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OIL AND GAS LEASE -- Introduction

All parties to an oil and gas lease view development as the ultimate goal. To this end, provisions in a lease should permit the oil company freedom to carry out an efficient exploration, drilling, and development program. However, this freedom should be tempered by the interests of the mineral owner.

A sample of a general oil and gas lease can be found on the North Dakota State Land Department’s Mineral Management website:  Sample of Oil and Gas Lease.

A note of caution: the contents of this web page discuss traditional lease provisions. Modern leases may vary these traditions to a considerable degree, so careful review of a lease by knowledgeable legal counsel is ESSENTIAL to gain a complete understanding of a particular lease form.

Most modern company-offered oil and gas leases can be divided into several parts: 1) “Habendum” or duration clause and possibly a delay rental clause; 2) Granting, warranty, and lesser-interest clauses; 3) Royalty clause and Bonus Payment; 4) Savings clauses; and 5) Other clauses.

1) HABENDUM CLAUSE (DURATION OF LEASE)

Oil and gas leases are generally divided into two separate time periods: the primary term and the secondary term:

Primary Term

The first period, or primary term, is the maximum number of years that the company has to decide whether or not to explore and drill for oil or gas. Generally, this term should be short—from one to three years (e.g., see paragraph 1 of the State lease where the primary term is five years). 

In general for a lease to be extended beyond the primary term, the company must be producing oil or gas that is attributable to the leased tract or, as discussed below, engaged in operations related to drilling on the leased tract or on a unit that includes a portion of the leased tract. Otherwise, the lease will ordinarily terminate at the end of the primary term (e.g., see paragraph 3 of the State lease).

Production Defined

Generally, production (i.e., a producing lease) is defined as actual production in “paying quantities” over a reasonable period of time. In other words, the company must, over a reasonable period of time, earn a profit after deducting current operating expenses and marketing costs.   The company may not be interested in operating a marginal well whereas the mineral owner may feel that any royalty payment is better than no payment.  Accordingly, there can be times when a company and a mineral owner may not agree on whether production from a well justifies operation.  In those situations, it may be a legal issue as to whether the company is obligated to operate a marginal well, that is, whether the well is producing a paying quantity.

Mineral owners will point out that paying quantities does not require a profit over and above the sunk costs of exploration, drilling, and completion. Thus, a well may produce in paying quantities by producing only a few barrels of oil per day. Indeed, about 30% of onshore oil production in the United States comes from “marginal” wells (i.e., wells that produce 10 or less barrels of oil per day). In a small minority of states (North Dakota is not believed to be among them), production in paying quantities does not mean actual production, but only capability of production.

The State lease in North Dakota refers to “commercial quantities” (e.g., see paragraph 1 of the State lease).

Secondary Term

If production in paying quantities is established, the lease will continue into its secondary term. Generally, the applicable clause may read, "This lease will remain in force and effect for a term of [3] years and as long thereafter as oil or gas produced” (e.g., see paragraph 1 of the State lease).

Delay Rental Payments

For the privilege of delaying the start of the drilling during the primary term of the lease, the lease may provide for the payment of a delay rental during the primary term. The amount of delay rental is usually nominal (e.g., $1.00 per mineral acre) and is generally paid annually during the primary term but only if a well has not been “commenced”. Because primary terms in modern leases are often short (e.g., 1 to 3 years), many leases do not provide for delay rentals or expressly provide that all delay rentals have been prepaid as part of the bonus. If the lease primary term is short (e.g., 1 to 3 years) and if the acreage leased under a single lease is kept small (e.g., 160 acres) (see below), negotiating for delay rentals should be a low priority.

Recommendations

A mineral owner should carefully consider the following recommendations:

1. Keep the primary term as short as possible as this encourages early exploration. Generally, do not sign a lease with a primary term exceeding three years. In actively developed areas, a one year primary term or even less is sufficient.
2. If the lease contains a delay-rental clause, be sure that it provides that the lease will automatically terminate without further action or requirements if the delay rental is not properly paid.
3. In general, assuming a short primary term, do not insist on delay rentals. Other provisions are more important to negotiate than delay rentals.

Above all, recognize that an oil and gas lease is potentially long term. It may last for decades -- even long after the mineral owner has died.

Next Pages

Mineral Lease -- Introduction and Habendum clause

Mineral Lease -- Granting clause

Mineral Lease -- Royalty clause

Mineral Lease -- Saving clauses

Mineral Lease -- Other clauses and Closing Thoughts

Last Updated July 30, 2010

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