In this week’s episode of All Things Marcellus Attorney Clark explains how Pipeline Right-of-Way Agreements and Oil and Gas Leases typically include company “options”. Doug explains how Option Agreements operate and what a pipeline or gas company must do in order to exercise the option to enforce the agreement.
In the first part of this week’s radio show, Doug walks through Pipeline Right-of-Way Option Agreements and how they operate in favor of pipeline companies and not landowners. Specifically, Pipeline Option Agreements are designed to give the pipeline company a period of time or “option period” in order to review and study the property and the potential pipeline route to make a determination whether to move forward and finalize the pipeline agreement.
For example, Pipeline Option Agreements carry an upfront “option term” generally between two and five years, during which time the pipeline company and its agents will conduct environmental surveys, including wetland delineation surveys, archaeological surveys and additional fieldwork to determine whether the proposed property and planned easement route will work for the company’s purposes. The company may plan to use a certain route for a pipeline easement, but due to environmental conditions, typically wetlands, or other constructability issues, the planned route is not feasible. By giving itself an option, the pipeline company has the ability and time to study the pipeline easement route to determine its feasibility. If the planned route does will not work, the company may amend the route or alter the pipeline path across a different area of the landowners property, or the company may have to re-route the easement to neighboring lands to avoid wetlands or other constructability issues.
Pipeline companies generally prefer the longest option term they can negotiate with the landowner to give them as much time as possible to study the route and decide whether to finalize the agreement. Property owners should always negotiate to shorten the length of the option period to the fewest years possible. While the option is in effect, the pipeline company has contractual and rights and the property is encumbered such that the property owner is limited in what they can do in the easement area. Once the option is exercised, the pipeline company obtains all the rights granted in the underlying Pipeline Right-of-Way Agreement.
Pipeline companies typically attempt to pay the smallest amount of money upfront to purchase the option from the landowner and the company will also attempt to negotiate the longest possible option term. In other words, pipeline companies may offer a property owner r as little as $500 upfront, commonly paid within 30 to 60 days of execution of the Pipeline Option Agreement, in exchange for the company receiving an option period of somewhere between 2 to 5 years. Landowners’ lawyers much negotiate aggressively to shorten the option period and must negotiate to maximize the upfront option payment. It is very common for pipeline companies to negotiate the upfront money paid for option agreement.
Attorney Clark also explains how he typically negotiates an upfront option payment that will exceed anticipated legal fees for the pipeline agreement negotiation process. For example, Doug explains that he always seeks to negotiate at least a $2,000 upfront option payment as this generally covers all legal expenses and the property owner’s taxes due for Pipeline Agreement option payment. However, $5,000, $10,000 and even higher upfront option payments are not unreasonable to request. In some cases, option payments can be much higher, but pipeline negotiations are driven by the property owner’s leverage in each case. That is why leverage assessment is so important when negotiating Pipeline Right-of-Way Agreements.
Once the property owner’s lawyer negotiates for the highest possible option payment and the shortest option term, the attorney must then negotiate to establish black and white rules as to what the pipeline company must do in order to actually exercise the option.
For example, if the Pipeline Agreement contains a two-year option, with a $2,000 upfront option payment, and a subsequent consideration and surface damages payment of $100,000 for pipeline installation, the property owner’s lawyer should require the company to tender the full $100,000 payment simultaneously with written notice to the property owner that its exercising its option. Non-negotiated option agreements, which the company is always prefer, commonly only require that pipeline company notify the property owner in writing of its intent to exercise the option, but do not require the actual consideration and surface damages payment at that time. Often the significant consideration and surface damages payment is not required until just “prior to the commencement of pipeline installation operations on the property”. This loophole may allow the pipeline company to send a letter to the property owner notifying them that they are exercising the option, but holding off tending the subsequent consideration and damages payments for several years, or even longer. Again, the property owner’s land remains encumbered by the option agreement without the owner ever receiving any compensation beyond relatively small initial upfront option payment.
Accordingly, when negotiating Pipeline Right-of-Way Option Agreements, attorneys must negotiate to maximize the upfront signing payment, negotiate to limit the option period -amount of time the company has in order to exercise its option- and must negotiate clear requirements that the company must meet in order to exercise its option – which should include the exercise of option payment consisting of all consideration and anticipated surface damages payments. As Attorney Clark explains, the Pipeline Agreement itself must also be negotiated aggressively to limit the company’s rights and maximize property owner compensation, but too often option terms are not negotiated to the detriment of landowners.
Oil and Gas Lease – Option Agreements?
Oil and Gas Leases also commonly contain company friendly options. Attorney Clark explains how there are typically two types of options that are commonly included in Pennsylvania Oil and Gas Leases.
The first option involves the gas company’s decision whether to pay the upfront per-acre signing bonus and accept the lease. Most oil and gas leases are accompanied by “Orders for Payment” or “Orders of Payment” documents that establish the amount and timing for upfront per-acre bonus payments. These Payment Orders typically give the gas company three to four months to decide whether to pay the upfront per-acre signing bonus and accept the gas lease. If the gas market collapses or if the company does not feel that the lease has the value represented in the Order of Payment, the gas company may reject the lease and elect not to pay the per-acre signing bonus without any negative consequence to the company. Also, if the gas company finds a title issue regarding oil and gas right ownership, the company may elect to pass on the lease. Gas companies typically honor the Oil and Gas lease terms and pay the promised per-acre bonus when there is no title issue, but there are many cases where gas companies elect not to pay according to the terms of the Order of Payment and allow the gas lease to become null and void. Virtually every Pennsylvania oil and gas lease provides the company at least 60 days to tender the upfront per-acre bonus payment which allows the company to internally assess the submitted oil and gas lease and decide whether to pay the per-acre bonus and accept the lease.
The second type of option commonly found in oil and gas leases is the company’s option to extend the lease for an additional primary term. A typical gas lease option involves a lease providing the company an initial primary term of five-years followed by a company option to extend the lease for an additional five-year primary term. This option for a lease extension is achieved by the company paying the Lessor (royalty owner) the same consideration as was paid to initially to accept the lease.
For example, if the gas company paid a $2,000 per acre bonus for a five-year primary term lease, the company would have the option at the end of that five-year primary term to extend the lease in the event the company did not conduct any “operations” to hold the lease by production in the first five-years. The company could exercise its option and extend the lease for an additional five-year term by tendering a $2,000 per-acre bonus payment prior to the end of the initial primary term. Attorney Clark explains that this company option extension provision gives the oil and gas right owner no choice in the matter.
Gas lease extension options can be very powerful in favor of the drilling company. For example, in some cases a company may have entered into oil and gas lease for only a $100 per-acre bonus payment. Then, at the end of the five-year primary term the company has not conducted operations they can exercise their option to extend the lease for another five-year primary term by again paying only $100 per acre. This may be true even though the leasing market at the end of the initial five-year primary term may have increase by twenty times or more over the original leasing rates. Thus, the Lessor landowner is stuck under the terms of the lease extension option and the company can extend the lease by only tendering a $100 per acre payment as opposed to the new market rate of $2,000 per acre or higher.
As an opposite example, if the original gas lease was signed at a $2,000 per acre bonus and the bonus rate after five-years has now dropped to $500 per acre, the gas company will decline to exercise the extension option at $2,000 per and allow the lease to expire. Then, the company may make a new lease offer at the current $500 market price which may also involve a decrease in royalty percentage from the original lease executed in a better leasing environment.
In sum, if the gas leasing market has improved during the five-year lease term, the company will exercise their existing option to lock in the lower per acre payment and buy more time to drill. If the gas leasing market declines during the five-year lease term, the company will decline to exercise its option to extend and potentially tender a new lease with much lower consideration and more company favorable terms.
When negotiating oil and gas leases, it is almost always best to try to eliminate any company option to extend the lease. Although there may be times where royalty owners agree to an option to extend voluntarily, typically it is not in the Lessor’s best interest to provide the company a unilateral option to extend their gas lease.
Attorney Clark also explains how option agreements are also common in compressor station negotiations, meter site agreements, storage agreements and essentially all oil and gas related contracts. It is extremely important for Pennsylvania property owners and gas right owners to understand how option agreements operate and how to negotiate the options in order to decrease their detrimental impact. Remember, all oil and gas lease agreements must be negotiated and option agreements are a particular aspect of many oil and gas contracts.