapeake might have wrongfully withheld from royalty checks in the Barnett Shale.

NARO leaders and oil and gas industry attorneys said it’s a rotten way to be the “good neighbor” that the drilling industry claims to be, especially for Chesapeake, a company that in the last decade bought municipal goodwill in North Texas by slapping its brand on everything from Fort Worth’s Thanksgiving parade to its buses. Not coincidentally, Chesapeake’s tactics of squeezing royalty owners became much more aggressive about the same time the company was going through a major financial crisis.

Lawyers and others said the drillers are banking on the fact that few people question what’s going on, and even fewer have the means to take companies to court. The expense involved in auditing, much less suing, huge companies is beyond the reach of all but a very few. Plus, the drillers seldom get fined for their actions even when they are found to be at fault, so the math is heavily weighted in their favor.

“If they get caught once in a while but get away with it most of the time, it’s still a win for the gas companies,” said Steve Townsend, a Pennsylvania lawyer who regularly deals with royalty issues. “There’s really nothing for them to lose.”

Class action suits, a tool by which a limited number of plaintiffs theoretically could push for justice for large groups of royalty owners, have been made much more difficult thanks to U.S. Supreme Court rulings, because of the patchwork of different contracts and state laws involved.Wrongful deductions for post-production costs are only one tool being used by some gas companies to reduce their royalty outlays. If a lease includes a clause prohibiting post-production costs from being deducted, a company might change the term to “gas enhancement costs” and deduct them anyway. Some companies sell their gas to affiliates or subsidiaries at rates substantially below market value and then pay royalties only on those lower rates. Sometimes pipeline operators will charge several times the going rate to move gas to interstate transportation lines, and the gas company takes that out of royalty money, too. The costs of selling the gas get charged to royalty owners and sometimes an “impact fee” to recoup what the drillers pay in taxes or fees.In Pennsylvania, landowners are finding out that loans taken out by drillers, with mineral leases as collateral, have led to liens being placed on the real estate itself, even though the drillers own no surface rights. Landowners have even found themselves liable for a driller’s bills — of more than a million dollars in one case.

“There is no end to their creative accounting,” said Moyer. It’s like Enron.

In some cases, questionable deductions from royalty checks represented just a few hundred dollars on thousands of dollars in royalties, but the amounts added up over time. That was the case with the Hyder family’s suit against Chesapeake. Last month, a San Antonio appellate court ruled that Chesapeake had wrongfully taken $700,000 by charging post-production costs against royalties. But that was on a big property — 948 acres straddling the Tarrant-Johnson county line — with 22 wells drilled between 2006 and 2010. The court ordered that money to be repaid and ordered Chesapeake to pay the Hyders’ legal costs as well, bringing the total judgment to about $1 million.

On royalty checks for a typical homeowner with a small lot — and likely no accountants on the payroll to watch — the deductions might not have been noticed. But that’s not been the case recently for some Pennsylvania mineral rights owners. The radical reductions in royalty money there — to the point that some people got negative-value“checks” — have people up in arms.

Carolyn Knapp and her husband own land in Bradford County in northern Pennsylvania, where they leased minerals to Chesapeake.

French: “One landowner was saddled with a $1.2 million bill for a compressor station Chesapeake built.” Courtesy Carol French

French: “One landowner was saddled with a $1.2 million bill for a compressor station Chesapeake built.” Courtesy Carol French“Over a year ago, the money we were being charged for post-production costs began to skyrocket,” Knapp said. “I mean just skyrocketed. And it’s all lumped as ‘post-production’ or ‘market enhancement,’ but we have no idea what those words really mean in terms of what’s involved.“For instance, the gas companies are rebuilding some roads they ruined — is that included in what they’re taking from our royalties? What about the houses they’ve had to buy after some bad spills? Are we paying for those as well? Technically, those expenses occurred post-production, so they might be, but who knows? To try to get to see the business records of those companies is just too costly and time-consuming for regular folks.”

Even if Knapp had money to hire someone to do that, there is little chance she’d have the legal right to force the issue. According to NARO’s Simmons, in order to get to look at a company’s books to determine what they are being charged for, royalty owners would have had to make sure an audit clause was included in their mineral leases.

“Most people just get so excited about the money that they sign the lease without taking it to a specialist,” he said. “Later they think something isn’t right and want to look at the books. But if you didn’t put a clause in the lease giving you the right to audit, you can’t.”

Simmons lays some of the blame for the problem on the royalty owners themselves. “You wouldn’t buy a house without an inspection, yet a lot of people don’t bother to inspect what they’re signing when they sign that lease,” he said. “And that often leaves them out in the cold, because the gas companies are not going to change that to suit you.”On the other hand, Simmons said, “It’s flabbergasting what these companies are doing to people. It’s unbelievable. They’ll write down that you get a 12 and a half percent share of the leasing unit’s production in royalties and add that no monies can be taken from that except for the purpose of enhancing the gas to bring a better price. Which sounds good, but isn’t.”It isn’t enough, he said, because the gas companies can claim that any costs incurred are enhancing the gas value. And this is where the issue gets very tricky.

In other areas and other years, when drillers were producing “sweet” oil, not gas, a well’s output was sold immediately to pipeline companies, and royalties were figured based on oil value at the wellhead. But natural gas must be put through several processes before it is marketable; therefore, it has little or no value at the wellhead. That leaves lots of room for interpretation of what should be included in the cost of getting the gas ready to sell.

“You put it in separator tanks to separate out the water and any other gases that might come up with the methane you want. That costs. Then you’ve got to move it through pipe. That costs. Then you’ve got to dehydrate and compress it — another cost. Then you have to sell it,” Moyer explained. “All of those are enhancements, and the gas companies are claiming that the royalty owners have to pay a share of all of that. Which is not how they [royalty owners] read the lease at all.”

In Colorado and Oklahoma, McFarland said, post-production costs cannot legally be deducted from royalty payments. “It’s the oil or gas company’s sole responsibility to get that gas into marketable condition.

“In Texas, they go by the specific language of the lease — which is why the airport and Hyder suits were lost by Chesapeake,” he said. “Both of those had leases that were very specific about no costs being taken from the royalties. Unfortunately, not everyone has a lease like that in Texas. Very few do, actually.”

The standard lease in Pennsylvania calls for royalty owners to receive a minimum share of 12.5 percent, and courts had allowed nominal deductions that brought that slightly lower. But a case decided by the Pennsylvania Supreme Court in 2010 changed the situation drastically.

That case, Kilmer v. Elexco, pitted several landowners against the company that gathered lease agreements that were then sold to Chesapeake and other gas companies. The landowners were challenging the landman company over the minimum royalty figure, claiming that if post-production costs were allowed to be deducted, gas companies would inflate those costs to the point where royalties would all but disappear.

The Pennsylvania Supreme Court ruled that while landowners had a legitimate concern about gas companies inflating supposed post-production costs, that probably wouldn’t happen because “gas companies have a strong incentive to keep their costs down … .”

Not so much, as it turned out. “The court ruled that deductions that dropped royalties below the state minimum of 12.5 percent were allowable,” said Root, “and that opened the floodgates to the gas companies doing exactly what the landowners thought they would and which the court said they wouldn’t. … That’s when these problems started. That’s when some people started seeing half or nearly all of their royalty checks disappear.”

A bill now moving through the Pennsylvania legislature could change that in the future, if it passes. But a new law wouldn’t help royalty owners who have already signed leases.

When the state high court ruling was announced, Chesapeake and a number of other companies “all raised the amount they held from royalty checks,” he said. “As did Statoil and Talisman — but then last September, both of those companies paid back all of those post-production and enhancement monies to their royalty owners and don’t charge them anymore.”

Most of the companies instituted post-production charges that topped out at about 15 percent, Moyer said. But Chesapeake went much further, raising deductions to 30 or 40 percent of the royalty amount and in some cases to more than 90 percent.

“In March 2013, when Chesapeake was reeling financially, that’s when they started taking most of the royalties in several parts of the state,” he said.

Chesapeake founder and former CEO Aubrey K. McClendon, dubbed “America’s Most Reckless Billionaire” byForbes magazine in 2012, was famous for mixing personal business with company business. He bought or built mansions in Oklahoma City, in Minnesota, in Vail, Colo., and on “billionaires’ row” in Bermuda. He kept a leased fleet of jets at his disposal in Oklahoma City, where he built a 111-acre corporate campus that includes a 72,000-square-foot gymnasium for employees, four restaurants, and a theater. It all cost hundreds of millions of dollars at a time when the glut of natural gas had dropped the price below the cost of actually getting it out of the ground. He was forced out of the company in 2013.

Those expenditures, plus Chesapeake’s continual expansion, from the Barnett Shale to the Marcellus to Ohio, Oklahoma, and elsewhere, stretched the company too thin, even for the second largest producer of natural gas in the country. By the end of 2012, Chesapeake was nearly broke, and its stock value was tumbling.

Townsend said he “hates to pick on Chesapeake, but they’re the first, the most aggressive, and the one that keeps getting caught. And it’s nearly impossible to find out what they’re calling production or enhancement items because they don’t have to make that public here in Pennsylvania. If Chesapeake pays a county $60,000 for the drilling tax to drill a well, is that being charged to the landowner? They say they’re not doing that, but who knows because we don’t get to audit them.”

Not far behind Chesapeake is Range Resources, which was sued back in 2008 by landowners who wanted their leases cancelled because royalty payments had dipped below the 12.5 percent threshold. The class action suit, which included 25,000 landowners, was withdrawn after the decision in the Kilmer suit, then re-filed with a new angle, claiming that the landowners were being charged for marketing and gas management fees, as well as not being paid royalties for other salable hydrocarbons that were separated out of the natural gas — including propane, benzene, and oil. Range settled and finally paid $22 million — but after deductions for legal fees, the average landowner in the suit got less than $800. As part of the settlement, Range has continued to drill and pump gas from the properties involved.

Carol French, a landowner who spent months getting out from under her gas lease even though it had expired without any wells being drilled, is an outspoken critic of the way gas companies do business in her state.

“In Pennsylvania there are no laws on the byproducts of natural gas — propane, oil, and so forth — giving landowners a share in those royalties,” she said. “So while the landowners don’t get any share of those hydrocarbons, you can bet that they’re still paying for their separation out of the natural gas and to make those products ready for sale.”

The Chesapeake model does not stop with deducting post-production and enhancement charges. Their corporate structure is predicated on the idea of the company taking money at each step along the way — money that otherwise would go to landowners.

“The way Chesapeake set up their company allows it to make a lot of money from royalty owners just in the way they do their accounting,” McFarland said. “They set up a system that has affiliate companies and subsidiary companies doing the drilling, the fracking, separation of the gas, the gathering of the gas, the compression, and even the marketing.”

That structure means that, when one affiliate levies a fee on another affiliate, the fee is charged back to the landowner, and those fees find their way to Chesapeake coffers. When the fees and deductions are inflated, the company’s profits go even higher. Chesapeake pays royalties to landowners based on the value of the gas as sold to its affiliate. Since those prices are always lower than market price, McFarland said, so are the checks to royalty owners. On the other side, the subsidiaries that do the drilling and separating charge higher than normal rates to Chesapeake — and those costs are again passed on to landowners, in order to finance Chesapeake’s bailout financings.

A striking example of the practice involves the gathering lines that bring the gas from the wellhead to a compressor station. Chesapeake’s subsidiary pipeline company, Chesapeake Midstream Operating, was sold in July 2012 to another affiliated company, Access Midstream Partners. In that sale, covering its gathering lines nationwide, Chesapeake received $4.76 billion.

According to a report last month from the online investigative news site ProPublica, in Pennsylvania, Access Midstream almost immediately began charging Chesapeake 85 cents to move 1,000 cubic feet of gas, while the same amount of gas moved by another company in the same lines cost only 9 cents. That markup came right out of royalty payments.“That was an outrageously high fee,” said NARO’s Root. “But that’s how Chesapeake does it. I’ve got cases where Chesapeake is claiming to have gotten $3.56 per mcf [thousand cubic feet] at the point of sale and then taking out more than three-quarters of that in deductions — like pipeline fees — before figuring royalties.”Within a relatively small area, there might be four different companies operating under several different types of leases, Root said. So a landowner with one type of lease might be losing most of his or her royalties to Chesapeake’s post-production or enhancement fees, while a neighbor who leased to a different company might have no deductions.

Townsend said the problem is so bad in Pennsylvania that sometimes the gas companies “take money out of royalty checks for several months’ previous post- production or enhancement costs, leaving royalty owners essentially owing the gas companies for the right to take their gas.”

Worse, he said, is that even when royalty owners decide to band together in a lawsuit, the statute of limitations on suing over royalties is four years. “So if someone realizes they’re being cheated and have been cheated for 10 years, well, even if they bring a suit and win it, the gas company only has to reimburse them for the most recent four years of cheating.”

Pennsylvanians are also discovering an entirely new issue, one that has little to do with royalties but a lot to do with gas companies and their leases: Drilling companies are taking loans out against their properties.

McFarland said that oil and gas companies have taken out lines of credit against the value of the mineral rights on properties they have under long-term lease. “Oil and gas companies do that all the time to give themselves enough cash to drill, but here in Texas, the lien only attaches to the oil or gas company’s mineral interests — it doesn’t affect the surface owner at all,” he said.Gary Miller, of Ohioville in south-west Pennsylvania, went to his credit union in October 2013 to take a loan out on his 12-acre property. “I filed for a mortgage, and not long afterward I got a call to come into the credit union to take a look at something,” he said.When he went in, he was told that a title search had discovered a lien on his property. “I couldn’t believe it. I looked, and sure enough, there was a lien on my house for $500,000. Then they told me to take a second look: It turned out it wasn’t for a half a million dollars, it was for half a billion dollars. Can you imagine? I had a $500 million lien on my house!”

Miller called Chesapeake and asked why there was a lien against his property. Chesapeake explained that it wasn’t a lien on his property, it was a lien on the mineral rights under his land and surrounding properties.

“The thing was that the company making the money available to Chesapeake needed a physical address, and they happened to use mine. Which meant no refinanced mortgage.”

Miller, who is retired and living on about $1,500 a month, wanted to refinance the note on his land to lower payments and leave him enough money to buy a truck. But he said that no one has been willing to give him a loan, at least at a rate he can afford, while that lien is there.

“When the frackers first came and offered me nearly $2,500 an acre — a total of $30,000 — in bonus money, that was fantastic. But now, with everything I’ve heard and with this lien … well, since they haven’t started drilling yet, I hope they never do. I hope the lease expires because I’m sick of this, and I don’t want anything to do with Chesapeake or any other gas company.”

He’s not alone. Carol French and Carolyn Knapp went to the Bradford County courthouse when they first got wind of mortgages being taken out on property without the owners knowing it and found 31 properties in the county with such liens against them.There’s more out there.

“We had landowners here getting bills for equipment that was leased by Chesapeake and that they didn’t pay for,” said French. “Like when their own [affiliated] drilling company, NOMAC, was drilling, the farmer who had that well was named as a prudent partner in the drilling. And in our state, being named a prudent partner means you’re held responsible if the other partner, the company, doesn’t pay up. One landowner here was saddled with a $1.2 million bill for a compressor station that Chesapeake had built but didn’t pay for.”

The problem was even bigger than French knew. As early as August 2011, according to numerous news reports, Chesapeake had mortgaged the mineral rights on more than a thousand properties in Bradford County, preventing some of those owners from getting loans on their property.

Diane Ward, a former secretary-treasurer of Standing Stone Township in Bradford County, explained the problem in a public meeting in 2011 with Bradford County commissioners. The meeting was taped by several local news organizations. “The mortgage is technically on the mineral rights, but it has to be filed on the property,” Ward was quoted as telling the commissioners. “In the courthouse there is no separation between the mineral rights on the one hand and the land and buildings on the other. So unless you’ve separated your property, it’s all one deed.”

Which is why Miller finds himself saddled with a $500 million lien on a $275,000 property. “Chesapeake says there’s no problem, but I still can’t get my loan, and I still don’t have my truck,” he said.

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