Mike May is the author of, “Negotiating Oil and Gas Leases: A Book for Land Owners” and “Investing in Oil and Gas (5th Edition)”. He is also a licensed Petroleum Engineer with over 20 years of experience in the Oil and Gas Industry. We asked him for his opinion on a wide range of topics. Those topics and his answers are below. You can learn more about Mike on his website, http://www.limestoneoil.com.

On the Shale Boom and Mineral Rights

Shale gas is a relatively new phenomenon in the United States. Recently huge deposits of shale gas have been discovered all over the United States. With the fairly recent large-scale success of fracking, it is now often economical to drill and attain this shale gas. This stands to benefit landowners as they are often able to lease their plots of land to companies for small-large sums of money. In the United States, all natural resources under one’s property are considered private -- and rights are usually owned by whoever owns the land. These people are Mineral Owners. When Mineral Owners begin to receive royalty payments, they “graduate” and become “Royalty Owners.”

On Leasing Your Land

The first step in leasing your minerals is to negotiate, and agree, on the terms of a leasing contract with an exploration and production company. The way a lease contract is set up entitles the mineral owner to a percentage of the market value of all oil and gas produced. This number usually ranges between 10-25% and a company will take into account the amount of risk and resources it takes to drill a successful well when negotiating the royalty rate. Companies put huge amounts of capital on the line for projects that may end in total failure.

The process of leasing, or re-leasing, your minerals is fairly simple. There are two terms (periods of time) involved in this process. The first term is known as the “Primary Term”. The primary term is the period of the time where a company has exclusive drilling rights. For example, a company will pay a bonus payment of X dollars for the exclusive right to your land. This usually lasts for one, three, or less commonly five years. During this period, the company does not have to take any action in the area.

The next term is known as the “Secondary Term”. In the secondary term a company will have rights to a lease as long as they “establish production in paying quantities”. Essentially this means a company will have rights to the land as long as the wells are producing. This ensures the company gets a return from their investment. As long as the wells are producing in “paying quantities” the company will retain gas and oil rights while paying royalties.

After the primary term is over, and no drilling has occurred, the owner is allowed to “re-lease” the land to a different company. It is the same process as the first time around. The key to whether the mineral owner is free to re-lease the property comes down to the term, “paying quantities.” If there are royalties being paid when the primary term ends, one is not allowed to re-lease. However, if there are no royalties being paid, an owner is allowed to re-lease. Situations where “paying quantities” is in question are generally decided on a case-by-case basis.

What kind of income can I expect from leasing? 

When leasing rights, there are often two sets of payments. The first payment is upfront and usually referred to as a bonus payment and is based on a per-acre scale. It’s comparable to a sign-on bonus with a company. The money is up front and comes with no strings attached. The rate paid may vary from hundreds to thousands per acre. At this point the company has exclusive rights to the minerals, as outlined in the contract, for the length of the contract. They are not forced to drill and sometimes the entire lease will run out without any activity.

The second payment, that may or may not come, are royalty payments from the mineral extracted. These payments range. Some states have a minimum set in law so the owner gets his fair share.

Does it matter to whom I lease; smaller companies versus Bigger Companies?

An overlooked concept is to whom you should lease your gas & oil rights. Big companies have their advantages as does smaller companies. However, there is a distinct difference. Some background details are needed before the differences can be seen.

Larger companies have a lot of capital and are usually interested in larger projects. When signing a contract with a larger company one can expect a big sign on bonus and then no activity for several months or even years.  These companies have massive capital and the time to do research on an area. This means that the valuable gas royalties will not be paid until the area is developed. Sometimes a contract will run out with no activity done in the area. The only way to get out of this is to wait until the contract expires and sell the rights to someone else. This is usually at least several years and may kill the dream of early retirement. Signing with a smaller company is the opposite. The bonus payment will not be as high but they will usually rush to develop the area. 

Smaller companies do not have the capital or time to leave an area of land they lease undeveloped. This means there is likely a lower bonus payment, but gas royalties can be expected to come a lot sooner.  Bigger companies are looking for those huge projects with a huge payoff. Smaller companies are willing to take smaller and less profitable projects; usually because of a lack of capital and resources. There is risk to both of these options. However it is usually impossible to evaluate the risks and will often come down to personal preference.  If one is looking for royalty income sooner, the smaller company route is the way to go.

What to Know When Attempting to Lease Your Land 

One big concept is the idea of “hot” and “cold” areas. There are many regions of gas shale in the United States and only so many entities that are drilling and extracting gas. During any period there will be areas that have a lot of activity and areas that have a small amount of activity if any at all. For example one really hot area right now is the Marcellus Shale region in Pennsylvania. Another big hot spot that is very popular right now is the Bakken Shale region in North Dakota. A landowner in these areas receives tons of offers on their land. In a case like this it is wise to shop around and see what different companies have to offer.

This can also happen for other reasons. Currently the Marcellus Shale region in New York is worthless because of New York’s current memorandum on fracking. Without fracking drilling for natural gas in shale is not effective at all. For this reason this area is very cold and companies will not even look at leases in the area. 

Having a Knowledgeable Source When Negotiating a Contract 

It is important to be consulting with someone versed in Oil and Gas law when negotiating a contract. There are many areas of a contract that are extremely difficult to navigate unless you are well versed in oil and gas law. There are sections that determine where & when a company can drill, where the pipelines may go, among other things. Overlooking these factors when negotiating a contract can be a huge mistake. Also take in account the small company versus large company factor. Rights sold to a larger company may not be acted upon for months or years. Weigh your options and think about everything carefully before signing a lease.

In Part 2, we will ask Mike about royalty deductions and making sure your royalty payments are accurate.

Part 1 was originally posted on shaleforum.com