Mineral Rights Leases: Form and Function - Module 3 of 5

Mineral Rights Leases: Form and Function

The mineral lease establishes legal rights for subsurface development in the United States oil, gas and mineral extraction industry. This module explains the general forms and functions of contracts common across oil, gas and mineral transactions. The discussion begins with the goals of a mineral rights lease and how the law has developed to meet these goals. We will then turn to the fundamental characteristics of a modern mineral rights lease and conclude with an explanation of several common savings clauses.

Purpose and Nature of Subsurface Rights Leases

The owner of valuable subsurface commodities - including fossil fuels, precious metals and other commercially-valuable substances - has the right to economically benefit from them. If these benefits are to be conveyed, they must be conveyed through a legal arrangement. In the oil, gas, and mineral extraction industry, this legal arrangement is commonly established by a mineral rights lease.  A mineral rights lease is executed between the owner of subsurface minerals and a developer and explains the terms and conditions that both parties must adhere to during the extraction process.[1]

Mineral leases differ from other real property leases in three important aspects. First, the lessee has the right to use the land and to take substances of value from it. The same cannot be said in a typical landlord-tenant arrangement, which only entitles the tenant to possession of the property. Second, rights conveyed in a mineral lease are not necessarily limited by time. Third, a lessee’s rights to use and access the property where the subsurface minerals are located must be shared with the surface owner.

While leases are governed by the straightforward rules of property conveyances, mineral leases are hybrids between contractual agreements and conveyances of rights. A mineral lease is a property conveyance because the mineral owner grants a transfer of possession, easements or other property rights through the document. On the other hand, a mineral lease is a contract because it contains legal promises regarding compensation, use and other aspects of the developer’s use of the land.

Courts treat mineral leases differently depending on whether the state law tends to treat such leases under principles of property law or contract law. Some states, such as oil-rich Texas, see mineral leases as creating interests as fee-simple property estates on behalf of the developer-lessee. Other states, such as Oklahoma, Kansas and California, instead classify the lessee’s interest as a “profit á prendre,”[2] which is an agreement that creates rights to others’ lands to take value from them.[3] Courts in still other states treat oil and gas leases as both a conveyance of mineral rights and as a contract between the property owner and development company.

Interests Conveyed in Mineral Leases

As a minimum, a valid mineral lease must contain a granting clause and a habendum clause.

A granting clause explains the rights a mineral owner grants to the lessee development company. To meet common law requirements, a granting clause must identify the size of the interest in the subsurface right granted, the specific substances covered by the lease, uses permitted in the exploration and development of these substances and a description of the land covered by the lease. A granting clause typically allows the lessee the opportunity to search for, develop and produce oil, gas or other valuable commodities without imposing a legal obligation to do so.[4] Mineral rights lessees are also obligated to abide by the accommodation doctrine, which prohibits unnecessary damage to the lessor’s land by prohibiting unreasonable interference with the surface of the land.

The habendum clause, commonly referred to as the “term clause” of the mineral lease, sets the duration of the lease. Habendum clauses encompass two important time periods recognized by mineral leases: the primary term and the secondary term. The primary term is the time in which the lessee may maintain its mineral rights without attempting any extraction of the subsurface commodities.[5] The purpose of this primary term is to give the lessee adequate time to make full economic use of its claim. The length of the primary term is negotiable and typically dictated by market conditions.

The secondary term allows the lessee to maintain its rights under the lease so long as it is producing minerals in an economically viable manner. The secondary term typically extends for an indefinite time. The secondary term begins when the lessee starts to extract minerals covered by the mineral lease, continues while the lessee is productive and ends when production ceases. Temporary pauses in production do not bring the secondary term to an end. [6]

Several cases have addressed the starting and ending points for the secondary terms when the lease agreement is ambiguous or subject to interpretation. For example, in Breaux v. Apache Oil Corp, a developer installed an access road to a planned extraction site during the primary term but did not commence extraction until two days after the lease’s primary term expired. The Breaux court considered both the language of the lease and the facts surrounding the dispute and decided that the lessee had commenced operations sufficient to move the process forward into the secondary term.[7] But, if the developer had done less – such as just securing permits and contract to drill but not actually doing any work on the site or receiving any royalties – he may have lost the rights to extract minerals.[8]

Breaux is one example of a case questioning when production starts, triggering the secondary term of a mineral lease. Parties also sometimes disagree regarding what legal standards apply to the cessation of production that would end the secondary term. Courts in oil and gas producing states have interpreted the production necessary to maintain the secondary term as “production in paying quantities” or “PPQ.” In other words, an extraction operation must bring in a certain threshold of revenue to maintain production status.[9]

The Texas Supreme Court established a test for determining production in paying quantities in Clifton v. Koontz. In Clifton, the court held the mineral rights owner (seeking to end the lease) had the burden of showing that there had been no production in “paying quantities” on the property in question during the relevant period. If an extraction operation carried out under a mineral lease is profitable enough that a prudent operator would keep it running, it may continue indefinitely pursuant to its rights under the secondary term.[10] If it is not, however, the Clifton standard deems it unproductive and unable to support the secondary term.

Delay-Rental Clauses

With the exception of Oklahoma and Louisiana, every state treats mineral rights leases as creating property rights in favor of the lessee that terminate automatically if the lessee fails to meet one or more conditions.[11] Savings clauses are included in most mineral rights leases to afford the lessee with needed flexibility in a system that values productive use of the land.

The first essential savings term that should be included in most mineral leases is the delay-rental clause. This provides the terms and conditions for payments of rentals from the lessee to make up for delays in drilling during the lease primary term.

A delay-rental clause allows a mineral rights holder to maintain its rights under a lease even if it cannot immediately act on it. The purpose of this clause is to ensure that the lessee does not lose the its rights merely by virtue of failing to drill during the primary term. The clause allows the lessee to pay a pre-negotiated fee to extend the time that it has to commence exploitation of the resources. Notably, however, delay-rental clauses only allow for this exchange to take place during the primary term. Once the secondary term begins, delay-rental clauses cannot be used to extend the lease term after the economic usage of the lease is stopped.[12]

            There are two common forms of delay-rental clauses. The most popular delay-rental clause is structured to automatically terminate the lease “unless” the lessee commences extraction operations or pays a delay rental fee prior to a specified date. If the work doesn’t start and the fee isn’t paid, the lease interest ends automatically.

The less-popular but still common “or” delay-rental clause contractually obligates the lessee to either drill a well, pay the delay rentals fee or surrender the lease. Failure to do any of these three constitutes a breach of contract but does not result in automatic termination of the lease.

The latter, “or” delay-rental clause, allows the lessee more flexibility as it may choose to not pay the fee and risk a breach of contract lawsuit for damages rather than paying the fee. In fact, some courts have required repeated failures on behalf of the lessee to pay rentals on time in order to justify forfeiture of the lease.[13]

Delay-rental clauses only apply to the primary term of a mineral lease, so developers often negotiate other terms to help them preserve their rights under the lease if they encounter a period of non-production in the secondary term. For example, a pooling clause allows the mineral rights lessee to treat all adjoining subsurface estates as a single resource, with each unit of land being entitled to a proportional development right.

Comparable to delay-rental clauses are provisions for shut-in royalties. Shut-in occurs when valuable minerals are on the property but are not being sold or used due to temporary adverse conditions.[14] For example, this issue can arise when a lease holder has rights to more than one type of subsurface mineral, but temporarily holds off on pursuing one of them due to complications and expenses of setting up drilling operations for multiple substances.[15] Shut-in royalty provisions provide that the lessee’ rights under a mineral lease can be maintained by the payment of a shut-in royalty.

Other Savings Clauses

Pooling clauses afford some flexibility because production off-site could potentially maintain the lessee’s rights in the secondary term despite a lack of production in paying quantities on each parcel. If five adjoining pieces of land are considered one “pooled” estate, producing resources on any of those five parcels could justify the continuation of the secondary lease for all five.

A force majeure clause is a common contractual term that excuses performance of certain contractual duties in the event that circumstances beyond the party’s control prevent performance, or, in this case, usage of the land for production. So, if a mineral lease has a force majeure clause, it excuses the lessee from performing drilling or mining operations when doing so would be impossible or unreasonable due to weather, surface conditions, labor strikes or any other circumstances the lessee would be unable to prevent.

Delay-rental clauses help lessees maintain their rights during the primary term, and clauses like pooling arrangements and force majeure afford mineral developers some flexibility during the secondary term. But certain savings clauses, including dry hole and cessation of production terms, can help lessees preserve their rights under a mineral lease during either term.

A dry-hole provision applies when a lessee drills a well or mine pursuant to a mineral lease during the primary term, only to discover operations are not possible. Dry-hole terms give developers a reasonable period of time to either drill a new well or pay a delay rental, which prevents them from losing their rights under the lease. [16] Often, dry-hole provisions and cessation of production clauses are combined into a single term.

Cessation of production clauses also hedge against the risk created by the hardline “production in paying quantities” standard courts apply to mineral lease holders during the secondary term. Rather than requiring production to continue in paying quantities, a mine or well operator may want to take time to improve production or gather information. If a mineral lease has a cessation of production clause, the mineral developer would be able to temporarily stop production in paying quantities under certain conditions without ending the secondary term. In fact, courts have created the temporary cessation of production doctrine that protects lessees from inadvertently terminating their lease rights if they are able to prove that the work stoppage was temporary and reasonable, even if the lease agreement had no cessation of production term.[17]

Savings clauses, however, cannot be used to delay production indefinitely, since doing so would cost the lessor the opportunity to make arrangements with more effective developers. Courts have inferred the implied covenant for further development to prevent a mineral rights lessee from holding onto a mineral estate forever without making good use of it.[18]

Under the implied covenant for further development, courts may terminate mineral rights leases that are being unfairly underused. Courts review several factors when determining whether a lessee’s rights should be extinguished. Relevant factors include the quantity of subsurface minerals likely to be found, the market conditions, neighboring operations, physical characteristics of the land, the cost of drilling and related activities, the willingness of a competitor to operate on the tract of land in question, the time lapse since the last extraction was performed and the general attitude of the lessee regarding further development. If a lessor is able to show that termination of the lease is merited under these factors, she will be allowed to lease the property to another developer.[19]

Conclusion

            Mineral rights leases serve a niche role in the law, and as a result they have developed a unique form and function. This basic introduction to the main components of a mineral lease should help prepare you for the next section of the course, which provide a more in-depth explanation of other key contracts common across oil, gas and mineral transactions.