Royalty Owners – You Have the Power to Audit

Posted By: Steven Townsend

 A Pennsylvania landowner challenged his gas royalty deductions — and won

TUNKHANNOCK TOWNSHIP — For more than four years, the natural gas company tapping the Marcellus Shale beneath Paul Sidorek’s 150-acre property in rural northeastern Pennsylvania took deductions for preparing and shipping his share of the gas. The deductions reduced his royalties by $5,000 a month, sometimes more.

Mr. Sidorek, an accountant, contested the charges and in September, the arbitrator who heard the case agreed with him.

The wells’ operator, Chesapeake Energy Corp., had breached the terms of the lease agreement, the arbitrator found. He ordered the Oklahoma-based company to repay all of Mr. Sidorek’s past deductions and to stop taking them in the future.

“To hold otherwise would be to render the express language of the lease prohibiting such deductions a nullity,” he wrote.

The arbitrator’s decision applied only to Mr. Sidorek’s case and it does not set any legal precedent for other landowners with similar gas leases fighting similar deductions. But for the sizable and increasingly vocal community of Pennsylvania gas leaseholders who feel they are being cheated out of their fair share of gas sales from their land, the victory signals that the fight to recover their losses can be won.

“Chesapeake is not even reading the leases when they take those deductions,” Mr. Sidorek said at his sparse office in Wyoming County. “They are imposing it whether it’s applicable or not.”

“My point is people should stop complaining and just take it on.”

Left with $0 or less

More than 4,000 Pennsylvania landowners are likely being harmed by unfair practices and inflated deductions by Chesapeake and its affiliates, officials with the state Attorney General’s office said when they filed a lawsuit making similar claims against the company in 2015.

The company has called those claims baseless and that case is slowly moving forward. Oral argument on preliminary objections was slated to be held Jan. 13 in Bradford County Court but was postponed when the senior judge recused himself for personal reasons. The parties are waiting for a new judge to be assigned.

The company is also working to resolve other cases related to royalty issues in the state, including a more than $17 million federal class-action settlement involving thousands of landowners. A mediation session is scheduled for March 8.

In a statement, Chesapeake spokesman Gordon Pennoyer said the company is “pleased to have resolved this matter with Mr. Sidorek,” but he said Mr. Sidorek’s characterizations of the company’s actions are inaccurate.

“Individual leases spell out different contractual obligations for the parties involved,” he said. “Chesapeake acts in accordance with the provisions in each individual lease.”

Landowners have pushed unsuccessfully for legislation in Harrisburg that would limit the amount of deductions that companies can take for so-called post-production costs. Such costs mount up as gas is piped and processed after it leaves the wellhead and before it gets to buyers.

The grumbling turned to a roar last fall when frustrated landowners held rallies and chartered buses to the Capitol to complain that steep deductions were leaving them with royalty statements for $0 or less.

Lawmakers have said they are interested in addressing the issue, but are wary of backing legislation that could interfere with private contracts.

Other lawsuits are ongoing or contain settlement terms that come short of the complete reimbursement and prohibition on future deductions that Mr. Sidorek won in arbitration.

All of which makes Mr. Sidorek’s case remarkable. “I’m hoping to get a little hope out there,” he said.

It is difficult to know for sure how unique Mr. Sidorek’s result is because arbitration proceedings are not public the way court cases are. Jackie Root, president of the state chapter of the National Association of Royalty Owners, said she is not aware of anyone who has lost in arbitration “and this is probably the first report of a real win.”

“Believe me,” she said. “We are cheering.”

Mr. Sidorek’s lawyer, Edwin Abrahamsen Jr., said he doesn’t know of any other cases that have actually reached a decision yet in Pennsylvania, but this year he expects to have 8 to 12 more cases arbitrated and tried.

“I think that Paul’s is a sign of what’s to come when people actually press it forward,” he said.

‘Enough to send my grandson to college’

Mr. Sidorek was initially reluctant to lease his land — several parcels surrounding a beloved hunting cabin in Auburn Township, Susquehanna County, with a view that stretches 70 miles west.

As he helped accounting clients analyze offers from drillers rushing to secure access to promising regions of the Marcellus Shale, he learned about the intricacies — and drawbacks — of different companies’ proposals.

He was especially reluctant to lease with Chesapeake. When he did sign a lease in November 2009, it was with a competing gas company, Texas-based Southwestern Energy Production Co. — for $187,000 less than what Chesapeake had offered.

“I didn’t want to deal with them,” he said.

Less than a year later, Southwestern sold the lease to Chesapeake.

Still, Mr. Sidorek had negotiated strong, individualized lease terms, including a clause forbidding the company from reducing his royalty payments by deducting “the costs of producing, gathering, storing, treating, dehydrating, compressing, transporting or otherwise making the oil and/or gas produced from the leased premises ready for sale or use.”

Regardless, Chesapeake, relying on other language in the lease, deducted from Mr. Sidorek’s royalties what it determined was his share of the costs the company bore to get the gas to market, starting with his first payment, in 2012.

Mr. Sidorek would not disclose the value of those accumulated deductions or how much Chesapeake repaid him after the arbitrator’s order, but he said the company had taken between 50 and 85 percent of his royalties each month. The reimbursement, he said, was “enough to send my grandson to college and buy him a house.”

Underreporting the price?

Mr. Sidorek did not convince the arbitrator about the second half of his case — a claim that Chesapeake was underreporting the price it actually received from third parties who bought the gas.

In November 2016, the arbitrator found that Mr. Sidorek had “failed to prove that higher revenues were available to [Chesapeake] from unaffiliated customers in the markets in which they operated.”

That loss appears to irk Mr. Sidorek nearly as much as the win pleases him.

An expert he retained calculated that Chesapeake likely sold the gas for higher prices at more lucrative trading points than it reported and — had Mr. Sidorek received his share of those higher prices — his total royalties over the years would have been $250,000 to $900,000 more.

Both aspects of his case — the deductions and the question of proper pricing — have broad financial implications not only for landowners, but also for a state facing a yawning budget deficit, he said.

Without documentation to confirm the sales price that Chesapeake reports on landowners’ royalty statements, “We don’t know what they sold it for, we don’t know where they booked that income, and the state doesn’t either,” Mr. Sidorek said.

“Harrisburg needs to understand that for $1 million of deductions that are taken, that’s $30,000 in state income tax that you’re not receiving,” he said. “So how many millions of dollars of deductions are there?”

Ms. Root, who leads the state advocacy group for royalty owners, took a crack at that calculation.

Between July 2009 and September 2015, Chesapeake deducted between $127 million and $190 million from royalties in Pennsylvania, she estimated, depending on assumptions about the price of gas and the rate of deductions.

At the 3.07 percent state personal income tax rate, that amounts to between $3.9 million and $5.8 million in foregone taxes over those six years.

Mr. Sidorek, 65, is looking toward retirement. Although he is volunteering time to advise his accounting clients as they take similar cases to arbitration or court, he is not accepting new clients. But he encourages other landowners to challenge deductions before the statute of limitations narrows what they can recover.

“This matter just irritates me,” he said. “I think of friends that wanted to have a little bit better life. Cut back and stop working at their job. And then Chesapeake comes through and now, zoom, 70 percent of your royalties are ours? That’s not right. It’s not right.”

Laura Legere: llegere@post-gazette.com.

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