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A MINERAL OWNER’S INTRODUCTION TO OIL AND GAS LEASES

M. Brian McMahon

An oil and gas lease is a contract between a mineral owner, the lessor, and typically an oil company, the lessee, which describes the parties’ rights and obligations for the development of oil and gas reserves. The lease conveys to the oil company the mineral owner’s rights to explore, develop and produce oil and gas. In return, the oil company gives to the lessor a monetary share of the value of the oil and gas produced. The lessor’s economic benefits include a rental, a royalty based on the value of the oil and gas produced, and often a bonus.

The leasing process usually begins when a prospective lessee offers a lease to a mineral owner. A mineral owner presented with a draft lease should study it paragraph by paragraph to understand and assess its provisions. But many mineral owners have little background enabling them to understand and negotiate the leases offered to them. So the bargaining positions of the parties are usually uneven. The mineral owner may not even know that the terms of a lease are negotiable. The prospective lessee does not have a fiduciary duty to protect the mineral owner’s interest in the negotiation process. Nor does it have any obligation to suggest that the lessor seek expert advice.

The following is a basic introduction to oil and gas leases, with a focus on California practices, to assist mineral owners to understand and assess proposed leases. This introduction does not attempt to cover all provisions in all leases. All leases address certain core issues, but they often do so using different language affecting the rights and obligations of lessors and lessees in different ways. This introduction to the oil and gas lease focuses on the core issues. A number of important issues will be discussed only briefly or not at all. Note that the lease clauses described below may be found in separate paragraphs or may be combined with other clauses in the same paragraph.

Typical Clauses in an Oil and Gas Lease

The Bonus Clause provides for a onetime payment of money to the lessor as an inducement to execute the lease. The expectation of royalties may not provide enough incentive for a lessor to sign a lease, because royalties will not be paid until oil and/or gas is produced. That may take several years after the lease is signed. Only some lessees offer bonuses.

The Habendum Clause determines how long the lease will last. Leases consist of a primary term and a secondary term. The primary term consists of a specified number of years, which may vary from lease to lease. Lessors typically benefit when the primary term is short, because a short primary term encourages the lessee to begin drilling and production operations sooner than it otherwise may want to. With some exceptions, if oil or gas is not being produced by the end of the primary term, the lease terminates. The secondary term begins when oil and gas is produced and continues so long as oil and gas is produced in paying quantities. The secondary term is indefinite in duration and may continue for a great many years.

The Rental Clause addresses the lessee’s responsibilities during the primary term of a lease. Payment of rentals keeps the lease in force during the primary term if the lessee delays operations for drilling a well. Otherwise, if the lessee neither pays rentals nor begins oil operations during the primary term, the lease terminates. The rental payable to the lessor is calculated as a specified dollar amount per acre. The rental clause in any given lease may take one of two forms. The “paid up lease” requires the lessee to pay at the beginning of the lease the rental due for the entire primary term. The “delay rental” requires the lessee to pay a rental at the beginning of every year until the lessee begins to drill. A lessee might include the paid up rental form in the lease to make sure that the lease does not terminate for the lessee’s inactivity during the primary term.

The Royalty Clause has been traditionally defined as the lessor’s share of the oil and gas production free of the costs of production. This means that the lessors should not be allocated any of the costs of production; that is, the costs incurred to bring oil and gas to the mouth of the well. There are two elements to the royalty calculation that affect how much money the lessor will receive. First, the royalty clause provides that the Lessor will receive a specified share of the monetary value of production. In California leases, royalty shares owed to lessors are usually expressed as percentages. A 12.5% royalty share of the value of the oil production used to be standard, but more recently, until the value of oil dropped precipitously, lessees were giving lessors a higher royalty percentage share. The royalty share given to the lessor may vary with the price of oil. Higher royalty shares are usually given to lessors when the price of oil is high, and lower royalty shares when the price of oil is low. Some leases provide a sliding scale royalty which varies the royalty percentage over the life of the lease depending on the price of oil. Royalty percentages for gas rarely vary because gas prices are not as volatile as oil prices.

The second element of the royalty clause addresses how the oil and gas production is to be valued. The royalty clause may provide that the value of the oil and gas is measured by the price that the lessee receives from selling the oil. But if the lessee refines the oil, the oil is not sold and there is no sale price. In that situation, the lease will provide an alternate method of valuing the oil production. A lessor should insist that the lease define the method the lessee will use to value the oil when the oil is refined in the lessee’s refinery. Failure to address this issue in the lease will usually cause the royalty to be underpaid.

The Date and Parties Clause determines the date when the lease is fully executed and who the lessors and lessee are. It is important that the names of all of the lessors be included either in this clause or in an appendix to the lease.

The Consideration Clause provides that the lessor will be given a specified small amount of money as consideration for entering into the lease. The consideration is given in addition to the rental, bonus, and royalty.

The Granting Clause grants to the lessee rights that are necessary for the lessee to develop the oil and gas reserves, such as the right to enter the surface of the property and use the surface to the extent reasonably necessary for the oil and gas operations on the leased land, the right to use the subsurface for oil and gas operations, the right to explore, drill and extract oil and gas, the right to build pipelines, build tanks, build roads if needed, erect power lines, and the like.

The Description of the Property Clause provides a legal description of the property subject to the lease and its acreage.

The Dry Hole, Cessation and Continuing Drilling Clause require the lessee to begin drilling operations on another well within a specified time period if the lessee drills a well, but no oil and gas is found, and to continue oil operations until it drills a well that produces oil and gas in paying quantities. If a year passes between the drilling of a dry well and the drilling of the next well, the lessee may be obligated to pay delay rentals to the lessor even though the lessee has begun oil operations.

The Development Clause requires the lessee to fully develop the lessor’s oil and gas resources. The lessee’s obligation to drill wells does not end with the drilling of a single well. The lessee must continue to drill wells until the lessor’s property is fully developed. The lease provides details about what the lessee must do to fully develop the property, and may include specifications of horizontal and vertical spacing requirements.

The Offset Well Clause requires the lessee to drill wells close to the boundary of the lessor’s property if a well on a property adjacent to that of the lessor’s is producing oil and gas. The purpose of offset wells is to prevent drainage to the neighbor’s well of the oil and gas beneath lessor’s property.

The Suspension Clause permits the lessee, after drilling the first well, to cease drilling more wells if specified conditions apply, such as if the price of oil drops below a specified price, or if there is no present market for the gas production.

The Free Use Clause gives to the lessee the right to use oil and gas produced on the leasehold without having to pay royalties for the oil and gas so used. Oil and gas produced on the leasehold may be used for such purposes as fuel to operate the wells, and injection into the oil and gas producing zones to stimulate production. But the lessee may not deduct from royalties the cost of fuel oil, gas or electricity used on the leasehold for production that it purchased from third parties, unless the lease specifically allows the lessee to deduct such costs. Some recent leases provide that the lessee may deduct the costs of purchasing electricity used on the lease to produce oil and gas. This recent practice is inconsistent with historical practices requiring that the lessee pay all costs of production.

The Lesser Interest Clause provides that the royalties and rents are proportionately reduced if it is discovered that the lessor owns less acreage than the mineral estate described in the lease.

The Relief from Performance Clause, sometimes called the Force Majeure clause, absolves the lessee from liability from failure to perform its lease obligations if certain excusing conditions beyond the control of the lessee hinder or prevent the lessee from performance. Excusing conditions usually include such events as war, riots, inability to obtain adequate drilling rigs, and laws, rules, regulations and executive orders of governmental entities that prevent the lessee from fully performing its lease obligations. A key protection that the lessor should include in this provision is that specified conditions relieving the lessee from performance must be beyond the control of the lessee. The lessor should also include in this provision a time limit after the excusing condition no longer exists in which the lessee must resume the performance of its lease obligations.

The Commingling of Production Clause addresses how the lessor’s oil is to be measured and valued if oil production from the lease is commingled with production from other leases. Measurement of the amount of the lessor’s production requires installation of meters. Valuation of lessor’s oil can be difficult if lessor’s oil is a different quality from other oil with which it is commingled. A lessor should insist that objective valuation methods are included in this provision.

The Lessee’s Obligation to Pay for Costs Clause requires the lessee is to bear all costs of production such as labor and materials furnished in its operations. The lessee has no right to charge the lessor for any costs incurred in the production of oil or gas. The clause should also protect the leased land from liens arising from the Lessee’s operations.

The Damage Clause defines liabilities of the lessee arising from its operations.

The Operations Clause defines the lessee’s rights and obligations on the leasehold regarding how it conducts operations. For example, the lessee may not place any well within a specified distance of buildings or other constructions that were on the property when the lease began.

The Lessor Inspection Clause gives the lessor the right to examine the lessee’s operations as well as specified information from lessee’s books about the production, such as the volume of oil and gas produced. The lease may even provide that the lessor has the right to inspect the lessee’s books to determine the sales price received by the lessee for the oil and gas production.

Pooling and Unitization Clauses. Pooling refers to a situation in which a lessee brings together small tracts which have different lessors in order to produce oil and gas more efficiently or to comply with state spacing requirements. Unitization refers to a situation in which there is a joint operation of several tracts by more than one lessee. Unitization is typically done to make expensive operations economically feasible such as secondary recovery operations where steam is used to increase production from wells. Unitization also permits the operation of multiple leases as a single operation where costs and production are shared equitably. Examples are where drilling is not permitted or capable of being performed on all contiguous leases and where injection of fluids is required into multiple contiguous leases to enhance production and/or prevent subsidence. Pooling provisions vary considerably from lease to lease. Pooling provisions must be read very carefully. Both pooling and unitization raise issues about how the lessor’s royalty is to be valued.

The Assignment Clause permits the lessor and lessee to assign their interests in the lease to third parties provided that written notice is given to the other parties to the lease and provided that those who receive the assignments are subject to the rights and obligations of the lessor or lessee as the case may be.

The Surrender Clause allows the lessee to terminate any part of the lease or the entire lease and be relieved of all obligations for the part of lease surrendered, including the payment of royalties. This clause does not relieve the lessee of the obligation to remove equipment, abandon wells or restore the surface of the portion of the leasehold surrendered. The lease should require the lessee to file a quitclaim deed, if the lessee exercises its right to surrender the lease.

The Notice and Demand Clause requires that the lessor give written notice to the lessee if it believes that the lessee has breached the lease. It allows a specified period of time for the lessee to cure the breach.

The Indemnity Clause requires the lessee to indemnify the lessor for claims against the lessor by third parties for damages or injury caused by the lessee.

The Tax Clause specifies the lessor’s and lessee’s tax responsibilities related to the lease.

The Warranty Clause states that the lessor owns or guarantees its ownership of the leased property. Because most lessors do not have any expertise in proving property ownership, they should reject such a clause in the lease.

These are brief descriptions of clauses usually found in leases. Lessors should consult an oil and gas attorney if more information about lease terms is needed.

Some Pointers for Lessors

  • Many of the terms of an oil and gas lease are negotiable. Do not be misled by claims that all leases are the same and the lease proposal is a take-it-or leave-it offer
  • Carefully review a lease presented to you and ask for explanation if you do not understand what the terms of the lease mean.
  • The royalty will continue for the life of the lease once oil and/or gas are produced. The royalty clause is the most important clause in the entire lease for the lessor. Be sure to negotiate for a high but fair royalty percentage. Be sure also that the method used to value the oil production is fair. Be especially wary when the lessee will process the oil in its own refinery. Because the oil will not be sold but used by the lessee, it is important to provide in the lease how the lessee will value the oil for purposes of paying royalties.
  • Where a lessor’s oil production is commingled with oil from other leases, the lessor needs to understand how the oil will be valued for purposes of paying royalties. Oil production from different leases can differ in quality which translates to different values. The lessor’s oil may be more valuable than the other oil with which it is comingled. The lessor should inquire as to the method the lessee will use to evaluate the crude oils of different qualities for purposes of paying royalties.
  • Clauses which permit the lessee to pool or unitize oil production raise serious complications. Consult a lawyer before signing leases with pooling or unitization clauses.
  • Be sure that that the lease requires the lessee to cap the wells and return the well sites to their original condition. There are many deserted wells in California with no responsible companies to cap the wells and clean up the sites.

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