Understanding Oil & Gas Leases

While you may be familiar with auto or apartment leases, when it comes to land leases involving oil and gas exploration, it’s complicated.  

Most people familiar with these kinds of leases are quick to advise that if you’re not an oil and gas leasing expert, it’s best to find someone who is, as well as an attorney who is experienced with oil and gas leases, to ensure your interests and property are protected.

Caveats aside, oil and gas are valuable commodities, and their presence could be a worthwhile opportunity for the landowner and the exploration company looking for a lease. Many exploration companies are in the business of buying and selling leases. Make sure to visit DealStream to explore a variety of oil and gas deals ranging from property leases to mineral rights.

Like any lease, an oil and gas lease is a contract between a lessor and a lessee. In this case, the lessor is a landowner with mineral rights, and the lessee is a company or individual that seeks to extract those oil, gas, or minerals out of the ground for profit. Sounds simple, right? But these contracts are known to feature many complex clauses.

Drill down further (no pun intended) in this article to learn more

In this business, people refer to a “landman” versus a landlord. The landman, some of whom work for exploration companies, is the person who approaches the landowner about leasing to extract oil, gas, or other resources.

When it comes to these oil and gas leases, there's no such thing as a 'one-size fits all lease' which means negotiation can be a big part of the process. Form 88, however, is available online as a template for these kinds of agreements, which feature many provisions covering two footprints – one above ground (surface rights) and one below ground (subsurface rights).

Surface leases

Surface leases will spell out what a developer can and cannot do on your property and when it comes to drilling, there's a lot that goes on up there. You’ll be asked to agree to allow trucks access to the site as well where to place various equipment such as metering facilities, the construction of drilling rigs, and don't forget the need to grade your land for roads and parking.  We've just scratched the surface here. A well pad, for example, might cover several acres.  

Be aware that drilling operations can run 24/7 and that an oil and gas exploration company may seek to lay natural gas pipelines across your land even if your land is not used for the well pad. What happens to these pipelines and any ongoing payments paid to the landowner should be among the provisions in a lease.

Experts agree it’s important to look for a Pugh clause in your lease, which ensures the release of non-producing portions of your land after the initial lease term.

Subsurface leases

A subsurface contract allows the oil company to explore your property, drill, and produce minerals from your land.  Extracting natural gas may require drilling closer to the surface or 5,000 feet or more below, depending on the type of formation. Your lease may or may not limit the company to one particular depth of exploration. 

This land is my land, this land is your land

Drilling operations generally do not tap into a large pool of crude oil located precisely under one piece of land. Most oil reserves are often distributed across several parcels of land, which is why oil and gas companies may want to aggregate your land with adjacent properties.

To consolidate and fairly compensate the landowners, an oil and gas lease will seek to combine several tracts of land to cover the area of a single oil well. Under this "pooling" arrangement, each party owns their portion of the oil from the well.

Another way to consolidate is with a "Joint Lease," which combines two active oil and gas leases into a "joint operating agreement." Under this agreement, operators determine which assets are shared, and new royalty percentages are defined.

Lastly, it’s also possible to combine the production of many different oil wells into one shared contract as part of a process called  “Unitization.” 

‘Shale’ we explore a few more lease details?

Look for most leases to offer an up-front or bonus payment as an enticement to sign an oil and gas lease. Think of them like a signing bonus paid to an NFL or other professional sports player in that they are paid upfront (generally 60-90 days after the contract is signed). To receive this bonus payment, landowners may be required to make one payment at the beginning of the lease contract and sign a "paid-up lease agreement." Bonus payments are honored regardless of whether extraction ever happens. You might not get any royalties in this case, but you don't go home empty-handed, either.

About Royalties

An oil and gas royalty is a monthly paycheck that mineral rights owners receive whenever resources are extracted and sold from their land. Royalty fractions are negotiable and are generally between 1/8th and 1/4th of the production royalty. Look for a Gross or Cost-Free Royalty Provision, to ensure post-production costs are not deducted from your royalty.

Length of a standard lease: 5-10 years

There are two terms in a gas and oil lease: known as the primary term and the secondary term. The primary term indicates the number of years allotted to satisfy the main purpose of the lease: exploration for oil or gas. When the primary lease term expires, the contract is extended into a secondary term if the exploratory period has been successful (oil and gas have been produced). 

The oil company typically makes an extension payment when the secondary term begins. Some landowners don't add a secondary term to their lease agreement, so they can negotiate for a better deal with the oil companies when the lease expires.

Some leases may automatically renew after the standard term expires and give the oil company the right of first refusal to match any offer for renewing the lease the landowner receives from a competitor. Because an automatic renewal locks you into the original agreement, the right of first refusal may allow you to get the best deal.

Sometimes, a well becomes much more than a well. It becomes a gas storage facility when the developer decides to pump natural gas back into the well with the hopes of retrieving it later, when prices may be higher. In these cases, a separate gas storage lease agreement may be warranted with due consideration as to how gas storage affects your gas royalties.

To lease or not to lease? That is the question

On the surface of things (or subsurface even), leasing mineral rights is a great way to retain property ownership while allowing drilling operations on your land in hopes of a steady stream of oil and gas royalties. However, you should consider the long-term effects of having a drilling company as your next-door neighbor. And remember that an oil and gas lease might affect your rights to your land for future generations who might inherit your property.  

Leasing land for oil or coal production close to a residential or agricultural area is generally viewed as a bad idea. That's because companies are permitted through oil leasing to demarcate some part of the land and water to extract mineral resources which can be bad for our environment, our climate, and our relationships with human neighbors. 

Lastly, some other considerations

• Potential Damage - There's always the potential for drilling operations to damage personal property such as buildings and crops. The lease can be written to require fences or other safeguards to protect people and livestock. 
• Free Gas - Leases may provide natural gas for the landowner's use.
• Lease Assignment - The lease may contain a clause that allows the company to assign or sell the lease to other firms.

Like any other business deal, please make sure you’ve researched the potential leasing company. And never lose sight of the fact that as the mineral owner of your property, you have the power to control what happens to your land.