In order to produce oil and gas from a property, the producer must have legal rights to produce, called “mineral rights.” There are multiple forms of mineral rights ownership, and the form most-commonly used by oil and gas companies is to “lease” exploration and production rights from “mineral estate” owners.
Mineral Estate
So, what is a mineral estate? In simple terms, full ownership of property, called “fee simple absolute,” includes both the right to use the surface, called the “surface estate,” and the right to produce minerals from beneath the surface, called the “mineral estate.” (Oil and gas companies sometimes refer to mineral estate as “fee minerals.”) It is possible to split or “sever” the mineral estate from the surface estate, and split estates are fairly common in oil-and-gas-prone areas. For example, the seller of a property in a prospective area may want to retain existing or potential-future oil and gas profits and can make a provision to reserve some or all of the mineral estate as part of the sale.
Owners of severed mineral estates have the implied right by law to use the surface as “reasonably necessary” to explore for, extract and transport oil and gas, even if not expressly agreed and documented between the surface estate and mineral estate owners. Courts have ruled that those surface-access rights exist by implication because it would be a senseless action to split an estate if the parties did not intend for the mineral estate owner to have access necessary to produce minerals. The mineral estate owner must pay the cost of all oil and gas operations, but is entitled to all production revenue. The mineral estate owner does not need the surface estate owner’s consent to begin operations, although all states have advance-notice requirements as well as regulations about how close a well can be to a dwelling.
Why Lease?
Now we need to address that fact that it is not usually the mineral estate owners who conduct oil and gas operations because most mineral estate owners don’t have the necessary knowledge, organization and/or funding. Oil and gas companies have those capabilities, and seek access to prospective acreage, but don’t like to make large up-front payments to acquire mineral estates because oil and gas is a speculative and high-risk business and investments can be completely lost. Accordingly, oil and gas companies usually make offers to “lease,” rather than buy, the rights held by minerals estate owners. A lease is a risk-and-profit-sharing arrangement that has advantages for both parties.
To begin a lease, the oil and gas company (“lessee”) and the mineral estate owner (“lessor”) negotiate lease terms and the oil and gas company prepares a lease document. The key negotiated elements of a lease are the “bonus,” “royalty” and “primary term.”
Lease Bonus
Upon execution of the lease, the oil and gas company will pay an agreed bonus amount. The bonus is non-refundable and guarantees the mineral estate owner a minimum profit even if it is determined that there is no oil and gas beneath the property. However, the bonus amount is much less than an oil and gas company would have to pay to buy the mineral estate outright, reducing their up-front cash outlay and loss exposure. Bonus amounts are usually expressed as an amount per net mineral acre (“Net mineral acres” means the number of acres covered by a lease times the lessor’s ownership % in the mineral estate). Bonus payments can range from as little as $1 per net mineral acre to several thousand dollars, depending on the attractiveness of the overall area, quality of the specific acreage, competition for leases, and overall industry and market conditions. Demand for leases tends to fluctuate as oil and gas prices rise and fall.
Lease Royalty
The mineral estate owner will be paid additional amounts in the form of a monthly “royalty” if the oil and gas company successfully produces oil and/or gas. A royalty is a percentage of the value of any oil and gas produced, free of any exploration, development and production costs. Thus, both parties to a lease share in actual production results based on actual product prices. However, the mineral estate owner has the important advantage that their share of production value is not burdened by costs. (Many oil and gas companies have lost money on leases that generated substantial royalty payments for the mineral estate owners.)
Royalties have traditionally been 12.5% but have gone as high as 25% in some exceptional areas. A high royalty rate is not necessarily better for a mineral estate owner because there will be no royalty payments if there is no production, and a high royalty rate can reduce the amount and duration of work that an oil and gas company can economically justify – particularly if oil and gas prices decline. In contrast, a lease bonus is a single, up-front payment and does not burden go-forward development economics.
Lease Primary Term
A lease has a limited duration. The initial term of the lease, called the “primary term,” is a period of time allowed for oil and gas company to establish production and begin royalty payments. The lease will terminate at the end of the primary term if the oil and gas company does not establish production, or establishes production that stops before the end of the primary term. Primary terms on private leases are commonly 2-5 years and may be longer on state and federal leases.
Some leases have options for the oil and gas company to extend the primary term by making an additional payment. Some leases have a clause that the lease will not terminate at the end of the primary term as long as the oil and gas company is actively and continuously engaged in drilling operations. Leases also commonly have a clause to address situations where a gas well has been drilled that is capable of producing but the oil and gas company cannot establish production before the end of the primary term due to lack of a pipeline connection. The lease can be extended by paying a “shut-in royalty,” which is usually a nominal amount.
During the primary term, the oil and gas company makes all operating decisions and pays all costs. The oil and gas company has an option, but not an obligation, to do work such as drilling a well(s). The oil and gas company may elect not to drill if events diminish their expectations for a property, such as poor results of other wells drilled nearby, better results from other areas, falling oil and gas prices, etc.
Lease Delay Rentals
Most older leases included a provision that the lease would terminate on the first anniversary date (during the primary term) if the oil and gas company had not started drilling, UNLESS a “delay rental” payment was made to defer the drilling obligation for another year. Delay rentals are typically nominal amounts, such as $1 per acre. Drilling could be further deferred throughout the primary term by making additional delay rental payments on each anniversary date (except the last anniversary date because a delay rental cannot extend the primary term).
Delay rentals have the appearance of a penalty for not drilling but the practice was originated long ago by oil and gas companies wanting to establish a procedure that made clear that a lease does not obligate them to drill – delay rental payments are compensation to keep the lease going without drilling. Today, most private leases do not require annual delay rental payments but a delay rental provision is still needed for the aforementioned reason. Accordingly, leases without annual delay rental payment requirements are called “paid up” leases, and all delay rentals that would be due throughout the primary term are deemed to be paid up-front as an unidentified portion of the cash payment that includes the lease bonus. Some private leases are still being drafted with delay rental provisions and delay rental payments are often required in state and federal leases.
One of the reasons that paid-up leases have become more common is that an oil and gas company can lose a lease before the end of the primary term if a simple oversight is made and a delay rental payment is not made on time, or a check is lost in the mail. Lease bonuses have gotten so high in some unconventional development areas that the old way poses too much risk of loss, and annual payments of small amounts is an unnecessary administrative burden.
Secondary Term
If the oil and gas company does drill and establishes production that extends beyond the end of the primary term, the lease will continue for as long as production continues in “paying quantities” (at a profitable level for the oil and gas company). This extended period is commonly referred to as the “secondary term.” During the secondary term, the oil and gas company has the option to drill additional wells and do other work to the extent allowed by regulations. The “paying quantities” provision exists in part to motivate oil and gas companies to diligently manage leased properties and to pursue economically-viable options to boost production and extend the life of wells and fields.
Et Cetera
There are a few points worth mentioning now that we’ll cover in more detail in future posts:
- Lease “brokers” sometimes acquire leases that they can sell to oil and gas companies, so lease offers do not always come directly from an oil and gas company. However, an oil and gas company must eventually become involved because a lease has no value without drilling and production.
- State regulatory agencies have rules about how many acres are required to obtain drilling permits, how close wells can be on the same mineral estate tract, and how close wells can be to neighboring tracts. Rules differ for vertical and horizontal wells.
- Leased properties are often “pooled” with other properties to form work areas large enough to qualify for a drilling permit. They may also be “unitized” with other properties to form even larger work areas, such as for horizontal drilling projects. Units may also be created in mature oilfields for enhanced recovery operations such as a waterflood.
- Sometimes oil and gas companies first approach mineral estate owners for permission to include the property in a seismic survey. They may negotiate a lease option at the same time that gives them the right to lease the property if they like the results of the survey. The lease option will specify what the lease terms would be.
- It is very common for mineral estates to have multiple owners, particularly with severed mineral estates that were severed long ago. Those estates can be jointly owned by a surprisingly-large number of heirs who may not even know each other. Oil and gas companies must try to locate all interest owners in order to lease a property, and do not have to have uniform terms for all owners.
- Leases have traditionally allowed deductions from royalty payments for off-lease "post production" costs that may be incurred by the oil and gas company to have the royalty owner’s share of production gathered, treated and processed into marketable condition and transported to a sale location. Oil and gas companies consider those activities to be components of the sale arrangement and the costs a reduction in sale proceeds. However, some more-recent lease agreements prohibit deduction of those costs. Oil and gas companies generally resist these types of agreements because it effectively gives the royalty owner a share of sale proceeds higher than their stated royalty percentage and puts more cost burden on the oil and gas company.
- It is customary for oil and gas companies to pay the surface-estate owner for certain damages, such as damages to growing crops, even if the surface owner is also the mineral estate lessor. Payments are also commonly made for new roadways created on the property and for use of existing roadways. Some states now require surface-use agreements to be established that usually have broader provisions with more compensation for the surface owner, such as payments for well pads and gathering-pipeline corridors.
If you're interested in learning more about this subject, check out our U.S. Mineral Rights and Leasing eLearning course. It provides in-depth coverage of oil and gas land issues. A description can be accessed here.
Energy Training Resources is not a law firm and this post should not be construed as legal advice. You should contact an attorney competent in oil and gas matters if you need legal assistance.