NARO Comes to Susquehanna

Local natural gas rush watchers were introduced to a new player on 26 March, 2009 when the National Association of Royalty Owners, NARO US , held a public information session at the Mountain View High School auditorium. NARO was established in 1979 and recently formed an Appalachia Chapter to serve the interests of royalty owners in our area.

The meeting was co-hosted by First Liberty Bank and Trust. This NARO PRESS RELEASE describes their agenda and speakers. The auditorium was close to full and presentations were among the best I have seen.

There are other good sources of information, such as the Penn State Natural Gas Impacts website. NARO offers a national perspective and serves as a lobbying activity for the landowners and royalty owners. That's important in an industry with big players competing for advantage in a highly regulated government-controlled environment. For example, NARO is lobbying against the federal proposal to eliminate the 15% depletion allowance that owners get now on their royalty income taxes.

This point was impressed on me by several speakers who emphasized the need for royalty owners to manage their gas interests in a realistic business fashion. It's more than just getting a good lease and collecting checks (if you're that lucky). Think of it as a multi-decade investment business that requires proper structuring and managerial oversight.

Both the First Liberty and Lester Greevy presentations discussed options for distributing the the investment estate across generations while minimizing estate and inheritance taxes. I had been considering a Limited Liability Corporation (LLC) option, but Mr. Greevy made some very persuasive points in favor of a Family Law Partnership (FLP). As an example, if the surface and subsurface estates are separated and a subsurface FLP is formed , the limited partners may hold 97% non-voting interest and, because of the non-voting aspect, be discounted 40% on estate tax. The details of selecting a business structure (personal ownership, LLC, FLP, etc.) depend on one's family and financial situation. Since the choice will have a long term impact, it seems wise to get professional legal and financial advice when assessing the options.

Additionally, the subsurface gas rights will be assessed by Pennsylvania for estate/inheritance taxes. This value assessment may be highly speculative since there is little knowledge of how the Marcellus gas well production rates decline over time and what income streams may result. The key seems to be to get good assessment and legal talent on your side to establish a likely income stream and the discount rate for calculating present value of that stream.

Some speakers claimed that Range Resources estimates it can take hundreds of wells to establish the decline rate in a new shale formation (like the Marcellus). The decline rate is the rate at which gas well production declines over time. Usually, a shale well starts at very high rate ( 4 Million or more cubic feet per day) and declines to less than half in 1 to 3 years and tapers off to a constant lower flow for decades. The big question is the shape of that exponential curve. And that is not yet well known.

While the discussion focused on the uncertainties of assessing underground gas value for estate tax purpose, it seems the same problems could arise if the state allows local governments to include gas rights in assessing property taxes as is being proposed by some.

Another point had to do with the establishment of "pools"or "production units" by the gas companies. The companies set these units and, based on the relative acreage of each owner in the unit, allocate the gas production royalties to each owner. By including a small percent of an owner's acreage in a unit, the company may control all the owner's acreage, depending on how the lease is written.

The ultimate size or composition of a pool is not obvious when a permit is issued. As an example, Cabot filed a permit for drilling 65 acres locally; subsequently, they altered the boundaries to make a slightly different area that tied down over 850 acres. The good thing is that other landowners received a share of production royalties; the not so good thing was that some owners had all their land tied up based on a very low percentage share of the unit and royalties. Makes a good argument for establishing acreage (or percentage) limits on pooling and for Pugh clauses in a lease.

State Representative Sandy Major gave a good rundown on pending legislation. You can get details on the state legislature website for HB10, HB977, HB473, HB808, HB934 and its companion SB297, and HB834. She also discussed Governor Rendell's proposed severance tax and the new Republican counter proposal to lease State Forest lands.

HB10 is designed to counter a 2002 State Supreme Court ruling that precludes local property tax assessment on the value of underlying gas. The bill is intended to force only the lease holder (i.e., the gas company) to pay. Having seen an earlier version of this bill, that intention was not explicit. Unless extremely well written, this bill is very dangerous.

It will be litigated by the companies and that litigation is apt to include 2 key points : first, the necessity, in equity, to tax equally all underground gas, not just that leased; second, the validity of existing lease contracts that establish liability of the landowner to pay ad valorem (property taxes) taxes in proportion to his royalty share. In other words, if your gas rights are assessed for $10,000 and you have a 15% royalty rate, you may be liable for added tax on your $1,500 share. Of course you may be due a reduction for the loss of 85% of your gas rights. But what about your neighbor who has no lease? Why should he escape taxation on his assumed underground gas rights? This bill may prove more a problem than a solution.

HB977 has some very desirable benefits. It declares the Marcellus shale gas as being covered by the Oil and Gas Conservation Law with added protection from gas drainage by companies on nearby land. It forbids any horizontal drilling under unleased land. It introduces unitization concepts which should protect the rights of unleased owners, but may need updating to reflect the geologic realities of shale gas deposits as opposed to oil deposits.

The Governor's severance tax proposal is intended to go 100% to the general treasury with no allocation to local governments to cover the cost of services in gas producing areas. This tax is in addition to normal corporate and personal income taxes on gas production and royalty incomes. Even so, I think a severance tax, modified to allocate a fair percentage to the gas producing counties and towns, is preferable to the HB10 property tax proposal.

Finally, the House Energy Tax Force has an alternative proposal to the severance tax. This proposal would lease 390,000 acres of Forest Service lands for a minimum of $2000/acre over the next 3 years. It would produce more income than the severance tax, would not be a dis-incentive to gas production. and allocates a portion of the revenue back to gas producing towns and counties. Although the allocation formula needs reworking to be fairer to the Marcellus Shale areas, this seems the best option for getting new gas related revenue.

All of these bills are being reviewed in committee and it will be a while before anything is settled.

It's not easy to assess the impact of these potential state laws or to track their progress; the same can be said for prospective federal laws and state and federal regulations. Maybe by having Sandy speak, NARO was making a subtle point about their value to land and royalty owners.