Negotiating an Oil and Gas Lease

Negotiating an Oil and Gas Lease

Oil and gas leasing is a complex area. The landowner wants to monetize and be paid for the resources on their property, while the oil company wants to maximize its profits and ensure a steady supply of products. Oil and gas leases often require extensive negotiations between the two parties. It is essential to get legal help from an experienced oil and gas attorney before you sign any oil or gas lease agreement. Here are some things that may come into play when negotiating an oil and gas lease.

In oil and gas leases, several key terms need to be considered:

  • Bonus – The owner of the mineral rights gets a one-time upfront payment when the lease is signed
  • Primary term – The amount of time the lessee has to drill the initial well
  • Royalty fraction – The percentage of the revenue the lessor will receive (in addition to paying all costs of production) – the fraction is usually somewhere between an eighth and a quarter
  • Delay rental – If the drilling is delayed, the mineral rights owner may be paid an annual payment until the well is drilled
  • Shut-in royalty – The payment the lessee may make to keep the lease in force when they have not yet successfully drilled a well
  • Depth clause – The driller is only allowed to drill to a certain depth, as specified in the agreement because without limits, a driller would be entitled to all the oil or gas in the well

Price is Only Part of an Oil and Gas Lease

The price paid for the oil or gas under a lease agreement is only one consideration. Many landowners may get caught up in price negotiations without considering other major factors. In the end, a landowner wants to maximize the value of the oil or gas on their property while protecting their financial interests. In addition, they also want to preserve the value of their land beyond simply extracting the resources.

Although there are terms that are commonly part of leases, keep in mind that all of the above terms are negotiable. Landowners have bargaining power in the deal, and they do not need to accept terms handed to them by larger companies. They may negotiate with multiple parties to secure the best deal.

There will likely be many money or payment issues aside from price that must be addressed between a lessor and lessee. For example, the lessee may incur post-production costs that can be significant. They may want to pay royalties based on a price that reflects the investment they must make to treat or transport the oil or gas. Most major oil companies will use leases that are calculated at the “mouth of the well,” meaning they can deduct post-production costs from the amount on which they pay royalties. There have been recent court cases that have held that lessees do not have to pay for the use of oil and gas from the wells “off-lease” to support their production when the use was supported by the language of the lease.

The larger the parcel of land involved, the more issues the parties may encounter. For example, the lessee will not want to lease the entire parcel when only certain parts of it may contain oil or gas. Once they drill and determine which parts of the land contain oil or gas, they would release the rest of the land to the lessor.

Eliminate as Many Ambiguities as Possible in an Oil and Gas Lease

There may be numerous ambiguities that can lead to difficulties and litigation between the parties. It is in both parties’ best interests to define as many terms as clearly as possible when negotiating an oil and gas lease and to account for as many contingencies as they can. The landowner should read all terms carefully, especially knowing that oil and gas companies enter into many leases and they and their legal counsel likely have superior knowledge.

Many leases are not as cut-and-dry as the lessee simply paying a portion of the oil or gas that it extracts. The parties should account for various possible situations in their leases, such as when a well begins to produce less oil or gas and the royalty payments to the lessor decrease. Also, the lessor often suffers a decrease in the value of their property from drilling operations on their land while they continue to own the surface estate. At a certain point, they may not make enough money from their mineral and gas rights to make leasing them worthwhile, but they may still be locked into a lease.

Finally, one major issue in every oil and gas lease is a potential indemnification provision. The lessee is undertaking activities on the lessor’s land over which the lessor has no control. The lessor could find themselves legally liable in the event the lessee is negligent. Thus, a lease agreement may include some form of indemnification for the lessee, even though courts do not always favor indemnification provisions.

The Parties Should Know Who They Are Getting Into Business With

Landowners negotiating an oil or gas lease are partners in some way with the lessee. The better the lessee does, the more the landowner makes in royalties. From the landowner’s perspective, they should do their due diligence on the lessee before executing a contract. Leasing the land to the wrong person can cost money and can lead to legal problems. The two parties will be in a contractual relationship for many years. The lessor should know the true identity of the lessee and understand their experience and track record of success. Before signing any oil and gas lease contract, a lessor should do extensive research on their counterparty.