The Fundamentals of Oil and Gas Leases in Texas

Oil and Gas Leases

The oil and gas industry remains a staple of the Texas economy. Property owners who own mineral-rich land often lease the oil and gas rights to a company able to produce those resources. Property owners in turn benefit from a royalty interest in the oil and gas production from the producer (the lessee). The lease itself is a contract which also conveys the mineral estate. Without the ability to lease rights to oil and gas, the industry itself could not exist in Texas.

Components of a Lease

In order to be legally binding, the lease must include three components: a description of the land, the term of the lease, and the royalty reserve for the lessor. The description of the land being leased should be a legal description which provides enough information to identify the property fully and accurately.

The term of the lease must be clearly defined and separated into two parts, the primary term and the secondary term. The primary term is for a fixed time period, frequently defined by the number of years that a lease will last. If the lessee is unable to find oil during that primary term, the lease will end after that time period. The secondary term becomes effective if the land produces oil and gas, and the term lasts as long as the land continues to produce.

The final component of the lease is the royalty interest in production. The lessor will receive a percentage of the value of or the proceeds of the production. The royalty also acts as interest in real property, so it can be conveyed to another person. Typical royalty interests range from one-eighth to one-fourth.

Common Lease Provisions

In addition to the three required components, many common lease provisions are available which provide greater flexibility for the lessor and lessee. For example, in addition to the royalty interest, the lessor may receive a bonus for executing the lease, the amount of which is rarely defined in the lease. Taxed as regular income, the bonus is the number of dollars per net mineral acre, determined by multiplying the landowner’s interest by the number of leased acres. For example, one-tenth of the mineral interest in one hundred acres of land means that the lessor owns ten net mineral acres.

Another common provision is a delay rental, which is the amount that a lessee pays during the primary term to keep the lease active if the land is temporarily not producing oil. Although not as commonly used today, the delay rental is an annual fee which the lessee pays in order to keep the lease from expiring. Currently, lessees are opting to pay in advance instead of signing a delay rental. Lessees frequently pay an extra sum in order to have a three-year lease, which is “paid up,” meaning the fee to keep the lease in effect is paid at the time the lease is executed. Frequently a paid-up lease offers the option to extend the lease for an extra two years as well.

Because landowners don’t always own 100% of their mineral rights, a proportionate reduction is another common lease provision. In that case, the lessor is entitled to a proportionate amount of the mineral rights, usually phrased as, “If this lease covers less than half of the oil and gas in the leased premises, then the royalties and other sums provided herein be paid to lessor shall be proportionately reduced.”

Provisions are also available to keep leases in effect when land temporarily stops producing, called temporary cessation.” Ridge Oil Co., Inc. v. Guinn Investments, Inc., 148 S.W.3d 143 (Tex. 2004). While the provision was intended to reduce litigation by keeping a lease from expiring unnecessarily, it has resulted in more litigation as parties determine how many days a temporary cessation should actually last.

Another provision written to keep a lease from ending when operations are disrupted is the shut-in royalty. If a lessee is unable to sell the product, perhaps due to market demand for example, the lessee can keep the lease in effect by making an annual payment, in effect paying for oil production that year and keeping the lease active.

Pooling is another lease provision that has grown from the need to adapt leases to reflect oil and gas production needs. Due to overproduction of oil, the Texas Railroad Commission determined that well spacing was necessary, that is regulating the number of wells on a piece of property and the amount of oil or gas that each well produces. Sometimes, however, the space allowed for a well is not sufficient for that well to produce the monthly allowance of oil for that area. As a result, some areas are pooled together in order to meet the requirements for well spacing and oil production. Lessees then pay royalties based on all or part of the leases for a pooled unit. Limited to only specific depths, a pooled unit is created by requesting a designation which describes the boundaries of both the unit and the leases being pooled together. The Pugh clause is actually an amendment to the pooling clause, which has become extremely popular with lessors. It allows for greater control over production of pooled units when not all leased areas are included in a pool unit.

According to Vest v. Exxon Corp, and Montfort v. Trek Res., Inc., the landowner or the lessee of that land has to right to use as “much of the surface estate as is reasonably necessary to explore for and extract oil and gas.” Known as a surface use provision, it allows a company to use and adapt the land to facilitate the production of oil and gas. Using water from the land, installing roads, pipelines, or other equipment would all fall under this type of clause. Unless the lease includes specific limitations on land use, the landowner must allow the lessee to adapt the surface area to meet the needs of production. Getty Oil Co. v. Jones, 470 S.W.2d 618 (Tex. 1971). Texaco Inc. v. Farris, 413 S.W.2d 147, 149 (Tex.Civ.App.-El Paso 1967, writ ref’d n.r.e.). Lessees who use the surface area in a way that is “reasonably necessary” are also not required to compensate the landowners for damages, unless the lease provides for compensation.

With the increasing use of hydraulic fracturing and horizontal drilling technology, some landowners are adapting leases to allow greater control of and compensation for surface area use. A lease may specify how and where a lessee may access a tract of land, and it may ask for compensation for water use, especially with hydraulic fracking, which uses substantial amounts of water.

Oil and Gas leases are central to Texas business and law, allowing the successful production of minerals for producers and property owners. As the technology has become more advanced and as landowners have become more aware of potential issues, provisions for these leases have become more sophisticated. Working with an oil and gas lawyer is a critical part of ensuring success.

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