Anatomy of a Gas lease: Part I

Deciding to lease your property for gas drilling may be the easiest step. Next you have to negotiate the wording of that lease. This article offers a basic lexicon of leasing.

A gas lease is a binding contract with you (the lessor) granting a company (the lessee) the right to extract gas — and possibly other minerals — from your property. Adults are considered competent to sign, and therefore a lack of knowledge provides no excuse to demand later renegotiation or termination of the lease. You could have to live with your lessee – and your deal – for decades.

The Interstate Oil (and Gas) Compact Commission wrote a model law that served as the basis for NYS Article 63, Oil, Gas, and Solution Mining Law, which regulates oil and gas leasing. This law was passed in 1963 and last revised in 2005.

There is no standard lease. All the terms of every clause are negotiable. The heart of the lease concerns the length of time it remains in effect. These sections are referred to as the habendum (Latin: to have) clauses. They can be added or deleted in their entirety, except for the clauses that must be part of any lease for the company to extract gas legally.

These clauses are: primary term, secondary term, identification, granting, pooling and royalty or payment terms.

The Primary Term is the definite number of years that a lease remains in effect if no production begins. Some leases substitute operations for production, in which case necessary operations should be listed. Typically, leases run for two to ten years, but a lease may allow for an option to renew for a second two to ten years. In the Barnett Shale of Texas, three years is typical, whereas in the Marcellus Shale of Pennsylvania, five years is typical.

A Secondary Term provides that a lease remains in effect for an indefinite time: as long as production or shut-in payments continue. Again, as some leases substitute operations for production, necessary operations should be listed. Secondary term can also be extended through dry-hole or cession-of-production clauses. (See box at right)

The other necessary clauses are:

Identification includes: date that the lease begins, name of the land owner (lessor), name of the company (lessee), town & county, tax map number, boundaries (metes and bounds), neighboring properties, and acreage. By tradition, a well is named after the landowner. For example Grant 6 in Franklin was drilled in 2003 on land owned by David Grant, off Gay Brook Road.

Granting typically grants rights to explore, drill, produce, measure, and market oil and gas. Some leases substitute minerals for oil and gas, and if so, those should be specified. Unless specifically excluded, the right to use as much surface as is reasonably necessary is an implied covenant.

Pooling: A company may combine or pool some or all of your property with adjacent properties to form a spacing (drilling) unit. Your royalty payment then would be proportional to the area of your property in the unit. For example, if your royalty is fifteen percent on a third of the acreage in a drilling unit, then your share of gas from that well would be five percent.

Payment terms: The lease first presented by a landman (the boiler plate offer) contains clauses and terms that are most favorable to the company. It is remarkably short because much is unsaid but accepted as settled interpretation, such as implied covenants. A lease more favorable to you would have many more pages explicitly protecting your interests. New York State does not protect you by regulating the content of leases, except to require that the royalty fraction is, at minimum, a one-eighth share or 12.5 percent.

The body of a lease consists of the clauses that involve payment to you. The numbers there are referred to as deal terms.

The signing bonus is a one-time payment, typically calculated on a per acre basis. This bonus is paid at signing (“in hand paid”), but the amount is rarely included in the lease. For decades, bonuses paid in this area have been in the tens of dollars per acre, but recent bonuses in Hancock have been in the thousands. In Texas, where production from the Barnett Shale has been proven, bonuses can be over $20,000 per acre.

Delay rental is an annual payment, after the first year, if the drilling of the well has not begun. In effect, it is a penalty on the company for delaying drilling. Delayed rental is paid until operations begin or the lease expires. Typically it is one dollar to fifty dollars per acre per year. Nonpayment should terminate the lease. To avoid this, the entire rental can be paid in advance in a paid-up lease.

A surface use fee is a payment for the use of your property, if granted. It should provide for compensation of any damages to the property.

The royalty is the fraction of the value of the gas that will be paid to you. (Royalty has its roots in medieval law as the King’s share from the use of his property.) In the Hancock area, they are as high as fifteen percent, and for wells in the Barnett Shale of Texas, as high as twenty-six percent. Commonly your royalty is paid on gas at the wellhead, and therefore all downstream costs are deducted from the sale price. If this is the case, these post-production costs should be listed; for example: dehydration, compression, transportation, additional processing, and marketing. These costs can be ten to fifteen percent of the price. The royalty can also be based on proceeds (sale price), market value (tricky to calculate), or in kind (landowner sells his share of gas). Timing, method of payment, and penalties for nonpayment should be specified. The lease should allow for your access to the company’s records and books. (New York State makes no attempt to verify production figures — unlike any other state). Some leases require a minimum royalty, which discourages a company from maintaining a marginal well to keep a lease in force. For producing wells, royalties are many times greater than the signing bonus, making this clause the most important, economically.

A shut-in royalty is a payment if the company does not sell the gas once the well is completed – for example, if a pipeline is not available or if the price of gas is low. This should be for a limited period. Like the delay rental, nonpayment should terminate the lease. You should receive an amount similar to that for delay rental, but wells are rarely shut-in for long. A storage fee is rental for the underground storage of gas pumped down the well.

Leasing your property for gas drilling is a gamble, and if carefully negotiated and monitored, the clauses and terms of the lease can improve the odds of a good outcome. This article is informative and not a substitute for competent legal advice.

This is the fifth article in a series on gas extraction.