Common Contract Terms

Common Lease Terms:

Lessor / Lessee
In an oil and gas lease, the landowner or mineral rights owner is the lessor and the oil and gas company is the lessee.

Granting Clause

The granting clause outlines the purpose of the lease. It details the rights and privileges that the landowner is granting to the lessee, the size of the interest granted, the property involved and the substances that can be retrieved from the leased premises. This clause does not mandate that the lessee must explore, develop and produce oil and gas and other substances from the leased property, but merely gives them the right to do so if they so desire. A landowner should pay special attention to the substances that are subject to the granting clause.

Habendum Clause
The habendum specifies the durational period of the lease in which the rights and privileges specified in the granting clause will extend. Typically, the habendum clause divides the lease into a primary term and a secondary term. The primary term is a fixed period, usually 3 to 5 years, during which the lessee has the right to explore, develop or drill for oil and gas on the leased premises but is not required to do so. If the lessee does not develop the property during the primary term, the lease terminates unless the lessee has a right to renew the lease. The primary term may be extended into the secondary term by making the leased premises productive. Production requirements are state specific and need to be carefully addressed. During the secondary term, the lease is extended indefinitely as long as the well is producing in paying quantities.

Delay Rental
The delay rental clause requires the lessee to make yearly payments to the landowner during the primary term if the lessee has not commenced operations for the drilling of a well. The lessee’s failure to make the delay rental payment to the landowner in a timely fashion can result in the termination of the lease. A landowner should consult an attorney immediately if a lessee is late on the delay rental payment. The recent trend is to execute a “Paid-Up Lease” in which the delay rental payments are made in advance at the time of signing the signing of the lease. This method protects the lessee against a loss of the lease for failure to pay delay rental payments during the primary term. It also ensures that the landowner will receive full payment for the primary term.

Royalty
The royalty clause is probably the most economically important and contested clause in an oil and gas lease. The royalty clause requires that the lessee pay the landowner a percentage of the value that is derived from the production of the substances under their land. A landowner must be aware of the distinction between “net” and “gross” royalties. A landowner should typically negotiate for a gross royalty because a gross royalty is determined without making any deductions for expenses, such as processing, transporting, marketing and other costs, which are common in a net royalty.


Operations Clause

The operations clause may be the most important clause in the oil and gas lease. There are many variations on the operations clause but they all attempt to accomplish the same thing – to extend the primary term of the lease if “operations” are being conducted on the property or on lands that are part of the same production unit as the property. Many old leases do not define “operations”, leaving the question open to interpretation by the courts. Modern leases usually attempt to define “operations” to clarify what exactly the oil and gas lessee must do prior to the expiration of the primary term of the lease. For example, suppose the following: An oil and gas lease is set to expire on July 1, 2012. On June 30, 2012 the lessee comes on the property and stakes out a well. The existing lease does not define operations, but provides that the lease shall continue if operations are conducted during the primary term. It is unclear from the lease what acts are required to extend the lease and the landowner and lessee are probably headed for a lengthy and expensive battle in court to have the issue answered. Many, but not all, of these issues can be eliminated through a provision in the lease defining the operations necessary to keep the lease in force.

Renewal / Right of First Refusal

The renewal clause is a provision that allows the lessee (but not the lessor!) to extend the lease for an additional term (normally equal to the primary term) by paying the landowner the same bonus payment that was made when the lease was originally signed. A renewal clause never works in favor of the landowner. If the going rate for bonus payments rise during the primary term, the lessee can renew the lease for an amount less than market value. If, however, the going rate for bonus payments declines during the primary term, the Lessee can simply choose not to exercise the right to renew the lease and then renegotiate with the landowner for the reduced bonus payment.

One option that can be used in place of a renewal clause is a Right of First Refusal. With a Right of First Refusal, at the end of the primary term, the landowner has the right to negotiate a new lease with anyone he or she desires and the Lessee has the right to match any offer the landowner may get from a third-party. A Right of First Refusal ensures that the landowner will get fair market value for his or her property while also providing the current Lessee the ability to retain the property if they are willing to pay fair market value.

Shut-In / Delay In Marketing
The Shut In clause allows the lessee make agreed upon payments to the landowner in order to defer the production from a well that has been drilled and is capable of producing in paying quantities by shutting-in, or pausing, production. During the shut-in period, the lessee makes payments to the landowner, in order to keep the lease in effect. The standard shut-in royalty clause proposed by the lessees does not have any durational limit on how long the lessees can shut-in a well. It is essential that the landowner attempt to limit the duration of a shut-in clause as much as possible and negotiate for a fair shut-in payment.

Similarly, the Delay in Marketing Clause allows the lessee to refuse to sell gas that has been produced from the well and instead pay the landowner a set amount per year in lieu of royalties. Typically this would be done if the price of the gas was low and the lessee would prefer to store the gas and wait until prices have increased. The standard delay in marketing clause proposed by the lessee does not have any durational limitation. The landowner should attempt to limit the duration of the delay in marketing clause as much as possible.

Pooling and Unitization
The Pooling and Unitization clause gives the lessee authority to consolidate the leased premises with adjoining leased tracts. This ‘pool’ or ‘pooled unit’ is an area created to combine the mineral owners under one production unit in an attempt to operate efficiently and not cause waste. Any operations being conducted on property in the same production unit as the leased premises is deemed to have taken place on the leased premises. If placed into a pooling/drilling unit, you are eligible for royalties based on your pro rata share of your acres included in the pool whether or not the well is physically drilled on your property. It is important to note that the lessee may choose to place only a portion of your property in a pooling unit.

Horizontal Pugh Clause:
A Horizontal Pugh Clause is a lease clause that allows un-pooled acres of the leased premises to be severed from the pooled portions so that drilling or production on a pooled portion will not maintain the lease as to the un-pooled portions. (This is often times referred to as a “Horizontal Pugh Clause”). For example, assume you own 100 acres of land and you have 1 acre of the property put into a production unit. Without a Pugh Clause, all 100 of your acres are treated as if they are in production even though you are receiving royalty payments on only 1 acre. The remaining 99 acres cannot be leased to another oil and gas company and the lessee does not have to pay the landowner or take any further action to hold the 99 acres under lease. A Pugh Clause allows the lessee to hold by production only that acreage which is actually made productive. Any acreage that is not contained in a production unit must be released from the lease after a set period of time.

Vertical Pugh Clause:
A Vertical Pugh Clause is a lease clause that provides that the lessee maintains a lease only to those geological formations to which it has made productive over a set period of time. Without a Vertical Pugh Clause, a lessee has the right to drill a well to any depth at any time without paying additional consideration to the landowner. Thus, if at a later time technological developments allow for the mining of a different geological formation, the lessee will have to pay the landowner to lease the new geological formation.

Location Approval

A location approval clause mandates that the lessee obtain consent from the landowner as to the location of all wells and any other structures placed on the property. The typical location approval clause provides that the landowner may not unreasonably withhold consent. This clause is essential to maintaining control over how your land is utilized by the lessee.

Assignment
An assignment clause allows for the lessee to assign the lease to another party, typically without having to obtain the landowner’s consent. It is normally the goal in negotiation to require the lessee to get written consent for assignment or at the very least notify the landowner of an assignment within 30 days of the assignment taking place.

Notice of Default / Right to Cure
Almost all oil and gas leases contain a notice provision that requires the landowner to provide the lessee written notice of any alleged default in the agreement. An example of a default could include the failure to make required payments or a failure to comply with any other written terms or implied covenants of the lease. The lessee is then allowed a period of time, usually 30 to 60 days, to correct the default claimed by the landowner. The landowner cannot maintain a lawsuit against the lessee until the 30 to 60 day period has passed and the lessee has failed to correct the alleged default. The landowner should attempt to keep the notice provision as short as possible when negotiating an oil and gas lease.

Judicial Ascertainment Clause

Many older oil and gas leases contain a Judicial Ascertainment Clause that provides that the oil and gas lessee cannot be held in default of a lease until after a court has ruled that a breach of the lease has occurred and the lessee has had a period of time, usually 30 to 60 days, to correct the breach. Judicial Ascertainment Clauses have been held to be unenforceable in many jurisdictions, including West Virginia and Ohio.

Indemnification Clause
An indemnification clause provides that the lessee will be responsible for any and all damages and/or claims arising out of the lessees operations on the property. For example, if a person is injured and/or killed during drilling operations, an indemnification clause requires that the lessee pay for any and all costs of any lawsuit against the landowner, including damages and attorney’s fees.

Implied Covenants
An implied covenant is a lease obligation that is not stated in the lease, but nonetheless implied on the parties by the courts. Implied covenants can include a covenant to develop the property. Implied covenant laws vary from state to state; however, landowners should be careful as to not waive implied covenants in the lease.

Insurance

An insurance clause requires the lessee to carry a certain amount of insurance that would protect the company and the landowner in the event of a lawsuit for damages caused by operations. An insurance clause is especially important if the landowner does not have to consent to the assignment of the lease as the lease can end up being owned by a company different than that contemplated at the signing of the lease.

Warranty of Title
Most leases prepared by the lessee have provisions in which the landowner guarantees that he has title to the oil and gas beneath the surface of his land. This allows the lessee to recover from the landowner if it is later determined that the landowner does not own the oil and gas rights. A landowner should never agree to this provision as the landowner is never sure that he or she actually owns the oil and gas rights. Instead, a lease should state that the landowner does not warrant any title to the oil and gas.

Equipment Removal

An oil and gas lease should have a provision that requires the lessee to remove all equipment from the land when operations have concluded. The lease should also have a provision that requires the removal of all equipment and pipeline if the well is abandoned.

Force Majeure
Force Majeure is a term in almost all oil and gas leases which allows the lessee to extend the term of the lease if they are unable to drill and/or operate a well due to something outside of their control. In the standard oil and gas lease presented by the lessee, there is no durational limit on the force majeure provision. It is important to attempt to negotiate a maximum amount of time that the lessee may extend the lease through force majeure. It is also important to be sure that the force majeure provision provides for written notification by the lessee notifying the landowner of the force majeure event.

Recoupment of Royalties
A “Recoupment of Royalties” provision in a lease permits the lessee to recover an overpayment of royalties to the landowner. This would most likely only occur if the landowner partially or totally failed title and the landowner warranted title within the lease document. Under such a scenario, the landowner may even have to return the delay-rental or paid-up lease payments.

Free Gas
“Free Gas Clause” is a provision of an oil-and-gas lease which allows the landowner or the surface owner to use gas produced from the leased property without charge. It should be noted that the landowner is responsible for the cost of infrastructure and bears all liability regarding the use of the free gas. A modern trend now is to negotiate “Cash In Lieu of Free Gas” instead of receiving the free gas itself. Under this clause, the lessee pays the lessor a specified amount in place of providing the lessor with the use of free gas. It should be noted that the use of free gas from a deep well is highly pressurized and can be extremely dangerous without the proper infrastructure and care used. Also, if the property is in a “wet gas” area, additional processing may be required before the gas can be used.

Pipeline / Foreign Gas

It is well accepted that a landowner must allow the lessee to install pipeline on the leased premises to gather gas and get it to market if the leased premises is made part of a production unit. However, the lease should limit the use of any pipeline to gas and/or other products that are produced from the same production unit as the leased premises. The lease should forbid the transfer of “foreign gas” and other products that are produced from another production unit. Any pipeline for “foreign gas” should be contained in a separate agreement for which the landowner should be separately compensated.

Use of Water
The landowner should be careful to not grant the lessee the right to use sources of water located on the leased premises. Any such access should be contained in a separate agreement for which the landowner should be separately compensated.

Spud Fee
The landowner can negotiate a term into the lease that sets forth the amount of money that the lessee must pay the landowner in order to place a well on the landowner’s property. This amount can vary from as little as $5,000 per well to over $75,000 per well. It is important that the landowner limit the maximum size of the well pad if a spud fee is negotiated into the lease.

OIL AND GAS ISSUES

Held By Production (HBP).
When a well on the leased premises, or lands pooled therewith, maintains production levels that satisfy the ‘capable of paying quantities’ standard, the lessee maintains their right to operate on the leased premises. A provision in an oil or gas lease that allows the lessee, generally an energy company, to continue drilling activities on the property as long as it is producing a minimum paying amount of oil or gas. The held by production provision thereby extends the lessee’s right to operate the property beyond the initial lease term. These rights can be limited by a Vertical Pugh Clause.

Title Searches / Due Diligence
The title search is a critical component to the oil and gas lease. After you sign the lease, the lessee will have a period of time (typically 90 days) to perform due diligence in determining whether or not to pay for the lease. This due diligence consists of a title examination in which the lessee does a title search to determine if you own the mineral rights. During this title search the lessee is looking for any severances of the mineral rights from the surface as well as any existing oil and gas leases. The lessee will also search with the appropriate state department to ensure that there are no active wells on your property. The landowner is only paid once the lessee determines that the landowner is indeed the owner of the oil and gas subject to the lease.

Many landowners would like to short circuit this process by having an attorney perform a title examination on the property before signing the lease. While such a title examination is beneficial for the landowner’s own knowledge, it will not change the process for the lessee. The lessee will still perform its own title search and pay the lease based upon the information found in its title examination.

Top Leasing
Top leasing is signing a new oil and gas lease that takes effect after your existing oil and gas lease expires. This is typically done to lock in the lease terms in advance. It is important to note that you will not be paid for the top lease until the old lease expires.

Co-Tenant Rights
One major issue in the production of oil and gas is what happens when there are multiple owners of the same property. The laws for this vary from state to state. In West Virginia, the oil and gas may not be produced from a property unless all of the owners have signed an oil and gas lease. Other states are not so restrictive, however, in most cases the lessees would still like to get every owner of the land signed to an agreement.

Mandatory Pooling

Mandatory Pooling (sometimes called forced pooling) is a method used by oil and gas lessees to drill for oil and gas under a property that they have not signed to a lease. Mandatory pooling is a concept that is imposed by state government. West Virginia does not have mandatory pooling provisions. The authority for mandatory pooling in Ohio can be found at Ohio Revised Code § 1509.27.

Notary
In order for a document to be recorded at the courthouse, it must be signed in front of a disinterested notary public. If your lease was not signed in front of a disinterested notary public, you may have a claim to have your lease invalidated.