One of the more difficult things landowners are called upon to do is negotiate an oil and gas lease. Oil and gas leases contain many unique terms in the industry, making interpretation and negotiation difficult. To follow are some key terms to consider in negotiating an oil and gas lease:
- Habendum. The habendum clause is the opening paragraph of the oil and gas lease and typically grants the lessee a lease in all or a portion of the mineral estate owned by the landowner. This clause also expresses the specific rights the lessee will have to drill upon the land, including the placement of tanks, equipment, access roads, storage of gas, seismic testing, or the operation of an injection well. Thus, the habendum clause should be reviewed very carefully to determine what rights are being granted to the lessee.
- Primary Term. The primary term is the initial length of time that the oil and gas company has to start production on your property. Primary terms generally range from 1-10 years. If the lessee does not start production within the primary term then the lease is typically terminated. Landowners will want the shortest primary term possible, to force drilling to commence as soon as possible. However, primary terms may be maintained by the payment of “delay rentals” discussed below. Delay Rental. A delay rental is a payment by the lessee to the landowner to keep the primary term of the lease in force. Essentially, it allows the lessee to pay a fee, annually or monthly, to keep the lease in affect without actually drilling a well. Of course landowners want the highest delay rental possible, and will want to limit how long a lessee can delay the commencement of a well.
- Secondary Term. The secondary term comes into play after an oil and gas well has been drilled on the property. Typically, the lease will provide that after a well is drilled, the lease will continue “as long as oil and gas and their constituents are produced in paying quantities on the premises.” The secondary term allows the lessee the right to continue the lease as long as it has a producing well on the property. However, oftentimes disputes arise as to what constitutes a producing well. Landowners should avoid provisions that allow the lessee the right to determine in its sole discretion what constitutes “producing in paying quantities.”
- Royalty. A royalty refers to the landowner’s right to receive payments based upon the production of the oil and gas well on their property. The standard royalty is one-eighth or 12.5% of the gross production. Leases should be reviewed carefully to determine how the royalty is being calculated (gross production and/or net proceeds). Utica shale lease proposals have included offers of 15% to 20% royalties, both net and gross. Obviously, landowners should push for a higher royalty, although this is one of the more difficult items to negotiate.
- Shut in Royalty. Sometimes it becomes necessary to shut in the oil and gas well and stop production. The shut in royalty allows the lessee to shut the well down and continue the lease by simply paying a “shut in royalty” to the landowner. Landowners should attempt to ensure the shut in royalty is not an advance of production royalties, but rather in addition to production royalties. Also, landowners will want to obtain the largest shut in royalty that they can negotiate.
- Free Gas. Free gas has perhaps been one of the more important provisions for landowners over the last 80 years. The free gas provision typically allows the landowner to take as much as 200 to 400 mcf of free natural gas per year for the use of one dwelling house on the property. The free gas provision should be reviewed carefully as it often contains many tricky provisions regarding the use of the free gas, and the limitations on the same. Additionally, gas from a natural gas well can be “dirty” gas requiring certain types of equipment for its safe and efficient use. Therefore, be sure to have a licensed contractor assist you with the use of free gas from any well.
- Pooling and Consolidation. The pooling and consolidation clause allows your lease to be pooled or consolidated with other neighboring leases and considered one lease for purposes of determining whether or not a “producing well” is located on the property. The problem with pooling and consolidation is that it increases the number of acres which could decrease the amount of royalties paid to the landowner. Therefore, a landowner should attempt to limit the size of acreage in the unit involving pooling and consumption.
- Location of Well, Tanks and Equipment. Landowners should always consider adding a provision allowing them the right to approve of the location of any well, access roads, tanks, equipment, pipelines, etc. Most landowners are concerned with the aesthetics of their property, and certainly a large storage tank could be unsightly. Additionally, landowners should consider negotiating a requirement for the lessee to build a fence or other landscaping around the tanks and equipment. Provisions should also be included to require the regular repair and maintenance of the access road in addition to all equipment.
- Assignment. When the landowner begins negotiating the oil and gas lease, he needs to consider that he is about to enter into a partnership with the lessee for potentially several decades. The landowner should obtain references of the lessee to ensure it is reputable. Provided the lessee is satisfied with his soon-to-be business partner, he then needs to ensure the business partner will not assign the lease to a third party. The ability to assign the lease would allow the lessee to transfer the lease to a third party who might not be as credible a partner as the original lessee. For that reason, a landowner should request the right to notice and approval of any assignments of the lease.
- Right to use water. Oil and gas drilling require the use of water in drilling operations, and for that reason many leases authorize the lessee to use water off of the landowner’s premises. Landowners should be careful as the amount of water used in the drilling operation can vary widely. For example, the new drilling method in the Utica Shale can use in excess of 1,000,000 to 4,000,000 gallons of water. Landowners should limit any right to use water from their property.
- Notice of Default. A notice of default clause is contained in many oil and gas leases and essentially provides that the lease will not be deemed breached by the lessee until the landowner has provided at least 30 days notice for the lessee to cure any default. Landowners should attempt to negotiate the shortest notice period possible. Landowners should review the default clause carefully, as certain provisions can make it very difficult to terminate the lease even when the lessee is not complying with the terms.
- Indemnification clause. Landowners should request an indemnity provision to indemnify them and hold them harmless for any damages that occur as a result of lessee’s operations on the property. This should also include reimbursement for any damages to any water well on the landowner’s property. Although damage to water wells is very uncommon, it is still wise to include the provision.
- Held by Production/Pugh Clause. Most landowners are unaware that production from as little as one acre under their lease could be sufficient to establish “paying quantities” under their lease. This leaves the remaining unproductive portion of the leasehold “held by production.” This unproductive acreage (that not included in the drilling unit) cannot be leased to another party and will not yield royalties. To avoid this result, landowners should negotiate a “Pugh Clause” in their lease. The Pugh Clause requires the unproductive acreage to be released from the lease after the primary term, thereby allowing the landowner to lease the acreage to another party.
- Implied Covenants. Ohio courts have found that all oil and gas leases contain implied covenants to develop the property in a reasonable manner to maximize production and royalties. In some situations the failure to satisfy implied covenants can lead to a forfeiture of the lease. Landowners should prevent the lease from excluding implied covenants.
Oil and gas leases can often last several decades and therefore landowners should always consult an oil and gas attorney before signing an oil and gas lease.
NOTE: This general summary of the law should not be used to solve individual problems since slight changes in the fact situation may require a material variance in the applicable legal advice.
Bill Williams is an oil and gas attorney at the law firm of Krugliak, Wilkins, Griffiths & Dougherty Co., L.P.A.
Copyright © 2011 Krugliak, Wilkins, Griffiths & Dougherty Co., L.P.A.