Lease clauses

Published on: January 28, 2011

The Importance of Audit Rights in Oil and Gas Leases: Shell v. Ross

I always counsel my clients to provide in their oil and gas leases that they have the right to inspect and copy all documents of the lessee necessary to determine whether royalties have been paid correctly, and to audit the records of the lessee to confirm accurate payment of royalties. Royalty owners generally assume that the royalty payments they received have been calculated and paid as required by their leases. This is not always the case, as illustrated by a recent case, Shell Oil Company SWEPI LP v. Ross, 2010 WL 670549 (Tex.App.-Houston [1st Dist.], decided February 25, 2010. The case illustrates typical schemes used by producers to underpay royalty owners, and their efforts to prevent royalty owners from knowing how royalties are calculated and, when the royalty owners discover the underpayment, to prevent royalty owners from recovering the underpayment.

In Shell v. Ross, the trial court and Houston Court of Appeals held that Shell had underpaid royalties due to Ross. Shell has appealed to the Texas Supreme Court. The Texas Supreme Court refused to consider the case, but Shell has filed a motion for re hearing that is still pending. Other producers are very interested in the case: friend-of-the-court briefs have been filed by Chesapeake, Texas Oil & Gas Association, and the American Petroleum Institute asking the Court to reverse the Court of Appeals.

The facts of the case require some explanation but illustrate well the importance of verifying the correct calculation of royalties.

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Published on: October 15, 2010

Chesapeake Sued in Oklahoma For Underpayment of Royalties in Barnett Shale Wells

By John McFarland

A royalty owner in the Barnett Shale has sued Chesapeake in Oklahoma federal court for failure to properly pay royalties. The suit, Robyn Coffey vs. Chesapeake Exploration, L.L.C. and Chesapeake Operating, Inc., Civil Action No. CIV-10-1054-C, was filed on September 27 in the U.S. District Court for the Western District of Oklahoma, in Oklahoma City. A copy of the complaint can be viewed here: Coffey v Chesapeake.pdf The plaintiff seeks to bring the case on behalf of all royalty owners in the Barnett Shale formation, as a class action.

The plaintiff alleges that Chesapeake “employs a scheme” to reduce royalty payments by selling the gas to its wholly owned subsidiaries at a price “substantially less than either the market value at well or the amount actually received by Chesapeake Operating.”

The royalty clause in the plaintiff”s oil and gas lease is unusual. It provides for payment of royalties based on the “market value at the point of sale,” but not less than “the actual amount realized by the Lessee.” The clause says that all royalty paid to the lessor “shall be free of all costs and expenses related to the exploration, production and marketing of oil and gas production from the lease including, but not limited to, costs of compression, dehydration, treatment and transportation.” Most gas royalty clauses provide that gas royalties will be based on “the amount realized by Lessee, computed at the mouth of the well,” or similar language.

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Published on: June 30, 2010

Use of Fresh Water for Fracture Treatment of Horizontal Wells in Shale Plays

By John McFarland

A major issue in shale plays is the use of underground supplies of fresh water to fracture-stimulate the well. Horizontal shale wells are fracture-treated with fresh water to which various chemicals are added, and huge volumes of fresh water are needed. A 5,000-foot lateral horizontal well will use up to seven million gallons of fresh water. Depending on the availability of underground water at the lease, the operator’s use of that resource could have a substantial adverse impact on the landowner’s subsurface water supply.

The impact of fracing in the Barnett Shale was a subject of study by the Texas Water Development Board in 2007. The TWDB concluded that 89% of the water supply for the region of the Barnett Shale field was supplied by surface water sources, and that groundwater used for Barnett Shale development accounted for only 3 percent of all groundwater used in the study area. In East Texas, underground water is more plentiful and using it to frac wells may not place a strain on aquifers. But the Eagle Ford Shale is generally in a more arid part of the state where surface water supplies are more scarce and underground water is a more precious resource. Where the mineral owner also owns the surface estate, attention needs to be paid to the impact of mineral development on underground water supplies.

Companies have developed recycling methods to re-use frac water, which have been tested on an experimental basis. Devon has reported that it has been able to recycle a small percentage of the frac water used in its Barnett Shale wells and in the last three years has recycled nearly 4 million gallons. One obstacle is cost. It was reported that it costs about 40 percent more to recycle the water than to dispose of it by underground injection. Devon has said that its cost of recycling water in Barnett Shale wells is $4.43 per barrel, vs. $2 to $2.50 per barrel for typical water disposal into an injection well. Devon said that less than 5% of Devon’s revenue goes toward the cost of handling flow-back water. For a good article on recycling frac water, go to this link.

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Published on: June 10, 2010

EOG Resources Proposes Temporary Consolidated Field Rules for Eagle Ford Shale

By John McFarland

EOG Resources has filed an application with the Texas Railroad Commission proposing the adoption of temporary field rules for wells drilled in the Eagle Ford Shale in South Texas that could have a significant impact on thousands of oil and gas leases in the field. The application proposes to consolidate 27 designated fields that produce from the Eagle Ford Shale formation, and the proposed rules will replace any field rules previously adopted for those fields. The consolidated rules would apply to Eagle Ford Shale wells drilled in Railroad Commission of Texas Districts 1, 2 and 4. A copy of the notice of the Railroad Commission hearing for the adoption of the proposed rules may be found here:
eagle ford field rules.pdf. The hearing is scheduled for June 25, 2010, at 9 am in the William B. Travis Sate Office Building, 1701 Congress Avenue, Austin. Persons wishing to participate in the hearing must file a notice of intent to appear at least five working days in advance of the hearing date and serve a copy of the notice on the applicant and any other parties of record. More information can be obtained by calling the Office of General Counsel of the Railroad Commission at 512-463-6848.

Field rules are adopted by the Railroad Commission to govern the spacing of wells in a field. They specify how far wells must be from each other, how far wells must be from the nearest lease line, and how much acreage must be assigned to a well in order to obtain a permit to drill a well. The acreage assigned to a proposed well is known as a “proration unit.” Well spacing and density rules were developed by the Commission after it was given jurisdiction over oil and gas operations in Texas in the early days of the oil industry, principally because of unregulated drilling in the East Texas Field. Because of unregulated drilling in that field, wells were being drilled that were not necessary for the efficient development of the field, and oil prices plummeted. The Commission was also given authority to “prorate” production from a field — that is, to limit production, and to allocate or “prorate” the specified limit of production from a field among the wells in a field. The stated purposes of spacing and density rules are to avoid waste and protect the correlative rights of producers in the field. Theoretically, field rules should designate a size for proration units that approximates the amount of acreage in the field that can be efficiently drained by a single well.

The field rules proposed by EOG would provide:

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Published on: May 29, 2009

Continuous Operations Clauses in Oil and Gas Leases

By John McFarland

As landowners have become more sophisticated in their negotiations of oil and gas leases, they have begun to insist on the inclusion of a “continuous operations” or “continuous drilling” clause in their leases. The idea behind such clause is that the lessee should have a reasonable time to fully develop the leased premises, after which the lessee should release that portion of the leased premises not necessary for the production of the wells it has drilled.

There is no “standard form” of continuous operations clause. Generally, a continous operations provision should address the following:

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