Issues to Consider when Negotiating an Oil and Gas Lease

Before negotiating language terms of the Lease, an agreement should first be reached on the economic terms.  These terms typically include the bonus payment, the primary term, the royalty fraction, the delay rental (if any) and the shut-in royalty.  Additional economic terms may include an option to extend the lease primary term, a commitment to drill a well during the primary term or pay an agreed amount as liquidated damages, a promise to pool lands into a unit for a well to be drilled, an increased royalty after “pay out” of a well and a minimum annual royalty. 

The “bonus” is a monetary incentive provided to the landowner for agreeing to sign the Lease.  It is an up-front payment, generally computed on a per acre basis, and generally considered to be the first year’s rental.  Usually a Marcellus Shale driller is willing to pay a “bonus” significantly more than a shallow well driller. 

The “primary term” is the period of time during which an oil and gas lease will remain in effect, usually from one to ten years, in the absence of production, drilling or other operations specified by the Lease.  The Lease can be perpetuated past the “primary term” by production in paying quantities, drilling operations and/or the payment of “shut-in royalties” specified by the Lease.  The primary term should be as short as possible as the primary benefit to you, as the property owner, is to receive royalties from the gas well production. 

The duration of a gas lease is extended beyond the “primary term” if a producing well is drilled on the property or if the property is “pooled” with other leases to form a “unit” for a producing well.  In these scenarios, the gas lease is “held by production,” extending its duration, and expires when production ceases.  This is known as the “secondary term.”  Production, operations, continuous drilling and/or shut in royalty payments are often used to extend an oil and gas Lease into its secondary term. 

The minimum “royalty fraction” under Pennsylvania law is 1/8 (12.5%) of the value of the oil and/or gas produced and sold.  Basically, the royalty is your share of the production from beneath your property.  Marcellus Shale drillers may be willing to pay more than the state minimum.  It is also important to insure that you have the right to have a third party auditor verify the records of the production from your well.  Also, your royalty should be free of the costs of drilling and production. 

The “delay rental” is money paid to you to extend the terms of the Lease in the absence of operations and/or production that is contractually required to hold the Lease.  It is usually based on a per acre amount and is required to be paid on or before the anniversary date of the Lease during its primary term, and typically extends the Lease for another year.  Nonpayment of the delay rental in the absence of production or commencement of operations will generally result in the abandonment of the Lease after its primary term has expired. 

The “shut in royalty” is a payment in lieu of a production royalty when the well is capable of production but not producing due to a variety of factors, including maintenance, lack of a suitable market, lack of facilities to produce the product, or other situations defined in the “shut in” provisions contained in the Lease.  The Lease should clearly establish the allowable time limits for a well to be “shut in.” 

After reaching an agreement on the economic terms of the Lease, attention should be directed to the language terms.  The following should be addressed:

1.       A complete legal description of the property subject to the Lease should be included. 

2.       Royalty deductions for taxes and production costs.  Any deductions for post production costs such as transportation, dehydration, compression, treating and marketing costs should be deleted.  Also, the royalties should be based on the higher of market value or gross proceeds received at the point of sale, not net proceeds at the well.  Also, the sale of the gas produced at the well to affiliates should be addressed.  If there is an affiliate sale, the royalty should be based on the higher of gross proceeds or market value at the point of sale 

3.       The provision for the payment of royalties should include details as to the time, place and frequency of royalty payments.  There should also be a provision for interest on royalties not paid when due, preferably at an above market interest rate to discourage delinquencies.  There should be a right to terminate the Lease for failure to pay royalties, after a period of written notice and opportunity to cure.  A security deposit should be provided to secure payment of royalties.  The landowner should also have the right to inspect, copy and audit the books and records to assure correct royalty payments.  There should also be a minimum annual royalty clause based upon a set dollar amount per acre per year. 

4.       The term “operations” should be more clearly defined in the Lease Agreement.  It is important to define “operations” in terms of what constitutes drilling operations and when drilling operations are completed.  What “operations” will maintain the Lease in effect beyond the primary term absent actual production should be defined.  This is very important as “operations” will result in the Lease continuing beyond the primary term, as well as when the Lease will be terminated if production does not commence before expiration of the primary term.  Also, when production ceases, the secondary term and the Lease overall terminates.  

5.       “Pooling” occurs when the gas company accumulates smaller tracts of land in order to achieve the total acreage required to be granted a well permit from DEP.  “Unitization” occurs when the gas company combines multiple wells to produce from a specified gas reservoir.  It is always preferable to remove pooling and/or unitization provisions from the Lease.  If your property is large enough to develop without pooling with other land, the clause should be deleted entirely.  If a pooling clause is necessary, a maximum size of pooled units should be negotiated.  Also, if the District’s property is 40 acres or more, it is recommended that a “Pugh clause” be included in the Lease.  A “Pugh clause” is intended to prevent the holding of non-pooled acreage in a Lease while certain portions of the property are being held under pooled arrangements.  The main purpose of a “Pugh clause” is to protect the landowner from having their entire property held under a Lease by production from a very small portion. 

6.       If the District’s property is more than 200 acres, there should be a “continuous operations clause.”  This type of clause requires the gas company to release portions of your property not included within “production units” designated around producing wells, at some time after the end of the primary term.  Thereafter, each production unit stands on its own as a separate Lease, and production from each well holds under lease only that part of the property within its production unit.  If such a clause is necessary, it is important to specify maximum production unit sizes, and the maximum time between completion of one well and commencement of the next well in order to keep the Lease in force as to all lands beyond the end of the primary term. 

7.       Any assignment should require landowner’s consent and require notice and a copy of any assignment.  The assignment must not relieve the gas company of liability, but rather that they should remain jointly and severally liable with the new assignee for all Lease obligations.

8.       There should be a required notice in writing of a “force majeure” event.  The Lease should also include a maximum number of days beyond the end of the primary term that a “force majeure” clause can keep the Lease in force. 

9.       The lease must include a broad indemnity clause to protect the landowner. 

10.     It is important that you have the right to access information regarding the output of the well in order to determine whether the District is receiving the correct amount of royalty.  This right to information must include financial information subject to being audited in order to insure proper payment. 

11.     A “favored nations clause” should be included in the lease.  This type of clause stipulates that if better terms are negotiated with another property owner, the District will receive the difference within a certain amount of time or the Lease is invalid.  A favored nations clause may be negotiated for both the bonus and royalty or one or the other.  A time limit may restrict when the clause is in effect, and a geographic limitation is generally included to define the distance from the District’s property where the clause is to be honored. 

12.     Surface right protection should include the following:

(a)      Require compensation for all uses of and damages to the surface of the property from all operations. 

(b)      Consider providing agreed amounts for specific uses such as well locations, roads, pipeline easements, tank batteries, etc. 

(c)      Require that liquidated damages for breaches of particular agreements be included.

(d)      Remember that a Lease may remain in effect for decades and therefore, liquidated damage amounts should provide that those amounts will be adjusted annually based on changes in the consumer price index to account for inflation;

(e)      Require that employees and agents may be excluded from District property if they violate restrictions on the use of your property;

(f)       Require that the gas company must consult with and receive the District’s prior approval for the location of all roads, pipelines, gas wells and other facilities in order for them to be located to minimize interference with the use of the surface property;

(g)      While the Pennsylvania Oil and Gas Act requires, once production of a gas well ceases, that the land be restored to its prior state and that the gas well be plugged, the Lease should also include provisions specifically requiring that the land be fully restored, that all gas wells be properly plugged, and that all pipelines be removed.

As you can see, Oil and Gas form Agreements generally are one-sided, affording the landowners with only the minimal protections required by state law but doing little to protect District property and the District’s rights.  Therefore, it is strongly recommended that a Lease be negotiated to satisfy the above concerns.  Our office can assist in negotiating a lease that results in the maximum benefit to your School District.  Please contact us if you require assistance.

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