Utica Shale landowners:
How to profit from your oil and gas leases

Today's news is full of stories about local landowners gaining immediate riches because of the Utica Shale oil and gas boom. In most cases, those with newfound wealth have sold oil and gas rights to exploration companies under leases that contain a variety of well-established, sometimes archaic, payment provisions. This article examines the most common of such clauses.

  • SIGNING BONUS.

    This one-time, upfront payment is made to the landowner as an inducement for making a potentially long-term commitment to the exploration company under the lease. Although traditionally these payments were relatively small (measured in dollars per acre), they recently have grown to relatively large amounts (thousands of dollars per acre) in the heart of the Utica Shale play due to intense competition for leases.

  • DELAY RENTALS.

    The primary purpose of an oil and gas lease, from the landowner's perspective, is to encourage the exploration company to begin royalty-paying production of oil and gas as quickly as possible, because the royalty stream is assumed to be the most valuable aspect of the lease. Therefore, the typical oil and gas lease includes provisions that encourage prompt exploration. One such provision might state that the lease terminates in a year or two if the lessee has not begun drilling operations. Another common provision requires the exploration company to pay an agreed sum per acre, called a delay rental, for each year (after the first year) that the exploration company wishes to defer drilling or production.

    Delay rentals may be viewed as liquidated damages to compensate the landowner for the production royalties that the landowner would have received had the lessee promptly drilled for and begun production.

  • ROYALTIES.

    The economic heart of an oil and gas lease, from the landowner's perspective, is the royalty clause. A royalty is a share (stated in terms of a fraction or a percentage) of the production of gas and oil (or a share of the proceeds from their sale) that is allocated to the landowner under the lease. Stating a royalty in terms of a share of gross production means the payments to the landowner are not reduced by the costs of production.

    It is common for a lease to separately state the royalty payable for production of (a) natural gas, (b) the so-called wet gas constituents, such as butane, ethane and propane, and (c) oil. Traditionally, these royalties often were a one-eighth (12.5 percent) share, but in some areas of Utica Shale exploration royalty rates for these components have seen substantial increases to as high as 20 percent.

    A landowner also may require the lessee to pay a higher royalty on production after the lessee has recovered its costs relating to the well, such as costs of drilling, completing and equipping the well, and the bonuses, rentals and other required payments under the leases involved. Thus, a lease might require the payment of a 12.5 percent before pay out royalty and a 20 percent after pay out royalty.

  • SHUT-IN ROYALTY.

    To protect the landowner from a circumstance in which the lessee has drilled a well that is capable of producing natural gas but the gas is not actually extracted and sold, due to a low market price, the inability to process the gas for sale or the absence of a pipeline from the well to the marketplace, the lessee may be required to pay a shut-in royalty to the landowner. Although the lessee typically will propose a nominal annual payment as a shut-in royalty, the landowner should negotiate for an increased amount, though even a substantially larger payment may not approach the royalties from actual production. Another option would be to impose a time limit on how long the lease can be held solely by payment of the shut-in royalty.

  • SPUD FEE OR ADVANCE DAMAGE PAYMENT.

    A landowner will often require an exploration company to pay a stated sum before a well is actually drilled to compensate the landowner for the surface impacts at the well site and other areas and the loss of other income-producing use of the land during exploration and production. Surface impacts may include the removal of crops or trees, grading or filling activities and the construction of improvements such as temporary or permanent roadways, pads for drilling equipment and wells, storage tanks, processing equipment and the installation of pipelines.

  • FREE GAS.

    Another common way that landowners realize value from their oil and gas interests is to require the delivery of a stated annual quantity of free gas for use on the property. Although this is simple in concept, someone (either the landowner or the lessee) must install the pipes, the pressure-regulating equipment and the meters required to actually deliver the gas to the user safely and properly. For this reason, a lease often will permit the landowner to elect to receive a cash payment in lieu of actually taking the stated annual quantity of free gas.

As shown above, traditional oil and gas leases include a number of provisions that ensure that the landowner profits from its oil and gas rights. Because all such clauses are open to negotiation and often involve other, noneconomic issues, a landowner would be well advised to seek experienced counsel to assist in the negotiation process.

—Bruce L. Waterhouse Jr.
waterhouse@nicola.com