Should I Enter Into An Oil and Gas Lease?

Overview

Rural landowners can have various opportunities to earn income from their land that is in addition to income from crop and/or livestock production.  For some landowners, that might include the possibility of leasing some of the property for oil and gas production.  But, what should be considered before entering into a lease?   This past May, David Pierce, Burke Griggs, Shawn Leisinger and I took our Rural Law Program to Dodge City, KS for a presentation.  David Pierce made a presentation on oil and gas leases, and I took some notes of his discussion for future use on the blog. 

Today’s post takes a brief look at what Prof. Pierce highlighted as some of the basic issues to be think about before entering into an oil and gas lease.  Any lack of clarity in the commentary below is mine.

Possible Strategies

Doing nothing.  It’s important to remember that when a landowner is approached about entering into an oil and gas lease that an acceptable strategy is to do nothing.  There is no obligation to lease in a state (such as Kansas) that doesn’t have a compulsory “pooling” statute.  But, while there is no obligation to lease, if the land is not owned outright by one person any cotenant has the power to develop, and authorize others to develop, without the consent of other cotenants.  If that happens, there is then a duty to account to other cotenants for their share of the net proceeds (production revenue minus all reasonable costs of drilling, completing, and operating the well).  Similarly, if one cotenant seeks to develop the minerals, that could give rise to another cotenant seeking a partition. 

Similarly, when parents leave a tract of land to multiple children, and the parents don’t hold the leasing rights for the benefit of others that may create a duty to lease.  The children end up with undivided interests in the entire tract.  This means that the children receive all of the surface rights associated with the tract plus an undivided percentage interest in the oil and gas rights, plus the right to execute oil and gas leases for all of the undivided interests in their tract.  That last point is key.  Each child will end up with the right to enter into any lease covering the oil and gas rights held collectively by all of the siblings.    

A related issue to that of a cotenant developing the property without the consent of other cotenants is that, for a proposed horizontal well, a lessee might seek to use another provision in state law to consolidate nonconsenting parties.  This can happen if a state has a compulsory unitization statute.   Kansas has such a statute, but it has never been tested in court.  On the other hand, Ohio has used its compulsory unitization statute to combine the acreage necessary to conduct horizontal drilling into a shale formation.

Doing nothing presently.  Another viable strategy is that the landowner may simply not enter into an oil and gas lease at the present time.  Perhaps the up-front bonus money is not enough to allow the landowner to hire an attorney that is well-versed in oil and gas law for representation in the negotiation process.  In any event, with this approach the landowner could gain strength in any future negotiation process.

Other Questions to Ask

Its also important for a landowner to understand who they are dealing with.  Is it the developer or an intermediary?  If the landowner is dealing with an intermediary, the intermediary will be looking to sell the lease and probably receive an overriding royalty in the lease.  That’s an important point.  The profit the intermediary retains upon selling the lease could have been the landowner’s if the deal is struck directly with the developer.

Also, it’s a good idea for a landowner to determine what the party seeking the oil and gas lease is planning for the landowner’s property and the nearby area.  When is drilling to begin?  Is there a formation that they are trying to develop?  Have wells already been drilled in that area?  Have wells been drilled elsewhere?  Have other local landowners already executed leases and, if so, how many acres are under lease?  What is being paid to other landowners in terms of a bonus and royalty rate?  Can the landowner get the best deal that is offered?  Will the developer match the best deal another developer offers?  What can be learned about the company that is investing in the development of the land that will be leased?

Standard Lease Form?

One basic principle of oil and gas development is that there is not standard form for an oil and gas lease.  See, e.g., Kansas Natural Gas Co. v. Board of Commissioners of Neosho County, 89 P.750, 751 (Kan. 1907).  Thus, all of the terms of an oil and gas lease are negotiable.  But, an oil and gas lease should address three general topics:  1) the rights granted by the lease; 2) the duration of those granted rights; and 3) the amount of compensation that the lessor will receive during the lease term.

Successful Negotiation

While the terms of an oil and gas lease are negotiable, a party to the lease will not be satisfied with the contractual arrangement unless certain key points are achieved.  The lessee (developer) wants exclusive development rights and associated use rights that are broad enough to allow the lessee to develop.  In addition, the lessee must have adequate time to conduct the operations required to extend the lease.  Also, the lessee must ensure that the leased land can be developed under existing law regulating oil and gas operations.  From an economic standpoint, once the lessee commits funds to develop the lease, the lessee needs to be able to maintain the lease in effect as necessary to fully enjoy the benefits of its investment.  In that same vein, the anticipated economic returns must be adequate to justify the risks involved.

From the lessor’s standpoint, it is important to receive an adequate financial incentive to part with the oil and gas and related surface rights.   The lessee also wants continuing control over the surface estate prior before electing to make use of the surface to develop the leased land.  Likewise, the lesssor wants continuing control over all other mineral and related rights not encompassed by the rights granted to the lessee.  The lessor wants the ability to easily determine when the lease terminates in whole or in part, and the ability to easily determine the royalty due.  It’s also important the lessor gets an assurance that as development progresses the impacted surface will be timely and properly reclaimed so it can be devoted to other uses.  Similarly, the lessor wants the assurance that any disputes will be determined locally where the land is located, and that the lessor is able to access local courts to address disputes.

The Bonus and Obligation to Lease

Some of the most important details of the oil and gas lease transaction are not reflected anywhere in the oil and gas lease.  Usually the lease contains a recitation similar to the following:

“Lessor, in consideration of      one       Dollars ($   1.00    ) in hand paid, receipt of which is here acknowledged . . . .”.  As that recitation indicates, the lease is presented as a unilateral grant by the lessor, and the lease is typically signed only by the lessor. 

As for what makes the agreement binding on the parties, a conveyancing analysis is used to bind the lessee applying the requirements of delivery and acceptance.  Likewise, some lessees still use a sight draft to create a situation where the parties may, or may not, be bound pending the lessee’s review and approval of the lessor’s title.  The sight draft can create problems if it is not clear whether a contract to lease, with performance conditions, has been created or whether no obligation exists because the lessee is not bound in any way.  This creates opportunities for the lessor in a rising leasing market and opportunities for the lessee in a declining leasing market.  Thus, it is best to avoid the situation by nailing down the moment when the parties become bound. Perhaps the best approach is for a landowner to remain unbound, and free to deal with anyone, up until the landowner has the bonus money in hand. This places the urgency on the lessee to close the deal quickly.

Conclusion

These are some basic initial considerations for a landowner to work through before entering into an oil and gas lease so that the best negotiated deal can be struck.  Useful information for those thinking about getting into an oil and gas lease.