Basic Terms of an Oil and Gas Lease

Basic terms of an oil and gas lease- Almost all oil and gas leases follow the same basic format. The oil and gas lease cannot be compared to an ordinary apartment or real estate lease because they are not at all alike. Basically, the oil and gas lease permits the operator the right to explore for and produce petroleum. The landowner's rights consist mostly of the right to receive money. He receives three kinds of payments:

• A bonus
• Delay rentals
• Royalties

The landowner is paid a one-time payment of a bonus when he signs the lease, which he keeps whether a well is ever drilled. In exchange for the bonus the operator has the right for a limited period called the primary term to drill for petroleum. If the primary term is for more than one year and the operator has not yet drilled a producing well, he must pay at the end of each year of the primary term a delay rental to extend the lease for another year.

The lease may not be extended beyond the primary term by the payment of delay rentals, but if a successful well is drilled the lease is automatically extended so long as oil or gas is produced. In other words, when a successful well is completed the lease will last for as long as that well or any other well produces, and no delay rentals, which are a payment for the privilege of delaying drilling must be paid.

Once the well is producing, the landowner is entitled to a royalty of a certain percentage of production. In the past, one-eighth of production has been the standard royalty. This royalty is paid free and clear of all costs of drilling and all costs of production. The operator and his investors then own the other seven-eighths of production. This percentage is called the working interest. The working interest differs from the royalty in that:

1. It must pay' all costs of drilling and all costs of production even though it is composed of only seveneighths of the revenue.
2. Those that receive it control all drilling and production decisions.

If the operator has sold 75% of his interest to outside investors, then what he has sold is 75% of the seven-eighths working interest, and he has retained 25% of the seveneighths working interest. The royalty holder has only the passive right to payment after the oil is produced. You should be aware that the one-eighth royalty is traditional, but that amount, like all terms of the lease, is negotiable and may be higher if the land is highly desirable (but is rarely lower than one-eighth).

The lease contains many provisions that may be.of concern to the consultant, including a description of the surface area, the drilling location, surface damages, and perhaps specifications for restoring the surface. The lease may specify or restrict the use of water found on the premises for drilling mud, and it may limit access to the drill site to certain roads or entrances. The lease may even require the operator to build a road at his expense that becomes the property of the landowner. Most importantly, it may provide for early termination of the lease if drilling is not begun by a certain date, making the drilling schedule highly critical.

See Also: A Typical of Oil and Gas Transaction

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