Fee Simple – Complete Ownership
In most countries of the world, all mineral resources belong to the government. This includes all valuable rocks, minerals, oil, or gas found on or within the Earth. Organizations or individuals in those countries cannot legally extract and sell mineral rights without first obtaining authorization from the government.
In the United States and a few other countries, ownership of mineral resources was originally granted to the individuals. Some are for organizations that owned the surface. These property owners had both “surface rights” and “mineral rights.” This complete private ownership is known as a “fee simple estate.”
Difference of Fee Simple V.S Leasehold
To understand the differences between fee simple vs leasehold, it is important to remember that fee simple implies ownership. Whereas leasehold agreements simply renting. Leasehold agreements may grant access to surface rights, but the fee simple owner still owns the property.
Fee simple is the most basic type of ownership. The owner controls the surface, the subsurface, and the air above a property. The owner also has the freedom to sell, lease, gift, or bequest these rights individually or entirely to others. A fee simple defeasible simply refers to a fee simple ownership. The conditions are placed on the use of the land. If the conditions are not met, then the original seller is granted rights. This is back to the fee simple defeasible estate.
How Real Estate Transactions are Made
Let’s go back in time to the days before drilling and mining. Real estate transactions were fee simple estate transfers. However, once commercial mineral production became possible, the ways in which people own property became much more complex. Today, the leases, sales, gifts, and bequests of the past have produced a landscape. This is where multiple people or companies have partial ownership of or rights to many real estate parcels.
Most states have laws that govern the transfer of mineral rights from one owner to another. They also have laws that govern mining and drilling activity. These laws vary from one state to another. If you are looking to buy mineral rights or have concerns about mineral extraction near your property, it is essential to understand the laws of your state. If you do not understand these laws, you should get advice from an attorney who can explain how they apply to your situation.
Interest in oil, gas, and mineral estates qualify for 1031 exchange tax deferrals given the existence of perpetual interest. Leases, royalties, and production payments are often how the perpetual interests are conveyed.
Federal Tax Purposes
For federal tax purposes, mineral leases are considered a real property interest and eligible for 1031 tax-deferred treatment. Leases provide the lessee with the right to remove minerals for a specific period of time or until depletion along with incurring the costs of discovery and removal. Leases are also known as a working or an operating interest. The lessee may deduct the intangible drilling costs (IDCs) for removing the mineral. IDCs include labor, repair and maintenance, fuel, transportation, supplies, and other related production expenses.
For federal tax purposes, royalties are considered real property interest and qualify for 1031 exchange tax deferral treatment. Oil, gas, or mineral royalties do not represent an operating interest and do not incur or are responsible for production costs. Instead, the holder of the royalty receives a percentage interest in the materials removed for the life of the property.
Production payments are not eligible for 1031 exchanges given they are a right to the oil, gas, or mineral at a specific value, produced and paid from a percentage of removed minerals. Unlike oil royalties, production payments are finitely based upon a specified production versus royalties that are perpetual or until the mineral is exhausted.
Buying / Selling Mineral Rights
Buying/selling a coal seam is much more complex than buying/selling a car. When you buy a car you simply pay for it, file a title transfer with the government and drive the car home. When the car is worn out, it goes to the junk yard and the only thing that remains is a memory. However, when someone chooses to buy mineral rights, the buyer and all future mineral rights owners will have a right to exploit the property. And, the seller and all future surface owners must live with the consequences. Usually, mineral extraction will occur at some future time. Mining companies often schedule their equipment and employees years in advance. Or, the mining company might purchase the property as a future “reserve.”
It is also possible that the new mineral owner has no intentions of production. They are simply buying the property as an investment. Their goal is to sell mineral rights to a mining company who will assume the duties of production. Speculators who have no intent to mine purchase lots of mineral properties. They are simply attempting to be “middle men” who acquire valuable property from individual owners and broker those properties to mining companies for higher prices.
(These “speculator” buyers also frequently use options. In an option transaction, they offer the property owner a small amount of money today for the option of buying the property at a specified price on or before a specified date in the future. The speculator then quickly tries to find someone who will pay an even higher price and make a significant profit. If the speculator fails to pay the specified price by the expiration date, the property owner keeps the option payment.)
Decision to Purchase
When a company decides to purchase mineral rights, it also buys the right to enter the property and remove the resource at some future time. In most of these transactions, the surface owner has no say in when the mining takes place, how it will be done and what will be done to restore the property. Most disagreements between buyers and sellers occur at the time of mining. If the seller wants any control at that time, he must anticipate what might go wrong and write a contract that will preserve his wishes. Keep in mind that your grandson might own the property when extraction occurs. You were paid up front but he will live with the deal.
Mineral Leases and Royalties
Sometimes a mining company does not want to purchase a property because they are uncertain of the type, amount or quality of minerals that exist there. In these situations the mining company will be leasing mineral rights or a portion of those rights.
A mineral lease is an agreement that gives the mining company the right to enter the property, conduct tests and determine if suitable minerals exist there. To acquire this right the mining company will pay the property owner an amount of money when the lease is signed. This payment for reserves the property for the mining company for a specific duration of time. If the company finds suitable minerals it may proceed to mine. If the mining company does not commence production before the lease expires, then all rights to the property and the minerals return to the owner.
When minerals are produced from a leased property, the owner is usually paid a share of the production income. This money is known as a “royalty payment.” The amount of the royalty payment is specified in the lease agreement. It can be a fixed amount per ton of minerals produced or a percentage of the production value. Other terms are also possible.
When entering into an agreement leasing mineral rights, the property owner must anticipate any activities that the lessee might do while exploring the property. This exploration might include drilling holes, opening excavations, or bringing machines and instruments onto the property. In addition to reasonable mineral rights lease rates, defining what is allowed and what restoration is required is part of a good lease agreement.
Oil and Gas Rights
Mineral rights often include the rights to any oil and natural gas that exist beneath a property. The rights to these commodities can be sold or leased to others. In most cases, an oil and gas lease is granted. The lessee is usually uncertain if oil or gas will be found, so they generally prefer to pay a small amount for a lease rather than pay a larger amount to purchase. An oil and gas lease gives the lessee a right to test the property by drilling and other methods. If drilling discovers oil or gas of marketable quantity and quality, it may be produced directly from the exploratory well.
To entice the property owner to commit to a lease, the lessee generally offers a lease payment (often called a “signing bonus”). This is an up-front payment to the owner for granting the lessee a right to explore the property for a limited period of time (usually a few months to a few years). If the lessee does not explore, or explores and does not find marketable oil or gas, then the lease expires and the lessee has no further rights. If the lessee finds oil or gas and begins production, a regular stream of royalty payments usually keeps the terms of the lease in force.
One problem that can occur is when the lessee discovers oil or gas but has no way to transport it to market. Some lease agreements have a “waiting on pipeline” clause that extends the lessee’s rights for a limited or indefinite period of time.
Payment of Share
In addition to a signing bonus and the oil lease price per acre, most oil and gas lease agreements require the lessee to pay the owner a share of the value of produced oil or gas. The customary royalty percentage is 12.5 percent or 1/8 of the value of the oil or gas at the wellhead. Some states have laws that require the owner be paid a minimum royalty (often 12.5 percent). However, owners who have highly desirable properties and highly developed negotiating skills can sometimes get 15 percent, 20 percent, 25 percent or more. When oil or natural gas is produced, the average oil royalty payments can greatly exceed the amounts paid as a signing bonus. (Royalty estimation tool for dry natural gas.)
Oil and Gas Unitization and Pooling
Below the surface, oil and gas have the ability to move through the rock. They can travel through tiny pore spaces – such as between the grains of sand in sandstone or through the tiny openings created by fractures. This mobility allows a well to drain oil or gas from adjacent lands. So, a well drilled on your land could drain gas from a neighbor’s land if the well was drilled sufficiently close to the property boundary. Although this wouldn’t be included in the true oil and gas lease price per acre, it is an important influence on the property value.
Some states have recognized the ability of oil and gas to cross property boundaries underground. These states have produced regulations that govern the fair sharing of oil and gas royalty payments. These states generally require drilling companies to specify how gas and oil royalties will be shared among adjacent property owners when a permit for drilling is filed. The proposed sharing of oil and gas royalty payments will be based upon what is known about the geometry of the oil or gas reservoir compared to the geometry of property ownership at the surface. This procedure is known as “unitization.”
Some states do not have rules for unitization of oil and gas royalties. Other states have them but only for wells that produce from certain areas or from certain depths. These rules can play a critical role in a leasing or resource development strategy. Some people tell stories about landmen saying “Lease to me now or we will drill your neighbor’s land and drain your gas without paying you a cent.” In some situations, an absence of state regulations allows this to occur. If you are contacted about leasing your mineral rights, you should contact an attorney for advice on how the laws of your state will apply to your property.
Additional Note
In Pennsylvania the rules for natural gas sharing change at certain depths below the surface and at certain positions in the stratigraphic column. See the section labeled “Stratigraphic Column” near the bottom of this page for more information. In some areas the rules used for sharing Marcellus Shale gas can be different from the rules used for sharing gas from the underlying Utica Shale. Consult with an attorney on how these might apply to your property.
Mineral Rights Negotiations
A short story…. Two men were at the hardware store and in walks a guy who asks… “Have you leased your mineral rights yet? I’ll pay you $500 an acre – and write your check this morning.” One man grabbed the check and ran straight to the bar. The other man grabbed the lease and ran straight to his attorney. One of these men had a million friends that night. The other had a million dollars in the bank.
Three things are required to make a successful mineral rights deal:
- Knowledge
- Skill, and
- Patience
If your abilities fail in any one of the three, you can lose a lot of money. If you don’t have all three of these abilities, then find a good attorney or other mineral property professional. Their assistance usually doesn’t cost a lot, but the difference that they can make in the transaction can be enormous.
There’s More to a Good Contract than Money!
In addition to financial matters, a lease or sales contract can do more than simply specify the amounts paid to the owner. It can also contain language that protects the owner’s property and way of life while exploration, mining, drilling and production take place. The contract can set guidelines that protect the owner’s buildings, roads, livestock, crops and other assets. It can also reserve portions of the property that will not be disturbed during exploration, mining, drilling and production.
In most transactions the lessee is the one who prepares a contract for signature. If the owner signs without getting professional advice, the rights conveyed to the lessee might be greater than the owner wants to give away. Any owner who does not have knowledge or experience with oil and mineral rights transactions should seek advice or representation from an attorney or mineral property professional. Lessees will often accept significant revisions to what is contained in their standard lease or sales contract.
Buying a Home, Land or a Farm
When buying property in areas of potential or historic mineral development, a buyer should determine if a fee simple estate is being purchased or if ownership will be shared with others. Mineral rights transactions are normally a matter of public record, and copies of deeds or other agreements are filed at a government office.
Real estate buyers should ask the seller to specify what rights are being conveyed and have an attorney confirm that the seller owns what is being sold. In many areas the sale of mineral rights is recorded in the government record in a different deed book or database than the sale of surface property. This means that the deed to the surface property might not mention oil and mineral rights which have been sold away. In areas of historic or potential mining activity, the buyer of a property should hire an attorney who can do this research and confirm what is being purchased. This can prevent future surprises and problems.
The mineral rights buyer probably prepared the sales agreement and prepared it so that everything will be in his favor. Not only will he want to come in below the average price per acre for mineral rights, he wants the liberty to enter the property at any time, bring whatever equipment is needed, extract the mineral using any method, and make the minimum reclamation required by state law. A person who buys a home above these mineral rights one hundred years later will have no say in how the mineral owner uses his property as long as the mineral owner abides by the sales agreement and applicable laws.
State and Local Laws Always Apply
Most states have laws that regulate mining and drilling activity. There are also laws that regulate the sale of surface and mineral property. These laws are meant to protect the environment and all parties involved in property transactions. These laws are the only protection available to buyers or sellers on issues that are not specifically addressed in the mineral transaction agreement.
Although mineral rights laws are similar from state to state, small variations can make an enormous difference when applied to individual transactions. In addition, mining and oil and gas regulations can vary significantly from one state to another. These can also have an enormous difference when applied to individual transactions. Each transaction is unique and should be carefully considered before any permanent agreement is made.
What Qualifies as a “Mineral”?
The word “mineral” is used in a variety of contexts. Generally, ores of metals, coal, oil and natural gas, gemstones, dimension stone, construction aggregate, salt and other materials extracted from the ground are considered to be minerals. However, there is no definition of “mineral” that applies in every situation, and what is considered to be a “mineral” can vary from state to state and even change over time!
What Kind of Money Are We Talking About?
The amounts of money that change hands in mineral property transactions can be huge in comparison with the average person’s financial experience. The total yield (lease + royalties) or mineral sale price can often exceed the value of the surface rights. Let’s consider two examples:
A 100-acre property is completely underlain by a coal seam that is eight feet thick. The owner agrees to let a mining company remove the coal for a royalty of $3 per ton that will be paid upon extraction. Assuming a coal recovery rate of 90%, the owner would be paid nearly $4 million.
A 100-acre property is drilled for natural gas, and the royalties will be shared by owners of a 640-acre unit that immediately surrounds the well. The property owner is to receive a 12.5% royalty based upon the wellhead value of the gas, which at the time of production is $8 per thousand cubic feet.
Assuming an average well production rate of 2 million cubic feet of gas per day throughout the calendar year the property owner would be paid over $100,000 dollars for one year of gas production, making the natural gas royalties per acre extremely attractive.
Three Bottom Lines
Mineral rights and mineral lease transactions involve large amounts of money and are very complex. This article is intended to be no more than a brief introduction, and reading up on oil and gas leases for dummies will simply not give you enough information (it will introduce you to the situation only). If you are contacted to lease or sell mineral rights that you own, you should promptly get advice from an attorney who has expertise in mineral transactions and the laws of your state. If you do not have an attorney, you can contact the local Bar Association for guidance.
In general, the purpose of a lease or a purchase contract is to convey the rights of exploration and production to a mineral development company. However, the owner of the surface also has some rights. Basic rights of the surface owner are provided by state laws; however, every surface owner should decide if stronger protections are needed. The only way to preserve them is to be sure that the contract contains adequate language to protect crops, livestock, buildings, personal property, access and any other desires during the duration of a lease or permanently in the case of a sale. Lessees will often accept significant revisions to what is contained in their standard lease or sales contract; however, they are under no obligation to grant your requests. They can walk away.
If you want a good financial outcome before putting your oil and gas property for sale with protection for your property during and after mineral production, it is up to you and your attorney to be sure that you have a good contract. Knowledge and negotiating skills are what will determine the success of your deal. If you don’t have these you are taking a huge risk.
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