What Should You Look for in an Oil and Gas Lease?
Posted October 29, 2019
You’ve been approached by an Exploration & Production (E&P) company about leasing your land for oil and natural gas drilling. You like the idea of leasing your minerals and making some extra money. But before you put pen to paper, you want to make sure the lease you’re signing covers all the bases.
The problem is, if you don’t work in the oil and gas industry, it can be hard to know what a “good” Oil and Gas Lease actually looks like. What are the bases you need to have covered? What are the details you should be paying attention to? What are the key points you should be negotiating?
As a company that purchases mineral rights, we always look at the leases landowners have previously signed to help determine the value of their minerals (a better lease equals higher future value for the royalties). So we know some things to look for in an Oil and Gas Lease. Here are a few of the most important considerations for landowners.
Three Things to Look for in a Good Oil and Gas Lease
When you sign a mineral lease deal with an E&P, here are three things you want to make sure you have:
1. Gross or Cost-Free Royalty Provision
The first thing landowners typically want to know with an Oil and Gas Lease is, “What’s my bonus amount? What am I getting paid right now?” That’s important, but that’s just a one time payment. The ongoing revenue stream is just as important—if not more important. You want to maximize your royalty percentage. But it’s not just about getting a high royalty percentage. You also want to limit the amount of fees taken out of your royalty. To do that, you either want a gross royalty or a cost-free royalty.
When it comes to royalties, E&P companies charge landowners to market and transport their gas. If you don’t have a cost-free royalty in your lease, you’ll see fees in your royalty checks for things like transportation, gathering, processing, and compression. What the E&P Company is doing is taking the gas to market to sell to an electric company or another entity, and sharing those costs with you.
Depending on what market they go to, those deductions can be pretty extreme. You’re not going to know what the actual fee looks like between the operator and the pipeline company taking it to market, you just know you have to pay a certain amount. And, in a lower price environment, you get less in royalties while paying the same amount in fees.
A gross royalty will decrease the amount that comes out of your royalty in fees. In this scenario, the E&P company pays all the costs necessary to get the product to the point of sale. With cost-free, you’re not getting charged any of those transportation, gathering, processing and compression costs or any post-production costs. This is why it’s the number one thing to look for in an Oil and Gas Lease.
With a typical Oil and Gas Lease in Ohio, the royalty percentage landowners receive is usually between 15-20%. If the E&P company won’t give you 20% cost-free royalty, it it better to get an 18% lease with a cost-free royalty (instead of 20% without it). It can make sense to take a little bit less if you can get a true cost-free royalty out of the deal.
2. Surface protection & Pugh Clause
The idea when you lease your minerals is that it will be a smooth process, removing what’s valuable deep below the surface while keeping your property relatively undisturbed. For the most part, that’s the way it works. But there are always those rare exceptions when things don’t go according to plan. If that should happen to your property, you want to make sure you are protected.
By having surface protections in your lease, you ensure that if your surface area is disrupted as a result of drilling, you get paid again. You would receive fees for any sort of damage taking place on the surface of your property. Your lease may also include other specific information related to the surface—such as where a pad site would go, if one was to be placed on your property.
Another important thing to look for in your lease is what’s called a Pugh Clause. A Pugh Clause basically says that all the acreage need to be developed within the term of the lease or the E&P company needs to pay you to extend the acreage that has yet to be developed. If the term expires without part of the property being developed, then they have to release that acreage because it wouldn’t be considered HBP, or held by production. Only the acreage HBP would be in the unit.
So, for example, you have 100 acres leased to an E&P company on a five-year lease and 50 acres are put into a pooled unit. With a Pugh Clause, if they don’t have that other 50 acres pooled into a unit within that five-year term, then they have to pay you to extend the undeveloped 50 acres for five more years. Without a Pugh Clause, they could say those 50 acres are HBP and they wouldn’t have to pay you.
3. Length of lease
Typically in Ohio, with all the operators, the standard length of lease is what’s called a “five plus five”. That’s a five-year lease with a five-year option to extend the lease. What that means is, if you sign it, the company has five years to get your minerals developed. If they don’t have it drilled and developed within five years, then they have to pay you again, a bonus consideration, to extend it for an additional five years. From that point, they have five more years to get it drilled. If it’s not drilled within that 10-year period, then the lease expires (and a company could lease it again if they wanted to).
As mentioned above, this is the standard length of lease in Ohio. But if you are in a position to reduce the length of your lease, you should. For example, you could try to shorten the option period, asking for a five-year lease with a three-year option; or even a “three plus three”. The company is probably not going to do that, unless they really need the lease. Just like anything, the more power you have in the negotiation, the more you’re going to get in the negotiation. It just depends on how badly that operator wants that lease.
How You Shape Your Lease Can Impact Your Ultimate Return
Before you sign the Oil and Gas Lease and grab that bonus, it’s always a good idea to think about the future. What looks good on paper today might not always look as good in practice tomorrow. It can definitely pay down the road to take the aspects discussed above into consideration when crafting your lease.
The details of your lease also might come into play should you ever decide to sell your mineral rights for an upfront sum. Gateway Royalty takes into account all the above factors when purchasing mineral rights. For instance, if you are losing 30%-50% of your royalty interest due to fees, that would lower any potential offer Gateway would make to you. This is another reason your lease might end up being more or less valuable than you initially think.
Whether you’ve leased your mineral rights and you’re thinking about selling your royalties for an upfront payment OR you haven’t signed a lease yet and you’re interested in selling your mineral rights—we can help. Talk to Gateway Royalty today.