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Insight: To cut natural gas costs, Chesapeake pumps up royalty deductions

Chesapeake Energy Corporation's 50 acre campus is seen in Oklahoma City, Oklahoma, April 17, 2012. REUTERS/Steve Sisney
Chesapeake Energy Corporation's 50 acre campus is seen in Oklahoma City, Oklahoma, April 17, 2012. REUTERS/Steve Sisney

By Ernest Scheyder

SAYRE, Pennsylvania (Reuters) - As the natural gas industry struggles to cope with depressed prices, Chesapeake Energy Corp has begun shifting a much larger share of transportation and marketing costs to the owners of Pennsylvania land it leases.

The largest natural gas operator in Pennsylvania's Marcellus shale formation, Chesapeake started this year to take much heavier deductions from royalty checks it sends landowners to help pay to gather, compress, market and transport natural gas, in most cases cutting compensation by more than half.

The deductions, set entirely at the discretion of the company, are permitted under most Pennsylvania drilling leases. Such deductions are made in other states, mainly Texas, where energy companies have had a harder time passing on the costs. An ambiguous Pennsylvania law has allowed Chesapeake and others in the industry to push the practice further there, analysts, politicians and attorneys said in interviews.

For years, landowners said, most of the industry has charged small percentages of their royalties, typically 5 to 10 percent, a step generally accepted with little push-back. Some companies deducted nothing to cover costs.

Starting in January, however, Chesapeake began to deduct 60 percent or more from Pennsylvania royalty checks, according to a review of contracts and more than a dozen interviews.

The deductions, allowed under Pennsylvania's 1979 Guaranteed Minimum Royalty Act, have helped the company cut costs and boost shareholder returns. But inevitably they are upsetting some landowners who overlooked the fine print in their contracts.

"When they take such a large chunk, then you kind of go, 'It's not worth it to have them drill'," said Terry Van Curen, a retired accountant who along with his wife, Diana, owns 17 acres nestled on the side of a misty mountain in Litchfield Township, Pennsylvania. "Why are we paying to have them be on our land?"

Van Curen saw 85 percent of his January 2013 royalty check from Chesapeake deducted, up from 24 percent for December 2012. For May, the most-recent monthly payout he's received, his royalty check came to $122.08, with $274.70 deducted.

The first page of Van Curen's five-page lease agreement includes a clause guaranteeing a royalty of 12.5 percent on all revenue collected from his well, but with "adjustments on production," allowing taxes and other costs to be deducted. It's that small clause that has empowered Chesapeake to ramp up deductions and chip away at that 12.5 percent, attorneys said. Van Curen acknowledged he barely read that clause when a Chesapeake agent came knocking on his door in 2009.

Chesapeake declined several requests to comment for this article. In the past year the energy company has aggressively moved to cut costs and sell underperforming or non-core assets to offset low natural gas prices, which have held back profit.

The low gas prices are a direct result of the development of American shale reserves thanks to hydraulic fracturing, a process known as fracking. The rush to frack in the past four years has boosted domestic natural gas supplies, sharply depressing prices and pressuring Chesapeake and its peers.

Doug Lawler, who became Chesapeake's CEO in June after co-founder Aubrey McClendon was forced out following a governance crisis and liquidity crunch, emphasized the company's efforts to cut costs on a conference call with investors earlier this month. Chesapeake's shares are up nearly 60 percent since January.

Still, the company warned its costs to transport natural gas in Pennsylvania are rising. Pennsylvania's Marcellus shale region holds roughly a quarter of Chesapeake's 10.93 trillion cubic feet of proven natural gas reserves, enough to supply U.S. needs for nearly three years.

It is not clear how much money Chesapeake has saved by shifting more cost to landowners. Energy companies closely guard specific data on wells, and Wall Street analysts say it is nearly impossible to extrapolate how much the new practice has boosted Chesapeake's bottom line, thanks to constantly changing production volumes and natural gas prices across the company's thousands of Pennsylvania wells.

LEADING THE CHARGE

Chesapeake's new strategy has stirred criticism among the locals.

"I proudly support energy development across our state," Doug McLinko, a Bradford County commissioner, said during an interview at the RiverStone Inn, a popular watering hole for energy industry workers in Towanda, Pennsylvania.

"But these higher deductions are affecting working families and senior citizens."

The fear in Bradford County, a mountainous region on the state's northern border that produces more natural gas than any other Pennsylvania county, is these deductions may get even steeper as energy rivals catch on to the practice.

Talisman Energy Inc , the fourth-largest natural gas producer in the Marcellus, said it is deciding now whether to deduct costs from royalty checks.

"Any decision will be made in a thoughtful manner, taking into account considerations of our landowners," Talisman spokeswoman Phoebe Buckland said.

Royal Dutch Shell PLC , the third-largest producer in the Marcellus, said it takes deductions "on a lease-by-lease" basis and has done so for years at roughly 70 percent of its Pennsylvania wells. Earlier this year, though, Shell began deducting costs from the remaining 30 percent of its Pennsylvania leases, which it acquired as part of its 2010 buyout of East Resources.

"It is already a part of their lease agreement," Shell spokeswoman Kimberly Windon said of the legacy East landowners.

Statoil ASA , which holds a 33 percent interest in many of Chesapeake's Pennsylvania wells, does not deduct any costs.

Southwestern Energy Co and Cabot Oil & Gas Corp already deduct low percentages from royalty payouts to leaseholders, typically no more than 20 percent. The two companies declined to comment when asked if they planned to increase deductions.

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Map of operators in Pennsylvania's Bradford County:

http://link.reuters.com/jaw52v

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WHAT IS A 'ROYALTY'?

In 2008, several Pennsylvania landowners sued Southwestern Energy trying to get their leases invalidated, arguing that the company had no right to deduct any fees under the 1979 law. Two years later the state Supreme Court ruled that energy companies could deduct the fees since the law did not precisely define what a royalty actually is.

The court asked the state legislature to update the law, something it has yet to do.

In the absence of any update, Chesapeake sent letters to its leaseholders in early 2012 saying they would begin deducting costs from royalty checks, and in some cases send retroactive bills for costs dating back to the 2010 ruling.

Some members of the state House of Representatives plan to introduce legislation next month that would update the 1979 law and guarantee landowners a minimum of 12.5 percent royalty payment, regardless of costs.

"Are we as a government not responsible for fair play?" said Representative Tina Pickett, a Republican.

Pickett is responding to constituents like Janet Geiger and her husband, Dick, who own 10 acres leased to Chesapeake. The couple acknowledged they did not read their lease in full before signing it and now realize it allows costs to be deducted.

They have attended several Chesapeake community relations events at local libraries with company staff, but said they always came away frustrated their questions about deductions weren't answered to their satisfaction. Last month the couple received a check from Chesapeake for $45.28, after more than $450 was deducted.

"They take out, oh my God, line after line of deductions," said Janet Geiger, a retired nurse. "I never expected to get rich, but hell we don't get enough in royalties to pay the taxes on our property."

(Reporting by Ernest Scheyder; Editing by Edward Tobin and Tim Dobbyn)

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