A Big Firm Moves In; Landowners face new types of shale leases

Pittsburgh Post-Gazette
11 December 2011
By Erich Schwartzel and Elisabeth Ponsot,

OHIO COUNTY, W.Va. -- In its rapid ascent to become a top leaseholder in the Marcellus Shale, Chesapeake Energy came to West Virginia and put into play a strategy designed to narrow landowner rights and expand company control over all phases of the drilling cycle.

The Oklahoma City-based energy giant absorbed the region -- which sits above the natural gas rock formation -- in just a few months, driving down landowners' bargaining power, and in some cases preventing leases from expiring, locking landowners into those contracts indefinitely.

Chesapeake Energy moved into Ohio County through a quiet 2010 land swap with Range Resources -- unknown even to the landowners whose property rights changed hands.

Analysts on Wall Street and dairy farmers in this area now see the same thing: One powerful firm suddenly overtook the leases, and the rules of the game immediately changed.

A Pittsburgh Post-Gazette examination of hundreds of West Virginia leases signed between 2006 and 2011 revealed new lease practices that drastically changed the terms for landowners:

• Many leases were secured through land swaps (two companies exchange a lease) and flipping (a company sells a lease to another firm) that weren't publicized by the companies or announced to the landowners. In several cases, the same lease in Ohio County had four leaseholders or partial leaseholders in five years.

• Chesapeake, like other companies, turned to foreign firms and multinational conglomerates to fund the upfront costs of acquiring leases. The result is that multiple companies can have an interest in a single rig, potentially further complicating business dealings for landowners.

• Chesapeake has taken advantage of its ability to create "units," in which dozens of individual properties can be legally joined into one giant property. The practice complicates individual lease agreements and royalties because drilling operations on just one property in a unit locks all landowners into their current agreements. In West Virginia, sometimes just one property owner in the entire unit sees a royalty check, even if gas is extracted from underneath several plots of land.

• Longer leases presented by Chesapeake are written in greater detail to favor driller rights. These leases often include simultaneous agreements to allow pipelines and compressor stations on the property, as well as agreements that specify all of the post-production costs that may be deducted from leaseholder royalty checks.

• Finally, Chesapeake has used an expanded definition of the "force majeure" clause -- typically used in contracts to denote unforeseeable, catastrophic events that hinder production -- to extend lease terms, sometimes indefinitely, for new reasons that go far beyond the "acts of god" traditionally included in such clauses. Now, restrictive local regulations or a lack of transportation equipment may be grounds for a "held lease" -- one that the company continues to operate under past its expiration date.

A new company in town

Though the land swap in Ohio County was unannounced, Chesapeake's presence in the community came fast.

Farmers couldn't get lime for their land this spring because no trucks were available. The Ohio County Clerk's Office set up a dozen card tables in the hallway to accommodate overflow from gas representatives scouring deed books. The landmen who negotiate leases arrived in cars with phonebook-filled backseats, promising millions.

When Chesapeake workers showed up to survey properties in Ohio County, some landowners accused the crews of trespassing, saying they had signed with Range Resources. What they didn't know was that their leases had been swapped with Range for land in southwestern Pennsylvania.

Neither driller was required by law to notify the leaseholders of the change, which they say is an everyday occurrence.

"There are probably hundreds if not thousands of landmen putting together deals and selling them to companies big and small," said Matt Pitzarella, spokesman at Range Resources.

Sometimes the swaps and deals are between independent landmen and regional companies. Other times they're internal transactions, such as when Range
Resources absorbed a stake in the Great Lakes Energy Partners firm that secured leases across the Marcellus.

The leases also go from small, local companies into huge, multi-national firms playing catch-up to establish Marcellus dominance overnight, such as when Chevron purchased 4,400 acres from Brecksville, Ohio-based AB Resources earlier this year in another transaction.

"They don't publicize it a whole lot," said Kit F. Pettit, an attorney in Pittsburgh who specializes in representing landowners. "Sometimes it occurs on a piece-by-piece basis, sometimes on a much larger basis -- certainly there is a trend toward lease swapping."

William A. and Beverly B. Fluty first leased their 96-acre Ridge Runner Farm in Ohio County to Great Lake Energy Partners in 2006 for $960 per year.

"Since then everything kind of melded together into Chesapeake," said Mr. Fluty, 81.

First the lease was turned over to Range Resources in 2008.

Range swapped the Fluty lease with Chesapeake Energy in 2010, which in turn sold a one-third stake in its Marcellus acreage as part of a joint venture with Statoil of Stavanger, Norway.


Rapid acquisition

Chesapeake's portfolio includes nearly every shale play in the country, but those rapid-fire acquisitions create an imbalance: significant upfront costs for leases and a limited supply of equipment to drill and make money from the land.

The company spent nearly $275 million for leases in the past three years alone, and has said it is acquiring nearly 1,000 acres per working day in the mid-Atlantic Utica Shale region (Utica is a formation located deeper than the Marcellus).

The elbows-out approach is nothing new to Chesapeake, and indeed helped it win many admirers over two decades as it grew from a 10-person firm to a
global energy giant with more than 10,000 employees. But critics are wary of what they see as Chesapeake overstretching.

"Management's approach reminds us of a children's book titled, 'But I Waaannt It!' aimed at getting kids to realize they can't have everything they want," said Philip Weiss, an analyst at Argus Research, in a November paper urging shareholders to sell Chesapeake stock. "We think it would be better if management would show greater discipline and reduce its asset appetite."

To help finance the shale acquisitions, Chesapeake turns to foreign and domestic firms.

Statoil of Norway has its stake in Marcellus. BP of London owned partial Chesapeake holdings in the Fayetteville Shale in Arkansas before the company divested the play from its portfolio. For the Barnett Shale in Texas, the company teamed with Total S.A. of Courbevoie, France. And Chesapeake's holdings in the Eagle Ford Shale of South Texas are partially owned by the China National Offshore Oil Corp. of Beijing.

Mr. Fluty follows news of the joint ventures in the Wall Street Journal from his West Virginia farm and offered his advice for the firm as it courts other companies.

"If you want to get married, you want to have the right partner," he said.

Unitization

As Chesapeake and other companies flip leases and bring on new stakeholders, they are also rearranging the holdings they have -- joining several properties into a singular, odd-shaped unit that is treated as one giant property.

This "unitization" pools properties based on seismic testing that measures for sweet spots of natural gas. Gas companies say the practice minimizes surface impact and allows them to extract gas under multiple properties from a single rig.

But the units can stretch to 1,280 acres, pooling together several different kinds of properties and treating them as one.

When drilling activity on one property starts, all properties within the unit are considered "active" and therefore locked into current leases, including those on the verge of expiration. Those landowners then have no chance to renegotiate their leases or to discontinue the contractural relationship with the company.

In its most recent annual report to shareholders, Chesapeake said its "leasehold management efforts" included "scheduling our drilling to establish production in paying quantities in order to hold leases by production."

Chesapeake denies unitization is aimed at holding leases that would otherwise expire. The company did not make senior officials available for an interview, but issued a statement attributed to Stacey Brodak, Chesapeake director of corporate development.

"Pooling or unitization is a tremendously beneficial provision that enables lessors to share in development to which they would not otherwise be entitled," said Ms. Brodak.

The Fluty lease that traded back and forth over the past five years is now part of a Chesapeake unit with 28 leased properties. The units' borders cross Marshall and Ohio counties, and contain property owned by Elm Grove United Methodist Church and a Salvation Army in Sandhill, W.Va.

Unitization can complicate royalty payments. A 2010 Pennsylvania Supreme Court case ensured all landowners in a unit are proportionately compensated, but West Virginia law provides no such guarantee.

Instead, lease holders in West Virginia must have specific provisions in their lease that give them the right to receive royalties from their unit's drilling.

In a case where that isn't spelled out, only the property owner who houses the rig would be guaranteed royalty payments.

Top leases

By 2011, Chesapeake had become a dominant driller in Ohio County. The firm presented new agreements called "top leases" to landowners whose original contracts with Great Lakes or Range were soon to expire.

Some leases offered thousands of additional dollars per acre, and an 18 percent cut on royalties -- which would reflect current market conditions.

But they also often included terms that gave the driller more latitude.

Mr. Fluty, who was now a widower, signed a new lease with the company and bought 1,000 Chesapeake shares.

"I'm a land lessor and a stockholder," he said. "It's hedging my bets."

Under the new lease, Chesapeake could include Mr. Fluty in a unit of its design, and had the right to "change the size, shape, and conditions of operations or payment of any unit created."

Some Chesapeake top leases include language that extend the lease to other parts of the drilling life cycle, allowing for compressor stations, pipelines or storage facilities. Compressor stations in particular are seen as much more disruptive than a drilling rig because they are noisy and permanent.

Other leases allow Chesapeake to deduct post-production costs such as compression, transportation and equipment expenses from royalties, shifting some of the company's costs to the landowner.

The companies must specifically say which costs are being taken from the royalties, said Brian S. Wheeler, a Virginia attorney who's written articles on post-production costs in royalty payments.

Chesapeake's new top leases also safeguard against political conditions that might delay drilling.

"Force majeure" is typically a clause that allows companies to put a hold on leases in the event of an unforeseen situation, such as a destructive hurricane or workers' strike.

Now, leases allow companies to declare force majeure on any cause "not reasonably within [the company's] control." This includes strict local ordinances or moratoriums, or a lack of infrastructure like pipelines to take the gas to market.

By declaring force majeure, a company puts a hold on a lease, which can stretch a lease's terms (and expiration date) by months or years. And unless successfully negotiated otherwise, the leases contain no time limits for how long a company can invoke force majeure and lock a lease in place.

"It's possible that you will see companies claim force majeure because they believe they cannot drill within that township," said Mr. Pettit.

The issue is sure to play out in Pennsylvania, where communities continue to pass local regulations that have been called overly restrictive by gas companies.

And where Chesapeake holds thousands of leases.

Erich Schwartzel: eschwartzel@post-gazette.com or 412-263-1455. Elisabeth

Ponsot: eponsot@post-gazette.com or 412-263-1497.