Should You Sign that “Standard” Oil & Gas Lease?

Wednesday, November 24, 2010

Over the past 25 years, I have reviewed many Oil and Gas Leases brought to me by landowner clients. Usually they have been "printed" form documents and have mostly been similar if not identical, almost as if every developer was using the "same" form. The all reference, royalties, delay payments, bonus payments, and often "paid up" provisions. This phenomenon might lead one to conclude that there is a "standard" Oil Industry or Michigan Oil and Gas Lease Form.

The reality is that there is not, and has never been, a "standard" form. Oil and Gas activities are regulated by the State of Michigan, Department of Environmental Quality (DEQ) under Michigan's Natural Resources and Environmental Protection Act (MCL 324.61001 – 62103). While there are regulations and while the State leases lands for Oil and Gas (and has their own approve lease language), other than requiring certain provisions, the state has not mandated or approved any standard lease for.

Perhaps unfortunately, developers are left to their own creativity with written lease documents. You cannot rely on the fact that their form is printed and looks "standard." Many developers still use the anachronistic printed form lease language mentioned above. However, a number of them have become more creative, and some of the leases I have recently reviewed have made a broad leap from being an Oil and Gas lease to a much more general Resources Lease (even though generally still titled "Oil and Gas" Lease). It is also important to understand the most of the time, the person you negotiate the lease with is an independent agent (known in the industry as a "Landman"), either working for the developer, or independently and then selling or assigning the lease to an oil producer later. Consequently, you might ultimately be dealing with a completely different party than the party you originally negotiated the lease with. To avoid problems with oral communication and later misunderstanding, it is crucial that the written document be clear.

How Oil and Gas Leases Work

Traditionally, Oil and Gas Leases have two phases (referred to as "terms"), a "primary term," and a "secondary term." The primary term is usually a term of years (e.g., 5 years), and most often, involves the developer doing "exploration and testing" to determine if there is oil or gas in appropriate quantity on the premises. The "rent" for the primary term usually consists of a flat dollar-per-acre amount, and can be paid over the term, or can be paid all at once at the beginning of the lease term (the latter is referred to as "paid up" and is what I most commonly see in Michigan). This payment during the primary term of the lease is usually referred to in the lease documents as "delay rental payments," but is often colloquially referred to in the industry as the "bonus" or bonus amount.

The secondary term normally begins when actual production activity commences and payment is generally in the form of a percentage royalty on product that is removed. The Secondary term generally lasts as long as there is active production (and could continue for many years).

In the past, bonus amounts have been as low as a $10 flat fee for the entire parcel to $50 per acre. The customary royalty has been 1/8 of production, less the costs of the developer to remove and refine the oil or gas into usable form. And, in the past, there was usually little room to negotiate in most instances and these amounts were generally accepted.

The "New" Oil and Gas Lease

There has been remarkable change in the industry in recent years. The hugely increased worldwide demand for oil and gas, coupled with new measuring, explorations and drilling technologies, has created an upsurge in interest in farmland and other open land for oil exploration and production. In the past year, I have seen "bonus" amounts as high as $5,000 per acre (and have heard about even higher amounts), and well-informed land owners are negotiating the royalty. I have seen royalties of 1/6, or expressed as a straight percentage (e.g., 15%), without any reduction for the post-production costs mentioned in the previous paragraph! There is significant competition for lands which might either have oil or gas, or might become part of a "unitized" contiguous parcel which is or may be producing actively. Indeed, the motivation for many of the developers is to "tie up" the land so it cannot be leased by competitors or competing interests.

The key thought here, is that the landowner is today more than ever in a position to negotiate the lease and even to dictate terms. Landowners – particularly farmers – want to be able to protect their primary use of the land whether for cultivation, grazing, rental, or recreation. At the same time, if the oil and gas producer is going to make a tidy profit, the landowner certainly should share in that profit!

What You Should Look For in a Landowner-Friendly Oil and Gas Lease

When negotiating an Oil and Gas Lease, the landowner needs to keep in mind his or her interests. Of course, the primary consideration is continued, uninterrupted cultivation or other use of the land. In most cases, this means surface uses. Most developer-prepared leases do not thoroughly address these important landowner concerns. Nor do they, in my view, usually clearly define—and limit, where appropriate—the specific commodities being leased (and sold off the land). A Landowner-friendly Oil and Gas Lease should include, at a minimum, provisions that:

  • Clearly and precisely define what the minerals (oil, gas, and hydrocarbon related substances) that are being extracted. I recently reviewed a Lease that went well beyond this limited definition to include "other minerals" found and extracted. The problem was the "other minerals were not well defined. We took the position with the developer that if they found other minerals and wanted to extract them, we would negotiate at that time for additional lease payments or royalties, based on the quantity and value of minerals found (if we even wanted them extracted at all). Another issue that arises in nearly all Oil and Gas Leases is whether water can be extracted and used and what kind of water (e.g., fresh, brine, etc.) and in what quantities. It is also possible that the developer will inject brine into the subsurface, and the Landowner needs to consider their views about this activity. All these points should be specifically addressed in the written document.
  • Clearly and precisely define the activities permitted on the premises. Will the lease include the right to disturb the surface in any way? Will pipelines, power transmission lines, roads, pumping stations, tanks, or buildings be permitted? If so, it is important that the lease agreement reserve significant control over these things to the Landowner. These facilities must be constructed in a manner which is least likely to interfere with current or even intended future use of the land. Structures should be placed, to the extent feasible, at corners of parcels, near existing roads, and out of the way of the other potential uses. It is important that any underground facility be buried at "plow depth" (we prefer a specified depth – e.g., "not less than 48 inches" or similar language), and that above-ground facilities be thoughtfully placed (for example, it is imperative that above-ground structures be placed where they will not interfere with pivot-based irrigation systems). It is equally important that when any facility, road, or structure is place on the surface, that the landowner be additionally compensated (over and above the bonus and royalty) for the loss of that acreage from production. We recommend a Lease Provision that requires the developer to provide a site-plan for the Landowner's prior approval before any construction begins.
  • Clearly define those uses that the Landowner is reserving (which should be everything except the mineral rights being conveyed in the lease agreement). Lessees commonly want exclusive rights to certain physical attributes of the property so that they can exclude other uses which they think might interfere with their own use. However, the Landowner needs to be cognizant of the other opportunities available including wind leasing rights and telecommunication towers (and possibly solar rights in the future), as well as other mineral, gravel, sand, timber, etc., resources which might be sold from the property. The lease agreement should specifically reserve the right to the Landowner to lease and/or sell those items, so there is no misunderstanding in the future. Site plans and placement should also have in mind the possibility of wind and communications towers in the future.
  • For livestock farmers, it is important that the Oil and Gas Lease expressly provide for fencing and gating around surface facilities and structures, and that it provide clearly who is responsible for the fencing and gating.
  • Surface interference and Damage is clearly one of the primary issues to be negotiated and resolved. This includes siting issues as mentioned above, as well as the actual disturbance of the surface. If continued agricultural use is intended, a provision for separating and setting aside the topsoil should be part of the agreement. When laying underground pipeline or power conduits, the "double-ditching" method should be specified (requiring the producer to place topsoil on one side and subsoil on the other when trenching, and replacing subsoil first and then topsoil). Of course, modern trenching and equipment may obviate this need. The lease should also clearly provide for the producer to restore the surface to its original condition and at the end of the lease, to remove all surface equipment. The State of Michigan also has specific well closing and capping requirements and the lease should clearly provide for the Lessee's responsibility to comply with all state requirements.

  • Industry" Provisions

    There are certain provisions that are generally found (or should be addressed) in virtually every Oil and Gas Lease. They should be reviewed and understood. Negotiation of these provisions will be circumstances driven. The following list is illustrative, but by no means complete :

    • Pooling or consolidation refers to the producer combining your leased lands with (normally contiguous) land owned by other landowners that they have under lease. Michigan (as do most other states) has minimum acreage requirements for a single operation and for drill/pump spacing and has the statutory authority to require or order pooling in some circumstances. Most agreements also address voluntary pooling in the sense the producer may choose to pool lands over and above any state regulatory requirements. It is advisable for the Landowner to require in the lease that such "voluntary" pooling is subject to Landowner approval, rather than wholly at the producer's discretion, except to the extent that it must be done to comply with state requirements. Pooling can be a positive thing, as it may allow production and royalty payments to commence if there is production on some of the other pooled lands, and can also mean that your land could be under lease and never have any surface activity. However, the Landowner should retain some control over the pooling to insure limits on the numbers of acreage pooled, and the ability to sever land which has not been made part of the pool into a separate lease.
    • Warranty clauses, requiring the landowner to warrant and defend title to the land and/or minerals are consistently found in the printed lease forms. They should be deleted. As a practical matter, the landmen or developer will do their own title searching and due diligence prior to executing leases.
    • A Shut-in provision, allows a producing well to be stopped or shut down temporarily, usually for "reasons beyond the control of the producer." These provisions should be carefully reviewed and understood. They should provide for some kind of payment during the shut-in period, possibly accelerating over time, and for a limit on how long a well may be shut-in.
    • "Mother Hubbard" Clauses provide that the lease covers any contiguous land owned by the landowner. This provision should be eliminated or tightly modified. They are commonly found in the "fine print."

    Can I Get More Money Than Is Being Offered?

    Clearly, the bottom line here is whether the lease payments justify tying the property up. So, how much can you expect to be paid? The obvious (and lawyerly) answer is: it depends. There are certain formations that have been determined to have significant production or capability. If your land is in one of those formations, you can expect not only command higher payments, but to have greater negotiating leverage. If your land is in more "marginal" areas, you can expect lower payments and less willingness on the part of the lessee to negotiate the terms of its form lease. In other words, the proverbial statement, "your mileage may vary" applies here. There are, however, some points to keep in mind when considering entering an Oil and Gas Lease.

    As a general rule, the longer the primary term of the lease, the higher the "delay payment" should be. The landowner should try to keep the primary term as short as possible. Any options to renew should come with new delay payment obligations, possibly accelerating for each new renewal option. The primary term will be extended to the (possibly unlimited) secondary term if active production is established. Obviously the definition of "active production" is very important.

    Both delay payments and royalty payment provisions, particularly in a "hot" area, should be carefully considered. What is the "going rate" being paid for similar tracts? In addition to word-of-mouth and information from the potential lessee, there are resources, such as the Michigan Oil And Gas Association (remember that they represent the producer), the Michigan Department of Environmental Quality (DEQ), The National Association Of Royalty Owners (NARO), which represents landowners, which can provide information and links to other sources of information.

    Calculation of royalty payments is an important consideration. Stating the royalty in terms of a fraction or percentage is only part of the equation. How that payment is calculated is equally important. The percentage can be set in terms of the "market price" at the well head, or in terms of the actual price received for the product. It is also possible for the Landowner to receive payment "in-kind." Normally, the Landowner is not equipped to market crude oil, so this is generally more common for natural gas and usually limited to quantities the Landowner would use personally.

    Perhaps more important to the calculation is at what stage of production the royalty payment is applied. Traditionally, the producer would offer a 1/8 royalty, minus certain post production costs. Those costs can be substantial and as noted earlier, include items which are really not true "costs." More importantly, if the producer is getting the majority of the payment for the end product, it would seem more appropriate for them to bear the post-production costs. These provisions should be carefully reviewed and the Landowner should firmly negotiate for a "gross" payment. In the process, there may be some costs which will be agreed upon; usually they are taxes which it does seem appropriate for the Landowner to share.

    In the context of a (albeit rather long) Blog post, it is impossible to cover all the concerns and probabilities. It should not come as any surprise to the reader that I strongly recommend that any offered Oil and Gas Lease agreement be reviewed by counsel who is qualified to review and counsel on these issues.


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