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Top Ten Considerations In Advising Clients On Oil And Gas Leases

Editors Note: This article was contributed by Ohio-based lawfirm Bricker & Eckler Attorneys At Law. Bricker & Eckler’s attorneys offer extensive experience in a variety of specialized practice areas including shale oil and gas.

Landowners in many Ohio counties will be (or already have been) approached by landmen, lease brokers, and large oil and gas company representatives to enter into oil and gas leases, primarily for Utica and Marcellus shale oil and gas development. While often large landowners are approached first, eventually a wide range of landowners will be solicited, from farmers and individuals to public and private entities.

The financial terms of these modern shale oil and gas leases are unprecedented in Ohio. As clients consult attorneys for advice on oil and gas leases, it is extremely important the landowner understands an oil and gas lease may burden his/her property for decades.

Attorneys need to help clients think past the thrill of fast one-time money and advise them to negotiate fair and comprehensive terms in the oil and gas lease not only for their own protection, but for the sustained use and development of their property long after they are gone.

The best guidance that can be given to a landowner is recognition that to negotiate a modern shale oil and gas lease, expert legal counsel is well-advised. Traditional oil and gas leases were often two or three page documents, with scant details beyond establishing the location of the property, the duration of the lease, and the amount of the royalty payment. Well-negotiated modern oil and gas leases are sophisticated commercial transactions with negotiated terms that often exceed a dozen pages. An attorney representing a landowner must pay close attention to the impact these terms will have, and explain them in an easily understood manner so the client can make an informed decision in choosing to sign an oil and gas lease.

The ten considerations below are among the most important factors an attorney should consider when negotiating on behalf of a client for an oil and gas lease. It is important to note that there are many other provisions of an oil and gas lease that should be considered by an attorney before advising a client to sign the lease.

1. Financial terms of the lease

These terms naturally attract the most attention from the client, but should be reviewed carefully to ensure that the client is receiving a fair deal. The first sort of payment is known as the delay rental payment or up-front bonus payment. Depending on the number of oil and gas mineral acres owned, a landowner may stand to receive a significant amount of money from this payment. As it is only a one-time payment, however, an attorney should consider the value of a large upfront bonus in light of other lease terms to better protect the client over the life of the lease. The other major financial term is the royalty percentage and its definition. If oil and gas is found on a client’s property, payments from royalties may exceed the up-front bonus in the long run. Traditionally, oil and gas leases contained a ⅛ royalty (12.5%). However, modern oil and gas leases, especially those designed specifically for Marcellus and Utica shale exploration, have royalties that often reach anywhere from 15 to 20% and higher.

2. Duration of the lease

Oil and gas leases contain two terms constituting the duration of the lease. These provisions are important because oil and gas leases may encumber the property for decades or even centuries — there are Ohio oil and gas leases executed in the 19th century that are still valid today and encumbering landowners’ property. The first is known as a primary term, usually a time certain during which an oil and gas company must explore and drill for oil and gas on the property. Historically, this period was often for one to three years. In modern oil and gas leases, this period is usually set at five years or longer. The second is an indefinite time period called the secondary term. If oil and gas is discovered, the lease will usually contain a clause allowing the lease to continue for so long as oil and gas is produced “in paying quantities.” What constitutes “paying quantities,” what specific activities permit the lease to continue, and under what terms and conditions the lease may be forfeited are important factors an attorney should consider.

3. The geologic horizons being leased

With the advent of Marcellus and Utica shall oil and gas exploration, this term has become increasingly important. In traditional oil and gas leases, the lease was silent as to the geologic horizon, as the landowner owned (and leased) the property from the surface to the center of the earth. In modern leases, a landowner may choose to lease only deep geologic formations, such as Marcellus and Utica shale, and reserve shallow formations such as the Berea or Clinton sandstone, or even deeper formations for later leasing or development.

4. Type of minerals leased

Traditionally, a landowner who entered into an oil and gas lease leased all of the oil and gas under the property. The modern trend is for a landowner to specify which minerals are being leased. Depending on the geographic location of the property and the geologic formation being explored, there is the possibility to extract dry natural gas, natural gas liquids and condensates, and crude oil. An attorney should consider advising a landowner to bargain for the lease of specific oil and gas mineral rights in order to ensure the landowner is being paid fairly, and to make certain that the oil and gas company has no rights to any other minerals, such as coal, coal-bed methane, gravel, or sand.

5. Drilling or non-drilling lease

A landowner may be interested in leasing the property for oil and gas exploration, but may not want the associated surface ac tivities that come along with drilling, such as heavy equipment, noise, and oil and gas company employees on their property. Most Utica and Marcellus drilling sites occupy about 5–7 acres. Thus, a landowner may try to negotiate a non-drilling lease, in which the landowner’s property is included in a larger tract of land and the well is not drilled on the landowner’s property, but the landowner still receives an upfront bonus and a royalty associated with mineral extraction beneath the property. The downside to a non-drilling lease is that oil and gas companies may offer a smaller upfront bonus and lower royalty in exchange for the surface use prohibition.

6. Unitization and Pooling

In Ohio, oil and gas companies are permitted to unitize or “pool” property from different landowners and under different leases to form drilling units. Certain acreage amounts are required by Ohio law for an oil and gas well to be drilled. Often for Marcellus and Utica shale wells, oil and gas companies seek to form drilling units of up to 640 or 1280 acres for technical reasons. An attorney should advise a landowner as to whether and under what circumstances the land may be unitized, as well as the shape and size of the drilling units that may be allowed under the lease. In addition, the attorney should consider the inclusion of what is known as a Pugh clause in the lease, which releases ownership of any unused surface acreage or unused geologic formations back to the landowner at the end of the lease’s primary term.

7. Surface Use Prohibitions

In leases that permit drilling on the property, terms dictating how the surface may be used are particularly important. Although Ohio law sets certain minimum requirements that an oil and gas company must follow in locating the well and conducting operations, an attorney may include additional terms such as the right of a landowner to approve the location of the well, use of roads on the land, where pipelines may be located, and greater setbacks from certain buildings, such as residences or barns.

8. Water Protection

Drilling for oil and gas in Marcellus and Utica shale formations requires a process known as hydraulic fracturing, or “fracking.” This process involves the use of large amounts of water, in the range of two to six million gallons per well. Although large oil and gas companies are developing techniques to re-use water for fracking, the temptation to use water located on or under a landowner’s property may be great. An attorney should consider provisions limiting water use, or alternatively entering into separate agreements for water used in operations. In addition, there is the possibility that operations from oil and gas drilling may contaminate a landowner’s ground or surface water. While the oil and gas industry takes necessary precautions to avoid water pollution, an attorney for a landowner may want to consider requiring pre- and postwater sampling to establish baselines in case of future contamination.

9. Insurance and Environmental Indemnity Provisions

Marcellus and Utica shale drilling is a large industrial operation with which there is a risk of accidents and personal and property damage. An attorney may wish to consider negotiating appropriate indemnities for environmental contamination and other accidents, and require appropriate insurance coverage.

10. Compensation for Damage and Restoration of the Land

During the drilling process, a landowner’s property may be damaged in a number of different ways. Once the drilling has been completed, the remaining equipment left to produce the oil and gas will occupy a much smaller amount of land. An attorney should evaluate features unique to their client’s needs and seek to address those situations, such as damage payments and restoration. When entering into an oil and gas lease, a landowner must truly take heed of the maxim caveat subscriptor — signer beware! With capable counsel, however, a landowner can take advantage of the mineral wealth beneath the land and be confident of a fair deal and future protection.

About the authors: Glenn S. Krassen is the partner in charge of Bricker & Eckler LLP’s shale oil and gas practice group. Glenn can be reached at (216) 523-5469 or gkrassen@bricker.com. Rob James is a shale oil and gas and environmental associate at Bricker & Eckler LLP. He can be reached at (216) 523-5482 or rjames@bricker.com.

For more information about shale gas law, visit Bricker & Eckler’s website: http://www.bricker.com/home.aspx.

 
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