Mineral Rights Owners Have Scant Chance Of Renegotiating Terms

A study of mineral leases in the Fayetteville Shale Play of north-central Arkansas shows that more recent contracts carry significantly better royalty and signing bonuses than did the earlier leases.

(To see a graph depicting the average integrated bonus by month since 2006, click here.)

Leases typically have a term of five years, meaning some of the earliest leases in the successful gas deposit could be up for renegotiation next year. But can early signers expect to get better terms like their late-to-the-party counterparts?

The answer is disappointing: Probably not. If a production company hasn't yet drilled on a piece of property, it probably means that the company has determined the land won't be productive. And if production has already started, the lease terms are locked in until the well runs dry.

Under certain circumstances, a mineral rights owner can renegotiate for better terms. However, most gas producers have done their part to ensure only a few of the low-cost leases slip through their hands.

A University of Arkansas study estimates that activity in the Fayetteville Shale will contribute $17.9 billion to Arkansas' economy between 2008 and 2012 – a figure that is probably very conservative.

Charles Morgan, an oil and gas lawyer with the firm Dunn Nutter & Morgan LLP in Texarkana, Texas, said natural gas companies began collecting lease agreements in 2004 and 2005. It was no mystery that the Fayetteville Shale contained natural gas, but up to that point the technology did not exist to extract it profitably, he said.

Since so little was known about the Fayetteville Shale in those years, many of the earliest agreements paid mineral rights owners a 12.5 percent royalty – the minimum under state law – and a bonus of $25 per acre for the lease, said Morgan, who is licensed to practice in both Arkansas and Texas.

"Some of the lands had not seen a lease agreement in 50 years," Morgan said about the naivety of Arkansans during the early stages of activity in the Fayetteville Shale.

George Carder of the Carder Law Firm in Searcy has helped negotiate contracts on behalf of mineral rights owners. He said that while normal leases extend five years, some agreements are for three years and others extend 10 years. Most contain a clause allowing the production company to extend the agreement.

"The leasing companies, that's their first preference," he said. "Those that I've seen generally have something like that in there."

The agreements were often negotiated by third-party representatives acting on behalf of a natural gas company, Morgan said. The arrangement kept the lease acquisitions quiet, Morgan said.

As people realized large natural gas companies were collecting leases, mineral rights owners began saying, "Well, if Seeco is willing to buy that acreage, it must be worth something," Morgan said.

The goal early on was to lease the rights to as much land as possible and then determine where drilling would yield hydrocarbons, Morgan said.

Natural gas companies now would have a hard time signing up mineral rights owners to the terms of the original lease agreements. A study conducted by Morgan shows that the average bonus paid to mineral rights owners has steadily risen since January 2006, when a bonus netted about $150 per net mineral acre. In March 2008, the bonus payments reached about $500 per net mineral acre, and anecdotal evidence suggests that some mineral rights owners are getting more than twice that much.

And while royalty percentages have not jumped as substantially as bonuses, many mineral rights owners can expect their share to total about 17.5 percent, compared with about 15 percent in 2006. Morgan's study uses data provided by the Arkansas Oil & Gas Commission, which records only the highest royalty and bonus a gas company pays in a geographic section. A section is a defined 640-acre – 1 square mile – block whose mineral royalties are divided pro rata among owners.

Competition Pushes Prices

Competition drives the price of contracts between mineral rights owners and drilling companies, lawyer Thomas Daily of Daily & Woods PLLC of Fort Smith said. Daily and his firm represent several production companies involved in Arkansas' two natural gas-producing basins: the Fayetteville Shale in north-central Arkansas and the Arkoma Basin in western Arkansas.

If a producer fails to drill within the time frame established in a lease, the producer has most likely "lost interest," Daily said.

The industry usually develops land in a specific pattern. The drilling companies move throughout their leased territory, poking holes in the ground at regular intervals, Daily said.

"The industry wants to blanket the [Fayetteville Shale] play with wells that are about one mile apart," he said.

The wells, spaced evenly about one section apart, allow the gas companies to better learn the region's geology. Also, since drilling a successful well locks a section into a lease until all wells on that land stop producing, companies want to lock as many sections into their original lease agreements as possible, Daily said. The original lease signed by a mineral rights owner will cover all producing wells on the section.

Morgan of Dunn Nutter & Morgan cited two reasons for the failure of operators to drill on a specific piece of leased land: Either companies do not expect to find reserves because previous exploration near the site was not promising, or seismic mapping has shown the shale beneath the region has faults running through it.

"Faulting plays havoc with a horizontal well," he said.

Morgan said the companies now understand where the Fayetteville Shale's "fairway" is. The fairway is the region where the shale is at its thickest, contains few faults and has proven reserves, Morgan said.

And if a landowner is outside the prime region, "Odds are he won't get the chance to renegotiate," Morgan said.

Production companies do not make a habit of sitting on their leases, Daily said, but many have leased more land than they can manage, causing the less attractive plots to see little exploration.

"I'm confident that the producers are going to maximize their chance" to produce natural gas, Daily said. Lease agreements that are allowed to expire "are the ones that are least valuable," he said.

The lease agreement between a production company and lessor remains a business contract between two parties, Daily said, providing a mineral rights owner the ability to break a lease.

"The landowner should not get the idea that he is the captive of the operator," Daily said.

Common law determines that a production company is governed by "implied covenants," Daily said. The covenants boil down to the following statement: a production company should "extract all possible resources covered in the lease," Daily said.

Outside factors like the price of natural gas could mean that it would not be prudent for an operator to develop more wells on a site, Daily said.

"And that is exactly the issue: You are not required to drill and produce wells at a lease so someone can get more royalties," Daily said.

The production must also take place in a reasonable time frame, so long as other circumstances – such as a drop in prices – do not make exploration unreasonable.

"If an unreasonable amount of time elapses and the developer doesn't exploit the prospects of the land that exists, then the land reverts to the landowner," Daily said.

The operator keeps possession of all wells drilled to that point, Daily said, but the landowner may enter into new lease agreements with other production companies.

If a mineral rights owner is lucky enough to have not leased his mineral rights in the Fayetteville Shale, Morgan said, the owner should focus on the rate of royalties and not the per-acre signing bonuses.

"I always tell my clients you are better off giving up [bonus] money if you'll get better royalties," he said.

Carder, the Searcy lawyer, said a mineral rights owner must know his preferences when negotiating. And if a lease is coming to an end, he should expect a leasing company to drop by offering a "top lease" – a lease that allows a new production company to drill on a section as soon as a previous agreement expires. Negotiating for good terms on a top lease can help the mineral rights owner, too, because most leasing companies put a clause in their original contracts allowing them to match any top lease offered the mineral rights owner.

Morgan said negotiating and renegotiating a lease agreement for better terms comes down to one thing.

"It just depends on how good of a poker player you are," he said.

It's a game south Arkansans might wish to learn to play in case the Haynesville Shale Play extends into Arkansas, as some speculate it does.