Ownership Of Minerals, Interests Created In Oil And Gas Leases And Royalties

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August 21, 2018
Author: Karen J. Greenwell
Organization: Wyatt, Tarrant & Combs, LLP

A. Patents.
Title to all real property in the United States derives, in the first instance from a sovereign. When Kentucky became a state in 1792, it adopted all of the real property statutes then in effect in the Commonwealth of Virginia, of which Kentucky had formerly been a part. Those statutes provided specific mechanisms for the acquisition of title to real property from the sovereign, and those mechanisms were imported into the law of Kentucky.

In general, the goal of the statutes was to encourage the settlement and development of the vacant lands on western frontier that was then Kentucky. The statutes, first of Virginia and later of Kentucky, allowed individuals to acquire title to real property from the sovereign by means of a land grant or “patent.” Thus, with the application of unlimited time and money, most titles to real property in Kentucky can be traced back to a patent issued by the government of Virginia or Kentucky.1

B. The Patenting Process.
Kentucky’s current statutes relating to the acquisition of title from the Commonwealth are found at KRS 56.194 through KRS 56.240. Although the specific statutes have changed since 1792, the basic process remains largely the same. [1] Warrants and County Court Orders. Generally, the process for obtaining a patent under either the laws of Virginia or Kentucky required that the applicant first obtain the right to request ownership of a specific quantity of acreage. Typically this right was in the form of a “Treasury Warrant” which evidenced the applicant’s payment of the requisite per-acre price for a specific number of acres. In addition, Virginia issued “Military Warrants” to soldiers in the French and Indian War and the Revolutionary War.

In 1835 the Commonwealth of Kentucky assigned all lands that were then vacant and unappropriated to the County Court of the county in which the land was located. This authorized the county to sell the vacant and unappropriated land within its boundaries by issuing a “County Court Order,” which had the same effect as a Treasury Warrant.

None of the Treasury Warrants, Military Warrants or County Court Orders specified any particular property to which they attached. They merely entitled the holder to identify and claim vacant and unappropriated lands and to proceed with the appropriation process. While Treasury Warrants and Military Warrants were exercisable in all counties, the holder of a County Court Order could only use that authorization to appropriate lands within the county that issued the Order. A patent issued for property outside the county which issued the County Court Order is invalid. Consequently, it is very important both in evaluating the validity of the patent which forms the basis of the chain of title, and for running the chain of title, to correctly identify the counties in which the property has been located over the years.

The area which is now Kentucky was originally part of a single county of  Virginia, “Kentucky County.” Later, while still part of Virginia, Kentucky County was divided into three counties: Fayette, Jefferson and Lincoln. By the time Kentucky became a state in 1792 its area had been divided into eighteen Kentucky counties. Of course, it now has 120 counties made from those eighteen. Thus, any particular piece of real property may have been located within several counties in the past.

Records relating to real property will be located in the county clerk’s office of each county for which it has been a part, and the records in each of those must be checked in performing a title examination. The most comprehensive single source of information about Kentucky’s counties, their locations, their enacting legislation, is a publication which is now out of print called An Historical Atlas of Kentucky by Wendell H. Roan, Sr. This small, but fact-filled book will prove invaluable to anyone involved in mineral title examinations.

[2] Entries and Surveys.
Once an applicant obtained a right to claim land, it was the applicant’s obligation to identify an area of “vacant and unappropriated land”. Each county had an official surveyor. The applicant was required to notify the surveyor of the relevant county of: (a) the source of the applicant’s right to claim real property; and (b) the location of the property the applicant wished to claim. The county surveyor would note this information as an “entry” in his entry book, and that entry was the first step toward appropriating a specific tract of property.

After noting the entry of the claim for a patent in his entry book, the surveyor would ultimately survey a claimed area based on the locations provided by the claimant. The survey was copied into the surveyor’s book, and a copy was given to the claimant. The statutes contained numerous technical requirements for the survey, including that it be witnessed and signed by two disinterested householders of the county.

Failure to comply with those requirements could result in a determination that the patent was void and that the title based on it is invalid.

In the early days of appropriation of property within what is now Kentucky under the Virginia statutes, it was common for claimants (among them Patrick Henry) to send survey parties up the rivers and creeks surveying the water courses. Those surveys frequently resulted in patent claims which were corridors of property along the water courses and which did not reach to the tops of the adjacent mountains. It was, however, the practice of subsequent settlers to claim from ridge top to ridge top, giving rise to claims of title by adverse possession to the entirety of the hollow. The applicant was required to deliver the survey to the Land Office for the patent to be issued. The timing of the effectiveness of the patent depended on whether the applicant delivered the survey to the Land Office within the time specified by the applicable statute. If the survey was delivered to the Land Office within requisite time, the patent was effective from the date of the survey. If it was not timely delivered, it was effective from the date the patent issued.

The surveyor was not obligated to ensure that the property included in a survey was indeed vacant and unappropriated. This, and the fact that the surveyors frequently did not actually survey the property on the ground (as evidenced by the perfect shapes of many of the “surveyed” properties) resulted in many overlaps and conflicting claims to properties in Kentucky. Hundreds of reported Kentucky decisions reflect these disputes, and the courts’ efforts to adjudicate the priority of junior and senior patents and claims of adverse possession.

C. The “Ad Caelum” Doctrine.
Once an applicant received a patent from the Land Office, he became the owner of that property in fee. The fee owner is deemed to own the property from the top of the sky to the center of the earth (“Ad Caelum Doctrine”). Consequently, the owner has not only the right to farm, take timber or otherwise develop the surface of the property, but he also had the right to develop its underground mineral resources. Moreover, in addition to owning, using and developing the entirety of the property, the fee owner also has the right to sell or otherwise dispose of some or all of the property and/or interests therein.

An owner of real property can divide and transfer interests in real property in a number of different ways. Property ownership is frequently analogized to a “bundle of sticks” with each stick in the bundle representing some interest in the property. Conceptually, real property may be divided:
[1] vertically – by dividing the property into smaller pieces with each owner of a smaller piece having the full set of ownership interests;
[2] horizontally – by conveying ownership of different strata of the property as when the surface estate is severed from the mineral estate;
[3] among multiple owners, so that each owner has an undivided interest in the conveyed property; and
[4] by transferring an interest less than ownership of the property but which grants its owner a right with regard to the property. Each of these types of subdivisions will be discussed below.

A. Vertical Subdivisions of Property.
The simplest property division is the conveyance of the fee ownership of a specific portion of the grantor’s property. In the context of the “bundle of sticks” analogy, it would be as though the bundle had been broken in half, and half of each stick comprising the bundle was transferred away. The law relating to such transfers forms the basis for the courts’ understanding and articulation of more complex conveyances, such as the horizontal divisions discussed Section C, below.

B. Plural Ownership – Co-Tenancy.
More than one person can own the same property at the same time as cotenants. All of the co-tenants own the entire bundle of sticks together, with each having undivided interest in the entire property. Each co-tenant has the absolute right to possess the entirety of the property, and no co-tenant can exclude any of the other co-tenants from the property. If a co-tenant does make economic use of the co-owned property, that cotenant must account to all of his other co-tenants for their share of those profits. That is true even though the co-tenants may not have participated in the profit-making activity. When property is divided among multiple owners, the ownership interest of each of the co-tenants becomes a separate chain of title to be examined, because each of those interests is subject to further transfer either by deed or by will or through intestate succession.

The absolute right of each co-tenant to use and possess the entire property can obviously result in conflicts among the co-tenants. Kentucky’s statutes (KRS 381.135 and KRS 389A.030) provide a solution to this dilemma in the form of a partition action. Under those statutes, a co-tenant may apply to the courts for a partition of the property. If the property is such that it can be divided equitably and without diminishing the value of each co-tenant’s share, the property will be physically divided. A specific part of the property will be allotted to each co-tenant. If the property cannot be equitably divided in kind (as is the case with most mineral properties) the partition statutes provide for a judicial sale of the property. The proceeds of that sale will be divided among the co-tenants in accordance with their ownership interests.

C. Horizontal Subdivisions of Property.
Real property may be divided horizontally so that different parties own the surface and the mineral interests. The minerals may be further subdivided by conveying the coal, the oil, the gas, and certain seams of coal and/or certain depths or geologic formations to different owners. These severances are all effected by means of deeds in which the grantor either conveys or reserves certain interests out of his fee ownership. These deeds, and particularly the deed which separates the surface from the underlying minerals, are referred to as “severance deeds.”

The most common initial severance of real property is the separation of the ownership of the surface from the ownership of the underlying minerals. The term “minerals” when used in a severance deed has been interpreted in Kentucky to include oil, gas and related products unless the terms or context of the document require otherwise. Interestingly, in Kentucky the term “minerals” does not include limestone, at least in those areas of the state where limestone is the predominating subsurface material. In addition to granting the minerals, a severance deed will typically also give the grantee of the minerals specific rights to use the surface for the development of the transferred minerals. The most well-known of these provisions are found in the so called “broad form deeds” which were used to sever the ownership of hundreds of thousands of acres of property principally in Eastern Kentucky from the ownership of the surface. The broad form deeds were used by property aggregators to acquire vast acreages of minerals. While the most famous and most comprehensive of the broad form deeds - - the “Northern Coal and Coke Deed” - - was used in Eastern Kentucky, similar mineral aggregation occurred in Western Kentucky using similar, if frequently less comprehensive, broad form deeds. The broad form deeds, and specifically the Northern Coal and Coke deed, granted the mineral owner extensive rights to use the surface of the property for the development of the conveyed minerals, and for the development of minerals on other properties. Among the granted surface uses relating to oil and gas granted in the Northern Coal and Coke deed are: (i) the exclusive right to enter upon the land and to drill for oil and gas; (ii) the right to store oil and gas upon the land; (iii) the right to use, divert, and pollute water courses; (iv) the right to build or remove any buildings or other structures; and (v) the right to leave behind any refuse from the wells or mines.

In addition to the long litany of specific surfaces uses granted to the mineral owner, some broad form deeds went further to grant the mineral owner the sole right to grant easements on the property. This “easement granting power” is articulated in some Northern Coal and Coke deeds as follows:

and the exclusive rights-of-way for any and all railroads, tram roads, haul
roads and other ways, pipe lines, telephone and telegraph lines that may
hereafter be located on said land by the parties of the first part, their heirs,
representatives or assigns, or by the party of the second part, its successors
or assigns, or by any person or corporation with or without the authority of
either of said parties, their, or its heirs, representatives, successors or

Pursuant to this provision, the mineral owner and not the surface owner, has the sole right to grant an easement across the surface of the property. The purpose of this provision was obviously to prevent the surface owner from granting easements in the surface that would conflict with the grantee’s later development of the coal.

The extent of the rights granted by broad form deeds was the subject of extensive legislation and litigation in the late 1980s and early 1990s. As a result of that activity, Section 19(2) of the Kentucky Constitution provides that surface rights granted in a broad form severance deed will not be sufficient to allow surface mining on that property unless the proponent of the mining shows that surface mining was known and was in use in the area at the time the relevant severance deed was made. In all other respects, however, broad form deeds are effective in accordance with their terms, and they form the basis for much of the mining and oil and gas development that has occurred, particularly in Eastern Kentucky, since the early 1900s.

Many of the companies that were grantees under broad form deeds in Eastern Kentucky were primarily interested in developing the coal acquired pursuant to those deeds. Consequently, much of the oil and gas that they acquired pursuant to those broad form deeds was conveyed to companies or individuals for separate development. Hundreds of thousands of acres of oil and gas interests that had been severed pursuant to broad form deeds in Eastern Kentucky were conveyed to RJ Graf in the 1910s and 1920s. Much of that oil and gas is now controlled by large gas companies. Unlike the broad form deeds, many other severance deeds convey few if any express surface rights. In those cases, the concept of implied or appurtenant rights, discussed in Section II(D)(2), below, would apply. Although interests in oil and gas may be conveyed and severed pursuant to severance deeds, there are some distinctions with regard to the nature of the ownership of oil and gas, in comparison to solid minerals, which are discussed in Section III, below.

D. Easements, Appurtenant Rights and Other Use Rights.
In addition to creating multiple owners of the same property and dividing the property vertically and horizontally, an owner of real property also has the right to convey lesser interests that would entitle or allow another to make use of the property. These lesser interests can take many forms, but among most common are leases (which will be discussed in more detail in Section IV, below, and in other presentations) and easements.

[1] Easements.
An easement is not an ownership interest in real property. Rather it is a right in one person to use the property of another. Easements may be created by: (a) express grant; (b) prescription of adverse use; (c) necessity; and (d) implication. The most familiar way easements are created is by express grant, and the most familiar type of easement is an access road or passway.

For example, assume that A owns the entire hollow (“Whiteacre”) and a public road borders Whiteacre property at the mouth of the hollow. If A sells B the portion of Whiteacre lying at the head of the hollow (“Blackacre”), B may have no way to access a public road except by going through Whiteacre. In that case, A would typically grant B an easement for a road or passway through Whiteacre. That express grant would be included in the deed from A to B for Blackacre.

In this example, Blackacre would be referred to as the “dominant estate” because it is benefitted by the right to use Whiteacre. Whiteacre would be called the “servient estate” because it serves Blackacre by being used for a road or passway. The easement in Whiteacre is said to be “appurtenant” to Blackacre because it serves Blackacre, and the easement would be conveyed to any grantee of Blackacre. Easements which do not directly serve or benefit a specific property, such as a gas transmission pipeline right-of-way or an electric transmission line right-of-way, are referred to as “easements in gross.” At common law easements in gross were rights that were personal to the grantee and were not transferable. That situation has changed both by statute and common law, and commercial easements in gross are generally now freely transferable.

An easement may be acquired in the absence of an express grant by prescription, by implication or by necessity. For example, in the situation referenced above, if A did not expressly grant B an easement to cross Whiteacre, an easement might be implied because A conveyed the property to B without any access to a public road. Under common law and Kentucky case law, the courts would assume that A did not intend to sell B a piece of landlocked property which B could not access. Therefore, the courts will imply a right of access and an easement for B. If a piece of property is landlocked and has no access to a public road, an easement may be granted by a court as a way of necessity. An easement by necessity may be acquired on properties in circumstances other than the grantor/grantee relationship of A and B above. If a use is made of the property of another for the statutory period (typically fifteen years in Kentucky) and that use is open, notorious, hostile and under a claim of right, the user may obtain an easement by prescription. The requirements for an easement by prescription are the same as those as for adverse possession.

[2] Appurtenant or Implied Surface Rights.
When the first courts first analyzed the consequences of a severance of the surface estate from the mineral estate, they conceptualized the surface and mineral estates as though they were two adjacent pieces of surface property. The courts applied property concepts applicable to adjoining properties to their analysis of the access relationship between the surface and the underlying minerals. Based on the concept of an implied easement or an easement of necessity, the owner of minerals is deemed as a matter of law to have certain rights to use the overlying surface in the development of the underlying minerals.

In general, the mineral owner is entitled to do such things on the surface as are reasonably necessary for the development of the minerals. It may not, however, make those uses wantonly or maliciously. A mineral owner’s implied or appurtenant rights do not extend to using the surface for the development or benefit of minerals other than those covered by the severance deed. For example, the holder of severed oil and gas rights may use the surface of the property for the purpose of installing necessary roads, drilling wells, installing pipelines, tank batteries and other facilities that are necessary for the development of oil or gas from that property. Facilities that serve the development of minerals from other properties could not be constructed on that property pursuant to implied rights.

[3] Other Use Rights.
There are other lesser use rights which may be applicable in the context of severed minerals. One is the profit à prendre which allows the holder to enter the property and to take the benefits from the soil of the property. Some arrangements that are interpreted as being a profit à prendre include: the right to take driftwood, to fish, or to take game. A profit à prendre is non-possessory, and it is irrevocable and is assignable. A similar interest is a license. A license is typically not exclusive, and it is subject to revocation by the grantor. If, however, a license is coupled either with an estoppel such as an expenditure or reliance or with an ownership interest, then the license may become irrevocable.

Early courts evidenced a somewhat exaggerated view of the fugacious nature of oil and gas. They seemed to conceptualize oil and gas as being in large underground rivers, flowing freely from one property to another beneath the surface of the Earth. Based on this premise, they likened oil and gas to ferae naturae or wild animals which were free to run from property to property.

Based on this analogy, the earliest courts to consider the nature of ownership of oil and gas applied the law of wild animals to that question. The law relating to wild animals provided that wild animals were not owned by anyone. Rather, they were free, but subject to capture. When captured, they belonged to the owner of the real property on which they were captured or the person to whom such owner had given the right of capture. This concept gave rise to the “rule of capture” applicable in most if not all jurisdictions to the ownership and development of oil and gas.

The application of the rule of capture is essentially a non-ownership theory pursuant to which oil and gas are not deemed to be owned in place, like solid minerals. Under this theory, oil and gas is not truly owned by anyone until it is captured. The owner of severed oil and gas interests is the owner of the right to prospect for, develop and capture oil and gas from specific property. Kentucky is frequently classified in the oil and gas law treatises as a non-ownership state.

Once the minerals (or just the oil and gas) have been severed from the entire fee ownership of real property, the owner of that severed mineral interest may create new, lesser interests in the minerals, and it may convey those lesser interests to others.

A. Co-Tenancy Interests.
As noted above, the ownership of property may be divided among numerous co-tenants all of whom have an equal right to use and possess the property. The same is true of severed mineral interests.

B. Leases.
Perhaps the most common interest created from the mineral interest is a lease. Like an easement, a lease is not an ownership interest in property. However, it is a greater interest in real property than an easement in that it is a possessory interest which gives the lessee rights to possess the property against all the world including the lessor, and it is irrevocable except in accordance with its terms. Specific terms of oil and gas leases are discussed in more detail in Section VI below.

C. Non-Participating Royalty Interest.
This royalty interest is different from the landowner’s royalty that would be paid to a lessor under a lease. This is essentially a right to a stated fraction of the production of oil and gas from the property or a stated fraction of the lease royalty. As indicated by its name, this interest is “non-participating,” which means that its owners have no obligation to pay (directly or indirectly) any costs associated with the development of the oil and gas.

D. Non-Participating Mineral Interest.
This interest is similar to a co-tenancy interest in oil and gas, except that it does not carry all of the attributes of mineral ownership. The document creating this interest should be specific as to the rights and interests that the owner does not “participate” in. For example, the non-participating mineral interest may not share in any bonus payment or shut-in well payments and it may be structured so that the nonparticipating mineral interest owner does not have the “executory right.” The executory right is the right to lease or otherwise develop the minerals.

A. Division of Lease Royalty Income-An Interest Created by the Lessor.
The lessor may convey an interest in the royalty to be paid to the lessor pursuant to a lease. By such a conveyance the lessor essentially conveys away a portion of his royalty. Such conveyances were common in areas of Eastern Kentucky as a way for a lessor of a lease to raise cash. The instrument creating this sort of interest should be carefully examined. Frequently, they also contain a provision which converts the royalty interest to an ownership interest in the event that the existing lease terminates.

B. Interest Created by the Lessee Out of the Leasehold.
The lessee can create several types of interests from its interest in the lease. These interests fall into basically two categories: (1) interest created out of the revenue to be generated from the development of the oil and gas; and (2) interests created out of the lessee’s working interest.

[1] Overriding Royalty.
The lessee may convey an overriding royalty to a third party. This is a portion of the revenues created by the lease. Typically, the overriding royalty is calculated prior to the payment of any expenses, and it does not bear any obligation for expenses. Because the overriding royalty interest is tied to the revenues produced under the lease, the recipient of an overriding royalty interest (or any interest created by the lessee), will want to include provisions in the granting instrument to protect the integrity of the lease to avoid a termination of the interest by the lessee through an intentional or contrived termination of the lease.

[2] Production Payment.
A production payment is an interest in the revenue similar to an overriding royalty. However, the production payment is limited in either duration or amount so that it is designed to terminate. A production payment is frequently used to repay an investor by allowing them to recoup a certain amount of revenue from the property free of costs.

[3] Net Profits Interest.
A net profits interest is a non-operating interest in that its holder has no right to be involved in the development of the property. It is a right to receive a portion of the production royalty from the lessee’s share. However, the net profits interest is calculated after the payment of expenses. Therefore, the holder of a net profits interest indirectly bears development expenses, but the holder of the net profits interest is not otherwise responsible for the payment of development costs. The document creating a net profits interest should carefully define the relevant costs and revenues attributable to the interest.

[4] Carried Interest.
With a carried interest, the lessee will pay the expenses associated with (or “carry”) the interest until the occurrence of some event--usually a revenue threshold. For example, an investor in a well might be carried so that he is free of the payment of any development costs until he has recovered 200% of his investment.

[5] Convertible Interest.
This interest is seen most frequently in a farmout scenario. A farmout occurs when a developer has a large lease area which he either cannot or does not want to fully develop. Rather than releasing a portion of the lease acreage, the lessee may “farmout” some or all of the leasehold to another developer. In a farmout scenario, the farmor (the original lessee of the lease) typically will retain an overriding royalty in any of the wells drilled on the farmed area. In addition, that overriding royalty may be a convertible interest, that can convert to a working interest. This feature allows farmor to convert its interest from a non-participating overriding royalty into a larger working interest. If the conversion is at the option of the farmor, the convertible right is frequently referred to as a “back in” right.

The oil and gas lease is the primary mechanism pursuant to which oil and gas development is conducted. Generally speaking, the lease grants to the lessee the exclusive right to explore for and develop the oil and gas on the property along with other related rights. In exchange for those rights, the lessee agrees to pay to the lessor certain royalties, whether in kind or in money.
A. Implied Covenants.
There are a numbers of covenants that have been implied by the courts into oil and gas leases.

[1] Covenant to Protect From Drainage.
The lessee is obligated to drill wells to prevent the leased property from having the oil and gas below it drained by wells on neighboring properties. Typically, compliance with spacing and set-back regulations relating to the location of wells will satisfy any drainage prevention obligations. However, if the lessor can show that drainage has occurred or is occurring, and drilling an off-set well would be feasible, then the lessee must do so. In order to show that drilling an off-set well is feasible, the lessor must address such topics as the costs of drilling, completing and operating the off-set well balanced against the potential recovery from such wells.

[2] Covenant of Reasonable Development.
The lessee is obligated to drill sufficient wells to prevent undue delay in the recovery of the oil and gas from the property or the possible loss of such oil and gas. The obligation applies only to known formations and leasehold areas which have been productive. The issues in determining whether the obligation to drill additional wells pursuant to the covenant of reasonable development include the likelihood of additional economic production and the possibility of affecting the production of existing wells by the drilling of new wells in the formation.

[3] Covenant of Further Exploration.
This covenant addresses the obligation to explore other formations or areas on the lease to determine whether additional drilling should occur. The obligation is “to the extent reasonable,” but the lessor need not prove that an additional well in an unexplored area or horizon will be profitable. The lessor must only show that a reasonably prudent operator would conduct additional exploration under the circumstances.

[4] Covenant to Market Production.
The lessee must use reasonable efforts to find a market for the production from the property. The lessee’s efforts in this regard are judged by the prudent lessee/operator standard which requires the lessee to act as a reasonably prudent operator would in similar circumstances. The prudent operator standard is not dependent on the specific circumstances of the operator, and it is not satisfied by simple good faith.

[5] Covenant of Initial Exploration.
This covenant requires the lessee to conduct initial exploration and drilling efforts on the lease. Typically, the lease will have a relatively short initial term, and it will terminate in accordance with its terms if initial exploration does not occur during the initial term.

[6] Covenant of Reasonable Care and Due Diligence.
This is essentially the application of the reasonably prudent operator standard to the lessee’s activities under the lease. All of these implied covenants may be overcome by specific lease provisions which either address the topics covered by each of the implied covenants or which expressly excludes the application of any implied covenants.

B. The Grant.
The granting clause defines property affected by the lease and the nature and scope of the rights granted to the lessee. The property may be described by metes and bounds, reference to a deed to the lessor, or by reference to abutting landowners. It has been the practice in the oil and gas industry to define the property by identifying the neighboring property owners. This practice is problematic and carries the risk that the description will be insufficient. In addition, oil and gas leases frequently contain what is referred to as a “Mother Hubbard” provision which expands the granted area to include any neighboring properties or interests owned by the lessor. This provision is designed to avoid any “gaps” or “gores” between the property descriptions that might result in adverse property ownership next to the lease.

The lease will contain specific surface rights, including rights to install pipelines and other surface facilities, and they frequently include the right to use the surfaced leased property for the benefit of other properties owned or controlled by the lessee. Of course, the lessor can grant only those surface rights which it has. Consequently, if the lessor is leasing severed oil and gas, any of the stated rights contained in the oil and gas lease may not actually accrue to the lessee if the lessor only has implied surface rights.

The grant also describes the production which the lessee is entitled to take. That production may include gas, oil, coalbed methane, other hydrocarbons and other gases produced with the gas. It may provide for the sale or other disposition of some ancillary products such as sulphur.

C. The Habendum.
The habendum describes the duration of the lease. As noted above, the lease typically has a primary term of two to five years and then an extended term to last as long as production continues on the property. Typically the production required to hold the lease is either expressed (or implied by courts) to be production in “paying quantities.” “Paying quantities” generally means production the value of which is greater than the costs associated with the production. Because production is a condition for the continuation of the lease, a cessation of the production results in automatic termination of the lease if there are no other savings provisions in the lease. Production from one well on the property will cause the entire lease to be “held by production.” That is, the entire lease, regardless of how large it is, may be maintained in effect by the existence of one producing well either on the property or pooled with the property [See Section E, below]. Because of the Draconian consequences of a failure of production, oil and gas leases are designed with various savings provisions to prevent the termination of the lease. One mechanism is the inclusion of a delay rental which allows the initial term to be extended without production by the payment of a certain sum of money, usually stated in dollars per acre. The delay rental payment may have additional savings provisions to prevent the lease from terminating if the wrong amount of delay rental is paid, or if it is misdirected or paid late. Otherwise, an incorrect payment is fatal to the lease. A “dryhole/continuation of drilling provision” allows the initial term to be extended if a well has been commenced, but is not completed, within the initial term or if a well is completed during the initial term but is a dryhole.

D. Pooling.
Most leases contain a provision allowing the property to be pooled with other neighboring properties. This allows a well to be placed closer to a property boundary or another well than would otherwise be permitted by the relevant setback and spacing regulations. In such a case, the regulatory production area around the well is considered to cover more than one property.

A typical pooling provision provides that a pooled well will be treated for all purposes as though it were a well drilled on the property. Thus, by drilling a well whose production area touches on a number of leases, the producer can hold each of the leases by production by the drilling and operation of a single pooled well. Consequently, a pooling provision may be problematic for a lessor of a large area in that it would allow the entire leasehold area to be held by production even though the lessor receives only a small portion of the royalties from a single well.

One solution to this issue is the inclusion of a so-called “Pugh Clause.” A Pugh Clause states that the installation of a pooled well will serve to hold the pooled area by production but not the remaining areas of the lease. Since pooling provisions are quite common in Kentucky, and Pugh Clauses are not, only a lessor with strong bargaining power will be able to cause a Pugh Clause to be inserted into his lease.

E. Royalty.
[1] Oil
The lease typically requires the lessee to pay a royalty to the lessee for oil or gas produced. The oil royalty is usually stated as a portion of the oil, and it may provide for the delivery of oil “in-kind.” However, the lessee generally prefers to sell the oil for its own account and to share the proceeds with the lessor. To accomplish that, the lease will grant lessee the right to sell the oil and to pay the lessor a portion of the proceeds of that sale. Oil is typically sold in the field at a field or wellhead price established by the distributor to whom the oil is sold. Thus, there is rarely much dispute about the pricing of oil sold from the lease.

[2] Gas
Gas pricing, however, is an entirely different story. Gas is typically no longer sold at the wellhead, and there is no longer a “field” price for gas. A gas royalty may be stated in terms of an index price, the proceeds of the sale of the gas, or a “market” price.

(i) Index Price.
The parties may choose to tie the royalty to a specific published index. This has a couple of advantages for the lessor. First, it is a verifiable amount, and it makes it easy for the lessor to confirm the correct value is being used in calculating the royalties. Second, it eliminates concerns that the lessee may be selling the gas at a price below market on a long-term or fixed-rate contract or to an affiliate. The lessee may have concerns about using an index since it creates the potential for it to pay a royalty calculated on a price higher than it actually received.

(ii) Proceeds.
Most lease forms provide that royalties be calculated based on the proceeds or revenue received by the lessee from the sale of the oil or gas. This formulation is beneficial to the lessee since it ensures that the royalties payable to the lessor are based on a price that does not exceed what the lessee actually received. As noted above, this focus on the actual revenue received by the lessee can be disadvantageous to the lessor if the lessee is selling the gas on a long-term contract or at a fixed price that is designed to be (or just happens to be) lower than the then-current market price.

The lessor’s royalty position can also be negatively affected if the lessee is selling the gas to an affiliate at a reduced price. This possibility is typically addressed by providing an alternate measure if there is no arm’s length sale. Because there is generally no established field price for gas, such a provision may require that the royalty be calculated based on comparable prices of gas in the vicinity, and agreed index or some other method.

(iii) Market.
More modern leases tend not to refer to royalties calculated based on “market” price because in most areas there is no such benchmark. If the parties insist on using “market” price for calculating royalties, care must be taken to define how that price will be determined, including the location of the “market.”

[3] Deductions.
Notwithstanding the fact that gas is rarely sold at the wellhead, many leases still refer to gas being sold “at the wellhead.” This circumstance led producers to calculate the wellhead price by netting out of the actual sales price the post-production costs of treating, compressing and transporting the gas. Because of recent controversies regarding the calculation of gas royalties, it is now imperative that the lease be specific as to the permissible deductions, the place for valuing the gas for sales purposes and the calculation methodology to be used.

[4] Natural Gas Liquids.
Natural gas contains methane and many other heavier hydrocarbons which can be removed as natural gas liquids by cryogenic or other processing. These hydrocarbons (such as propane, butane and others) can be fractionated and sold. Depending on the market price for each of these products and for the residual natural gas, the BTUs contained in these natural gas liquids (“NGLs”) may be more valuable in their fractionated form than as additional BTUs in the gas stream. In addition, most transmission pipelines require that the BTU value of gas in the line be approximately 1,000 BTUs per MCF. Consequently, if the gas produced is “rich,” (meaning that it has additional BTUs from the heavier liquefiable hydrocarbons) those additional hydrocarbons must be removed before the gas can be placed into a transmission line. The revenues and costs associated with selling and processing NGLs produced from the gas should be addressed in the royalty provision of the lease.

[5] Payment of Royalty and Remedies for Default.
Typically an oil and gas lease will contain a number of “savings” provisions to prevent the lease from being terminated or forfeited in the event royalties are not paid or are not timely paid. Frequently these provisions require that a lessor give notice that a royalty payment has not been made and will give the lessee a specified period of time in which to cure that non-payment.

The lease will set out specifically when royalties are due and the method of payment. If the identity of the lessor or the lessor’s address should change, the lease will typically contain a provision that excuses the lessee from making payments until it has received satisfactory documentation of that change. Further, the lease will typically provide that, so long as the royalty payment is sent to the last-identified address of the lessee, that payment will be sufficient even if it is not received or the lessee’s address has changed.

[6] Shut-In Payments.
A shut-in payment may become applicable if one or more wells exist on the property which are capable of production but which are for some reason not producing. The shut-in royalty is typically paid after the wells have been shut-in for a period of time, and it is in lieu of production. Because the shut-in payment is treated as a payment for production, it is as though the well was actually producing for purposes of keeping the lease in effect.

1 Some properties may not lie within the boundaries of a patent. Such titles may derive from possession of the property which has ripened into ownership pursuant to the doctrine of adverse possession.

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