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Thoughts on the Oil and Gas Lease

Last week I presented a paper at the Texas State Bar Advanced Real Estate CLE Conference for attorneys in San Antonio. I was asked to write a paper giving real estate attorneys a basic introduction to negotiating oil and gas leases. It might seem odd that real estate attorneys would want a primer on oil and gas leases; most people would assume that an attorney practicing real estate law in Texas would know about oil and gas leasing. And that used to be true, when the majority of attorneys had a rural general practice. General practitioners in Texas knew the basics of real estate and oil and gas law and often helped their landowner clients negotiate leases. Today, most real estate attorneys have little to do with oil and gas matters, and as practices have become more specialized the oil and gas specialty has diverged from the real estate specialty.

I was given thirty minutes to make my presentation – hardly enough time to do justice to the subject of oil and gas leases. The exercise of preparing my remarks caused me to focus on some basic concepts that I’ve not recently thought about, and I decided they would make a good topic for discussion here.

The oil and gas lease is in many ways a unique form of contract. It is the foundation of the oil and gas industry in the U.S. Because most minerals in the U.S. — unlike most of the world — are privately owned, some way had to be found for those willing to risk capital to exploit oil and gas to obtain rights to those resources. The oil and gas lease was the result. In its basic form, the oil and gas lease has remained unchanged since the early days of the industry.

The concept is simple: the mineral owner conveys the mineral estate in her land to the company that wants to exploit the minerals, for a term — a “primary term” of years, and a “secondary term,” for as long thereafter as oil or gas is produced. In that conveyance, the mineral owner reserves a cost-free interest in production – a royalty interest. The landowner thus transfers the risk and cost of development to the grantee, and retains a risk-free royalty interest in production.

The oil and gas lease is both a conveyance and a contract, and the law that has developed around the lease reflects both concepts. Its character as a conveyance has important consequences, and it is important for the landowner to understand those consequences, especially if the landowner owns both the surface and mineral estates. The mineral estate is the “dominant” estate, meaning that the owner of the mineral estate has the right, without compensation, to use so much of the surface estate as is reasonably necessary to explore for and produce oil and gas from the property. This basic idea is subsumed within the lease. The grantee in the lease acquires not only the mineral estate but also the right to use the surface estate for mineral development. This includes the right to build roads, lay pipelines, install production facilities, conduct seismic surveys, etc. And it includes the right to use groundwater for oil and gas exploration and production and the right to dispose of produced water and associated waste by drilling and operating injection wells on the property. All of these rights are implied in the grant of the mineral estate, and need not be specifically mentioned in the lease. If the landowner wants to restrict the lessee’s right of surface use in any way, those restrictions must be provided for in the lease. Absent such express contractual restrictions, the right of surface use is part of the bundle of rights granted to the lessee as part of the mineral estate.

An oil and gas lease is also a contract and enforceable as such. As the case law interpreting oil and gas leases began to develop, courts began to imply certain provisions into the lease, as a matter of contract interpretation. Courts considered that the lease imposed certain obligations on the lessee that were not expressed in the contract but were necessary in order for the parties to have the benefit of their bargain. These implied obligations are now well-recognized, and include the obligation to reasonably develop the lease and the obligation to protect the lease against drainage by wells on adjacent lands. Courts also created rules for construction of certain lease provisions. For example, leases remain in effect for a term of years and “as long thereafter as oil or gas is produced.” But what if there is a temporary cessation of production? Does the lease terminate? Faced with this question, courts developed the rule of “temporary cessation.” A lease will not terminate because of temporary lapses in production if the lessee acts diligently to restore production.

A body of law also developed around the construction of the royalty reservation in oil and gas leases. The royalty reserved in a lease is both an interest in the land – a real property interest that can be conveyed, devised, or gifted – and a contractual obligation of the lessee to make payments to the lessor. What does it mean that the royalty is “cost-free”? In Texas, courts have generally concluded that royalties are free of the costs of exploration and production but must bear their share of “post-production costs.” Again, this interpretation applies unless the parties provide otherwise in the lease agreement. How and when the royalty is calculated and paid is a source of much contention in the courts, largely because of the parties’ failure to adequately address the issue in the lease itself.

The law surrounding oil and gas leases continues to be a fascinating subject. As the technology of the exploration industry changes, new issues continue to arise and conflicts continue to result. But without this document, the oil and gas industry in the U.S. might never have been born.

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