Negotiating Oil and Gas Leases

by Brandon Baker

Many Oklahomans have the good fortune to own mineral interests, whether based on inheritance or their own acquisitions and investments.  In order to drill a well for the production of oil and gas, the producer must first acquire the right to do so from the surrounding mineral owners through either a lease, a forced pooling action, or a combination of both.  As such, oil and gas leasing activity has been a mainstay in the Oklahoma economy for generations.  

 

Many of our clients and friends receive various lease proposals from landmen and other leasing agents.  For those with limited experience in leasing minerals, it could be tempting to focus purely on the financial terms (the lease bonus paid up-front and royalty to be paid on production) and assume the remainder of the lease is either unimportant or non-negotiable.  These assumptions are not only incorrect, they can prove problematic for the mineral owner over time.

 

There are several negotiable provisions in a standard Oklahoma oil and gas lease which can greatly improve the mineral owner’s position over time.  This article will provide a quick summary of a few provisions that are generally beneficial to mineral owners.

 

  1. Limitation Clauses:  A depth clause can be utilized to restrict the minerals covered by the lease to a specific depth (usually the lowest depth penetrated by the operator’s well).  A depth clause leaves the deeper formations open for future leasing opportunities.  A so-called “Pugh Clause” limits the minerals covered by the lease to the minerals included in the drilling and spacing unit established by the Oklahoma Corporation Commission.  The Pugh Clause allows the mineral owner to re-lease any minerals not covered by the spacing unit at a later time.
     
  2. Cost Deductions:  The standard oil and gas lease will allow the operator to deduct various costs of production from the mineral owner’s royalty payment.  By adding certain provisions to the lease, the mineral owner can protect against these cost deductions and increase the amount of their royalty payments.
     
  3. Warranty on Title:  Mineral owners should be wary of the standard lease provision where they provide a full warranty on the ownership of the minerals.  Many mineral owners simply trust the leasing agent on the number of acres owned and the ownership of the minerals in general, only to be forced to repay some or all of their lease bonus if their ownership is proven invalid at a later point.  It is possible to lease minerals without a full warranty on title.
     
  4. Commencement of Operations:  A standard oil and gas lease will provide a primary term of 3 years, which can be extended as long as oil or gas are produced if a producing well is drilled or commenced during that initial 3 year period.  We can utilize a commencement clause in the lease to specifically define commencement of operations as a drilling rig on location (as opposed to clearing trees or bulldozing a pad site, as some operators will argue to be commencement of drilling operations).
     
  5.  Shut-In Royalty Clause:  The standard lease provides for a drastically reduced royalty payment during any period where the well operator has shut-in the well.  In addition a shut-in well is still considered to be producing and thus, extends the lease term.  With a shut-in royalty clause, we can limit the length of time an operator can extend the lease term with shut-in royalties.  This allows a mineral owner to pursue other leasing opportunities once that time has expired.  by Brandon Baker
     

This is not an exhaustive list, nor is it a complete explanation of each of the provisions noted above.  My goal is simply to provide a brief outline of a few provisions which can be used to a mineral owner’s advantage.  If the mineral owner is also the landowner, several other provisions are very important as well (such as use of water, access and roads, surface damage, etc.).  I should also mention that the financial terms (lease bonus and royalty) are often open to discussion and educated negotiation will sometimes result in higher payments for the mineral owner.

 

With careful analysis and negotiation, mineral owners can maximize their return in the short-term (with more beneficial financial terms), in the mid-term (with provisions that maximize their royalty payments and limit liability), and in the long-term (with provisions that allow them to exit the lease and pursue new leasing prospects).  There are many considerations for a mineral owner in effectively negotiating an oil and gas lease.  If you would like assistance with review, analysis, or negotiation of an oil and gas lease, please contact our office and we would be happy to serve you.