When negotiating and drafting oil and gas leases, understanding the basic framework that governs these agreements is essential. While there is no true “standard” lease, the primary areas and considerations of an oil and gas lease are discussed below.

Oil and gas leases are contractual agreements between a mineral rights owner (the lessor) and an oil and gas company (the lessee), giving the lessee the right to explore, drill, and produce the resources from the property. The leases are created so that the property owner can maintain their mineral rights while simultaneously leasing their land to the oil & gas company. Below, we explore some key components of an oil and gas lease and how these contracts are constructed.

Key Steps

The process begins with identifying potential drilling prospects and negotiating terms between the lessor and lessee. These negotiations focus on royalty rates, the duration of the lease, and the lessee’s operational obligations. Once the basic terms are agreed upon, the lease is drafted to include essential clauses that define the rights and responsibilities of both parties.

Defining Rights and Obligations

A typical oil and gas lease grants the lessee the exclusive right to explore and extract resources while outlining the lessor’s entitlement to royalties from production. The lease typically specifies two time periods: a primary term, during which the lessee must commence exploration or production drilling activities, and a secondary term, which remains in effect as long as production continues in paying quantities. The lease also establishes a royalty payment structure to compensate the lessor for the minerals extracted. The specific share of production received by the lessor and other interest holders may be finalized in a division order, a separate document that is distinct from the lease and typically executed after production begins.

A standard lease includes several key clauses that define the rights and obligations of both parties. These clauses ensure that the lease functions effectively and protects the interests of both the lessor and the lessee. Below are some of the most common clauses found in a typical lease:

Key Clauses in Oil and Gas Leases

1. Granting Clause: Defines the rights granted to the lessee, including the right to explore, drill, and extract the resources from the leased property. This clause may also specify the geographic and geological limits of the lease.
2. Primary Term Clause: Specifies the initial term of the lease, typically a minimum of three years. During the primary term, the lessee is not obligated to produce minerals but retains the rights granted by the lease. In most cases, the lessor’s guaranteed payment during this period is a one-time upfront bonus payment.
3. Habendum Clause: Defines the overall duration of the lease and controls the transition from the primary term to the secondary term. The secondary term remains in effect as long as production continues, ensuring the lease remains valid while the lessee produces minerals and pays royalties to the lessor.
4. Royalty Clause: Specifies the percentage of production revenue paid to the lessor. Royalties are typically calculated based on gross proceeds or market value and may include provisions addressing deductions for post-production costs.
5. Delay Rental Clause: Allows the lessee to maintain the lease during the primary term by paying periodic delay rental payments to the lessor if drilling has not commenced.
6. Shut-In Royalty Clause: Permits the lessee to pay a nominal royalty to maintain the lease when a well is temporarily shut-in due to lack of a market or other operational factors.
7. Pooling and Unitization Clause: Grants the lessee the ability to combine multiple tracts of land into a single production unit, optimizing resource recovery and complying with regulatory requirements.
8. Assignment and Release Clause: Outlines the lessee’s rights to assign or transfer their interests to another party, often subject to the lessor’s approval, and the conditions under which the lease may be voluntarily relinquished.
9. Force Majeure Clause: Protects the lessee from liability if unforeseen events, such as natural disasters or regulatory changes, prevent fulfillment of contractual obligations.
10. Termination and Surrender Clause: Defines the conditions under which the lease may be terminated or surrendered due to non-compliance, lack of production, or voluntary release.

What Do I Get?

Royalties are often the most significant factor when signing an oil and gas lease. These payments provide mineral rights owners with a percentage of the revenue generated from the sale of extracted resources. Simply put, royalties are monthly payments that landowners receive when oil or gas is produced and sold from their property. The royalty clause (mentioned above) specifies this percentage, ensuring that the lessor benefits financially from ongoing operations. These payments are calculated based on either gross proceeds or market value, providing consistent income as long as production continues.

In addition to royalties, mineral owners can also benefit financially through initial bonus payments. A lease bonus is an upfront payment made to the property owner shortly after the lease is executed. Bonus payments serve as an incentive to encourage owners to enter into the lease agreement. Unlike royalties, bonus payments are guaranteed regardless of whether production occurs. Even if no minerals are ever extracted, the lessor retains the bonus payment, ensuring at least some compensation for agreeing to the lease.

Addressing Operational Flexibility

Leases often include provisions that allow the lessee to maintain control over operations through clauses (mentioned above) like pooling and unitization, which enable the combination of multiple tracts for more efficient resource recovery. Additionally, shut-in royalty clauses provide flexibility when wells are temporarily inactive, ensuring the lease remains valid.

Adapting to Changing Circumstances

To protect both parties from unforeseen events, a force majeure clause may be included, temporarily suspending obligations in cases of natural disasters or regulatory changes. Similarly, termination and surrender clauses define the conditions under which the lease may be voluntarily relinquished or terminated due to non-compliance or lack of production.

Finalizing the Lease

After drafting, the lease undergoes a thorough review to ensure state and federal regulations compliance. Both parties must agree to the final terms, and the lease is then executed and recorded to formalize the agreement.

Conclusion

A well-constructed oil and gas lease serves as the foundation for a successful partnership between mineral owners and operators. By carefully negotiating terms, defining clear rights and obligations, and incorporating essential clauses, both parties can protect their interests while maximizing the value of the resources. Ensuring compliance with regulatory standards and addressing potential challenges through thoughtful provisions helps maintain the stability and longevity of the lease. Ultimately, a properly constructed lease paves the way for efficient operations and sustained financial benefits for all stakeholders.

The professionals of Mercer Capital assist clients with various valuation needs in the upstream oil and gas industry in both conventional and unconventional plays in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  Contact a Mercer Capital professional to discuss your needs in confidence.