Oil & Gas Lease: The Granting & Habendum Clauses (Spring 2021 Course Notes - GULC Evenings)

Purpose of the Lease and Lease Formation

Leases are generally written by the lessee, who aims to obtain rights to explore / drill / develop / product without obligations to do so for a primary term of years (outlined in the habendum clause), as well as to maintain the lease for as long as it makes business sense to do so if “production in paying quantities” is obtained (outlined in the habendum clause as during a secondary term). Lessors receive their main benefits from leases through cost-free royalties on revenues / production. Courts generally protect lessors by outlining “implied covenants” of oil and gas leases such as the lessee’s obligations to test the premises, protect the lease against drainage, develop the lease after hydrocarbon discovery, and market production.

Upon lease signing, lessors obtain a bonus (a certain number of dollars per acre) via bank draft / “order for payment” which is subject to conditions, meaning that it is not a negotiable instrument / unconditional promise to pay. Prior to production and during non-production, the lessor also obtains (rarely now) “delay rental” payments. Upon production, the lessor obtains royalties. A common condition for bank drafts is that the title under lease gets approved (i.e. it is not defective). So long as it is approved, the bonus must be paid (if it is not approved, then the lessee can refuse to honor the draft or adjust the draft amount accordingly). When a draft is not honored after approval, the lessor can recover for it or revoke the lease, but in some jurisdictions courts find that because oil and gas leases are land interest conveyances, they do not require consideration.

Issues arise when a draft is refused at a time when the original lessee has already assigned the lease to another party who may qualify as a bona-fide purchaser. A title secured by fraud in the execution of an instrument is void but title secured by fraudulent inducement is voidable; in the former case, no title passes to a bona-fide purchaser, while in the latter case, title will pass if the bona-fide purchaser has no actual or constructive notice the tile is voidable (to combat this, lessors often put in lease clauses which provide that the lease in question is null and void if the bonus is not paid). Issues also arise related to lease formation through a lack of understanding of the oil and gas business (and its legal niceties) between unsophisticated lessors and landmen. The statute of frauds also poses as a problem for leases fairly often (sufficient certainty lacking in the lease, etc.).

Nature of the Leasehold Interest

Leasehold rights are generally acknowledged to be property rights created by a deed and not a landlord-tenant lease. Some courts describe the interest as a fee simple determinable estate in the oil and gas in place, while other courts view the interest as an irrevocable license (which doctrine applies usually depends on whether the jurisdiction follows ownership-in-place (because the interest continues indefinitely if there is production; some states call the interest a license / “profit-a-prendre” if the granting clause merely grants lessees the exclusive right to search / develop / produce; a fee simple interest is created if the granting clause purports to convey the oil and gas in place) or exclusive-right-to-take (where the granting clause does not matter and the interest is equal to a license / “profit-a-prendre”), respectively).

Significance of the Classification of Lease Interests

If the lease interest is a license / profit-a-prendre, it is incorporeal and nonpossessory, meaning that it can be abandoned and the only remedies available are nonpossessory(quiet title or an action in trespass). If the lease interest if a fee simple estate, it is corporeal and possessory, meaning that common law rules of abandonment do not apply but the possessory remedies of trespass quare clausum frigit and ejectment will be available. The interest classification also affects which statutes apply (related to taxation, intestate succession, and judgment liens).

Granting Clause: The Rights Granted by a Lease

Lease grants must cover what rights are given to use the land, what substances are covered, and what land and interests are subject to the lease. Surface use is one source of potential conflict (regardless of whether the lessor owns the surface or another surface owner does).

Substances Granted by the Lease

Some issues arise based on the substances granted by mineral leases. Often, unexpected substances are found during production of the expected substances that were not originally considered in the lease. Furthermore, natural gas and oil rights are sometimes separated by right, but casinghead gas and natural gas / petroleum liquids are extracted during oil and gas production projects, respectively. Courts have also deemed that injected carbon dioxide (injected by lessees to increase recovery) is personal property owned by the lessee and not owned by mineral right by the lessor.

Lands and Interests Granted by the Lease

Land identified in oil and gas leases either is described using government survey-based descriptions or the “metes and bounds” approach which uses natural monuments and even bounded surrounding properties to describe the land in lease. In order to ensure that the lease covers all of the lessor’s land, lessees often include the following clauses:

• “In-gross”: makes royalty / bonus payments dependent on the actual reception of a gross acreage outlined in the lease, instead of based on a per acre payment (in case the lessor fails to accurately outline the number of acres on the lease)

• “Mother Hubbard” / “cover-all”: covers all adjacent areas to land described in a lease (the adjacent parts often also being owned by the lessor via adverse possession), often used for land which is described via metes and bounds

• “After-acquired title”: allows lessees to have rights over adjacent lands which the lessor will obtain in the future (during the lease?)

• Warranty: relevant to the “after-acquired title” clause; this is a covenant that the lessor will promise to defend the lessee against future lawful claims and demands; lessees can recover damages associated with failure of title from the lessor amounting to the damage caused onto the lessee, up to the amount of compensation received by the lessor through the lease (also, in some jurisdictions, the words “grant” and “convey” create limited warranties; warranties are often struck by lessors, however)

• Proportionate reduction (lesser interest): If a lessor owns an interest in minerals in or under the leased land less than the entire fee simple estate, then the royalties and rentals to be paid the lessor can be reduced proportionately (this accounts for the fact that many mineral rights owned today are increasingly fractionalized)

• Subrogation clauses: allows a lessee to protect his lease interest by paying property taxes and satisfying liens and debts secured by mortgages encumbering the property

The Lease Primary Term

The lease primary term length is subject to negotiation between the lessor and lessee, often depending on the bargaining leverage of the parties and the amount of the bonus that the lessee is willing to pay. In unproven areas, 10 years is common (and required in Tennessee and Louisiana as a maximum for any primary term); for proven areas, 1-5 year leases are more common.

There exists an idea of an “implied covenant to drill a test well” within a reasonable time after the beginning of the lease, so as to account for royalties as consideration for the lease. This implied covenant is at odds with the lessee’s right, not obligation, to drill; so, recent courts (except for Indiana) have allowed for nominal “delayed rental” payments to be made to lessors to extend the primary term of a lease without having to do any drilling (this extension is usually annual). Issues arise when lessees fail to pay rentals properly.

Maintaining or Extending the Lease Primary Term by Operations

Delayed rental “unless” clauses also often include “well completion” / “operations savings” clauses which allow for the extension of a lease if the lessee is engaged in required operations at the end of the primary term (i.e. not producing oil or gas but engaged in the drilling or reworking operations of a well).

The Secondary Term: Extension and Maintenance of the Lease

Secondary terms are sometimes outlined for in the habendum clause of an oil and gas lease for lessees to hold onto a lease past the primary term “so long as oil or gas are produced”; courts vary on the meaning of produced, with some finding that it requires a well to actually be producing and marketing in paying quantities, while others finding it to mean that a well is merely capable of producing in paying quantities. Fixed leases don’t allow for secondary terms.

References:

https://www.westacademic.com/Lowe-Anderson-Kulander-Ehrman-and-Griggss-Cases-and-Materials-on-Oil-and-Gas-Law-8th-9781636591698