Fundamentals of an Oil and Gas Lease
By Paul R. Yagelski, Esq.
You, the landowner, have been offered an oil and gas lease, but what is an oil and gas lease? What does it do? What are some of the things that you can expect to see in an oil and gas lease? What do the various provisions mean?
Before you enter into an oil and gas lease, you, as the landowner, should have at least a basic understanding of an oil and gas lease, so that when you sign an oil and gas lease, you have an understanding as to what rights you are granting to the oil and gas company, what rights you have under an oil and gas lease, and what the obligations are of both you and the oil and gas company. You should not enter into an oil and gas lease without having an understanding of the fundamentals. You need to be informed as to what you are doing by entering into an oil and gas lease and how you will be affected; otherwise, there can be adverse consequences to you. You do not want to be, and should not be, surprised.
What is an oil and gas lease?
First, what it is not, is a landlord tenant lease, either a residential or commercial lease. What it is, is a contract under which you are leasing the oil and gas rights and, if you own the land, you are also leasing your land for purposes of developing the oil and gas.
Is there more than one type of oil and gas lease?
Yes, there are three types: a surface use lease, a non-surface use lease, and a dual purpose lease. Most leases that are offered to the owner of the oil and gas rights are surface use leases under which the land to which the oil and gas rights have been leased is used to develop the oil and gas.
The landowner may also be offered a non-surface use lease. Under this type of lease, the oil and gas company leases only the oil and gas rights, but does not obtain the right to use the land to develop the oil and gas. In this type of lease, there is usually a provision that prohibits the oil and gas company from using the landowner’s land without the written consent of the landowner. A non-surface use lease allows the landowner to lease the oil and gas rights and obtain a bonus and royalty, while at the same time protecting the surface of the land. A non-surface use lease is often offered in circumstances where the landowner has a small amount of acreage, but the land is necessary to form a production unit.
The other type of oil and gas lease is a dual purpose lease. Under this type of lease, the landowner not only leases the oil and gas rights for development, but, in addition, the landowner allows the oil and gas company to store gas underneath the landowner’s property.
What are some of the provisions that are normally found in an oil and gas lease?
An oil and gas lease will normally contain the following types of provisions: a granting clause, description clause, term clause, royalty clause, pooling clause, surface-use clauses, and various miscellaneous clauses.
What is the granting clause?
The granting clause is the clause under which the owner of the oil and gas rights leases the oil and gas rights to the oil and gas company along with the right to develop the oil and gas on a specifically described piece of real estate.
Where will the granting clause be found?
The granting clause is the first substantive clause in the oil and gas lease. It is normally found right after the introductory paragraph which identifies the parties who are entering into the lease.
What will you find in the granting clause?
The granting clause will specify the rights that have been granted; e.g., the lease of the oil and gas rights, the right to develop the oil and gas on a specifically described piece of real estate, and the activities that can be conducted on the real estate for purposes of exploring for and developing the oil and gas. The activities can include, but may not be limited to: exploring for oil and gas by geophysical, geologic, seismic, and other methods, including core drilling; the right to stimulate the strata or formations that have been leased using any and all methods and technology available at the time and thereafter; the right to conduct surveys; drilling, operating for, developing, producing, removing, transporting, and marketing oil and gas; the right to a right-of-way to transport by pipelines through the leased premises either the oil and gas from the lands covered by the lease or from lands that are pooled or unitized with the leased land; placing equipment, electric power lines, telephone lines, water lines, impoundments and ponds, compression and collection facilities, roads and structures for production of oil and gas; the right to enter upon the lands covered by the lease for the aforesaid purposes; and the right to conduct secondary or tertiary recovery operations.
If the lease is a dual-purpose lease, the granting clause will also include the right to store gas under the leased premises. If the right to store gas is not in the granting clause and the lease is a dual-purpose lease, there will be a clause somewhere else in the lease, which will grant the oil and gas company the right to store gas under the leased premises.
What is the description clause?
The description clause describes, usually by a deed book volume and page number and a tax Id number, the property that is being leased or that will be used under the oil and gas lease to develop the oil and gas. This clause is normally a part of the granting clause or it can be set apart in a clause by itself to develop the oil and gas. At times, the description of the property is set forth in a separate attachment or exhibit.
What is the term clause?
The term clause, also known as the habendum clause, is the clause that provides the term or length of the oil and gas lease. This clause will normally contain a primary term and a secondary term.
The primary term is the initial term or initial length of the oil and gas lease; e.g., three, five, seven, ten years, or possibly longer from the effective date of the lease.
The secondary term is the term that follows the primary term. It begins at the end of the primary term and can continue the oil and gas lease in effect indefinitely. The secondary term usually begins by use of such words as: and as long thereafter; and so long as; or as long thereafter. As an example, the habendum clause of an oil and gas lease may read something like the following:
This lease shall continue in force for a term of five years from the date of this lease (the “primary term”), and as long thereafter as operations are conducted on the leased premises, or as long thereafter as there are wells producing oil and gas, or so long as the leased premises shall be operated by the lessee in the search for oil and gas (“secondary term”).
What is the royalty clause?
The royalty clause sets forth the percentage royalty that the owner of the oil and gas rights will receive from the production of the oil and gas. The royalty will be either a net royalty or a gross royalty.
If the royalty is net royalty, various deductions will be made before the royalty will be received. These deductions can include the expenses for gathering, storing, separating, treating, dehydrating, compressing, transporting, enhancing, or otherwise making the oil and/or gas produced from the leased premises ready for sale or use. The deductions may also include taxes.
If the lease is a gross royalty lease, the royalty provision should include language to the effect that there shall be no deductions whatsoever of any kind or type or nature for any reason. If a gross royalty is being offered, it is important that the language used does in fact create a gross royalty.
In addition to the payment of a royalty, the oil and gas lease may provide for other types of payments; for example, a bonus and a shut-in payment.
The bonus is an amount per acre that is paid by the oil and gas company at the inception of the lease. The payment of the bonus will allow the oil and gas company to forgo development and production of oil or gas during the primary term of the lease. Language in the lease that indicates that the lease is a paid-up lease means that a bonus, or amount per acre, is being paid for the right to not produce oil or gas during the primary term if the oil and gas company chooses not to do so for any reason.
A landowner may also be paid a shut-in payment or royalty should a well or wells be shut-in or not used due to lack of market, lack of transportation, repairs, etc. This payment is normally a minimal amount; e.g., five, ten, fifteen dollars per acre per each year that a well or wells is shut-in.
What is a pooling clause?
A pooling clause allows the oil and gas company to pool the leased land with other lands to form a drilling unit or units to develop the oil and gas. In the event your land is pooled, the oil and gas lease can continue after the end of the primary term as long as the lessee is, for example, engaged in the production of or search for oil and gas, either on your land or on lands with which your land is pooled.
What is a surface use clause?
Surface use clauses normally provide what can or cannot be done with the leased premises. Such provisions may include: what operations can or cannot take place on the leased premises, the manner in which the oil and gas company is to conduct their operations, what equipment or facilities may be placed on the leased premises, how the land will be reclaimed once the oil and gas operations are completed, how the water on the leased premises will be protected, and what the landowner can and cannot do on the leased premises, and more.
What type of miscellaneous clauses can be found in an oil and gas lease?
The following types of miscellaneous clauses or provisions can be found in an oil and gas lease or should be inserted to protect the landowner.
- Indemnity. This clause protects the landowner in case a claim or suit is asserted against the landowner and/or the landowner incurs some type of liability, loss or damage due to the activities of the oil and gas company.
- Taxes. This clause normally deals with the payment of the taxes that may be incurred due to the oil and gas company’s activity. It specifies who is responsible for the payment of taxes and in what amount. It also provides for payment to the landowner where there are certain penalties, roll back or recapture of tax abatements, or should a tax be imposed under a governmental program as a result of the operations of the oil and gas company.
- Audit rights. This clause allows the landowner to examine, inspect, or audit the books, records, and accounts of the oil and gas company to verify the accuracy of the reports, statements, and payments that are being made to the landowner.
- Dispute Resolution. This clause specifies the forum in which a dispute will be decided; e.g., a court or in arbitration.
- Default. This clause normally specifies the circumstances under which a landowner can claim that there has been a default under or the termination of the oil and gas lease.
- Force Majeure. This clause normally allows the lease to be extended due to certain acts or occurrences, such as acts of God, adverse weather conditions, strikes, riots, or other occurrences that may be specified. If one of the acts or occurrences specified in the clause takes place, the lease will remain in effect or be extended for the time period during which there is a force majeure event and normally for a certain period after the termination or elimination of such event.
- Warranty of Title. Under this type of provision, the oil and gas company tries to have the landowner warrant title to the land involved and/or the oil and gas rights.
The aforesaid are basic provisions that the landowner can expect to find in an oil and gas lease. There are others. Some provisions will not be found in the original oil and gas lease presented by the oil and gas company to the landowner; e.g., water protection or reclamation may not be found in the original oil and gas lease as such provisions are normally for the protection of the landowner. Provisions of the oil and gas lease may be added to or changed through the use of an addendum.
When offered an oil and gas lease, the landowner should consult an attorney, who is experienced in oil and gas law, so that the lease can be reviewed in detail, its effect explained, and legal counsel provided as to how the landowner may be protected.
Even if you, the landowner, have seen and have an understanding of an oil and gas lease; nevertheless, you should have the lease and any attendant documents reviewed by an attorney with oil and gas law experience. The oil and gas companies have developed the oil and gas leases for themselves. Their provisions are normally to the advantage of the oil and gas company. You as the landowner need protection. You need to level the playing field. The oil and gas company has its own legal counsel. You also need your own legal counsel.