A Brief Legal Introduction to a Landowner's Oil and Gas Ownership

A Brief Legal Introduction to a Landowner's Oil and Gas Ownership
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Significant developments in oil and gas law in the U.S. date from the first commercial oil well in the U.S., drilled to a depth of approximately 70 feet in 1859 near Titusville, Pennsylvania. Oil and gas law drew from preexisting legal doctrines, such as land ownership extending to the center of the earth and minerals being subject to capture like wild animals. This comment provides a brief and incomplete educational overview of a landowner's oil and gas ownership in the United States. Consult experienced legal, financial, and tax professionals in specific situations.

The basic proposition is that the surface owner owns minerals in the ground; however, minerals may be bought and sold separately from the surface. Consequently the current surface owner may only own a fraction of the subsurface minerals or none at all. In a few jurisdictions if the mineral owner fails to drill or otherwise develop within a specified period of years, typically 10 years, the mineral ownership reverts to the surface owner. In other limited situations, the mineral interest might revert back to the surface owner if the mineral owner failed to properly register and pay taxes on it. In the absence of rules recombining the mineral and surface ownership, the mineral interest rapidly splinters into small fractions due to inheritance, creditors' claims, and fractional business transfers, especially during the cyclical oil booms and busts. Consult an experienced professional to precisely determine the ownership situation of minerals beneath a given tract of land.

Under the "rule of capture," a well bottomed on one's land is free to produce oil and gas that may have migrated from adjoining properties. To maximize efficient production (maintaining high reservoir pressure is a key consideration), regulatory agencies have developed well location and spacing rules and "pooling" production units under which mineral owners proportionately share the oil and gas produced.

A mineral owner is legally entitled to utilize a reasonable amount of the surface, typically without the consent of the surface owner, to produce the minerals. The "accommodation doctrine" requires that the mineral owner minimize interference with existing surface uses. Advances in directional drilling facilitate this. Typically some consultation occurs to reduce disputes. Proposed legislation in some states would modify these rules.

A mineral "estate" owner has the basic right to develop (drill and produce), and to transfer development rights to a third party (called the "executive right" to "lease"). The right to drill is obtained by a third party oil company in a document called a "lease." The mineral owner is entitled to financial payments including "bonus" (when a lease is signed), "delay rental" (a payment to delay drilling activity), and "royalty" (a payment based upon production). There are numerous varieties and potential fractional sharing of these payments. Tax issues abound. Fundamentally, the size and estimated production life of the field as well as the quality of the petroleum being produced is significant. Light sweet crude (less than .5% sulfur) is best. All payments are subject to negotiation and a prudent mineral owner will conduct appropriate due diligence before reaching an agreement.

The oil and gas lease is typically classified as a type of deed ("fee simple determinable") and is recorded in the local public real estate records. The oil and gas lease has many variations and may, for example, cover only certain depths or subsurface horizons and exclude the production of certain minerals. It contains a "primary term" and a "secondary term." Traditionally, during the primary term, the lessee (oil company) must drill or pay delay rental. Failure to do either typically terminates the lease under a so-called "unless lease" but may not under an "or lease." A third type, perhaps most common today, is a "paid up lease" under which one payment maintains the lease for the entire primary term. The secondary term involves mineral production or related activities that should be carefully defined in the lease. All lease provisions, including times and payments, are subject to negotiation and a mineral owner should consult an experienced professional.

Precisely what activities keep the oil and gas lease in force during the secondary term must be specified in detail. While the traditional rule is that actual production must occur, well logs, testing, or pooling may extend the lease. A "reasonably prudent operator" standard broadly applies to drilling and production activities. This allows stoppages under the "temporary cessation" doctrine. A stoppage of no more than 90 days is frequently written into the lease.

The traditional royalty payment was 1/8. Thus, for every 8 barrels produced, the mineral owner received one barrel and the production company received seven. "Royalty" goes back to the English king owning all the land and receiving a payment for mining activities. Royalty provisions and amounts are negotiable. While the mineral owner does not have any production expenses, once the oil or gas is at the surface, a variety of post-production costs such as gathering, treatment, and transportation might be deducted from the mineral owner's share. A "division order" divides the financial payments among the various parties. It is often calculated to seven decimal places (essentially accurate to $1.00 per $10,000,000 divided). This requires a highly experienced professional.

A "royalty owner" is only entitled to a fraction of the produced minerals while a "mineral interest owner" is entitled to explore, drill, and produce. Consequently a royalty owner has no right to create an oil and gas lease. The easiest situation, increasingly rare, is when one person or entity alone owns all of the mineral interest. If two or more individuals are co-owners (tenants in common), any one alone, without consent of the other co-owners, may sign (execute) an oil and gas lease but must account to the other co-owners for their share of the profits. If the mineral property is owned in a "life estate" then both the "life tenant" (one with the current right of occupancy and use) and "remainderman" (one acquiring the property when the life tenant dies) must execute (sign) an oil and gas lease. Rare exceptions include actions to prevent drainage or continuing to operate a preexisting lease under the "open mine doctrine" with the life tenant receiving the royalty payments. Legally designated "homestead" requires both spouses to sign an oil and gas lease.

All fractional interests are complex and of great importance since millions of dollars may be at stake. Is it a fractional interest of the minerals (for example, 1/32 of the minerals), a fractional interest of gross production (for example, 1/32 royalty) or a fractional interest of the royalty (for example, 1/32 of royalty)? Reservations and transfers of ownership interests in deeds and leases are complex. Small variations in wording are quite significant and all documents require preparation and analysis by a highly experienced professional. There are multiple forms of royalty terminology such as "floating royalty," "fixed royalty," "landowner's royalty," "nonparticipating royalty," "participating royalty," and "overriding royalty." When petroleum prices are high and a significant amount of production is occurring, even small fractions may translate into millions of dollars. Again, one must consult an experienced professional to correctly create documents and understand what fractional interest, such a mineral interest or royalty interest, that one owns.

This comment provides an incomplete brief educational overview of a complex topic and is not intended to provide legal advice. Always consult an experienced attorney and an experienced financial professional in specific oil and gas ownership situations.

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