Historically, mineral owners (“lessor”) and landmen/oil companies (“lessee”) spend most of their time focusing and negotiating the bonus payment, primary term and royalty provisions of an oil and gas lease. These provisions are important, but they represent only a small number of the critical elements of the lease. The following is a list and a general description of these and other provisions commonly included in an oil and gas lease.
Oil and Gas Lease Provisions Definitions
Consideration – Sets out the consideration (also referred to as the lease bonus) paid to the mineral rights owner. Most states require that consideration must be paid to validate the contract. However, historically, the actual consideration paid to the lessor remains confidential, as the lease usually describes it as “$10 and other valuable consideration.” Consideration is also called the bonus payment. A lease bonus payment is calculated on a $/acre basis, and paid to lessor at the time the lease is signed.
Granting – Transfers rights in the leased lands from the lessor to the lessee and describes the rights and activities allowed, such as exploring, drilling, conducting geologic and geophysical surveys, laying pipelines and building roads, just to name a few.
Description – Leased lands must be locatable and therefore properly described. Depending on the history of the lands (Original 13 colonies established by Great Britain, the Louisiana Purchase from France, Mexican or Spanish Cession, etc.), they can be described using the English Units of Measure, Metes and Bounds or Section, Township and Range and others.
Mother Hubbard – In the event there was a mistake made in the description, this provision provides that the lease will also cover lands owned or claimed to be owned by lessor if the lands are adjacent or contiguous to the described lands.
Habendum – This provision sets out the primary term of the lease. Usually described in number of years in which the lessee must either establish production or begin drilling operations before the lease expires.
Royalty – A portion of the proceeds from the sale of production which is paid monthly to the lessor. The royalty payment is usually described as a fraction such as 1/8th or 1/6th.
Shut-in Royalty – A gas well can be shut-in for many reasons. Shut-in commonly means the well is manually turned off due to reasons such as a pipeline needed to move the gas to market has not been completed or the price of gas has dropped to a point where it is temporarily uneconomic to produce. The shut-in royalty clause allows for the lessee to make a shut-in payment to the lessor in lieu of making a royalty payment.
Pooling - Forced Pooling allows the lessee to combine 2 or more leases together in order to meet the minimum number of acres required by the state regulatory authorities to drill and produce a well. For example, if the state requires 640 acres be allocated to the drilling of a gas well, but lessor only owned and leased 320 acres, the lessee can lease an adjacent 320 acres and pool both leases together to make a 640 acre pooled unit. Production from a well drilled anywhere within the 640 acres would be allocated equally to each of the 320 acre leases.
Delay Rental – Lessee has the option to either begin drilling operations during the first year of the primary term or pay a delay rental which would extend the lease into the following year. Lessee has the continued option to pay an annual delay rental each year during the primary term in lieu of drilling a well. If the delay rental is not paid, the lease will expire. The delay rental will not extend the lease beyond the end of the primary term. Lessee may also ask for the option to combine the delay rental with the initial lease bonus, which would effectively result in the lease being a paid-up lease.
Cessation of Production – If production from a well that has perpetuated the lease beyond the expiration of the primary should cease to produce, lessee shall have (usually) 120 days to commence operations for the drilling of a substitute well. And if the substitute well is completed as a well capable of producing in paying quantities, the term of the lease shall be extended for as long as the substitute well continues to produce in paying quantities.
Pugh Clause and Continuous Development – Many leases cover large properties. At the end of the primary term, a Pugh Clause provides for the lease to terminate as to un-drilled and/or non-producing portions of the leased lands. For example, if the lease covers 1,000 acres and the state regulations call for 640 acres to be allocated to a producing well, then the lease should terminate as to the leased lands outside of the 640 acres allocated to the producing well. The Continuous Development clause allows for the primary term to be perpetuated for as long as there are continuous drilling operations being conducted anywhere on the leased lands.
From the example above, a Continuous Development clause would allow the primary term of the 1,000 acre lease to be perpetuated as long as there are continuous drilling operations anywhere on the leased lands. Once drilling operations have ceased with more than 120 days elapsing between the completion of one well and the drilling of another well, the lease will terminate as to the leased lands which lie outside of a state regulated drilling and spacing unit containing a producing well. This will allow the lessor to lease these lands again.
Proportionate Reduction – In the event it is later determined that lessor owns less than 100% of the minerals or a smaller interest in the minerals than originally thought, lessee may proportionately reduce rental and royalty payments paid to lessor. Although there is a warranty clause in the lease that seems to guarantee a clear title, the lessee needs this provision in order to make payment adjustments.
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