Understanding the Basics of an Oil and Gas Lease, Part I

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

This is the first in a two-part series describing what a surface or mineral owner should look for if they decide to lease their oil and gas to a developer. This part describes the considerations for the landowner before he signs a mineral lease so that his private property is protected and the second part describes what the development company will want in the lease and our recommendations for a response.

Leasing your mineral estate, whether it is oil, gas or other underground minerals, can result in either joy or heartache, depending on the lease terms. Ownership rights for the surface and the subsurface can vary depending upon how the land was first patented into private ownership. Under some federal homestead or patent acts, the landowner received the surface ownership and ownership of all subsurface oil, gas or minerals; under other homestead or patent acts, the surface owner only received certain minerals; and under still other homestead or patent acts, the surface owner received the surface only, and no subsurface oil and gas or minerals at all.

There are also those cases where the surface and minerals were originally patented into private hands, but later the minerals or oil and gas are split from the surface and are now under different private ownership than the surface. For those who own either the surface and/or minerals, the opportunity to lease the minerals can be a complicated, although profitable venture. However, profitability is only part of what the landowner should consider. Once the property owner decides to split and lease the oil, gas or mineral estates– a process called “severance” – the landowner needs to understand his assets and liabilities before he signs a lease.

Before you sign

Oil and gas developers are increasingly contacting landowners to lease their subsurface rights, many times making unsolicited offers that seem like amazing deals to the landowner. Yet, oftentimes, numerous developers are all vying for the market. By simply asking around, the landowner can find out if there are other developers that may be interested in leasing the minerals. Like any commodities market, soliciting bids or proposals from various developers is likely to net the landowner top dollar for the right to produce oil and gas from his estate.

Duration of the lease agreement

With regard to an oil or gas lease, the agreement should specifically define the amount of time allocated for the developer to inspect and study the land for its feasibility for production. This is normally between three and five years. If the developer fails to begin development and/or production of oil or gas within this amount of time, then the lease agreement should either terminate automatically, or the landowner should receive additional compensation for the time certain that the land is burdened by the lease. Otherwise, the developer may tie up the land indefinitely with little prospect of ever producing oil or gas. From the landowners’ perspective, a shorter lease term with no option to renew is better because it forces the developer to develop the lease faster. If an option to extend the lease is given, payment for that option should be up front.

Once development occurs or starts to occur, the development company will want the term of the lease to be held open by either “production” or “operations.” Extending the lease by “production” means the lease continues as long as oil or gas is produced. Importantly, the landowner should consider the amount of land covered by the lease once production occurs. This is called the “Pugh Clause.” For example, a landowner should not want to have his entire leased acreage held by one well. Therefore the landowner should carefully define the amount of land one well can hold.

A lease extended by “operations” is one that, although the company is not producing, the company is “seriously” trying to get production from the lease. Care should be taken to define “operations.” For example, a landowner should not agree that the lease remain open or be extended simply by the construction of a small section of road.

Finally most oil and gas developers will want the lease held open by paying a shut-in royalty. Shut-in royalties are paid when oil or gas is discovered but either the price is too low or there is not enough quantities to be profitable and the well is shut-in. The company will want to pay a small “royalty” to the landowner to argue that the lease is being held open by production. Landowners should try to either limit the circumstances a lease can be held open under a shut-in royalty, or negotiate a large enough royalty that it is worth the landowners’ while.

Bonus payment

Frequently an oil or gas developer uses a bonus payment to entice the landowner to sign a lease. While this is fairly standard, a landowner should ensure that no strings are attached to the bonus payment.

Royalty calculation

There are a number of methods to calculate the royalty to the landowner. The formula used to calculate the royalty should be defined in the lease. Importantly, the cost of production should not be subtracted before the royalty is calculated and paid.

Surface use agreements and damages. Many states have enacted “split estate” statutes to attempt to resolve issues that result when a mineral owner leases his oil, gas and minerals, and a developer seeks to trespass or enter the private surface land to access the leased minerals. Once the minerals are leased or split, the law has determined that the minerals are the “dominant estate” and the oil or gas developer has the right to enter onto the surface of the property for all purposes reasonably related to oil or gas production.

However, the developer must negotiate with the surface estate owner in good faith to reach what is known as a “surface use agreement.” This agreement provides for protection of the surface resources, surface reclamation requirements, and payment of damages caused by the oil and gas operations. Even if the oil and gas or other minerals are owned by the same landowner as the surface, a separate “surface use agreement” should be prepared from the mineral lease and, if possible, the surface use agreement should be negotiated at the same time as the mineral lease.

Conclusion

These are but a few issues that will arise as mineral leases are negotiated. Others include reclamation, water rights, pooling, assignment, underground storage rights and more. General information on these other topics will be covered in part two of this article, to be published in an upcoming edition of the Roundup.