Oil and Gas Leases: Understanding the Basics of an Oil and Gas Lease Part II

By Franklin J. Falen and Abigail M. Jones Budd-Falen Law Offices, LLC

This is the second in a two-part series describing what surface or mineral owners should look for if they decide to lease their oil and gas to a developer. Part I, which ran in the May 14 edition of the Roundup, described considerations for the landowner before he signs a mineral lease so that his private property is protected, and this part describes what the development company will want in the lease and our recommendations for a response.

As explained in Part I of this series, leasing your mineral estate, whether it is oil, gas or other underground minerals, can be profitable, assuming care is taken to negotiate the lease and protect the land from long-term liability and damage. Part I covered issues such as negotiations with multiple developers, duration of the lease agreement, bonus and royalty payments and liability and surface use agreements. Part II will discuss other lease terms that the landowner should consider to ensure that his long-term interests are protected.

Liability

The oil and gas lease should include a provision requiring the landowner and the developer to defend and hold each other harmless from claims for any future loss or damage arising from the various uses of the property. Any loss to the landowner arising from an oil or gas developer’s use and occupation of the land will be small compared to the potential loss to the developer from the landowner’s use of the land. Typical landowners cannot, and should not, assume such a risk. Thus, landowners should limit their potential liability as much as possible – say, to the receipt of insurance proceeds or some other specified amount.

Water rights and water protections

Water rights and water quality are essential elements of ownership of property in the West. Therefore, a landowner should be aware of his existing water rights, and any effect oil or gas productions may have on his water rights or water use. Any agreement to sell or lease water to a developer should be part of a separate written contract and must separately comply with state law.

‘Pooling’ and unitization

Most Western states allow or require unitization or pooling of all the lands that cover the underlying geologic formation into a drilling unit. The purpose of unitization is usually to prevent waste and to protect other landowner’s rights. Unitization can also be accomplished voluntarily by landowners. As well, the oil or gas resources can be “pooled.” While this is very economical for the developer and generally results in more efficient operations and production of the resources, the landowner should be wary of such practice and impose limitations where necessary to prevent his land from being tied up without any actual production on his individually owned tract. As well, both unitization and pooling are likely to have legal consequences on the landowner’s rights and royalty interests.

Assignment of rights

The lease agreement will specify whether the landowner and the oil or gas developer may assign their contractual rights and obligations to third parties. Oil and gas producers always seek broad rights to sublease, assign, and mortgage their rights, without the consent of the landowner. Such broad rights may be necessary for the developer to obtain financing. Landowners, however, should demand to be notified of each transfer in order to keep track of who is ultimately responsible for any default of the lease.

Liens

The lease agreement should require the oil or gas developer keep the land free and clear of all liens related to the production of oil or gas. It is the responsibility of the developer, not the landowner, to contract for, and make payments for, all labor and materials related to the construction and operation of the oil or gas well and any reclamation. The landowner must take care to ensure that no liens are filed against the land.

Underground storage rights

Since carbon capture and storage may become a more viable process, landowners should ensure that the lease specifically reserve all underground or subsurface storage rights or “pore space” in the landowner.

Termination

One important provision of any contract is the default and termination clause. While an oil or gas developer will, in all likelihood, have the ability to terminate the project at any time and for any reason, the landowner will only be permitted to terminate the lease agreement under very limited circumstances. The landowner should reserve the right to terminate the agreement if the oil or gas developer fails to pay, maintain adequate insurance, commits abandonment, fails to pay taxes, goes bankrupt, or fails or neglects to perform any obligation set forth under the lease.

In the event of a default of the lease, the developer will demand the right to first be notified of the default and then be given the opportunity to cure the default prior to termination of the lease agreement. The landowner must take care to identify which party or parties are to be notified in the event of a default and to prohibit any “partial” default of the lease.

Reclamation and decommissioning

Although surface reclamation is generally addressed through the surface use agreement, it is important to also include provisions and requirements for reclamation and decommissioning in the lease as well. In order to prevent the oil or gas developer from simply “walking away” from the project, the landowner should demand what is known as a “decommissioning security,” to be established as soon as oil or gas is produced on the site. This security is generally a specified amount of money which is put aside by the oil or gas developer to ensure there is sufficient funding available for removal and reclamation at the end of the project.

Reclamation is necessary not only after termination of the oil or gas production, but also during construction, operations, and repairs. The landowner cannot rely on governmental authorities to ensure the reclamation of his land, but should ensure that the land will be reclaimed as he sees fit.

Reclamation measures should identify the means to keep track of the original condition of the property, either through photographs or an assessment prepared by a range professional. Other reclamation measures should include: which improvements must be removed and to what extent they should be removed; reclamation of roads; erosion issues; dust control; and trash removal.

As well, in the event of default or termination of the lease, the landowner should specify how much time the oil or gas developer is permitted to remove all drilling and operating structures from the land. Payment must also be established during this time period, including increased payment or obligations should the developer fail to remove the structures within the specified period of time.

Condemnation

Although an oil or gas developer does not have authority to condemn a lease, if there is significant development in an area, the company may want to develop a pipeline to get the oil or gas to a processing plant or market. When negotiating the lease, the landowner should request the company will agree not to condemn his land for pipeline or other purpose.

Miscellaneous

Finally, the lease agreement should address other issues such as which laws apply, in which state may either party go to court to enforce the terms of the agreement, attorneys’ fees and what happens to land included in the conservation reserve program or similar governmental program.
Conclusion

Oil, gas and other mineral production can be a highly valuable natural resource. Yet landowners must be aware of all the possible risks, as well as the benefits, associated with entering into these lease agreements. The topics discussed above are just an illustrative sample of some of the most important issues facing landowners when considering leasing. While complex, these lease agreements represent a potential for landowners to supplement their income and to provide for their families.