The Marcellus Shale: Understanding the Legal Issues from a Landowner’s Perspective

What is the Marcellus?

The Marcellus Formations in PA

The Marcellus “Fairway”

It’s a GREAT Time to get Started in the Marcellus!

Pennsylvania Active Rig Count Vertical Exploratory Stage Over—Horizontal Production Phase Now In Full Play

Marcellus Shale Permits Issued & Wells Drilled 1 st quarter 2010

Marcellus Shale Permits Issued & Wells Drilled 2010 YTD through August

Horizontal Development The Marcellus “Pitchfork”

Gas Leasing from a Landowner’s Perspective

Gas Leasing - How does it work? Typically, representatives from a gas producing company will contact the owners of the OGM (Oil, Gas and Mineral) rights in a location where the gas producer wishes to explore and, hopefully, produce. The owner of the OGM rights may not be the owner of the surface estate.

Gas Leasing - How does it work? The gas company representative may be an employee of the gas company or, more commonly, a professional Landman. Regardless, ask to see his or her credentials. In the case of a professional Landman, ask for proof of his membership in the American Association of Professional Landmen. In the unlikely case of a gas company employee, ask for details about the company such as how many Marcellus wells it has drilled, how many are currently in production, etc.

Gas Leasing - How does it work? If you are approached by someone other than a professional Landman, exercise increased caution and scrutiny. Be extra cautious where the instrument presented is something other than a true oil and gas lease. Watch for words like “option,” “option agreement” and “marketing agreement” in the title.

“Option” or “Marketing” Agreements “Wal-Mart logic” – add your acreage to theirs to increase the collective bargaining power… Peer pressure/fear of being excluded… The landowner authorizes the marketer to try to lease the OGMs to undisclosed third parties in return for a percentage of any up-front monies paid by the third party upon execution of a lease. The landowner is assured minimum per-acre up-front monies and minimum royalty percentages if a lease is successfully executed, both of which are typically reasonable.

“Option” or “Marketing” Agreements Many landowners are primarily interested in these two economic provisions and sign them. HOWEVER – the “option” or “marketing” agreements typically include a form lease attached as an exhibit. By executing the option or marketing agreement the landowner forfeits any ability to negotiate any other lease terms. These agreements may be useful to attract interest on the part of a gas producer sooner, but be sure to exercise heightened scrutiny and caution when presented with them.

Basic Lease Clauses - Economics Landowners are typically drawn first to the “economics” of the proposed lease. Bonus: A one-time payment to induce a landowner to sign a lease. Ranges greatly from a few hundred dollars per acre to upwards of $6, per acre. Delay Rental: A payment made by a lessee to hold the lease while deferring drilling. Typically expressed as a price per acre per year in the primary term of the lease. Royalty: Recurring payments reflecting a share of production. Statutory minimum is a 1/8 interest, or 12.5%. Higher royalties - between 15% and 20% - have been negotiated.

Basic Lease Clauses –Economics Note: where drilling and production never occur on a lease, the bonus and delay rental payments constitute the bulk of the value the landowner will receive. HOWEVER, where production occurs, the royalty payment income stream represents the lion’s share of the economic value paid to the landowner.

Basic Lease Clauses – Term Typically, an oil and gas lease has 2 terms: 1)a PRIMARY term for a stated number of years during which the lessee has no duty to drill and for which DELAY RENTAL is paid; and 2)A SECONDARY term that lasts from when production is achieved “for so long thereafter as oil or gas or either of them are produced in paying quantities.” These terms are negotiable.

Basic Lease Clauses – Term Gas leases extending the primary term take your property off the market for longer periods of time, be sure to factor this in when evaluating the adequacy of bonus payment and delay rental offers. Trend – extend the primary term and front-load the bonus, delay and other damage payments into a “paid-up” lease. Not the best for the OGM owner. If no drilling occurs, the lease lapses at the end of the primary term. If drilling occurs during the primary term, the secondary term is triggered. Trend – strange and unusual language is added to the secondary term to perpetuate the lease beyond production. Very bad for the OGM owner.

Other Important Lease Clauses NOTE: Many of these lease clauses will not appear in a draft oil and gas lease first offered by a gas producer. They require specific negotiation. Mother Hubbard clause - states the lease includes all lands of Lessor whether adjacent to the leasehold or not (generally, adds land not specifically described in the lease) Unitization clause – the acreage under the lease is added to or unitized with other lease acreage. Production on any acreage within the unit holds all leases within the unit by production, even if no production ever occurs on some acreage within the unit. “Pugh” clause – provides the landowner with some relief in the event that some of his or her acreage is not unitized.

Other Important Lease Clauses Access easements – provide for the right to enter upon the property for purposes of the lease. Location of roadways, pipelines, well sites, etc. - Unless negotiated by the OGM owner they will be at the discretion of the lessee. Best practices – commits Lessee to utilize industry best practices in development of the lease (e.g. horizontal, not vertical, Marcellus wells) Arbitration provision Non-disturbance clause – Prohibits surface access to the property (except possible seismic testing).

Other Important Lease Clauses Pipeline easements - Provide the right to install, construct, lay, maintain, operate etc. These are necessary to get gas to market BUT they can be overly broad; OGM owners (especially those who also own the surface) may wish to limit the number, size, location, etc. Timber, crop damage clauses – compensates the owner of the surface for damages to timber, standing crops, fences, etc. cause by production activities. Gas storage clauses – give the lessee the right to store gas on the property, even if that gas was produced elsewhere. These clauses should be carefully examined, particularly when the secondary term of the lease is linked to the gas storage clause.

Other Important Lease Clauses Water rights – The lessee’s right of access to and use of water on the premises, if any, should be addressed. Issues pertaining to water quality monitoring and responsibility in the event of contamination should be addressed as well. Assignment – most gas leases are assignable, and for good reasons which the lessee may require. However, it is reasonable to require the lessee to give Lessor notice of the assignment. Depth horizon limitations – There are a number of formations in Pennsylvania capable of producing oil or gas or both. Development in a particular area is often within a particular formation (for example, the Marcellus). Limit the formation for which the oil and gas lease applies to preserve future rights in the development other formations.

Other Important Lease Clauses Royalty calculation methods - Describes what costs may be subtracted from the royalty to be paid to the Lessor. These costs can be significant and can result in a significant reduction in the royalties paid to Lessor over time. End of lease provision – Requires lessee to record an instrument which indicates the expiration of the lease. Spud fees - Provides compensation for surface damages caused by well sites being located on the property. Setbacks – Specification of setbacks from buildings, ponds, streams, and wetlands.

Other Important Lease Clauses Information – Lessee must provide Lessor with a copy of the drill site plan, MSDS sheet, production records, etc. upon request Free Gas/Payment in Lieu of free gas Bonds/well plugging insurance – Provide for source of payment for well-plugging in lessee is unable to do so when the gas runs out Land restoration – Provide specific requirements for reforestation, slope restoration, wildlife food plots, etc. Taxes/tax penalty provisions – Require the lessee to compensate the Lessor for any penalty imposed as a result of a change in use of the property under Clean and Green, CREP, etc.

Other Important Lease Clauses Shut-in clauses – Define whether and on what terms a well may be “shut-in” or production intentionally stopped temporarily. Payment provisions – Require cashier’s or certified checks, no DRAFTS Disposal of water – OMG owners should require that water used in the drilling and production processes be disposed of off-site and in accordance with applicable state and federal environmental laws and regulations. Transportation rights – These provide the right to construct, operate, maintain and repair gas transportation pipelines, pump stations etc. Landowners should avoid granting transportation rights or negotiate them separately for additional compensation

Other Important Lease Clauses Indemnification – Recommended for Landowner protection, these clauses require that the Company indemnify Landowner from any and all claims and costs arising from Company’s operations, including attorneys’ fees. Removal/forfeiture of equipment at end of lease – Require Company to remove its equipment at the end of the lease or forfeit it. Severance tax – Allocation of any severance tax which may be imposed by the Commonwealth. Commonly, the Landowner pays tax only on that portion of the gas removed for which Landowner is paid a royalty. Real estate taxes – Allocates the liability for payment of real estate taxes on the premises together with any future increase in real estate taxes.

Bad leases – some are not even leases at all but rather are conveyances of the entire OGM interest. Sometimes for as little as a few hundred dollars an acre –Even when a Landowner challenges a bad lease and wins it takes considerable money and time (in which interest in producing the property may have come and gone). Pushy Company representatives “standard form of contract” = the Willy Wonka approach Peer pressure/threat of being left behind Marketing/option agreements Speculators interested in acquiring your OGM rights at discount Watch Out For:

Existing leases – “heaven to hell” –Are they still good? Consult with an attorney. Temptation on part of smaller operators to produce from the Marcellus using cheaper traditional vertical methods under existing leases Non-production, expiration of leases not documented of record Special Issues in NW PA

Conclusion – So what do I do? Know who you are dealing with – is he or she a professional Landman. Ask for credentials. Know what it is you are being asked to sign. Is it a lease or a marketing agreement? Take the document to a qualified lawyer for review. Only lawyers are licensed to advise you concerning your legal rights under these agreements, and to negotiate these instruments on your behalf. Only lawyers carry legal malpractice insurance to provide a fund for your recovery in the event that you receive bad advice. Choose your attorney wisely. Inquire about that attorney’s experience in dealing with oil and gas leases. Ask whether or not the attorney has malpractice insurance and if so what the limits of that insurance are.

Conclusion – So what do I do? Consider using a consultant. Consultants, while not lawyers, can be an invaluable source of information to you and to your attorney in maximizing the “economic” provisions of your lease, particularly where the consultant has recent experience and knowledge of the current leasing environment in the area. BUT: check their credentials too! Self-proclaimed experts are coming out of the woodwork in other parts of the commonwealth, claiming expertise because they once signed a lease as a landowner…we are fortunate in our area to have seasoned veterans who are capable of bringing depth of knowledge of the industry to the table.

Conclusion – So what do I do? Involve your tax planning professionals and investment advisers early. There are significant and distinct potential tax ramifications involved with signing a lease, receiving up-front lease payments and receiving royalty payments over a significant period of time. You will want an investment adviser to help counsel you regarding how best to invest the income you receive from your lease. Choose these professionals wisely as well, making sure that they understand and have experience with oil and gas lease issues. If you do not have a tax planning adviser or investment adviser with specific experience in this field, your oil and gas attorney should be able to refer you to one.

Conclusion – So what do I do? Update your estate plan, or prepare one if you don’t have one. Your oil and gas attorney may be able to assist you with this as well, if he or she has experience with complicated estate planning issues pertaining to oil and gas leases and income streams. The potential tax ramifications to you and to your family in NOT revising your estate plan could be significant. Through the use of Family Limited Partnerships, Trusts or other planning tools, maximize the wealth that you pass on to your family while minimizing your tax bill.