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Provisions of an Oil and Gas Lease

By Paul R. Yagelski, Esq.

What is normally found in an oil and gas lease?

The landowner/royalty owner has been offered an oil and gas lease. What are the provisions? What provisions will normally be found in an oil and gas lease? What provisions may be involved? What provisions should be considered for inclusion?

Normally Found in an Oil and Gas Lease

The following clauses are normally found in an oil and gas lease:

Granting Clause

This clause sets forth the oil and gas company’s rights and the activities that it can undertake in developing the oil and gas. If the landowner wants to know what the oil and gas company can do on the landowner’s land, this clause will tell the landowner. The rights and activities of the oil and gas company may be limited through negotiations. If so, the limitations need to be set forth in the lease. Normally, this is done in an addendum that amends and supersedes the provisions of the lease. In fact, whatever changes are made to the lease are normally made in an addendum.

Description Clause

This clause describes the property that is being leased under the oil and gas lease or if only oil and gas are being leased, it describes the property under which the oil and gas lie. The description needs to be accurate. In addition, what is being leased should not include adjacent or contiguous lands as the bonus will not normally cover adjacent or contiguous lands. Very often, the land itself is being leased along with the oil and gas thereunder; however, sometimes it is only the oil and gas that is being leased. If it is only the oil and gas that is being leased, this should be stated. Otherwise, representations may be made that should not be made. If it is not specified in the lease that only oil and gas are being leased, this should be specified in the addendum.

Oil and Gas

The rights to the oil and gas are being leased, but what are oil and gas? How are they defined? Oil and gas can cover a number of items. Oil and gas may be defined as covering different types of gases. Oil and gas may also be defined as covering certain minerals. The definition is important as it can affect how the royalty is calculated.

Term

The term clause sets forth the length of the lease. It is sometimes referred to as the habendum clause. The term clause consists of a primary term and a secondary term. The primary term is usually a fixed term; e.g., 3, 5, 7 or 10 years, and it normally begins at the effective date of the lease. The secondary term starts at the end of the primary term; however, certain activities, operations, events, etc., must normally be taking place at the end of the primary term in order for the lease to be extended into the secondary term; e.g., a well is producing gas on the premises or operations are being conducted for the production of gas. If the lease is extended into the secondary term, the lease can continue indefinitely as long as the activities, operations, events, etc., called for in the secondary lease term provision of the term clause, are taking place at the end of the primary term.

Royalty Clause

Along with the bonus provision, this is one of the most important provisions for the royalty owner in an oil and gas lease. This clause should be reviewed very carefully. There are two types of royalties, a net and a gross royalty. Normally, the oil and gas lease contains a net royalty. If the lease provides for a net royalty, this means that post-production deductions will be taken from the royalty. This means that if the lease provides for a net royalty of 15%, the royalty will not be 15%. The royalty will be lower due to deductions. These are post-production deductions or deductions taken after the production of the gas from the wellhead in order to make the gas marketable.

In a gross royalty, no deductions should be made from the royalty. If the royalty is to be a gross royalty, it is very important that the language of the royalty clause be examined as it may be the intention that the royalty is to be a gross royalty, but the language does not in fact provide for a gross royalty.

As they say, the devil is in the details. The royalty clause must be examined very carefully so it comports with the royalty that has been negotiated.

Pooling

Horizontal laterals can extend far in excess of 5,000 feet. This may involve multiple properties. As such the oil and gas rights to the properties under which the laterals will pass need to be secured, normally by an oil and gas lease. Once the oil and gas rights are secured, then these properties will be placed into a pool or a unit. A unit can be 640 acres, one square mile; 1,280 acres, two square miles; or the size of the pool may have no limitation. If the landowner’s property is in a pool, the royalty compensation received will normally be based upon the amount of the leased acreage, which is in the pool, bears to the total number of acres in the pool. In other words, if the landowner has ten of his leased acres in a 100 acre pool, or 10% of the pool, the landowner’s share will be 10% of the royalties that are derived from the pool. This is the normal way of apportioning the royalty when there is a pool. This clause should be reviewed to make sure that this is the way that the apportionment will be done as there are other ways to apportion the royalties. In addition, the landowner should know whether the landowner’s property has been placed in a unit. This can be done through a provision in the pooling clause that requires that the oil and gas company to notify the landowner when the landowner’s property is placed in a pool.

Shut-in Clause

It may happen that after the primary term of the oil and gas lease has expired, an oil or gas well needs to be shut-in. This can be due to a number of reasons. There may be a lack of market for the gas. Maintenance may need to be done to the well. Transportation for the oil or gas may not be available. If any of the aforesaid occur, or any of a number of other reasons specified in the shut-in clause occur, this clause allows the oil and gas company to shut-in the well, during which time there is no production, but the oil and gas lease remains in effect. In addition, a shut in clause will normally provide that after a certain period of time, if the well is shut-in, the landowner will receive some compensation. This is usually a minimal amount per net mineral acre.

Force Majeure

Every oil and gas lease will have a clause which stays the running of the lease if certain events occur; e.g., an act of God, strike, rebellion, inability to transport gas, etc. The clause should be checked to ascertain what constitutes force majeure. A provision should be negotiated that requires the oil and gas company to notify the landowner when a force majeure event occurs.

Title

Every oil and gas lease will contain a provision that states that the landowner warrants the title to the oil and gas and the leased premises. The landowner should not warrant title. The oil and gas company will do its own title check to see if the landowner has good title. As the oil and gas company is checking the title and will know whether the landowner has good title, there is no necessity for the landowner to do so. If the landowner does warrant title and a problem with the title occurs, because of the warranty the landowner may be forced to clear up the title problem, which can be expensive. In addition, if there is a title defect, the oil and gas company may stop paying royalties until the title defect is cleared up.

Bonus

Normally, in Marcellus leases, or unconventional oil and gas leases, delay rental payments, payments that are made during the primary term to keep the lease in effect where no production or operations to produce gas are taking place, are paid upfront in one lump sum once the oil and gas company checks the landowner’s title. The language as to when the bonus will be paid should be reviewed carefully as the language may leave it open as to when payment will be received. Payment is often dependent on the length of time it takes to do the title search. If the time period is not limited or if a specific date is not set beyond which the oil and gas company can no longer pay the bonus, the landowner/royalty owner may be waiting a long time before it receives its bonus. The landowner/royalty owner needs to have certainty as to when the bonus is going to be paid, and if the bonus is not paid when specified, the oil and gas lease should terminate.

Although a bonus provision is normally part of an oil and gas lease, more often than not, an oil and gas lease will be accompanied by a separate document called an Order for Payment. If there is an Order for Payment, this document will specify when and under what conditions the bonus is to be paid, and when it accompanies the lease, it is controlling. The terms of the Order for Payment should comport with what was negotiated as to the amount of the bonus and when it will be paid.

Surrender Clause

This clause allows the oil and gas company to surrender all or any portion of the oil and gas lease.

May Be Found In an Oil and Gas Lease

Although not always present, the following clauses may be found in an oil and gas lease:

Operations Clause

This clause will define what operations are. This will be important if the secondary term provision of the term clause provides that operations for the production of oil and gas must be taking place at the end of the primary term in order to extend the lease into its secondary term. If there is such a provision, it is important that operations be defined; otherwise, operations may be construed by the oil and gas company to mean something other than what the landowner/royalty owner would define them to be.

Extension of Term

Although not in every oil and gas lease, it is not unusual to see a provision for the extension of the primary term in the lease. If the primary term is about to expire and none of the provisions of the term clause have been complied with, in order to extend the lease into the secondary term, an extension of term clause allows the oil and gas company to extend the primary term usually by the payment of the same bonus as was paid at the effective date of the oil and gas lease. The bonus normally has to be paid prior to the expiration of the primary term in order for the extension clause to apply.

Assignment

An assignment clause allows the oil and gas company to assign the lease. The landowner/royalty owner should know if an assignment occurs. A provision should be negotiated to require the oil and gas company to notify the landowner/royalty owner when an assignment occurs and to provide the landowner/royalty with the assignee’s contact information. In addition, some assignment clauses contain a provision that allows the oil and gas company to be relieved of its obligation upon assignment. This should be restricted. Upon assignment, the oil and gas company should continue to be bound by any liability and obligation incurred prior to the assignment.

Confidentiality

It is not unusual to find a clause in an oil and gas lease that requires that the lease’s provisions be kept confidential. For various reasons, the oil and gas company will not want the terms and conditions of its oil and gas lease disclosed, particularly the royalty percentage and bonus amount. If there is such a provision, disclosure of the lease’s terms to the landowner/royalty owner’s accountant, tax advisor, financial advisor, attorney and to family members should be allowed.

Should Be Considered

The following clauses should be considered for inclusion in an oil and gas lease:

Additional Compensation

In addition to the royalty and bonus, the landowner may also be able to obtain other compensation. For example, compensation for each well that is placed on a wellpad may be negotiated. Further, compensation for a pipeline right of way may also be negotiated. If neither are negotiated, then the only compensation that the landowner will receive will normally be the royalty, the bonus and the shut-in payment.

Pugh Clause

A Pugh clause allows the landowner to remove from the lease that portion of the leased premises that has not been placed into a pool or unit at the end of the primary term of the lease. In other words, if the landowner has 100 acres under lease and only 10 acres has been placed in a pool or unit at the end of the primary term, a pugh clause allows the landowner to withdraw the 90 unpooled acres from the lease.

Location of Operations

If the area in which the oil and gas company can operate is not limited, the oil and gas company normally will have the right to operate anywhere on the leased premises subject to certain state mandated setback requirements. The area in which the oil and gas company can operate can be negotiated. If it is negotiated, this needs to be specified in the lease; i.e., the addendum.

Access

Just as the location of operations can be negotiated and limited, access to the leased premises can also be negotiated and limited. If it is not, access can be from anywhere. If access is not limited, the oil and gas company may access the leased premises from a location objectionable to the landowner.

Facilities and Equipment on the Leased Premises

There may be facilities and equipment that the landowner may not want on the leased premises. For example, the oil and gas company may determine that an impoundment pond is necessary and decides to place one on the leased premises. If this is not prohibited in the lease, the oil and gas company can place one on the leased premises and the landowner may find this objectionable. Placement of facilities and equipment can be negotiated.

Fencing and gates

The landowner may have fencing or gates on the leased premises. These may be destroyed or have to be removed due to oil and gas operations. If they are, provisions can be inserted in the oil and gas lease to replace the fencing and/or gates that have been removed or destroyed. In addition, the landowner may want to have fencing and gates installed; e.g., around the well pad for safety reasons. This can be provided for in the oil and gas lease.

Water

There may be water or water sources on the leased premises that must be protected. Water and water sources can be protected either upon reliance on a state statute or regulation, if one has been passed or adopted, or a specific clause can be negotiated for this purpose.

Reclamation

The landowner can rely on state reclamation requirements, if enacted, in order to reclaim the site upon completion of operations or the landowner may wish to negotiate a reclamation clause.

Audit clause

For whatever reason, the royalty owner may question whether what is being paid as a royalty is correct. An audit clause allows the royalty owner to obtain information from the oil and gas company in order to check its royalty statements to confirm whether the royalties are being paid in accordance with lease. If there is no audit clause, then there is normally no provision in the oil and gas lease that contractually obligates the oil and gas company to provide the necessary information. If the oil and gas company does not provide the requested information or the information received is not satisfactory, then the landowner may be forced to sue for the information it wants. This process can be lengthy and expensive.

Dispute Resolution

If a dispute occurs between the landowner and the oil and gas company and if there is no provision specifically provided for in the oil and gas lease as to how or where a dispute is to be resolved, the dispute will normally be resolved in state or federal court proceedings. An alternative form of dispute resolution is arbitration. Arbitration is generally quicker, less time consuming and not as lengthy as a proceeding in state or federal court.

Indemnification

Oil and gas operations can cause damage to property and to individuals. A good indemnification clause should be negotiated to make the oil and gas company responsible for defending and indemnifying the landowner should a claim be brought due to the operations or activities of the oil and gas company.

Insurance

There should be a clause in the oil and gas lease that requires that the oil and gas company have insurance to cover its operations, activities, etc. Oil and gas companies normally do carry insurance, but the landowner may want to negotiate the amount of coverage.

There are other provisions that may be included in an oil and gas lease. The oil and gas lease that the landowner receives should be reviewed with an oil and gas lawyer.

What is set forth herein should not be considered to create an attorney-client relationship nor be considered to be legal advice. If you have an oil and gas lease, our oil and gas lawyers are here to help in reviewing and negotiating an oil and gas lease.