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Oil and Gas Leases 1

Oil and Gas Leases 1

Basic Description of Oil and Gas Leases

The parties and their interaction in an oil and gas lease

A landowner who owns both the surface rights and the mineral rightsto their farm is usually approached by a landman to begin the leasing of the mineral rights. The landman, more often than not, works for an oil company and is a vital part of the oil company’s exploration team. This exploration team is assigned to your area and looks for land to lease for exploratory drilling. An oil and gas lease is created by the oil company after the landman has studied geologic maps of the area and researched deeds and acreage at the local courthouse. It is necessary to determine who owns the land and the mineral rights, since only the legal owner can be named on an oil lease. There is a lot of homework on the oil company’s part before a landman comes to discuss an oil and gas lease.

A landman only comes to a landowner when all the pieces of the proposed oil or gas lease are in place. Now the negotiations begin in earnest with each landowner and farmer in the designated area. Titles are researched and blocks of land are put together to create the lease area.

Most farmers and landowners are aware that various states, in fact the majority of states, separate the mineral rights from the surface rights of the landholding. Therefore, the landman, the exploration team, and the oil company ensure ahead of time that the landowner does have the right to lease the mineral rights according to the terms in the oil and gas lease.

After everything is in order, the landowner is presented with an oil or gas lease. The lease states the rights and the obligations of both the oil company and the landowner. If a landowner has very little experience with legal contracts and leases, the document can be sometimes difficult to understand.

The landowner is the Lessor and the company is the Lessee. When the landowner signs the lease, the owner will be given a “Bonus.” The bonus is a sum of money, agreed upon both the Lessor and the Lessee to be given on signing of the oil and gas lease. If there are producing wells near the land, the bonus can be substantial. If there is no drilling yet or none of the existing wells are not producing, the bonus will certainly be low. The landowner should check with the other landowners in the area and even somewhat further away to establish the amount of bonus the other landowners have received.

There is a length of time established in the oil and gas lease. It is called the “term.” This is the primary term of the lease. Any additional amount of time after this leased time is called the secondary term. A secondary term can be written as for as long as the oil and gas are produced in paying quantities. The primary term is usually a fixed length of time, such as a year.

Another part of the oil and gas lease is royalty payments. It is an agreed on percentage of the profits of the oil and gas. The reasonable costs of the Lessee’s operations are deducted first and the landowner receives a percentage of the remainder.

If the term of the oil or gas lease extends beyond the time that the bonus was paid, and a well was not drilled, then the Lessee is required to pay the landowner an agreed on sum. This sum could be $1.00 or more per acre. This is called a delay rental. The payment is due on or around the anniversary of the lease. Occasionally oil and gas companies pay this fee up front when an oil lease is negotiated and signed. The company’s failure to pay a delay rental on time cancels the lease.

There are implied covenants that are part of the agreement, such as that the Lessee will protect the property from drainage, will develop the property after drilling the first well, will conduct all operations as a careful operator, and will attempt to secure a market for the oil and gas. The Environmental Protection Agency requires that the property be returned to a usable environmentally safe condition after drilling and production on the lease site has concluded.

How Gas Leases differ from Oil Leases

Unlike oil, which is liquid, gas is physically processed from its natural gaseous state, compressed, and liquefied for transport. Gas is not always used in the region where it is produced and therefore a network of pipelines became the means of transport. There are no local refineries as there are with crude oil. It is transported from the well by transmission through a natural gas pipeline. The capital investment to move gas along the pipeline is substantial compared to transporting oil to local and regional refineries. There are over 280,000 miles of pipelines in the United States. The price received for natural gas at the well is determined by the gas sales contract. The market for gas is determined by the season and the need for natural gas and liquefied natural gas. As a result, there is a significant difference between oil and gas leases.

Natural gas produced and consumed in the same state is called intrastate gas. Natural gas produced in one state and transported to another state is interstate gas and this gas is federally regulated because it is transported across state lines. Gas prices were regulated until 1989 by the federal government. Before deregulation, gas contracts were long term and somewhat inflexible for the life of the contract, which could last from ten to twenty years. Since deregulation, gas contracts became much shorter in duration. The spot market actively deals in gas contracts. Oil has not had the same regulations as gas.

Since gas is in a vapor stage until compressed and liquefied for transport, gas is more difficult to offer a royalty in kind or at the well, as in oil lease royalty. Most landowners take cash and credit for their royalty. The extreme volatility of gas makes a cash royalty the better of the options available.

Oil royalties may be paid in oil. The landowner may elect to receive oil from the oil company and then market the oil. Most landowners choose to receive the royalty in cash at the posted price of the oil. A landowner deciding to receive the oil as the royalty payment can market the oil royalty back to the Lessee for marketing and receive cash through that arrangement.

On the other hand, gas royalties usually are paid in cash. Gas price is difficult to value given the fluctuating and volatile markets lately. Gas royalty clauses usually state a royalty in market value, or in kind. Few landowners opt for an in kind royalty because of the necessity for compression for transport across the network of pipelines.

Landowners can specify separate royalties for oil and gas production. Landowners in negotiating the lease can place a due date for receipt of royalty payments and if timely payments are not made, there can be an interest charge for late payment placed in the lease.

How Royalties are Calculated

Oil and gas leases contain a royalty clause. A royalty is the landowner’s share of the gross production, which is free of the costs of production. It is probably the most important part of the lease to the landowner. Landowners can have problems understanding how the royalty is determined.

There are certain costs in drilling and producing a paying oil or gas well. The costs are divided between the production company and the landowner. The production company bears the exploration, production, and marketing costs unless there is a clause in the lease that states differently. Expenses that occur after production can be borne by the production company or shared by the production company and the landowner.

The royalty clause can specify that the royalty be established at the well, which means that the landowner’s royalty payment is free of production costs. The landowner’s royalty can also bear a share of the costs that occur after production. If the lease reads that the royalty is fixed in the pipeline or at the place of sale or at some other delivery point, then a new set of costs occur and are part of the deductions from the royalty. It will be the costs after the oil or gas has been extracted at the well.

There are three methods generally used for computing and establishing the royalty payment and how it is valued. The first method is market price and value of the oil or gas. Sometimes the market price at the well in the field is used as the prevailing price. Landowners usually have been taking the field price at the well because it allows the price to rise as the price of crude oil and gas rises. Some leases have royalty clauses that state that the royalty is set at the highest price or percentage posted for fields within one hundred miles by any major oil company for similar grades and gravity on the day that the oil is removed.

The second method ties the royalty to actual revenue received from the sale of the oil or gas. In this case, the royalty received may or may not be equal to the actual market price of the oil or gas. This method of computing royalty is used mainly with gas royalties. The production company can and has committed to long-term contracts and the royalty, in that case, is more dependable. Unfortunately, in a rising market, the production company cannot be flexible with set in place long-term contracts.

Another method of commuting royalty is the “in-kind.” The landowner takes possession of the oil or gas produced for the landowner’s share of the oil or gas production before the oil or gas is marketed by the production company. The landowner can insert a clause in the lease to take royalty either “in kind” or “in proceeds.” This clause allows the landowner more flexibility and a higher royalty based on decisions of the market.

The landowner is subject to taxes on the royalty from the production company. The taxes are federal taxes and state taxes on the royalty. The landowner can also be subject to the cost of moving the oil or gas from the well to the refinery and storage tanks.

Royalty interests on a lease can be sold in part or in the entirety by the landowner. A royalty can be split among several persons, such as surviving relatives and family for the life of the lease.

A sample clause from a standard lease is as follows

“Royalties payable to Lessor are (a) on oil, and on condensate saved at the well, one-eighth of that produced and saved from said land, the same to be delivered at the well or to the credit of Lessor in the pipe line to which the wells are connected. Lessee may from time to time purchase any such royalty oil or condensate in its possession, paying market price therefore prevailing for the field where produced for oil or condensate of like kind and gravity on the date of purchase. (b) On gas, including casting head gas or other gaseous substances, produced and saved from said land (1) when sold by Lessee, one-eighth of the net proceeds realized there from by the Lessee computed at the mouth of the well or (2) when used by Lessee in the manufacture of gasoline or other products, so manufactured, plus one-eighth of the net proceeds realized by the Lessee from sale of the residue gas computed at the mouth of the well, or (3) when ‘used by Lessee off said land for any other purpose, the market value, computed at the mouth of the well, of one-eighth of the gas so used.

An example of how royalty is determined:

Interest

Gross Revenues

Minus

Net Revenue
Exploration
Production
Operating Expenses
Income

Working Interest

Share of Revenues 100% minus 8/8
Minus 1/8%
State production tax
Product handling fee
Federal withholding tax
Net revenue
Lease costs
Lease operation

Net operating income

Royalty Interest

Share of gross revenues 1/8%

State production tax
Production handling fee
Federal withholding tax
Net revenue

The typical fractions used in oil and gas leases can also be expressed in percentages such as 1/16 = 6.25%, 1/8 = 12.5%, 1/7 = 14.29%, 5/32 = 15.63%. The current trend is to counter the lease royalty offer with what the landowner considers a fair percent of the 100%.

Mineral Rights in Oil and Gas Lease

Minerals rights in an oil and gas lease differ from surface rights. A landowner may own the surface land but not the mineral rights of that land. The owner of the land should check on whether he/she has ownership of mineral rights or title on the land.

One of the places to check on real ownership is through an independent landman or a bank. The landowner can also use an abstract company. Whoever is the one contacted to perform a mineral title is then empowered to obtain an ownership report or mineral takeoff.

The owner of the land, in order to legally negotiate with an oil and gas production company, has to know whether they have clear title to the mineral rights of that land. In many cases, the mineral rights are separated from the surface rights.

After the landowner has received a report of the land’s mineral rights and who holds those rights, then the owner can discuss and negotiate in good faith with any oil and gas production company.

Only the mineral right owner may execute an oil or gas lease conveying his interest to the production company.

Surface rights and ownership of land is when the mineral rights have been detached. The surface rights owner can have the full use of the land; however, surface possession is subject to the mineral rights owner’s right of extracting the minerals.

Oil and Gas Lease Negotiation

Portions of the oil lease that are commonly negotiated

An oil and gas lease is a legal document that binds a mineral rights landowner. There is nothing simple about negotiating an oil and gas lease. Usually the landowner is approached after the landman, a key representative of a production company, has done the basic work of establishing the geological formations, researching the local area and lease ownership. The landman establishes the rate of production for other existing wells in the area. The landman has established that the landowner possesses ownership of the mineral rights and the surface rights.

The landman for the oil company has found other companies with possible trades and agreeable to joint ventures. Whenever the landman approaches the landowner, all the basic groundwork has been established. The landman brings the lease to be signed.

The landowner can and should thoroughly read the oil and gas lease, which is a binding contract. If there are items or proposals in the lease that the landowner does not agree with, then those clauses should be discussed and possibly changed or adjusted. Oil and gas companies write leases that are beneficial to the oil and gas companies.

The landowner of the mineral rights should look closely at the terms, both the primary and the secondary term, and the royalty. The royalty can and is paid in many different ways. Landowners can look at what the royalty percent is and how often paid.

Simply asking one’s neighbor about their agreement-lease may not be any real advantage. The neighbor may not have taken time and effort to research the terms and clauses and just accepted the lease as presented. Not all leases are written the same, therefore the landowner’s neighbor may have a somewhat different lease.

Negotiating a fair and equitable oil and gas lease requires research and sometimes having an attorney sit in on the negotiations.