12 Things to Consider before Signing an Oil and Gas Lease
The Oil and Gas industry is booming in Ohio. Drilling and production continue to increase across the State. This provides Ohio landowners who are approached about an Oil & Gas Lease with both great opportunity and significant risk. While a well drafted lease with the appropriate legal terms and protections can be a tremendous benefit for the landowner far into the future, a poorly negotiated lease can cause indefinite headaches and legal problems for the landowner. Here are 12 things landowners should consider before signing an Oil and Gas Lease in Ohio:
1. An Oil and Gas Lease is a Long-Term Relationship with an Oil and Gas Company
An Oil and Gas lease is a legal document between the landowner (lessor) and an operator (lessee) that allows the operator to produce and sell the oil and gas minerals beneath the property. Unlike a sale of land, an Oil and Gas Lease creates a lasting, long-term relationship between the landowner and the Oil and Gas Company. For this reason, it is important to make sure that the company that has approached you is a reputable operator in the region.
2. The Company’s Land Agent is NOT on Your Side
A “land agent” (also known as a “landman”) is a person that the Oil and Gas Company has hired to negotiate leases with landowners. Oil and Gas Companies pay land agents to obtain leases that are favorable to the company, not to the landowner. Do not be mistaken, the land agent is looking out for himself and the Oil and Gas Company he works for, not you. If you do not know the ins and outs of oil and gas law in Ohio, you should consult a lawyer who does and whose job it is to look out for your best interest.
3. Maximize the Cash Bonus Payment
The cash bonus payment is the guaranteed portion the Oil and Gas Company pays the landowner up-front for signing the Oil and Gas Lease. This bonus payment is generally calculated on a per-acre basis and is paid within a certain number of days after the lease is signed. Maximizing the cash bonus payment is critical because it is the only financial benefit that the landowner is guaranteed by signing the lease. Ongoing royalties from production are also important, but there is a chance they may never result in payments unless a well is drilled and meets certain levels of production and revenue. For this reason, it is critical to negotiate the maximum possible cash bonus payment.
4. Do NOT Settle for Net Royalties
Not all royalties are created equal. Increasing the royalty percentage that you are paid is only part of the battle. A key issue in negotiating royalties is whether the royalty is paid on gross proceeds or net proceeds from the sale of oil, gas, and other hydrocarbons and related products produced from your property. A net royalty allows the Oil and Gas Company to deduct post-production costs from your royalty payment. These deductions can be quite large and, in some cases, in some instances, can reduce the royalty payment by 50% or more. For this reason, it is critical to negotiate a gross royalty (also known as a cost-free royalty).
5. Avoid the “Mother Hubbard” Clause
An Oil and Gas Lease will specifically identify the parcels that the Oil and Gas Company is leasing from the landowner. However, many Oil and Gas Companies try to extend the reach of the lease to property that you own or claim an interest in that is not specifically identified in the lease. They do this by including what is known as a “Mother Hubbard” clause in the lease. This clause is unwarranted and should be negotiated out of the lease.
6. Do NOT Warrant Title
Many Oil and Gas Leases include a clause where the landowner provides a warranty of title to the Oil and Gas Company. Such clauses amount to an unfair attempt by the Oil and Gas Company to shift the burden of conducting or insuring the title work from themselves to the landowner. Warranting title only puts you at risk of future litigation and liability. Oil and Gas Companies have the resources and the manpower to conduct their own title investigation and should be responsible for doing so.
7. Protect and Specify Your Right to Audit the Company
If you have doubts about whether the company is properly calculating your royalty payments, then the only method of investigating this is to audit the Oil and Gas Company’s records. Auditing an oil and gas company can be an expensive and difficult process. It is essential that you negotiate lease provisions that clearly define your right to audit the company and that obligate the company to provide the pertinent records so that you have the tools necessary to ensure the company is paying what it owes to you without incurring exorbitant expenses in doing so.
8. Know the Difference between the Primary Term and the Secondary Term of the Lease
Many landowners are confused by the difference between the primary term and the secondary term of an Oil and Gas Lease. Oil and Gas Companies often seek a five-year primary term. This means that the lease will expire five years after signing unless operations commence, or the primary term is extended. When operations commence the lease enters the secondary term. The secondary term continues indefinitely until operations cease. Some landowners believe that they can renegotiate the oil and gas lease after the primary term regardless of whether operations have commenced. This is not true, and it is one of the reasons why it is so important to negotiate a favorable lease. You must negotiate your lease as though it will last for decades because there is a good chance that it will.
9. Protect Against a “Shut-In”
For a variety of reasons, Oil and Gas Companies sometimes “shut-in” and cease production from their wells. When this occurs, the landowner will not receive royalties until production restarts. To protect against this situation, you should negotiate shut-in protections which include limits on the amount of time the well can sit idle, as well as payments to the landowner during a shut-in period.
10. Include a Pugh Clause
The purpose of a Pugh clause is to protect the landowner when the Oil and Gas Company produces from some, but not all, of the landowner’s property. Without a Pugh clause, if the Oil and Gas Company commences operations on any portion of the landowner’s property, the lease moves into the secondary term on all the property. Therefore, the part of the property that is not being utilized (and not producing any royalties) is held by the lease with no benefit to the landowner. You should negotiate a Pugh clause to avoid letting this happen to you.
11. You Do NOT Have to Give the Oil and Gas Company the Right to Use the Surface of Your Property
Although the oil and gas are underground, Oil and Gas Companies generally seek surface rights when leasing property. Surface rights allow the company to construct well pads, pipelines, access roads, and other facilities on your property for their convenience. Allowing the company to use the surface of your property can drastically diminish its uses, character, and value. Many landowners do not realize that surface use is negotiable and that companies are often willing to agree to a “no surface use” clause in an Oil and Gas Lease. A “no surface use” clause prevents the Oil and Gas Company from utilizing or disturbing any part of the surface of your property and allows you to benefit from an oil and gas lease without sacrificing your use and enjoyment of the surface of your property.
12. If You Do Grant Surface Use, then Negotiate Additional Compensation and Legal Protections
For some landowners, granting surface use makes sense if the Oil and Gas Company is willing to pay a larger cash bonus and royalty to obtain the right to use the surface of the property. However, there are several important protections that you should negotiate if you choose to grant surface use. Specifically, landowners should negotiate clauses requiring mutual agreement to the location of surface facilities, a siting/spud fee, and specifics for restoration of the property after operations cease. These and additional surface protection terms can provide you with additional compensation and the appropriate protections to preserve the use and value of your property despite the Oil and Gas Company’s operations.
Note: This information is intended for general guidance only. This is a list of some of the important issues that a landowner should consider before signing an Oil and Gas Lease. It does not address the particular issues that a landowner negotiating an Oil and Gas Lease might face and it is not a substitute for legal advice and guidance that address your specific situation. Call us to discuss your unique circumstances to find out how we can help you.