Important Aspects of an Oil and Gas Lease

ANR-88
Agriculture and Natural Resources
Date: 
07/20/2020
Clif Little, Extension Educator, Agriculture and Natural Resources, Ohio State University Extension, Guernsey County

Oil and gas exploration may have great economic implications for landowners; however, money is not the only issue at stake when preparing a lease. A good lease is about maximizing economic gains and protecting the land resource and usability. The terms of a lease should be favorable to both parties. Each landowner has a different set of goals, and those goals influence the desired lease terms. A lease is negotiable, and landowners should work with a knowledgeable attorney to amend an oil and gas lease to meet their desired goals. The topics below, which are discussed here for educational purposes only, have the potential to dramatically impact landowners. Landowners should always consult an attorney prior to signing anything. Photo of a large well pad showing yellow containers and a blue pump.

Is the Farm Leasable? 

Before entering lease negotiations, the landowner must ensure the land is leasable. It is plausible the landowner’s rights are encumbered by old leases they are unaware of. A landowner can research property lease records in the county recorder’s office. It is also possible to hire a title company to perform this search. 

Landowner Groups

Joining a landowner group is beneficial if each landowner within the group has leasable land and if the group is represented by a competent attorney. When considering participation, one should clearly understand the legal consequences of leaving the group, the length of commitment required, and the possibility of being dropped by a potential lessee if, for example, their lands are not contiguous with the other parcels. In addition, one should fully understand how the landowner group administrators and attorney are going to be paid. 

Purpose of the Lease

A landman may be a drilling company representative or an independent person seeking to secure oil and gas rights for investors or planning to flip the leases. Landowners are often presented with what is commonly referred to as a “standard oil and gas lease.” The lease provided by a company is usually a well-prepared document written from the company’s perspective. Legal representatives for the company write leases to protect, extend, and transfer as many rights as possible to the company.

A lease usually starts with a description of the purpose, such as: This lease is to drill, inject, or store oil, gas, liquids, and other related hydrocarbons from the well(s) drilled, or produced on leased property or pooled unit. Some leases are all encompassing and include other minerals and/or constituents. Storage, injection, transmission, compression, and other industry-related activities might also be addressed. Terms for mining and operating for oil, gas, and other constituents; for laying pipelines, building tanks, power stations, and other structures; and for the use of water are also often mentioned.  Landowners should closely read items describing what is being leased. A landowner may choose to limit or reserve for themselves the ability to negotiate separately some of the lease items and discuss each item with their attorney. 
 
Companies sometimes include an EXHIBIT “A,” Oil and Gas Lease Addendum. The addendum becomes part of the lease. The terms of this document override and control the lease. In other words, the terms and conditions set forth in the addendum prevail, even when they are inconsistent or conflict with the terms and conditions set forth in the lease.  The lease or addendum also should describe what causes the lease to be null and void. 

Once a lease is signed, and possibly before payment, a lease memorandum is recorded at the county recorder’s office. The lease memorandum does not contain the details of the lease agreement. Landowners should discuss recording their entire lease document to prevent loss of the original paperwork. Some modern leases also attempt to prevent landowners from discussing the specific terms of their lease.  

Lease Payment

Payment details are outlined in the provisions of an oil and gas lease and right-of-way grant. They can be a complex element of a lease or grant. Understanding these provisions is essential. In modern oil and gas transactions, landowners are often offered a signing bonus in consideration for granting a lease or right-of-way. It is common for companies to offer this payment in the form of a bank draft once the agreement is signed and notarized. For many landowners, who are accustomed to exchanging paper notes or personal checks for purchases, a bank draft can be a new financial experience. Understanding the elements of a bank draft can be very helpful. 

Bank Drafts

Many companies in shale development and the leasing of land use bank drafts. A bank draft, in simple terms, is a conditional form of payment that is honored within a stated time period. The draft itself appears similar to a personal check. One key element typically included in a bank draft is a list of conditions for payment. These conditions should be carefully reviewed prior to signing the lease or any related agreement. A company might state a back draft is the standard form of payment; however, it is important to know the landowner may have the option to control the form of payment. Ultimately, the landowner determines the standards of payment. The wording within the bank draft is serious because it determines when a landowner can expect payment. Terminology and conditions written into the bank draft can cause a substantial delay or cancellation of payment, even in cases where landowners have clear title and ownership. 

A transaction involving a bank draft occurs between a landman and a landowner when a landman offers a bank draft in exchange for a signed and notarized agreement. The landowner may be instructed to take the draft to the bank. Some banks are not familiar with the type of bank drafts oil and gas companies use for payment and may not know how to process them. If a landowner accepts a bank draft, it is important to have the leasing company’s bank contact information. The landowner’s bank or the landowner then sends the bank draft to the leasing company’s bank. This step sometimes has an associated cost, either in the form of a bank charge or a priority mail charge. The company’s bank then confirms and notifies the sending party that the bank draft has been received. Bank drafts typically contain language that details the schedule for payment. Conditions may stipulate a specific length of time a company has before it must honor the draft. The time limit begins when the party that sent the draft is notified it has been received. 

During this time period, the landman or company often records a memorandum of the lease or grant, creating a cloud on the landowner’s title that the landowner must have removed from the title if payment is not received in due time. 

Although each company has its own preferences and conditions in terms of bank drafts, the landowner should be aware of a few key features. Following are key terms and conditions that appear in a typical bank draft.

Payment within a specified period. The time period can range from 15 to 180 or more days. Landowners should keep in mind these are typically business days. Weekends and holidays do not usually count. Reasons for this delay in payment may be to check the title thoroughly, investigate production potential of the area being leased, secure more areas of interest, or secure a purchaser of the lease or grant, etc. Before signing, a landowner has the right to negotiate the time period in a bank draft.

Payable on approval or approval of title. This term can be vague and confusing. What exactly does payment on approval mean? Landowners should request a clear explanation of what does and does not constitute clear title. The explanation should be put in writing in the bank draft and the lease or grant. In addition, a written definition of what constitutes company non-approval of payment should be secured.

Neither party shall be liable for payment. This is the most significant feature of a bank draft. Can a company back out of the deal if they are short on funds? What if the company cannot secure enough acreage in the area? It may be that neither the landowner nor the company is bound to honor the lease. Prior to signing, it is advisable to consult an attorney in considering the “no liability” aspect of a bank draft. 

It is possible to have companies conduct thorough research prior to signing an agreement, and exchange the lease or grant for an unconditional, nonrefundable, certified check. Another method is to keep the signed and notarized original lease or grant in an attorney’s office and exchange it for payment after the company has time to research the title. It also is possible for the landowner’s bank to hold the lease or grant in escrow and then exchange it for payment.

The conditions of payment described in bank drafts are a critical component of an oil and gas lease and right-of-way grant. They should be carefully considered by landowners and their attorneys. The attorney should look at the entire document including the payment terms and bank draft prior to signing. If a bank draft is accepted, it is wise to define clear title, to limit the “no liability” clause, and to keep the days to payment as short as can be negotiated. In addition, it may be advisable to refrain from officially recording the lease or grant memorandum until it has been paid in full. 

Length of Lease

The top of a lease states the length of its primary term. For example, there may be a statement such as “5-year oil and gas lease.” This is often referred to as the primary term or the time frame the company has before a well is drilled and found to produce in “paying quantities.” From an economic standpoint, the sooner a company drills, the sooner a landowner receives royalty payments. In addition, if no drilling takes place, the shorter the length of the primary term, the sooner a landowner is free to lease to another company. Because drilling for oil and gas does not guarantee production, most leases include a clause or clauses that keep a lease in effect even if no producing well is found. A property owner should clearly understand all the ways the lease can stay in effect. Once a well begins production and is producing in “paying quantities,” the secondary terms of a lease are in effect. Some leases add the subtitle “Extensions,” which is used to describe the options for extending a lease. 

Acreage

A landowner should understand the acreage being leased and the acreage on which payments will be made. It may be beneficial to itemize the acreage X $/acre = sum to be paid as the signing bonus. In addition, understand if these funds are refundable. Sometimes a standard lease includes a statement such as, “Including all lands and interest therein, contiguous or appurtenant to said described land and owned or claimed by lessor, whether or not specifically described.” What acreage is included in rental payments? What amount of land is delineated in this lease? One may wish to use the legal deed description of the land. Words such as “appurtenant to,” “claimed,” and “now and in the future” may be unnecessary. Some leases may be “Paid-up.” This usually means the lessee has paid any rentals, via the signing bonus, they may owe in the future. A per acre signing bonus is another means of payment. For example, the landowner is paid $1,000 per net mineral acre at the signing of the lease. Other leases pay a sum each year during the primary term or until a well is in production or capable of production. Most likely, this payment stops when production, or some phase of production, starts. Landowners being paid in such fashion should ask themselves what happens if the company goes bankrupt. It is also important to describe remedies for nonpayment. 

Leases sometimes use terms such as “in the process of well development” or “in search of oil or gas,” which may hold a lease after the primary term expires. In addition, companies sometimes ask to increase the unitization acreage so the land is drawn into a larger unit with a well (not necessarily producing) to hold the lease. 

Other Structures and Utilities

A property owner may want to be consulted about and agree to other structures and utilities. These terms are sometimes negotiated separately. If a property is to receive other structures, recommended practice is for the landowner to ask for them to be marked on an aerial photo that includes points of ingress and egress. Some examples include a tank separator, compressor, pump jack, storage tanks, and lease road. It is possible for landowners to specify minimum distances the well and other structures can be placed in proximity to a home or buildings. Landowners may also want to describe how gates and fences are installed and who is financially responsible for maintaining them. If a landowner has livestock, fencing and gates are important, but so are structures encompassed with fencing. They can be a source of noxious weed seed, and this should be addressed in the lease. Property owners may also want to clearly describe the right to use the leased premise from the lessor and lessee perspective. Landowners who farm use land in support of, but not limited to, agricultural farming practices and home site buildings. They might want to ensure that activities for oil and gas development do not alter drainage, pool water, or affect springs or wells. A lease should describe the removal of equipment once the well stops producing. Landowners have also negotiated non-development oil and gas leases that prevent all surface activities from impacting their property. Essentially, the development company drills under the farm. This is the same type of lease some state parks and national parks use. 

Photo of fenced area containing large above ground pipes, valve assemblage, and pig launching site.
 

Storage of Materials 

Storage or payment clauses are used to keep a lease in effect when no producing well is found. If one does not intend for the property to become a storage unit for oil and gas produced elsewhere or for byproducts of production, make sure this is clearly stated in the lease. It might be wise to eliminate storage clauses and work with an attorney to create a separate lease agreement for storage. In the opening of an oil and gas lease or right-of-way grant, terms such as “lease exclusively unto [sic] said Lessee” are sometimes used to describe the bundle of rights landowners are making available to the interested development company. Leasing or granting rights exclusively may prohibit landowners from negotiating those items in the future with any other companies. 

Strata and Pipelines 

In terms of land development, landowners should look at land as having vertical and horizontal components. There may be advantages to leasing only the formation or formations the drilling company intends to develop. Doing so frees the landowner to lease deeper or shallower formations to another company. In addition, leasing a specific formation to the drilling company limits the arbitrary assignment or sale of other strata. The landowner’s attorney should be asked about a “Pugh Clause.” Such a clause is used to release nonproducing acreage and strata from the lease. 

If pipelines are going to be installed on the premises, it is advisable to negotiate pipeline agreements separately from the oil and gas lease. Some pipelines are for the well located on the leased acreage. A standard agreement, however, allows for the installation of pipelines used to transport product from other lands. A landowner can influence the location of lines, their use, purpose, number, size, depth, and the reseeding of these land-disturbing installations, as long as the lease is amended to include the same. 

Lease Duration

Once a well is drilled and is producing in “paying quantities,” the secondary terms of the lease are triggered, allowing the lease to remain in effect for an indefinite period. The term “paying quantities” is purposely vague. Landowners must determine how little compensation they are willing to accept to keep the lease in effect. It is beneficial to define “paying quantities” in economic terms, such as a minimum payment per month, and to determine what happens when the well stops producing. 

Royalty 

The economic components of a lease have many subtleties. For example, is the oil and gas royalty free of any deductions such as treating, separating, etc.? Some leases spell out and define potentially ambiguous terms. Others are intentionally ambiguous. Either way, the descriptions are the basis for royalty and directly influence what deductions can be made. Many deductions are possible, and because the basis is often difficult to measure, it is virtually impossible to evaluate the accuracy of payments. It can be helpful for the landowner to negotiate access to company records pertaining to their well. Modern wells are paying from 12.5% to 20% royalty.

Controversies between landowners and companies typically arise from the long list of production and postproduction expenses deducted from checks, not from the negotiated royalty percentage. It might be possible to list, or perhaps limit, the deductions made from the royalty. How production royalty is calculated also can make a difference. Royalty payments can be based on quality and quantity of oil and gas production. If oil and gas companies vary in their ability to market hydrocarbons, royalty can be based on locally published rates (market value) or on actual company receipts. In addition, the landowner should consider whether payment should be based on wellhead (at the well) production or on point of sale.

Another statement found in leases that impacts royalty deductions is cost associated to make the product marketable.  A landowner is advised to ask an attorney to clearly state the lessee has a duty to make products marketable and to market all production. Landowners also might want protection from sales of their hydrocarbons to subsidiaries of the development company. Lessors may want sales to be based on “arm’s length transactions” to disinterested parties.

Landowners with more than one well might want to identify the well each royalty payment is for. A well number on checks could note this. 

Royalty payments are arguably one of the most controversial areas of a lease. In consultation with an attorney, landowners should carefully review all statements pertaining to royalty payments. 

Delay Rental/Shut-In

The delay rental is usually an annual, per acre payment to the landowner paid until a well is drilled and producing in “paying quantities.” A similar type of payment is discussed in the area of a lease that deals with “shut-in.” Shut-in royalty is a payment in lieu of the production royalty. It is usually paid at the same rate and manner as the delay rental. Shut-in does not necessarily mean a well is incapable of producing; it simply means it is at the company’s discretion whether to keep the well in production.

The “shut-in royalty or rental” is a payment made to the landowner when the well is not being produced. The terms of the payment often specify the number of consecutive day’s shut-in before payment is made. The problem with such a statement is that a lessee can easily avoid payment by turning on the well for one day, providing little financial return to the lessor. For this reason, modern leases specify consecutive or cumulative days per calendar year that trigger rental payment. The shut-in royalty or rent is a negotiable item. This payment, unless otherwise stated, may keep a lease in effect. As with all fees, landowners should be aware of when these items are to be paid and the consequences for nonpayment. 

Spud Fee

A spud fee is a payment made to the landowner for drilling on their property. This can be an important economic component to the landowner since many acres of land can be utilized in a modern wellsite. Payments made to landowners for drilling on their property range from zero to tens of thousands per well site. A spud fee helps compensate the landowner for the loss of use of the land and for possible changes in tax status. If the land was taxed under Current Agricultural Use Valuation Assessment rates (CAUV), the county auditor may remove this acreage from CAUV, resulting in a higher tax liability for the landowner. It is also possible for landowners to establish fees associated with other activities such as temporary work areas, seismic, pipelines, pig launchers, compressors, waterlines, holding ponds, and separators. 

Payments

This phrase or a similar one is found in some leases: “No default shall be declared against the lessee by the lessor for failure of the lessee to make any payment or perform any conditions provided for herein.” The landowner must work with their attorney to ensure that consequences can be expected for the lessee’s nonpayment or noncompliance.

Free Gas

Typically, free gas is not offered with deep lateral formation leases.

Resolving Disputes

Disagreements between companies and landowners are sometimes unavoidable. A landowner needs to work with their attorney to insert phrases or clauses that support swift, cost-effective resolution. One possible method of dispute resolution is to use three disinterested persons—one appointed by the lessor, one by the lessee, and the third by the two so appointed. The award of these three persons shall be final and conclusive. Leases often state issues are not binding unless they have been ruled so in a court of law. Most landowners do not take a matter to court out of concern for cost. Nonetheless, it is prudent to keep all resolution options available, including an option to use a local court. If an issue cannot be resolved, the lessor may desire to terminate for non-compliance, according to terms written in the lease. Should this occur, the lessor may need to assume quiet title and should ensure recovery of all cost associated with such action. Landowners may wish to mention the venue of law, so all actions and proceedings arising from a lease be considered under the jurisdiction of Ohio in the county of residence.

Water Protection

While it is unlikely, it is possible that ground or surface water is impacted from oil and gas exploration and/or pipeline development. Landowners would be wise to document flow rate and quality for all water sources prior to hydrocarbon exploration and or drilling. Many laboratories, such as the Penn State Agriculture Analytical Laboratory, can perform basic screening of oil and gas contaminants. It is prudent for landowners to have the lessee test, at their expense and at a lab of lessor choice, for drilling contaminates and related constituents. Such tests would be to assure water is safe and to document any changes that occur as a result of well production. These tests should be completed prior to exploration and/or drilling and following well production. If the landowner determines there has been water contamination because of lessee’s activities, the landowner may want to be provided potable water (provided in like measure quantity/quality as to lessor judgment) at no expense to lessor. It is also possible the lessor and family need to be removed from their home because of an accident caused by the lessee. As a remedy for such an event, it may be possible for landowners to include provisions for alternative housing and compensation for loss of farm production. Landowners should work with their attorney to protect their water source, and document water quality pre- and post-drilling. Developing an emergency relocation plan that includes strategies for compensation and damages is recommended. Photo of a fenced area with a pit lined with black material holding water. The sign on the fence says no trespassing, no swimming, PFD required.

Water Usage

Original offers to lease often contain options to use landowner water at no expense. Landowners may want to consider water usage as a separate agreement.  

Noise Protection 

Each landowner places a different value on serenity. Production generates noise, such as that of a compressor station, and the landowner may want the lessee to reduce noise to an acceptable level (opinion of lessor) with the lessee covering all costs associated with noise reduction or spacing the installations such that they reduce landowner annoyance. 

Government Programs and Taxes

Many landowners have participated in USDA practices that are destroyed because of exploration and development. The USDA can force landowners to pay a recoupment fee if such installations are removed. It is also possible that a government agency may decide to tax emissions or transmission. Some modern leases contain language that attempts to protect the landowner from changes in tax status.

Landowners may want a clause in their lease that protects them in the event a lien is placed against the lessor’s interest in their property because of lessee activities. It would be prudent for landowners to work with their attorney to insert clauses to provide for these often unexpected costs.

Pooling and Unitizing

Pooling allows the drilling company to pool or form a drilling unit with adjoining property owners. Unless landowners have very few acres, they should exercise caution in granting a company unrestricted pooling/unitization or consolidation. If the land is unitized as part of a drilling unit, the owner usually splits the royalty with other contributing landowners. The percentage of the royalty received is based on the acreage contribution to the drilling unit (an area identified contributing to the production). When unitized, if the producing well is not capturing oil and gas from a landowner’s property they may or may not receive royalty, yet their land and lease may be tied to the unit. This area of a lease can be used to bind large tracts of land. Pooling/unitizing is beneficial to the drilling company because it allows them to treat the unitized land as a single lease. It is possible that wells drilled anywhere on the unitized acreage keep the lease in effect. It is difficult, however, to determine how many acres are needed to efficiently develop a resource. From a large-acreage landowner perspective, it may be beneficial to limit unitized acreage.

Warranty Title

Guaranteeing title from a landowner perspective may be an unnecessary risk. Most initial offers to lease ask the landowner to warranty title. This clause usually states, “the lessor hereby warrants and agrees to defend the title to the lands herein described.” This means that if a question of ownership arises, the burden of proof may be on the landowner. It is prudent to discuss the ramifications with one’s attorney before agreeing to warranty title. 

Timber and Other Surface Damage

Timber is often damaged during the installation of a well pad, access road, or pipeline installation. This can be handled in various ways. Perhaps the lessor receives a mutually agreed upon price or lessee shall pay for an appraisal of the timber by a forester of lessor choice. The appraisal value of any timber damaged as a result of lessee’s activities then can be paid to the lessor within a designated period. Landowners might want all timber to remain in their possession and/or might want to have the timber removed to a specific location for their use. Landowners who manage timber might choose to have a consulting forester estimate value of the timber had it been allowed to mature. 

It is also possible for buildings, fencing, water distribution, and crops to experience some impact as a result of drilling activities. It is possible for the landowner to describe compensation for these inconveniences or losses in the lease. 

Use of Premise Resources

Landowners may want to describe how the land and resources can be used. Terms like, “as to lessee judgment, and not unreasonably withhold” describe opinion more than fact and are subject to varying interpretation. It is usually beneficial to more accurately describe these items in writing.

Hold Harmless

Landowners should work with their attorney to ensure within the lease they are not liable for the actions of the lessees or their agents. Some modern leases also describe the type and level of coverage the lessee is to carry.

Equipment Protection

Landowners who have livestock will want fence to protect the animals from equipment. The lease should describe the type of fencing and who is responsible for maintaining it. Points of ingress and egress may need to be defined, including whether a locked gate at the entrances is to be supplied and maintained. 

Audit Clause

The lessor may want to consider the right to examine lessee books and audit/inspect records and accounts relating to lease agreements. 

Transfers, Assignments, Trades 

Landowners may want to protect random assignment of items (including, but not limited to, the geological horizons, production well, tank batteries, and transmission lines) whether in primary phase or production phase. One may see the term “the landowner shall not unreasonably deny the right to assign.” Such statements are vague. An attorney can establish acceptable, concise language. It is reasonable that the landowner be at least notified prior to assignments and even perhaps approve or disapprove in writing. 

End of Lease

Nothing lasts forever and the landowner should work with their attorney to outline what happens when production stops. The description may contain what is to be done with the haul roads and other structures or buried lines, and how long the lessee has to remove equipment and restore land. In addition, the lessor may want to be furnished with a recordable release of lease. 

In closing, the opportunity to negotiate an oil and gas lease on one’s farm does not come along often. The terms agreed upon in the lease have the potential to affect the future operations of the farm and its real estate value. Only a portion of items relating to an oil and gas lease are covered here. Landowners should take time to understand their lease document and seek an experienced oil and gas attorney for advice. Weigh the factors in a lease, decide what is most important, understand what elements can be given up, and identify what elements must be negotiated.

References

Fambrough, J. (1997). “Hints on Negotiating an Oil and Gas Lease,” Technical Report 229, Real Estate Center, Texas A & M University.

Hall, P.K. (2016). “Facing the Possibility of Leasing for Shale Gas Development on Your Land,” ANR-30. Ohio State University Extension. Retrieved from ohioline.osu.edu/factsheet/anr-30

Harrison, G.A. (1997). “Negotiating Oil and Gas Leases on Indiana Farmland,” EC-564. Purdue University.

Weidner, K. (2013). “A Landowner’s Guide to Leasing Land in Pennsylvania,” Penn State Extension. Retrieved from extension.psu.edu/natural-gas-exploration-a-landowners-guide-to-leasing-in-pennsylvania

Wright, P.L. et.al.. (1986). “Oil and Gas Leases in Ohio,” Bulletin 732. Ohio State University Extension.

Special thanks to Peggy Hall, OSU Extension legal educator, for reviewing this document.