CHAPTER 11 BEYOND THE STANDARD LEASE FORM SELECTED OIL & GAS LEASE ISSUES
| Jurisdiction | United States |
(Nov 2004)
BEYOND THE STANDARD LEASE FORM SELECTED OIL & GAS LEASE ISSUES
Watt Beckworth Thompson & Henneman, L.L.P.
Houston, Texas
Richard D. Watt was a founding partner of the Houston firm of Watt, White & Craig, and was with that firm until 1990. He is a founding partner of Watt Beckworth Thompson & Henneman, L.L.P., where he practices general civil litigation and oil and gas, with an emphasis on oil and gas litigation. He is currently a member of the council of the State Bar of Texas Oil, Gas and Energy Resource Law Section, and additionally, actively participates in both oil and gas and ranching pursuits.
Dick earned a B.A. in 1969 and a J.D. in 1972 at the University of Texas.
He is a member of the Houston Bar Association; American Bar Association; State Bar of Texas; and Phi Delta Phi Fraternity. He has been an Author/Speaker at numerous legal and oil and gas industry related seminars
Selected papers/publications: "Application of Discovery Rule In Oil and Gas Litigation: 1995 Update -- The Plaintiffs' Perspective," Advanced Oil, Gas and Mineral Law Course (State Bar of Texas, 1995); "Drainage From A to Z," 12th Annual Advanced Oil, Gas and Mineral Law Institute (State Bar of Texas, 1994); "Judicial Process for Evaluating Producing and Non-Producing Oil and Gas Properties," Austin Geological Society and Travis County Bar Association and endorsed by the State Bar of Texas, Environmental Law Section (1994).
I wish to thank my colleagues Brad Moody, MaeLissa Brauer Lipman, and James Thompson for their input and assistance in this endeavor, and also to thank Pennebaker - LMC of Houston, Texas for providing the graphic found at the end, that illustrates many of the concepts discussed.
When I was asked to present this paper on the biggest problems confronting a landowner and an oil company when they negotiate an oil and gas lease, I was flattered to be asked, because apparently it was thought that I might address these problems understanding the position of both sides, and perhaps even offer solutions.
Whether or not I provide solutions, I have practiced law for 32 years, and have represented numerous land owners and oil companies, in both the negotiation of leases and the litigation of their terms. I own working interests and have participated in the drilling of numerous wells, and I also own royalty in wells. I own surface where I own no minerals, and minerals where I own no surface. Of course, none of this makes me objective, but I do think, right or wrong, that I have at least thought about both sides' view on most major issues.
Having explained my background, I intend to discuss my view of the most difficult issues that I see in lease negotiations between sophisticated parties -- the real "deal-breakers." In doing this, I will ignore the business points, like how much bonus or how much royalty, but will recognize that these certainly push the negotiations. I will also omit mention of many lease clauses, recognizing that all of the clauses are important, but I want to focus on what I view as the most difficult issues to resolve, both in coming to an agreement, and drafting language that fully and completely expresses that agreement.
Obviously, my choice of topics is subjective. Some of my choices are predictable enough -- for example, the royalty clause, while others may seem less obvious -- like the assignment clause -- but for me hold special importance, as will be explained.
In discussing these, I will rely primarily on Texas law, because that is my background, but will sometimes comment on the law of other jurisdictions, when I understand it, and believe it helpful.
Finally, with that said, it should be obvious that the importance and weight given to these issues should be proportional to the importance and economic potential of the proposed lease. Said shortly, a lease from a mineral owner who owns no surface covering an undivided 1/10th mineral interest under a 10 acre tract in East Texas will not deserve the level of attention, at least in terms of lawyer time, that would be expended on a 10,000 acre ranch in South Texas or Colorado, with extensive surface value and improvements, that overlies a potential 400 bcf gas field.
1. The Royalty Clause
The single most difficult provision in an oil and gas lease is the royalty clause, and understanding some of the difficulties requires a look back in time.
Royalty was originally viewed as an expense free interest, with the landowner getting the smaller fraction. Instead of buying the minerals to drill -- which would have eliminated any requirement to pay royalty -- oil companies and landowners developed a system where the oil companies would "lease" the land, and for the privilege would generally pay bonus money, and agree for the oil company to pay an expense free royalty.
Because this royalty was expense free, it was a small fraction, usually 1/8th. The lessee got 7/8ths, recognizing that it would bear all -- 100% of 8/8ths -- of the risk, financial and otherwise. The agreement to pay the landowner the small fraction grew out of recognition that the landowner took no risk, while the oil company took all risks.
But this arrangement further assumed that these two parties would share the fruits of the enterprise, if any, in the agreed ratio of 7/8ths and 1/8th. This assumption -- that the royalty owner and the oil company, except as to costs, were in the same boat -- was the cornerstone of implied covenant law. Because of this, early on the courts held that the lessee was not obligated to act as a fiduciary towards the lessor, but instead held that the lessee was required to act only as would a reasonable and prudent operator considering the interests of both lessor and lessee, because if it acted in this manner, and both parties held the same interest, then this level of conduct would protect both parties. 1
But as times changed, so did the oil and gas business, particularly as to transporting, treating and marketing oil and gas. This was especially true as to gas, at first considered worthless, as gas became increasingly valuable after World War II. As a result, the U.S. Supreme Court decided in 1954 that the Natural Gas Act of 1938 allowed the Federal Power Commission (now the Federal Energy Regulatory Commission, or FERC) to regulate the wellhead price of gas that was sold into interstate commerce. 2
But the price of gas sold in intrastate commerce remained not regulated, and as shortages of gas developed, and demand increased, the unregulated intrastate price naturally increased in value, while the regulated interstate price stayed capped at a low, regulated price.
Until that time, which occurred in the mid-to-late 1960s and 1970s, most people generally assumed that the "market value" of gas was simply what a willing buyer would pay a willing seller.
During this same period after 1945, an infrastructure of pipeline systems evolved, where oil companies would produce gas and sell it to gas pipelines. Once the gas was bought by the pipeline, the oil company would be paid, and would pay royalty on that price, and the pipeline, having bought the gas, would in turn act as a merchant, and sell the gas to its eventual end-user.
When early gas...
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