The Practice of Oil & Gas Has Changed

When I started to practice in the late 1970s, the practice had not changed dramatically since the early part of the 20th Century. Small local and medium-sized regional producers relied upon various means to determine where they might find oil and gas in the ground, meaning both where on the surface they might drill a well and how deep to drill into a particular geologic formation. The producers would make their determination of where to drill and then approach the landowner(s) of the land in question, almost always those landowners being farmers with parcels large enough to allow a well to be drilled far enough away from buildings to comply with spacing laws and to not interfere with the landowner’s farming operations.

The producer then offered to lease the land with a standard pre-printed lease which had a crude legal description of the land in question, such as: “Approximately 93.8 acres bounded on the North by Jones, on the East by Smith, on the South by State Route 5 and on the West by Killbuck Creek.” The leases almost always offered the landowner 1/8 of the gross income produced by the well(s) in question, thus paying the landowner 12.5% of the gross sales of oil and natural gas produced. Sometimes the producer paid a very modest sum (perhaps a hundred dollars per acre, or even just a couple hundred dollars total) upon signing the lease, never much more than that, and virtually never anything more than the 1/8 royalty from production, with an exception sometimes for “free gas” from a successful well to provide residential gas to heat the farmer’s home. The landowner was not required to spend a dime to drill or produce the well.

The producer bore the entire cost of drilling the well, which could vary greatly depending primarily upon the depth of the well. Small producers would typically share these costs with a group of investors, often their own competitors who would return the favor on wells they were drilling elsewhere, thus spreading out the risk of a dry hole among a larger group of investors. This investor group got 7/8 of the gross income from the well and hoped to recoup the cost of drilling the well and operating it out of that income stream. One well could be drilled on a parcel of a specified number of acres (for example, a 20-acre minimum was typical for wells of a certain depth, 40-acres for deeper wells), and that one well was drilled straight down into the earth into the geologic formation hoped to be productive. If the well was a good one, it typically produced enough to recoup the drilling costs in a fairly short period of time (months or a couple years) and then the production after that was mostly profit since the cost of operating a well was fairly modest by comparison to the income stream. Such wells could keep producing for decades, albeit on a declining production curve.

Most wells hit oil or natural gas or both and producers could make a very good living from this, some of them making an extremely good living. Medium-sized regional producers (think Quaker State or Pennzoil) followed the same basic procedures, except they bore all of the expense of drilling themselves and thus kept all 7/8 of the gross production, paying all of the operating expenses themselves. It was unheard of for major national or international oil and gas producers to be found in Ohio.

Over the last ten years or so, a revolution has occurred which has radically transformed the above process. Very simply, that revolution stemmed from some clever engineers figuring out how to drill down deep into the earth and then turn the drill bit from vertical to horizontal, thus allowing one hole in the ground to access a much wider portion of the geologic zone into which the well was drilled. This allowed the profitable production of certain layers of shales which previously were not profitable to produce.

While this revolution is often referred to in the popular press as being due to the “new technique of hydraulic fracturing” (called “fracking” for short), that is simply wrong. (Go figure, the media could get something wrong!) Fracking has been around for many decades, dating back as early as the 1930s. The vertical wells mentioned above were hydraulically fractured to enhance their production by breaking up (“fracturing”) the geologic formation in question to allow the freer flow of oil and gas through the formation and up to the surface. But when horizontal drilling was figured out, fracking those wells has turned out to make those wells productive beyond the wildest dreams of anyone working in the “oil patch” in Ohio at any time in the 20th Century. Indeed, there are reports of one horizontally drilled Ohio well producing as much as 400 traditional vertical wells in Ohio. This is simply phenomenal, and it has, in turn, revolutionized the traditional practices for oil and gas leases, not to mention making Ohio the Saudi Arabia of natural gas production.

While oil and gas producers still deal with landowners and the landowners are still most often farmers, the astute farmer will no longer be content to sign the same lease that his grandfather might have been thrilled to sign. We now see leases where instead of a nominal payment upon signing, the landowner can receive up to $5,000 or even $10,000 per acre just to sign the lease. Do the math and you can see that a modest 100-acre farm with a $5,000/acre bonus would yield a signing bonus of $500,000, often paid to someone who never had enough cash to do more than eke out a meager living on that 100 acres. Even if the well is a dry hole, the landowner keeps that signing bonus. And that astute farmer will no longer be content with the old 1/8 of production as an ongoing royalty, sometimes seeing royalties upward of 20% of the gross production of oil and gas from the well. So, if the well on that land hits, this can yield tens or hundreds of thousands of more dollars for the landowner over the following years.

Another new feature of horizontally drilled wells is that these horizontal spider webs can extend out for many thousands of feet once they turn horizontal, perhaps a mile underground. Everyone who owns the surface above those webs must participate in leasing in order for the producer to have a valid lease. As such, it has become common for large groups of landowners to join forces in negotiating with producers and sharing the signing bonuses and ongoing royalties. So the astute farmer needs to assemble a group of neighbors to pull together enough acres to support perhaps a mile or more of horizontal distance. And sometimes the group will include owners of just the mineral rights, since on occasion the ownership of the surface and the ownership of the mineral rights have been separated into different chains of title.

So, how does that farmer (or other mineral owner) become so astute and negotiate with the producers? How does a group of landowners join together for better bargaining power? How does the farmer know what is a good deal? There is only one good way to do that, and that is to hire a lawyer who is experienced in dealing with such negotiations. The producers on the other side are no longer the local folks who peddle leases out among their friends, but rather we now see companies like Shell and BP right here in Ohio. Be a smart landowner and go to the negotiation armed with good counsel. The oil and gas attorneys of Critchfield, Critchfield & Johnston are on the leading edge throughout the state of Ohio in such representation.