LEASE NEGOTIATIONS AT THE PUGH CLAUSE: COMPANY ANDMINERAL OWNER PERSPECTIVES

Presented by Stefanie P. Hines, CPLTA, JD

LEARNING OBJECTIVES

• After this lecture you should be able to

1) Describe a Pugh Clause

2) Recognize Pugh Language

3) Understand the production company position

4) Understand the landowner position and negotiation process

• Landowner protections are a key aspect ofmodern lease negotiations.

• A Pugh Clause is an operational lease provision,or a clause, in an Oil and Gas lease thatdetermines what happens to acreage that is“left out” of a unit/pool and does not have aproducing well situated on it.

• This is crucial for both the landowner andthe Landman to understand.

A PUGH CLAUSE IS A LANDOWNER PROTECTIONPROVISION IN A OIL AND GAS LEASE

HISTORY OF THE PUGH CLAUSEThe Pugh Clause is named after Lawrence Pugh. Pugh was anattorney from Crowley, LA. He coined the term "Pugh” clause inresponse to the case Hunter v. Shell Oil Co., 211 La. 893(1947) in which the court held that production from a unit thatincludes a portion of the lease or a tract from the lease will holdthe lease even if the tracts are not contiguous.

PUGH CLAUSE TERMINOLOGY

1) Unit: This a consolidation of mineral and leasehold acreagethat covers an area where there is a reservoir ofhydrocarbons. The unit is created by the leaseholdowner(company)in conjunction with state law. The leasesthat are part of unit must allow for unitization.

2) Tract: Describes that land that is being leased- usuallyreferring to individual parcels on a map.

3) Holding the Lease: This refers to how a company can extendtheir leasehold rights past the primary term of a lease.

HOLDING A LEASE• There are several ways a lease can be held past it’s primary term by an oil and gas

company.

• The primary term is the initial agreed upon time that the lease will be valid for regardlessof production or other operations- like renting a house. Typically 3-10 years. In theMarcellus and Utica a 5 year lease is the most common.

1) Extending the Primary Term- must be included in the lease language and is usually astandard provision. This takes effect at the end of the primary term when no drilling orunitization has taken place. Generally requires an additional payment.

2) Held by Storage- if a lease allows for storage then the acreage can be held if the leasebecomes part of a storage field or has a storage well on it.

3) Held by Operations- this means that something is happening on the land. What qualifiesas operations can vary greatly from moving dirt to requiring that a well be spud.

4) Held by production (HBP) this tends to be the most contentious and also the mainreason the Pugh Clause was created. This means there is a producing well in the unit or onthe property that the lease is part of. In theory a lease can be held be HBP for as long asgas or oil is produced in any quantity.

WHERE DOES THE UNIT COME FROM?

• Geologists determine the location where drilling is mostlikely to be successful.

• Units are then drawn on to a map by the landdepartment.

• The shape of the unit and size depends on themeasurement system. Typically in a metes and boundssystems units will be somewhat irregular shaped.

• In a PLSS System the units are typically rectangular.

• Different states have different rules about unit size andpooling.

• *this does not account for off-shore drilling or units on BLM lands.

In there United States there are 2 main types of Land SurveySystems:1. Metes and bounds- The original 13 colonies and states like

West Virginia and Kentucky have a metes and boundssystem that created irregular shaped tracts of land.

2. U.S. Public Land Survey system (PLSS) was created by theLand Ordinance of 1785 when the northwest was beingsurveyed. The starting point of this is at a point on theOhio-Pennsylvania border. This is also referred to asRectangular Survey and Jeffersonian Survey.

*there are other exceptions and states that followed othertypes of systems.

Land Measurement Systems

Metes and Bounds Units

A PUGH IS ESPECIALLYIMPORTANT IN METESAND BOUNDS STATES.

PLSS UNIT

Image from http://www.law.indiana.edu/publicland/

Ohio Lease unit

TYPICALLY TWO TYPES OF PUGH CLAUSES1) Surface

2) Depth

Some confusion in the industry over the terms “Horizontal” and “Vertical”there is a not a solid industry definition of what these two terms mean.They have been used interchangeably to describe both depth andsurface.

Some courts have referred to the Vertical Pugh as a Depth Pugh andothers have referred to the Horizontal Pugh as the Depth Pugh and viceversa.

The best practice is to see what the company standard is or the standardfor the shale play you are working.

DEPTH PUGH• The DEPTH Pugh has become a key provision in leases for landowners in

areas where deeper drilling and horizontal drilling(fracing) has becomemore prevalent.

• The depth Pugh severs the minerals at different producing formations orsubsurface horizons.

DepthPugh

http://www.shaleexperts.com/plays/utica-shale/Overview

SURFACE PUGH/GEOGRAPHIC• Releases or severs lease acreage based on surface area outside of producing units

– this does not take into account different depths.

ALTERNATIVE PUGH LANGUAGE

• Retained Acreage- Is basically a less descriptive version of theprevious two. It generally states that any acreage not part of a unitor well will be released at the end of the primary term.

• Implied Pugh- often found in the pooling/unitization provisions. Itusually states that in order to maintain any acreage outside the unitthe Lessee must pay delay rentals.

• Drilling obligation- For example, Lessee drills one (1) well in theprimary if does not drill the 2nd well within 1 year then will loseeverything but the first well and a 1000’ radius around it. That is aPugh within a drilling obligation

• Wellbore – releasing acreage or depths that are not part of thewellbore

• Horizontal Leg Pugh- releasing any acreage and depths that are notpart of the drilled leg

Example of an Acreage Pugh w/ Drilling Obligation:If you do not drill a second well within one (1) year you lose the rest of the acreage and retain the first wellwith an area of 1000’ radius around it. The circular area would be the acreage retained with the well and therest (rectangle) would no longer be subject to original lease.

LANDOWNER FACTORS1) Some landowners have multiple tracts of land that may or may not be

contiguous.

2) Land in areas where there drilling activity can be very valuable and thelandowner may have competing offers

3) Opportunity to maximize the profit or benefits from the tracts

4) Sometimes have the ability to receive additional funds for the acreageleft out of a unit or undrilled acreage. (Delay rental payments)

5) Having a lease that covers a lot of acreage but only receiving the benefitof some of that acreage is not good the landowner. The term for havingonly a small portion of your acreage make it into a unit is called being“clipped”

6) Royalty payments are determined by the amount of acreage in the unit

7) Can help a landowner when a Mother Hubbard clause has been insertedin the lease

8) Prevention of acreage being held for decades

9) Again- especially important in Metes and Bounds states

LANDOWNER LEASE NEGOTIATIONS• When does a landowner get to negotiate a Pugh Clause?

• The Pugh must be added into the lease a provision or into a leaseaddendum at the time the lease is entered into.

• Therefore, the landowner must be knowledgeable or their counselmust be knowledgeable.

• There is not a one-size fits all Pugh Clause- some Pugh Clauses arebetter than others

• At times a landowner may have an inherited tract of land that has avery old lease and will be approached to sign a ratification ormodification of the original lease terms- at this time those ownerscould and should try to negotiate for different terms including thePugh. Not all companies will easily accept modifications of oldleases.

WHAT TYPE OF PUGH SHOULD A LANDOWNERNEGOTIATE FOR?• Depends on the shale play, the amount and type of property owned

and the type of drilling in the area.

• Oil and Gas companies are very secretive about where and whenthey will drill, this can make deciding what type of Pugh moredifficult.

• Most landowners will opt for geographical or surface Pugh language

• Starting to see more landowners who negotiate for specific shaleplays- i.e. Marcellus only.

• Also starting to see more hybrid Pugh Clauses that limit the depthhorizon and the surface.

• ** There are many very poorly written Pugh clauses that do notaccomplish the goal.

LANDOWNERS ISSUES:• Many Pugh clauses put the obligation on the landowners to ask for a

release.

• Many landowners do not keep track of their leases. Now leases aregenerally not recorded so the landowner must go back to thecompany to request a copy of their lease.

• Even with a Pugh inserted in the lease this is a complicated conceptand the landowner still may find challenges to getting acreagereleased.

NO PUGH BECAUSE:

• Lack of knowledge

• Have requested other provisions such as drilling obligations orproduction language that may seek the same protections.

• Seek to get more money from bonus payments and do notwant to negotiate with the company

COMPANY VIEW:• Companies do not encourage Pugh clauses for private

landowners.

1) One of the TOP priorities of a Land department at aProduction Company is to HOLD ACREAGE

2) WHY? A producer will want to hold as much acreage aspossible in a valuable play without paying more to maximizeprofits and drilling opportunity

3) It is in the companies best interest to retain as much acreagein the lease in full force as possible in order to have moretime to decide when and where to drill.

4) Some companies will not agree to a Pugh.

OTHER ISSUES FOR THE COMPANY

• Complicates records keeping

• Deviates from the standard lease agreement

• Creates potential legal challenges

• The Pugh is a “landowner” protection

WHEN WOULD A COMPANY AGREE TOA PUGH?

• Negotiating tool- they are desperate for the acreage

• When they are dealing with other companies

• Have units already planned to cover most or all of theacreage

• Lease is in a dedicated drilling already

• In places like WV the company may need to ratify before theycan drill.

COMPANY RESPONSE TO PUGH CLAUSES• Just as landowners have become more savvy production

companies have also become savvy about predicting thechallenges they will face.

• For instance: creating “allocation areas” which are basicallyareas the company has determined that they want to drill inthe near future but have not yet planned the actual drilling.The leases are recorded as being part of an allocation unitand then held by operations.

• Another response is writing in Pugh clauses that do not haveautomatic termination but instead require the landowner torequest a release.

• Fighting the definition of production.

SAVINGS CLAUSES- THE COMPANY PROVISIONS1)Continuous drilling: allows a temporary cessation or pause inproduction without resulting in the termination of the lease. Usuallyhas a time limit for how long cessation can occur and drilling musthave previously commenced.

2) shut-in provisions: Allows company to pay a “shut-in rental” when awell can produce but that production is not being utilized.

3) dry-hole: if a dry hole is drilled the company can maintain the leasein force if the company pays the landowners a rental payment.

4) cessation of production: gives the company the ability to hold thelease while the company is attempting to resume or restoreproduction.

5) force majeure: says an that if there is a superior force or “act ofGod” that this is not the fault of the company and thus the lease willnot expire for reasons that the company can’t control.

What happens when a landowner finds out theiracreage is Held and they didn’t negotiate for aPugh or retained acreage?

• Angry phone calls

• Requests to release

• Lawsuits/ Challenges to the lease

STATUTORY RESPONSE TO PUGH ISSUES

• Some states are taking measures to prevent acreage frombeing held indefinitely.

• Oklahoma has a statutory Pugh clause that states:

• (b) In case of a spacing unit of one hundred sixty (160) acresor more, no oil and/or gas leasehold interest outside thespacing unit involved may be held by production from thespacing unit more than ninety (90) days beyond expiration ofthe primary term of the lease. 52 OK Stat § 52-87.1 (2014)

QUESTIONS OR COMMENTS?