What to Look for in Oil and Gas Leases

Washington PA Observer Reporter
30 May 2010

Editor's note: This is the second in a series of articles about legal issues surrounding drilling for natural gas in Southwestern Pennsylvania.

By James H. McCune

For more than 100 years, the oil and gas industry has used the oil and gas lease as the primary method of entering into an agreement with a landowner to explore for and produce oil and gas. The oil and gas lease has evolved over the years, and the advent of Marcellus Shale development has prompted additional changes and refinements to the lease.

Here are some of the more common provisions in the modern oil and gas lease, and some issues that affect landowners:

1) The Habendum Clause. The oil and gas lease typically remains in effect for a "primary term," that is, a specific number of years (for example, five years), and then continues indefinitely, provided that certain conditions are met. The terms of the lease usually provide that the lease continues indefinitely, provided that there is a producing well on the property. Sometimes the lease contains language that permits the lease to remain in effect for other reasons, for example, as long as the lessee is "taking steps" to develop a producing well, or "making efforts" to develop a producing well. Unless care is taken to negotiate language requiring a producing well to keep the lease in effect, the lease can sometimes remain effective longer, even though no producing well is ever developed.

2) What is covered by the lease. Virtually all oil and gas leases grant to the lessee far more than simply the right to drill for oil and gas. The typical lease also grants to the lessee many additional rights, including the right to build roads; to install pipelines of various sizes (which under certain circumstances can remain in effect indefinitely even if the lease expires because no well is drilled); to install utility lines; to install compressors and condensers; to conduct seismic testing; and to build retention ponds. Depending on the size and location of an individual parcel of land, the lessee might be willing to accept a "non-surface" lease, in which the lessee is granted no rights to use the surface of the land for any purpose.

3) Unitization or pooling. This clause grants to the drilling company the right to group or pool the lessor's land with other adjoining parcels of land in order to create a large "unit," which might consist of several hundred acres or more. These large units are necessary in order to drill the deep horizontal wells into the Marcellus Shale. These wells descend vertically from 5,000 to 9,000 feet, and then send out horizontal "laterals," as far as 6,000 feet or more. These modern well sites often contain multiple well heads, and multiple laterals. These laterals are parallel, and if seen from a bird's eye view would resemble a giant pitchfork.

Often a parcel of land is already the subject of a producing shallow oil or gas well which has been in place for several years. The companies seeking to develop wells in the Marcellus Shale will purchase the old lease from the original lessee. Many of the older oil and gas leases do not contain unitization or pooling language, and are of limited use to a drilling company that wants to develop a large unit so that horizontal drilling can take place. Sometimes the large drilling company will approach the landowner and ask him to sign a simple addendum or supplement to the old lease, which would then allow pooling with other land. This is in the interest of both the owner of the oil and gas rights, who stands to gain a royalty income stream, and also the drilling company, which can now put together a large unit for development. However, make no mistake about it: What the drilling company needs is of value to it, and it should compensate the owner of the oil and gas rights fairly for the supplement to the lease.

4) Storage. Some oil and gas leases contain provisions permitting the owner's land to be used to store gas. This is common in the northeastern United States, where pipelines transporting gas from other areas cannot keep up with the demand for gas in the winter, and stored gas is drawn down. The gas used from the storage field is replenished in warmer weather.

Storage fields must be carefully described and meet certain geological specifications so that the gas does not leak or migrate out of the storage field. Storage fields must be permitted by the Federal Energy Regulatory Commission. The existence of a storage field usually does not affect the exploration for the deep gas of the Marcellus Shale because the storage fields are located much closer to the surface.

5) Warranty of title. Many oil and gas lease forms contain language whereby the land owner/lessor "warrants title to the oil and gas, and agrees to defend the same. ..." This means that the owner of the oil and gas rights is promising by contract that he or she really does own the oil and gas, and if it later turns out that the lessor actually does not own the oil and gas, and therefore had no right to enter into the lease, then in theory, the drilling company could hold the lessor financially responsible for any economic harm the drilling company might suffer. Most of the drilling companies will agree to remove this provision, because they realize that most lessors really don't know for sure whether they own the oil and gas rights or not.

Most of the drilling companies will accept, in place of the warranty of title, an "affidavit of non-production." This is a sworn statement of fact, given by the lessor, whereby the lessor states under oath that he or she has not received any royalties or other payments from any source, there have been no surface operations, and that to the best of his or her knowledge and belief, there is presently no producing oil and gas lease in place.

The single most important factor for the owner of oil and gas rights in deciding which company to sign with is: How likely is this company to successfully develop a well or wells and pay royalties? here are many companies competing for the right to lease your oil and gas. Making the right decision requires a careful analysis of many factors. Has this company successfully developed deep horizontal wells in Washington County or elsewhere? Does this company have sufficient land under lease to create a workable unit? Does this company or its affiliates have sufficient capital to make the necessary financial investment?

James H. McCune is a partner in the law firm of Bassi, McCune & Vreeland, which is a member of Washington County Energy Partners.