Dallas Bar Association

Your Client Signed a Lease—What Comes Next?

by Rhodes W. Hamilton and Clifton A. Squibb

The February 2009 issue of Headnotes included an article by the foregoing authors entitled “Your Client Didn’t Sign a Lease—What Now?” That article addressed issues a practitioner might face when a client elects not to sign an oil and gas lease. This companion article addresses issues that arise once a lease is executed and operations and production begin.

Upon signing a lease, a lessor is usually pleased. A bonus check has just been delivered, no promises have been broken, and the oil and gas company has not yet had an opportunity to fall short of any expectations placed upon it by the lessor. But as time passes, such contentedness may fade as the lessor begins to question what lies ahead. Lessors who understand what to expect during the lease term will have peace of mind and will be well positioned to protect their interests.

Once a lease is signed, an operator will usually elect to have a title opinion rendered on the property describing mineral ownership and identifying any defects or irregularities in the chain of title that might impair marketability or give rise to any claims. The title opinion will contain comments and requirements that the lessee may attempt to “cure.” This “curative” may call for the lessor to furnish documentation in its possession or to execute correction deeds, amendments, affidavits or other instruments to clarify title. Before signing any curative instrument, a lessor should know exactly what the instrument is and how it affects the mineral interest.

If the lessor’s property is a residential lot or a small tract of land, the operator will usually elect to combine or “pool” the lease with other leases covering adjoining land. Pooling usually becomes effective when a declaration describing the pooled unit is filed in the real property records. The royalty is calculated pro-rata, based on the leased acreage in the unit and the total unit acreage.

Determining whether a particular exercise of pooling authority is valid may require navigating an esoteric body of case law. Yet lessors can guard against common pooling errors and abuses. Many leases limit the sizes of units or provide that all or some threshold percentage of leased property must be included in a pooled unit. Courts hold that such provisions require strict compliance. Less diligent operators also sometimes attempt to pool invalid leases and leases executed by individuals who own no interest in the described property. If the operator treats such leases as pooled, the royalty paid to the lessors under the remaining leases in the unit will be illegally diluted.

Once a well starts to produce, the most common question lessors have is, “When am I going to get my check?” Unless a lease provides otherwise, following initial production, royalty payments are due 120 days after the end of the month of first sales. Thereafter, royalties are due 60 days after the end of the calendar month in which oil production is sold and 90 days after the end of the calendar month in which gas production is sold. Lessees may withhold small royalty payments until the dollar amount accumulates to set statutory levels.

Prior to receiving payment, a lessor is frequently asked to sign a division order stating the decimal or fractional interest in production proceeds to which it is entitled. Prudent lessors will carefully examine such instruments before signing. At a minimum, the lessor should verify that the instrument accounts for all leased acreage included in the unit, including any adjoining strips and roadway acreage to which it has title. The division order should not misrepresent the payee’s pro-rata interest in production and should not modify previously-negotiated terms found in the lease. Although a lessee or payor is entitled to a signed division order, it may not condition payment on receipt of one unless it contains only the basic provisions listed in Section 91.402(c) of the Natural Resources Code.

An operator may withhold payment in several other situations as well. Section 91.402(b) allows a payor to suspend payment on the basis of (1) a title dispute affecting distribution of payment, (2) “reasonable doubt” that a lessor has clear title to an interest in production, or (3) certain title opinion requirements that are not satisfied after reasonable requests for curative. Accordingly, a lessor’s best interests are served by working with the operator to cure title defects. But as a practical matter, few titles are perfectly clean, and operators cannot overreach by citing minor defects as grounds for suspension of payment.

Rhodes W. Hamilton and Clifton A. Squibb, partners at Hamilton & Squibb, LLP, practice oil-and-gas and real-estate law. They can be reached at rhamilton@hamiltonsquibb.com and csquibb@hamiltonsquibb.com, respectively.

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