OIL AND GAS LEASES 101 - TexasBarCLE and Gas Leases 101 Chapter 1 2 defer drilling a well for a stated period. The typical delay rental clause provides for a delay rental to be

OIL AND GAS LEASES 101

by MATTHEW CARSON COTTINGHAM (“COTTIE”) MILES

bank of america plaza,25th floor 300 convent street san antonio, texas 78205 tel: (210) 227-7591

fax: (210) 227-7924

State Bar of Texas

NUTS AND BOLTS OF OIL, GAS AND ENERGY RESOURCES LAW

September 24, 2008 Houston

CHAPTER 1

MATTHEW CARSON COTTINGHAM (“Cottie”) MILES

BIOGRAPHICAL INFORMATION EDUCATION B.A. in Politics, 1994, Washington and Lee University, Lexington, Virginia

J.D., 1997, Texas Tech University of School of Law, Lubbock, Texas

PROFESSIONAL ACTIVITIES

Partner, Martin & Drought, P.C., San Antonio, Texas Board Certified in Oil, Gas & Mineral Law, Texas Board of Legal Specialization Board Certified in Commercial Real Estate Law, Texas Board of Legal Specialization Editor, State Bar of Texas Oil, Gas and Energy Resources Law Section Report, 2008 - Present Council Member, State Bar of Texas Oil, Gas and Energy Resources Law Section, 2006- Present Chairman, Natural Resources Section, San Antonio Bar Association, 2003-2006 Fellow, San Antonio Bar Foundation, 2002 - Present Member, Rotary Club of San Antonio, 2004 – Present

LAW RELATED SPEECHES AND PUBLICATIONS

Author, Water Wars: A History of the Edwards Aquifer Water Crisis, 6 S.C.ENVT’L. L.J. 213 (1997).

Author, A Statutory Lien with an Attitude, Real Estate, Trust and Probate Newsletter (October 2004).

Speaker/Author, State Bar of Texas 2004 Advanced Oil, Gas & Energy Resources Law Course, The Vacancy Hunter And The Landowner – Do Opposites Really Attract?

Co-Author, So Your Client Thinks He Wants to Buy Only the Surface, State Bar of Texas Oil, Gas and Energy Resources Law Section Report (December 2006).

Oil and Gas Leases 101 Chapter 1

i

TABLE OF CONTENTS

I. INTRODUCTION....................................................................................................................................................1

II. MINERAL ESTATE VERSUS SURFACE ESTATE............................................................................................ 1

III. ESSENTIAL LEASE CLAUSES ........................................................................................................................... 2 A. The Granting Clause....................................................................................................................................... 2 B. The Habendum Clause.................................................................................................................................... 2 C. The Delay Rental Clause ................................................................................................................................ 2

IV. OTHER LEASE CLAUSES ................................................................................................................................... 3 A. The Royalty Clause ........................................................................................................................................ 3 B. The Mother Hubbard Clause .......................................................................................................................... 3 C. Principal Savings Clauses............................................................................................................................... 3

1. The Shut-In Royalty Clause ................................................................................................................... 3 2. The Operations Clause............................................................................................................................ 4 3. The Dry Hole Clause .............................................................................................................................. 4 4. The Cessation of Production Clause....................................................................................................... 4 5. The Force Majeure Clause...................................................................................................................... 4 6. The Breach Clause.................................................................................................................................. 4

D. The Pooling Clause......................................................................................................................................... 4 E. Administrative Clauses................................................................................................................................... 5

1. The Warranty Clause .............................................................................................................................. 5 2. The Proportionate Reduction Clause ...................................................................................................... 5 3. The Equipment Removal Clause ............................................................................................................ 5 4. The Surrender Clause ............................................................................................................................. 5 5. Lease Memorandum Clause ................................................................................................................... 5 6. Assignment Clause ................................................................................................................................. 5 7. Free Use of Oil and Gas Clause.............................................................................................................. 5

V. DATE OF LEASE AND PARTIES........................................................................................................................ 5

VI. A BRIEF SUMMARY OF IMPLIED LEASE COVENANTS .............................................................................. 6

VII. TOP LEASES.......................................................................................................................................................... 7

VIII. CONCLUSION ..................................................................................................................................................... 7 APPENDIX A - Producers 88 Form - Paid Up............................................................................................................... 9 APPENDIX B - Producers 88 Form - Delay Rental ..................................................................................................... 11

Oil and Gas Leases 101 Chapter 1

1

OIL AND GAS LEASES 101 By: M. C. Cottingham Miles

Martin & Drought, P.C. San Antonio, Texas

I. INTRODUCTION An oil and gas lease is not really a lease; instead,

it is a determinable fee interest in land. See Stephens County v. Mid-Kansas Oil & Gas Co., 254 S.W. 290 (1923). The interest conveyed is considered a determinable fee because the estate may be terminated and returned to the grantor by certain contingencies or failures. Today's oil and gas leases are often referred to as an "unless" lease. The oil and gas leasehold estate terminates unless (i) a delay rental is paid, (ii) there are operations or production within the time specified, or (iii) there is a shut-in gas well and shut-in royalties are paid pursuant to the terms of the lease. Because the execution of an oil and gas lease creates an interest in land, it is subject to the formalities of the Texas laws of conveyancing which are found in Sections 5.001 to 5.043 of the Texas Property Code. Thus, the lease must be in writing, and acknowledged or sworn to in order to be filed of record. It also must contain words of conveyance and describe the land with sufficient particularity. In construing a lease, Texas courts follow the “Four Corners Rule” whereby parol and extrinsic evidence are not used to clarify the lease unless there is an ambiguity which cannot be solved within the four corners of the instrument. See Rutherford v. Randall, 593 S.W.2d 949 (Tex. 1980). The bottom line is that if a provision is not in an oil and gas lease except for the implied covenants discussed below, the terms of the lease and the rights of the lessor and lessee spelled out therein, control.

Both the land owner and the oil and gas lessee will benefit from the discovery, production, and sale of oil and gas; however, their interests are not always the same. The lessee, whose interest is solely in minerals, must bear all costs of exploration and development. The lessee traditionally seeks the greatest flexibility possible for its operations under the lease; therefore, it wants the right to drill, but it does not want any obligation to do so. The lessor, who at times owns also the surface, has an expense-free interest in the oil and gas, and he typically wants immediate drilling and rapid development which do not interfere with his current or prospective surface uses. Most negotiation over the terms of an oil and gas lease centers on these two differing concepts.

There is no such thing as a standard or statutory oil and gas lease. However, a typical producer oriented lease is known as the Producers 88 form. I have included two versions of the Producers 88 – a paid up form and a delay rental form so that you may see the various clauses discussed in this article as set

forth in the lease. Be advised that if you represent the lessor, you do not want your client to sign this form without an addendum providing more favorable provisions such as a vertical and horizontal release provision, a surface use provision (if applicable), a pooling limitation provision and a shut-in royalty limitation provision. I will always recommend for attorneys representing clients with significant mineral interests the use of a lawyer generated lease so that you simply skip the Producers 88 form. However, if you represent a producer, you should do everything you can to use this form with no lessor generated addendum if possible. The bottom line is that while Producers 88 form is used quite often, it is by no means standard, and if representing a lessor, you should exercise caution with any such form. That said, the example forms attached to this article are sufficient to merely show examples of the clauses discussed below.

II. MINERAL ESTATE VERSUS SURFACE ESTATE Before reviewing the various clauses of an oil

and gas lease, it is important to consider the surface estate and the mineral estate as an oil and gas lease is a severance with a possible reversion to the lessor, thus, a determinable fee. In executing any oil and gas lease, regardless of whether you represent the lessor or the lessee, it should be noted that the mineral estate is dominant as the surface estate is subject to an implied easement of surface use by the mineral estate owner to use as much of the surface as is reasonably necessary to carry out the intended purposes for mineral extraction under the lease. See Texaco, Inc. v. Farris, 413 S.W.2d 147 (Tex. Civ. App.—El Paso 1967, writ ref’d n.r.e.). An accommodation doctrine exists in connection with the use of the surface by the mineral estate owner; however, a discussion of same is beyond the scope of this article. Please review other articles regarding the accommodation doctrine, including So Your Client Thinks He Wants to Buy Only the Surface, State Bar of Texas Oil, Gas and Energy Resources Section Report (December 2006), by M.C. Cottingham Miles and Ryan M. Sweeney.

For representation of the landowner, the economic benefits of leasing are mainly limited to three points: bonuses, delay rentals and royalty. The bonus is the sum paid upfront to the mineral owner to obtain the initial execution of the oil and gas lease. The royalty is defined as the right under the lease to receive, cost-free, a fractional part of, or percentage of, the total production of oil and gas and produced from the client’s tract or lands pooled therewith. Royalty rights continue during the term of the lease or for a stated period of time. The delay rental is the sum that is paid during the primary term (discussed below), usually on a mineral acreage basis, for the privilege to

Oil and Gas Leases 101 Chapter 1

2

defer drilling a well for a stated period. The typical delay rental clause provides for a delay rental to be paid one year from the date of a lease. Upon timely payment, a lessee has another year to develop the lease. Therefore, if your client owns both the surface and the minerals, his only surface rights outside of implied covenants created by case law derives from the lease. Any surface uses must be expressly set forth in the lease; otherwise, the lessee may use any portion of the surface it reasonably wants. If your client does not own the surface; then, your client does not really have a concern as to how the surface is used so long as the lessee adequately indemnifies your client for any damages to the surface caused by the lessee.

III. ESSENTIAL LEASE CLAUSES The essential clauses of any oil and gas lease are

contained in just three clauses: the granting clause, the habendum clause, and the delay rental clause.

A. The Granting Clause. As to the granting clause, after the naming of the parties and establishing the effective date of the lease, the lease generally proceeds to the granting clause whereby the lessor grants the lease to the lessee for “Ten ($10.00) dollars and other valuable consideration.” Whenever you represent the lessor, you should insure that you deliver the executed lease to the lessee upon receipt of the bonus money. Bonus money is often paid by a bank draft; however, you should convince the lessee to pay by cashier’s check, thereby reducing the number of times that your client will call you regarding when the draft will be paid. The general language of the granting clauses states the lessor “grants, lets, and leases” the property exclusively to the lessee. The language “grants, lets and leases” should be used in favor of other language such as “grants, sells, and conveys” to clarify the intent that the estate created is a fee simple determinable rather than a fee simple absolute.

The granting clause usually sets forth the purpose for which a lessee may lease the property, which will normally include the standard “exploring for, developing, producing, and marketing” oil, gas and other minerals. The meaning of the term “other minerals” is discussed by the Texas Supreme Court case of Moser v. United States Steel Corp., 676 S.W.2d 99 (Tex. 1984), which is beyond the scope of this article. See So Your Client Thinks He Wants to Buy Only the Surface, State Bar of Texas Oil, Gas and Energy Resources Section Report (December 2006), by M.C. Cottingham Miles and Ryan M. Sweeney. As to the legal description of the property leased, care should be taken to be certain the property is described as accurately as possible such as with section, range and township, or by metes and bounds.

B. The Habendum Clause. The next main clause is referred to as the habendum clause. The habendum clause is the portion of the lease that makes the instrument a conveyance in fee simple determinable by stating the lessor has granted to the lessee the oil and gas contained in the property “for a number of years and so long thereafter as oil and gas are produced from the property or property pooled therewith.” It is the habendum clause that breaks a lease into both a primary and a secondary term. The primary term is a period whereby no action is required on the part of the lessee. The secondary term is the period in which the lease will expire unless some condition, such as production of oil and gas in paying quantities, exists. The habendum clause will often incorporate certain savings clauses, which we will discuss below, that act as substitutes for the existence of the condition (production of oil and gas in paying quantities). For example, a lease in the secondary term may state that if no production of oil and gas in paying quantities exists, the lease may still be held in force if a lessee pays shut-in royalties. Production, which may be actual or constructive (such as payment of shut-in gas well royalties or operations for drilling or working which extend beyond the end of the primary term) are essential for lease continuation purposes. See Watson v. Rochmill, 155 S.W.2d 783 (Tex. 1941). The term “produced” as used in the habendum clause has been construed to mean “production in paying quantities.” See Skelly Oil Co. v. Archer, 356 S.W.2d 774 (Tex. 1962). A well produces in paying quantities for purposes of lease continuation if the value of the oil and gas produced creates a profit, however small, after deducting incremental costs of lease operation and marketing without regard as to whether the cost of drilling, testing, completing and equipping the well are ever recovered. Furthermore, a lease which does not produce sufficient income to cover costs may still be perpetuated by such lackluster production unless it is determined that a reasonably prudent operator would not, under the circumstances, have operated the lease during the relevant period for the purpose of making the lease profitable as opposed to merely holding the lease for speculation. See Clifton v. Koontz, 325 S.W.2d 684 (1959).

By the terms of the habendum clause, production from any part of the leased premises, or lands with which the leased premises are pooled, will serve to hold all of the leased lands unless the lease expressly provides otherwise and subject to the lessee’s implied duties, which will be discussed further below. Johnson v. Montgomery, 31 S.W.2d 160 (Tex. Civ. App.—Amarillo 1930, writ ref’d).

C. The Delay Rental Clause. The final principal clause is known as the delay rental clause which negates any implied duty or implied covenant

Oil and Gas Leases 101 Chapter 1

3

to drill an exploratory test well during the primary term. If delay rentals are not paid pursuant to the terms of the lease, the failure to pay same may cause a termination of the lease because it constitutes a failure of a condition. Delay rentals have historically been used to allow the lessee to extend the primary term of the lease and gain additional time to achieve production. However, a noticeable shift away from delay rentals has recently occurred with most modern leases being essentially paid-up leases with no provision for the payment of delay rentals.

IV. OTHER LEASE CLAUSES In addition to the three main clauses, an oil and

gas lease typically has several other clauses. A. The Royalty Clause Royalties are

essentially the mineral interest owner’s share of production, free of the cost of production. There is no typical royalty; however, many printed leases, including the examples I have attached to this article, call for one-eighth of production. When representing the lessor, you are encouraged to find out the typical royalty where your client is leasing his lands as I have seen some lease royalties be as high as 27.5% in a “hot” area. Royalty on oil is generally payable in kind. It is important that the landowner reserve the right to receive his cost-free portion of the oil in kind. Some leases would purport to afford the lessee the right or option to purchase the oil at some determinable price, such as the market price prevailing for the field.

The typical lease usually states that the lessee shall receive royalty based on market value for gas sold or used “off premises,” but that on gas sold at the well, royalty will be computed based on net proceeds realized by lessee when sold by lessee. The Texas Supreme Court in Exxon Corp. v. Middleton, 613 S.W.2d 240 (Tex. 1981) held that gas royalty under 1934 leases where the gas was sold off leased tract should be based on fair market value at the well when produced and delivered. Be advised that “market value” may be less than the amount realized from the sale of oil and gas when the lessee successfully obtains a price higher than market value. See Yzaguirre v. KCS Resources, Inc., 53 S.W.3d 368 (Tex. 2001).

The most common method of calculating royalties on gas is the fair market value at the well. Gas, by its nature, cannot be economically stored at the well, so it must be transported, usually by means of a pipeline, and treated to render it marketable. Because of the cost associated with such transportation and treatment, the fair market value price at the wellhead will necessarily be less than the price of the gas ultimately sold after transportation and processing. Without explicitly stating so in the lease, a royalty calculated based on the market price at

the well makes the lessor’s royalty subject to deductions for the lessor’s pro-rata share of the costs associated with marketing, processing and transportation. See Piney Woods Country Life School v. Shell Oil Co., 726 F.2d 225 (5th Cir. 1984), cert. denied, 471 U.S. 1005, 105 S. Ct. 1868 (1985). Not even a clear statement that the lessor’s royalty will be calculated free and clear of such cost will prevent the lessor’s royalty from paying its pro-rata share thereof if the royalty is based on the market price at the well. See Heritage Resources, Inc. v. NationsBank, 939 S.W.2d 118 (Tex. 1996). See also Robert v. Swanson, 222 S.W.2d 707 (Tex. Civ. App.—Eastland 1949, writ ref’d n.r.e.).

Be advised that typically, lessee’s failure to pay royalty is a breach of the lease covenant and is not an event that would cause the termination under the lease. Reed v. James, 91 S.W.2d 946 (Tex. Civ. App. —San Antonio 1936, no writ.). In recent years, landowner attorneys have attempted to make the failure to pay a lease royalty a condition that could terminate a lease, such as the failure to pay a shut-in royalty.

B. The Mother Hubbard Clause. Following the property description, a lease will typically contain what is known as a “Mother Hubbard” clause. The Mother Hubbard clause provides that if a lessor owns any property contiguous with or adjacent to the leased property, the contiguous or adjacent property is also leased. The purpose of the Mother Hubbard clause is to bring small strips and gores into the lease under the theory that the lessor and lessee meant to include them and would have done so if they had known of the existence of the additional property. In the past, lessees have typically tried to incorporate other lands of the lessor by this clause; however, under the holding of Smith v. Allison, 301 S.W.2d 608 (Tex. 1957), the Texas Supreme Court ruled that the Mother Hubbard clause could not be used to add large adjacent tracts to the leasehold estate.

C. Principal Savings Clauses. A lease will often have saving clauses which identify conditions or activities that act as a substitute for production, holding the lease in force during the secondary term.

1. The Shut-In Royalty Clause. The shut-in royalty clause essentially states that if a lessee drills a well during a primary term that is capable of producing minerals in paying quantities and the well is shut-in for lack of a market or maintenance, the lease will not expire and will be held in force so long as the lessee makes some nominal payment. In reviewing this clause, a practitioner should look for the language that will identify what circumstances will allow the lessee to pay shut-in royalties and how long the payment of shut-in royalties may hold a lease in force. If representing the lessor, you try to limit the

Oil and Gas Leases 101 Chapter 1

4

duration of the payment of shut-in royalties to two (2) years or less.

2. The Operations Clause. The operations clause is a savings clause that states if, at the end of a primary term, there is not actual production, but the lessee is conducting “operations,” as defined in the lease, the lease will not expire so long as drilling operations continue. The purpose of this clause is to allow the lessee time to complete a well begun in the primary term which is completed in the secondary term. You should review what constitutes “operations” as defined in an oil and gas lease. For example, preliminary site preparations may constitute operations for a Producers 88 form whereas a lessor friendly lease might define “operations” as the act of placing a sufficient size drill bit in the ground to reach the desired formation depth.

3. The Dry Hole Clause. A dry hole clause provides that if a lessee drills a hole which fails to produce oil and gas in paying quantities, the lessee may move forward with same within a certain period of time and the oil and gas lease will not be terminated. Therefore, the dry hole clause prevents the termination of the lease when the lessee has drilled a dry hole and allows some length of time, such as 90 days, for the lessee to begin drilling another well on the property or property pooled with it for the lease to continue.

4. The Cessation of Production Clause. The cessation of production clause essentially codifies the temporary cessation of production doctrine by providing express terms for resuming production of a well for any reason. The cessation of production clause will provide a certain period of time, such as 60 days, for a lessee to resume production of a well if the well breaks down. The cessation of production clause will be strictly construed. Therefore, if the electric motor for an oil well breaks down, the cessation of production clause gives a lessee a certain time limit within which to resume production of oil and gas, and if the lessee does not meet that time limit set forth in the lease, the lease terminates. For example, if the lease specifies 60 days within which to resume production, the lessee may not take 62 days to do so. If he does, the lease will expire.

5. The Force Majeure Clause. The force majeure clause is another savings clause typically found in an oil and gas lease. Its purpose is to prevent termination of a lease due to the lack of production in paying quantities when the cessation of production is beyond the control of the lessee. The clause typically sets out certain events deemed to be acts of God, and therefore, beyond the control of the lessee. If you are representing the lessor, care should be taken to exclude from the list any conditions that are not truly beyond the lessee’s control. For example, floods and wars are probably beyond a lessee’s control; however,

the inability to obtain equipment at the lessee’s desired cost is not.

6. The Breach Clause. This clause attempts to substitute a damage suit for termination of the lease. It is not effective as to any condition in the lease such as payment of delay rentals or shut-in royalty; however, it is effective as to nonpayment of royalty (unless the form provides otherwise) and most nonperformances of the lease.

D. The Pooling Clause. A pooling clause allows the lessee to combine one lessor’s acreage or interest with other acreage in order to form a pooled unit. The terms “pool,” “unit,” and “proration unit” are often used interchangeably. The reasons and purposes of pooling include railroad commission spacing rules, field rules, and other reasons which are beyond the scope of this article. However, the vast majority of oil and gas production in Texas is accomplished by pooling two or more tracts of land. The effect of pooling is that production on any of the acreage pooled will hold the leases on all pooled interests. Therefore, if Lessor A’s interest in a 100 acre tract is pooled with the interest of Lessor B’s 200 acre tract and Lessor C’s 300 acre tract, and the lessee completes a well on Lessor C’s 300 acre tract, production from that well will hold the lease on the tracts of Lessor A and Lessor B. All three lessors will share in the production in the proportion that their interests bear to the total acreage pooled. In the above example, Lessor A’s share would be 100/600. Assuming the well produced $100,000 of gas in a month and that Lessor A owned all the minerals on his or her 100 acre tract and then leased the gas for a royalty of 1/4, the royalty for that month would be calculated as $100,000 x 100/600 x 1/4, which equates to $4,166.67.

A pooling clause provides that as to any of the lessor’s interest that is included in a pool from which there is a production in paying quantities, the lease shall remain in force as the lessor’s entire interest. Without any modification to the clause, the lessee could include only one acre of a lessor’s leased tract in a pooled unit and the lease would be held in force as to hundreds of acres for which the lessor would receive no royalty. To address this problem, a practitioner representing the landowner should consider the use of a Pugh clause in a lessor generated lease or as an addendum to a Producers 88 form.

The Pugh clause is used to prevent a lessee from using pooling to hold all of a lessor’s interest by production when only a portion of the lessor’s interest is included in a pooled unit. The Pugh clause will provide that only the acreage of the lease pooled is sustained by production, and as to any other acreage of the lease not pooled, the lease will terminate if production does not exist on such remaining lands or

Oil and Gas Leases 101 Chapter 1

5

lands pooled with such remaining lands before the primary term ends.

E. Administrative Clauses. Most leases will contain certain administrative clauses as discussed below.

1. The Warranty Clause. The warranty clause provides that the lessor warrants title to the mineral estate and further grants the lessee the right to discharge any mortgage or lease and be subrogated to the rights of the lienholder. I recommend that the warranty of title be struck on the theory that the lessee has or will research the title and should bear the responsibility for determining the validity of the title to the mineral estate. The portion of the warranty clause allowing for the discharge of liens and subrogation to the rights of the lienholder is probably necessary to protect the lessee’s interest in the minerals vis-à-vis a lienholder.

2. The Proportionate Reduction Clause. The Proportionate Reduction Clause provides that if the lessor owns less than 100% of the minerals under the property, his or her royalties and shut-in royalties will be reduced to correspond with the percentage of the mineral estate owned by the lessor.

3. The Equipment Removal Clause. The equipment removal clause gives the lessee the specific right to remove equipment from the well site after termination of the lease usually within a set time period, such as 60 days, after the termination date of the lease. If you are representing the lessor, care should be taken to make the removal of the equipment and restoration of the surface an express requirement of the lessee; otherwise, the lessee has no implied requirement to restore the surface. In Warren Petroleum Corp. v. Monzingo, 304 S.W.2d 362, 363 (Tex. 1957), the Texas Supreme Court stated that the sole question was to determine whether an oil and gas lessee had an implied duty to restore the surface of the land to the condition it was in prior to the commencement of the oil and gas work. The court ruled that the lessee had no express duty in the oil and gas lease, and that duty would not be read into the lease by implication. In Exxon Corp. v. Pluff, 94 S.W.3d 22, 30 (Tex. App.—Tyler 2002, pet. denied), the Tyler Court of Appeals followed the ruling in Monzingo. In Pluff, an oil and gas lessee abandoned certain drilling equipment and concrete structures on the lessor’s land after the oil and gas lease terminated. Like the lease in Monzingo, the lease in Pluff provided the lessee the right to remove its personal property and fixtures at any time during or after the lease terminated. However, because the lessee failed to remove its equipment and restore the surface of the land in Pluff, the trial court found for the lessor in the amount of $30,000. The Tyler Court of Appeals reversed and rendered in favor of the lessee holding that the lessee’s contractual right to remove its

equipment did not impose any implied or express duty on the lessee to restore the surface of the land of the lessor.

4. The Surrender Clause. The surrender clause of a lease provides that a lessee and its successors and assigns shall have the right at any time to surrender any portion of the lands covered by the lease in whole or in part thereby releasing the lessee from liability or obligation as to the acreage released and so surrendered. If a lessee has a 100 acre lease and releases 50 acres of it, the lessee’s obligations under the lease only extend to the 50 acres remaining leased.

5. Lease Memorandum Clause. If your client does not want nearby neighbors to know what deal he has agreed to with the lessee, I recommend adding a lease memorandum clause which will put of record the lease and its primary term, but usually nothing more.

6. Assignment Clause. Leases are freely assignable by either party without the permission or knowledge of the other party. I recommend adding a clause in a lessor form lease or in an addendum to a Producers 88 form requiring the lessee to advise the lessor in writing of the name and address of all assignees of the lessee and requiring the lessor’s permission for the assignment. Since Texas has no mandatory release statute, it is a good idea to also put a clause in a lessor form lease or in an addendum to a Producers 88 form requiring the lessee to furnish a notification and a release on termination of the lease. Failure to release after demand has been held to constitute a slander of title. See Kidd v. Hoggett, 331 S.W.2d 515 (Tex. Civ. App.—San Antonio 1959, writ ref’d n.r.e.).

7. Free Use of Oil and Gas Clause. Some lease forms provide that the lessee will have free use of the oil and gas produced from the property to use for its operations with no royalty to be paid on same. No limit is usually placed on this right of the lessee in the lease and could result in a significant amount of oil and gas being used without any payment to the lessor. It is recommended that this provision be struck or limited if you represent the lessor.

V. DATE OF LEASE AND PARTIES The first paragraph of a lease usually contains a

blank for the date of the lease. When representing a lessee, care should be taken regarding the lease date as it is controlling in determining (i) the duration of the primary term; (ii) the commencement of operations for drilling or payment of annual delay rentals; and in some cases, (iii) the date of the initial shut-in gas well payment. After the date of the lease, one should add the parties to the lease, who are the lessor and the lessee. Care should be taken as to exactly who is the lessor, and whether the lessor is a natural person or

Oil and Gas Leases 101 Chapter 1

6

persons, a business entity, a trust, an estate of a deceased person or a guardian estate, or an attorney-in-fact. One must ensure that the person signing on behalf of any entity, whether the lessor or the lessee, has the requisite authority to do so by careful review of any documentation creating the entity or relationship, such as a will, a certificate of formation, corporate bylaws, a declaration of trust or a power of attorney.

VI. A BRIEF SUMMARY OF IMPLIED LEASE COVENANTS A fundamental characteristic of mineral leases is

that the lessor conveys to the lessee the exclusive right to explore, develop, and operate the property in return for royalty on production. Any benefit derived or harm incurred by the lessor will depend on the lessee’s actions. If the lessee fails to operate prudently, the lessor will not be able to protect his rights so long as the lease remains in effect. Therefore, Texas case law has created certain implied covenants to operate as a means for courts to limit the lessee’s authority to conduct mineral operations on the lands leased.

The standard of performance is a reasonably prudent operator or “RPO” and the lessor has the burden of proving that the lessee has failed to act as a reasonably prudent operator would under similar circumstances. Thus, the reasonably prudent operator standard requires that the lessor prove that the desired action by the lessee would be profitable to the lessee because a reasonably prudent operator does not seek to operate at a loss. The lessee has no implied duty to drill wells unless the wells would be profitable. To impose a drilling obligation on the lessee, the lessor must prove that the lessee can recover oil and gas having a value in excess of all reasonable costs of drilling, producing, and marketing the oil and gas. Thus, drilling expenses are included in measuring profitability under implied covenant cases.

Three common implied covenants exist, which are as follows: (a) market production in good faith, securing the best available price, terms and conditions and giving due regard to the rights of the both the lessor and the lessee, see Amoco Production Co. v. First Baptist Church of Pyote, 579 S.W.2d 280 (Tex. App.—El Paso 1979, writ ref’d n.r.e.); (b) protect the leased premises from offset drainage which does not require the lessee to protect the lessor’s lands from all drainage but rather substantial drainage, see Amoco Production Co. v. Alexander, 622 S.W.2d 563 (Tex. 1981); and (c) development of the leased premises after the discovery of oil, gas, and other minerals, which does not impose on the lessee a separate obligation to explore, the exploration obligation being subsumed within the implied obligation to develop, see Sun Exploration & Production Co. v. Jackson, 783

S.W.2d 202 (Tex. 1989). The implied obligation to protect from offset drainage and to develop the leased lands after discovery of oil, gas or other minerals is subject to the lessor’s burden of proof that the proposed protection or development well has a reasonable expectation of producing in such quantities as to recover the lessee’s capital costs, costs of operation and a reasonable profit. In the performance of the offset drainage protection and development covenants of the lease, the lessee’s conduct is measured by that of a reasonably prudent operator in the position of the lessee acting under similar facts and circumstances. The reasonably prudent operator standard is also applied in evaluating a lessee’s conduct even if the obligation to drill is an express covenant obligation under the lease. See Good v. TXO Production Corp., 763 S.W.2d 59 (Tex. App.—Amarillo 1988, writ denied).

For easy reference of the three implied covenants, I have included the elements for each:

1. Covenant to Market: Lessor must prove

that: Lessee must market production from

the leased premises a. Within a reasonable time; and b. At the best available price.

Be advised that litigation including the covenant to market often involves self-dealing between the lessee and related or wholly owned entities.

2. Covenant to Protect Against Damage: Lessor must prove that: a. Substantial drainage exists; b. A reasonably prudent operator would

drill a well to protect against drainage; and

c. Damages, which are measured by the royalty amount the lessor would have obtained had the offset well been drilled, not by the amount of the oil and gas drained away.

The second element is the most difficult to prove because it requires that the lessor show that the offset well will produce in quantities sufficient to pay the lessee’s cost of drilling, completing and equipping the well, plus a reasonable profit to the lessee.

3. Covenant for Reasonable Development after Production has been Obtained: Lessor must prove that: a. There is a probability that additional

wells drilled would return the costs of drilling, completing and operating the

Oil and Gas Leases 101 Chapter 1

7

well, plus a reasonable profit to the lessor; and

b. The lessee acted imprudently in failing to drill additional wells.

Texas case law does not recognize an independent covenant to explore for minerals. It is a part of that reasonable development covenant above in that the lessor must prove that drilling additional wells would bring a reasonable expectation of profit to the lessee.

The remedies for a breach of the implied covenants usually consists of (i) recovery of damages (money), the measure of damages being the value of the royalty the lessor would have received if no breach had occurred rather than what oil and gas was drained away, and/or (ii) cancellation of the oil and gas lease in whole or in part, for which notice and demand to the lessee must be made first before filing an action.

A further discussion of implied covenants under an oil and gas lease is beyond the scope of this article. I encourage you to review the many articles regarding implied covenants under an oil and gas lease that exist, such as Implied Covenants – An Update, by Elizabeth N. Miller, presented at the 17th Annual Advanced Oil, Gas and Mineral Law Course in September 1999.

VII. TOP LEASES A top lease exists when another valid lease

is in effect on the same lands and generally takes one of two forms:

(1) An irrevocable and exclusive option to lease

when the present lease expires; or (2) A lease with or without warranty and with or

without proportionate reduction, but with an exception and reference to the existing lease, in other words, a “subject to” clause.

The idea is that when the current lease expires,

the “top lease” springs into life. Top leases often occur in “hot” areas. I encourage you to review any number of articles regarding top leases, such as Top Leasing and Tortious Interference with Contracts, by R. Paul Yetler, presented at the 14th Annual Advanced Oil, Gas and Mineral Law Course in September 1996.

VIII. CONCLUSION I hope this summary of oil and gas leases has

given you some understanding as to what you can expect when your royalty owner client hands you a Producers 88 lease form to review. You should always remember that there is no such thing as a standard oil and gas lease, as oil and gas leases vary often from one practitioner to another. Please feel free to contact me at (210) 227-7591 or by e-mail at [email protected] if you have any questions or if

you want to confer on a particular oil and gas question. I may not have all of the answers; however, I have reviewed quite a few leases and if I have not seen what you are asking about, I probably have some other friends who have. Good luck and good leasing!

Note: Other articles to read regarding an

overview of basic oil and gas leasing concepts and upon which the author reviewed and relied in drafting this article include: Oil, Gas and Mineral Lease for the Real Estate Practitioner, by Maston C. Courtney, presented at the 14th Annual Advanced Real Estate Law Course in 1992, Oil and Gas Leases: The Basics, by Ben F. McDonald, presented at the 22nd Annual Advanced Real Estate Law Course in 2000, and Texas Oil and Gas Leasing – A Primer, by Stephen A. Boykin, presented at the 28th Annual Advanced Real Estate Law Course in 2006.

The author gratefully acknowledges the assistance of Nancy Cano, Charlotte Baker, and Kathryn Gentry in the preparation of this article.

APPENDIX A

APPENDIX B