Just What Is An Oil & Gas Lease?
Oil and gas production has existed in Ohio since the early 20th Century. Indeed, the entire industry as we know it was essentially born in Northwestern Pennsylvania with the famous Drake Well in 1859. The legal documentation that gets this process underway today is largely unchanged for over one hundred years, with some minor variations from state to state but pretty much the same everywhere in the United States. This process stands upon the legal principle that a landowner owns the land in question “ad coelom et ad infernos”, which is an ancient Latin phrase which loosely translates that ownership is “up to heaven and down to hell”. Thus, any oil and gas found directly below the surface is also owned by the owner of the surface. In limited cases, the ownership of the underlying minerals is sold separately with its own chain of title different than the title of the surface, but that is rather unusual in Ohio so we will ignore that situation for purposes of this article.
The first relevant question is where do producers of oil and gas think that they might find oil and gas in the ground, meaning both where on the surface they might drill a well and how deep to drill into a particular geologic formation below the surface where the oil and gas is situated. This is more science than art, but is not a perfect process, although modern techniques have greatly reduced the risk of making the wrong guess. Producers make their determination of where to drill and then approach the landowner(s) of the land in question. The owners, especially in Ohio, are typically farmers (or other large rural landowners) with parcels large enough to allow a well to be drilled far enough away from buildings to comply with spacing laws and to not interfere with the landowner’s farming or other surface operations.
The producer then approaches the landowner with a document entitled “Oil & Gas Lease”, which allows the producer access to the surface of the land for the purpose of drilling down below the surface to try to find oil and gas. It is a bit curious to call this document a “lease” since it doesn’t contain many of the same characteristics of a traditional lease of, say, an apartment or a retail store in a shopping center. In some senses it is more of a “purchase” of the oil and gas, and in many regards it is more of a “contract” than a traditional real estate document. But “lease” is the traditional terminology throughout the United States.
Such leases in Ohio typically contain the following provisions:
- Signing Bonus. This is a dollar amount payable to the landowner upon signing the lease. Historically, this was a very modest amount, sometimes as little as $100, or perhaps $100 per acre of land leased. More recently, for wells anticipated to be large producers, found typically in Eastern and Southeastern Ohio, the signing bonus could be as much as $5,000 per acre of land leased.
- Royalty. This is expressed as a percentage, typically of the gross revenue generated from the sale by the producer of either oil or gas or both, and is the amount paid to the landowner as consideration for the lease. Historically, this was always 1/8 of the gross revenue. More recently, for well anticipated to be very productive, found typically in Eastern and Southeastern Ohio, the royalty could be as much as 20% of the gross revenue. In addition, some leases permit the landowner to take a limited amount of “free gas” for residential use, typically for home heating. The rest of the gross revenue goes to the producer and others who may have invested in the drilling expense, and they hope that the remainder of the gross revenue is enough to i) recoup the cost of drilling the well, ii) cover the costs of operating the well, including the eventual cost of plugging it some day when the oil and gas runs out, and iii) make a profit. A dry hole is an economic disaster, a successful well very lucrative for the producer. And if the producer does well, so does the landowner.
- Acreage Leased. The lease document must specify just what land is included. Typically it is the entire acreage owned by the landowner, but not always. Ohio law specifies that oil and gas leases must include a minimum number of acres per well drilled. That acreage minimum will vary depending primarily upon the anticipated depth of the well to be drilled. For example, many wells require at least 20 acres to support the drilling, others perhaps 40 acres, and the very recent shale formation wells which include horizontal drilling deep under the surface can require hundreds of acres. But whatever the producer needs must be expressly stated in the lease document. It is permitted and very common for the producer to then combine that leased acreage with other adjoining leased acreage in order to obtain the minimum required total. Modern wells in the shale formations found in Eastern and Southeastern Ohio are typically drilled horizontally once the drilling gets down about a mile under the surface, in which case all of the land above these spider web extensions must be leased. Sometimes a recalcitrant landowner can be forced to participate if everyone around has otherwise agreed to lease terms.
- Surface Rights. The lease will indicate what, if any, rights the producer has to traverse upon the surface of the land in question. For older wells, typically the producer had extensive rights to conduct operations on the surface, but not always as some leases are “non-drilling” leases, which means that the producer could access the oil and gas below the land but not use that landowner’s surface. Obviously the producer would have to have access to the surface somewhere, so a non-drilling lease would make sense only in connection with one or more adjoining leases which did allow surface operations. And even when the landowner permits the use of the surface for drilling activities, the specifics of such surface impacts can be negotiated and included in the lease document, including such things as the specific location of the drilling rig activity, the location of fluid storage ponds required during drilling, the location of storage tank batteries on the property after drilling, the path of pipelines, the obligation to restore land impacted during drilling, and other such limitations on surface usage. Ohio law imposes other limits regardless of what the lease states, such as a requirement to be a certain distance away from dwellings, public buildings, roadways and the like.
- Landowner Obligations. Typically a landowner has virtually no obligations under an oil and gas lease. That is, other than allowing the producer to try to obtain the landowner’s oil and gas below the surface, the landowner has no other duties. On occasion, a landowner might also be an investor in the cost of drilling the well, but that is the exception and not the rule, as normally the landowner is not required to spend a dime to drill or produce the well. Rather, the producer bears the entire cost of drilling the well, which could vary greatly depending primarily upon the depth of the well, with hundreds of thousands of dollars being common until recently and now many millions of dollars being required.
- Term. Most oil and gas leases have a “primary term”, which is typically a year or two, within which the initial well anticipated to be drilled must be started. The lease will then provide that the term will be extended longer, with the phrase usually being “so long thereafter as oil or gas is found in paying quantities.” The term “paying quantities” is often disputed in its applications, but generally means that there is enough oil or gas being produced and sold to at least keep covering the operating expenses. This is sometimes disputed today when a landowner, for example, might want to cancel an older lease, in order to sign a newer and more lucrative new lease, by arguing that the well drilled pursuant to the older lease is no longer economically viable and thus not producing in “paying quantities”. Sometimes a court must resolve this issue, but typically it is pretty obvious. But at some point, every lease will come to an end, even if perhaps many decades later.
- Plugging Obligation. All oil and gas wells will eventually run out of oil and gas. It could be a long time, as there are wells still producing in Ohio which were drilled many decades ago, but it’s “when” not “if”. Ohio law requires that such wells be “plugged” at that time, which means that the hole drilled down into the ground must be filled with cement and thus prevent any migration of other fluids up or down that hole. Sometimes a lease will address this obligation with some detail, although often it is not addressed and the parties simply look to the legal obligations under state law to address this. The plugging obligation is on the producer, although that can become a problem when the producer has gone out of business, in which case the state may step in and fund the plugging obligation, which can be as much as $25,000 or thereabouts just for an average vertical well.
So, how does the farmer or other land owner, who likely has never dealt with such an issue before, negotiate with a producer who does this every day? How does a group of landowners join together for better bargaining power? How does the landowner know what is a good deal? There is only one good way to do that, and that is to hire a lawyer who is experienced in dealing with such negotiations. The producers on the other side are no longer the local folks, but rather we now see companies like Shell and BP here in Ohio. Be a smart landowner and go to the negotiation armed with good counsel. The oil and gas attorneys of CCJ are on the leading edge throughout the state of Ohio in such representation.