The FHOA Lease has been designed to address each of the many concerns that freeholders have raised with the association regarding existing CAPL leases. The most important differences are as follows:
Equitable Risk/Reward Sharing - For many years, the governments of the prairie provinces (the “Crown”) have calculated royalties for wells producing from Crown lands on a sliding scale basis tied to well productivity and the price of oil or gas (see “Crown Royalties”). For wells producing low volumes during periods when prices are low, the Crown collects a low royalty which encourages the industry operator to continue to produce marginally economic wells. For high productivity wells during periods of high prices the Crown collects a much higher royalty. Historically, freehold leases have provided for a fixed royalty and the same royalty rate has applied to both gas and oil. In the early years of western Canadian oil and gas exploration and development, a fixed royalty rate of 12 ½% was standard. Later freehold lease forms provided for a negotiable fixed royalty rate which usually ended up between 15 and 18%. During the 2000’s, a number of shallow gas and coal bed methane development companies attached addendums to CAPL leases which provided for sliding scale royalties tied to productivity. The royalty rates in these addendums varied from 6% for low productivity to 18% for high productivity. Clearly these companies were protecting their downside risk but were not prepared to share the upside potential with the freeholders who owned the resource.
The FHOA Lease provides the freehold owner with the choice of a negotiated fixed royalty rate (for oil a separate rate may be negotiated and a different rate may be negotiated for gas, condensate and natural gas liquids) or a sliding scale royalty rate for which emulates the Alberta Crown royalty regime. The royalty rate for both gas and oil varies between 10% and 32% depending on the well’s average daily production and the price for the product during the production month.
In recent years, to encourage certain types of industry activity the Crown has introduced ‘royalty holidays’ whereby the Crown royalty rate is reduced as low as 2 ½% for a period of time or cumulative volume of production. These royalty holidays have had the effect of focusing industry activity on Crown lands. In some instances this has given rise to the drainage of offsetting freehold mineral rights. The FHOA Lease provides a freehold owner with the opportunity to grant a negotiated lower royalty rate for a negotiated period of time to encourage industry activity on the freeholder’s mineral rights. FHOA does not recommend the granting of such royalty holidays by freeholders except in serious drainage situations.
Freehold Mineral Tax - Most existing freehold leases, including CAPL leases, provide for the mineral tax levied on production by the Crown to be shared between the freeholder and the lessee with the freeholder paying his or her royalty share of the tax. It is industry practice (and in Saskatchewan it is mandated by legislation) for the oil company-lessee to pay 100% of the tax. The freeholder’s share of the tax is then deducted from royalties. This can cause confusion because in many leases, including CAPL 88 & 91, the freeholder is contractually required to pay 100% of the tax and invoice the lessee.
Prior to the federal government’s decision to phase out resource allowance, paying a portion of the freehold mineral tax was in a freeholder’s best interest as the resource allowance deduction associated with the non-deductible mineral tax paid significantly exceeded the tax itself. It is no longer in the best interest of a freeholder to pay any part of freehold mineral tax. The FHOA Lease provides for 100% of the freehold mineral tax to be paid by the oil company lessee. This has the effect of increasing the royalty rate in the FHOA Lease in comparison to CAPL leases by up to 2%.
Commodity Price –Although most oil pricing is relatively transparent, gas pricing is not. Many operators do not sell all of their gas production on the spot market but engage in complex contracting and hedging activities. The governments of the prairie provinces take the position that they don’t care whether an operator wins or loses in such activities, they collect royalties based on the weighted average price of all gas actually sold in their jurisdictions during the month. In most freehold leases, including CAPL leases, royalties are based on current market value. Some operators minimize their overall corporate royalty obligation by assigning low priced contracts to freehold gas (see “FHOA Concerns”, “Price”)
For royalty calculation purposes, the FHOA Lease defines a ‘Royalty Price’ which for crude oil, condensate and natural gas liquids is the greater of current market value or the actual price received for the substances including all payments from whatever source and which for raw gas (gas sold at the wellhead) and residue gas (gas sold at the plant outlet) is the greater of current market value, actual price received and the price used by the Crown to calculate Crown natural gas royalties.
Deductions - The Crown allows limited deductions from oil royalties (ie trucking costs). In the case of gas, the industry is allowed to deduct the costs of gathering and processing gas under a complex formula known as gas cost allowance (GCA). The GCA calculation provides for the deduction of all actual gathering and processing operating costs; the deduction of all capital costs on a declining balance basis; and for a rate of return on invested capital. The Crown has teams of auditors who monitor industry reporting of GCA. Existing freehold leases, including CAPL leases, provide for royalties to be calculated on ‘current market value at the well head’ or ‘on the lands’. Canadian courts have interpreted this to mean that the producer is allowed to deduct the costs to make the gas ‘market ready’. CAPL leases specifically provide for the deduction of any reasonable expense incurred in water disposal (CAPL 99), separating, treating, processing, compressing and transporting, including a reasonable rate of return on investment. The problem is that it is the lessee who determines what is ‘reasonable’. Some operators consider a rate of return on investment of 40% to be reasonable. This type of reasoning resulted in many freeholders who had leased their mineral rights under CAPL 88 leases receiving invoices rather than royalty checks in the late 1980's. CAPL 91 and CAPL 99 leases provide for a negotiated cap on the percentage of a freeholder’s royalty which can be deducted in making the leased substances market ready. Land agents typically offer an effective cap of 40% to 50%. Some operators treat the cap as a fixed percentage to be applied irrespective of the actual costs. Short of an expensive audit, freeholders have no way of independently verifying the amounts deducted for gas gathering and processing. The FHOA Lease provides for the energy company-lessee to deduct trucking costs from crude oil or condensate royalties provided these costs do not exceed a negotiated percentage of the crude oil or condensate royalty. In the case of residue gas, the FHOA Lease provides for the energy company-lessee to deduct the reasonable costs of separating, treating, processing and transporting the gas from the wellhead to the point of sale, provided the rate of return on invested capital does not exceed 15% and the total deductions do not exceed an negotiated percentage of the total royalty on residue gas.
Deep Rights Reversion - For almost a quarter of a century, Crown leases have provided for the lessee to return to the Crown all rights below the deepest formation proven capable of commercial production. Existing freehold leases, including CAPL leases, contain no deep rights reversion clause and an energy company-lessee can earn all of a freeholder’s mineral rights from the surface to the centre of the earth by establishing the capability of production in a shallow formation.
The FHOA Lease contains a deep rights reversion clause which provides for the lessee to only earn to the base of the deepest formation proven capable of production in paying quantities.
Zone Specific - Crown leases provide for the leasing of specific geological formations. So do the leases of sophisticated corporate owners of mineral rights. Existing freehold leases, including CAPL leases, contain no such provisions. The FHOA Lease provides for zone specific leasing in situations where the freeholder wishes to lease only specific formations or, in the case of deep rights reversion, where the freeholder has only deep rights available to lease.
Leased Substance Specific – The Crown and sophisticated corporate owners of mineral rights have leased petroleum and natural gas separately for many years. The CAPL has a separate lease form for use when the freehold owner holds title to only natural gas (all mines and minerals except coal and petroleum or coal, petroleum and valuable stone) but CAPL leases do not provide freeholders who own all mines and minerals with the opportunity to lease petroleum and natural gas separately.
The FHOA Lease provides for the leasing of petroleum only, natural gas only or both.
Shut-In Wells - Crown leases may be continued by a well capable of production in paying quantities. Similarly, the leases of most sophisticated owners of mineral rights require the capability to produce in paying quantities for lease continuation. Most freehold leases, including CAPL leases, provide for the lease to be continued with a well ‘capable of production’ or ‘capable of producing’, provided a shut-in or suspended well payment is made annually. In CAPL leases there is no requirement that the production be in paying quantities. In most freehold leases, including CAPL 88 and 91, the shut-in well payment is $1 per acre. Virtually any well in Alberta is capable of some production and, as a result, many freehold leases have been continued for speculative purposes with token payments to the freeholder. In 2011, the Alberta Court of Appeal upheld an Alberta Energy Regulator (formerly known as the “Energy Resources Conservation Board”) ruling whereby a well must be capable of producing in meaningful and material quantities in order to continue a CAPL lease and, in the Court’s opinion, meaningful meant that the “quantity was sufficient to provide a reasonable expectation of profits” (see “The Capable of Producing Issue”). FHOA commends the AER (formerly known as the “ERCB”) and the Appeal Court for imposing some level of fairness on the relationship between individual freehold owners and energy companies that lease our mineral rights. However there is no reason for the shut-in well provisions in freehold leases to be any less rigorous than the provisions found in Crown or sophisticated corporation’s leases.
In order to continue the FHOA Lease with a shut-in well, the well must be capable of producing in paying quantities and if there has not been at least 120 days of cumulative production during any lease year, a shut-in well payment equal to the original signing bonus divided by the number of years in the primary term payable must be paid within 30 days of the end of the lease year.
Unitization - CAPL leases provide the oil company-lessee with the right to unitize the freeholder's mineral rights with other lands without the freeholder’s consent based on whatever criteria the lessee deems acceptable. This is a convenience for the oil company-lessee but a potential disaster for the freehold owner who runs the risk that his lessee will have conflicts with its other business interests in negotiating a fair share of unit production for the freeholder’s account. The Crown and sophisticated corporate owners of mineral rights do not allow their mineral rights to be unitized without their consent.
The FHOA Lease requires the oil company-lessee to seek the freeholder's consent to unitization.
Offset Wells - The wording of the CAPL 88 and 91 offset clause is so convoluted that many freeholders do not understand that these leases provide no protection whatsoever from drainage through wells in adjacent spacing units if there is a dry hole or a suspended well on the spacing unit which includes the freeholder’s lands which was drilled into the zone or formation from which the adjacent well is producing. The wording in CAPL leases also gives rise to issues having to do with the meaning of the words ‘adjacent’ and ‘zone or formation’. (see “Understanding Freehold Leases” – “The Offset Wells Clause”, “About Offset Wells”). CAPL 88 & 91 leases also provide no protection from wells drilled in diagonally adjacent spacing units and, in the case of multiple offset wells, the production is averaged in calculating compensatory royalties. CAPL 99 provides lateral and diagonal offset protection but no protection from adjacent wells which were drilled before the effective date of the lease.
The FHOA Lease provides protection from all wells which commence commercial production from laterally or diagonally offsetting spacing units regardless of when the offsetting wells were drilled and regardless of whether a dry hole or suspended well exists on the spacing unit including the freeholder’s lands. Production from multiple offset wells is summed in calculating compensatory royalties.
Caveats - CAPL leases do not require the lessee to remove caveats filed against the freeholder’s title. In situations where a freehold owner has negotiated a deep rights reversion clause, unless the original caveat is amended or replaced, there is no way for any other energy company that might be interested in the freeholder’s deep rights to know that the opportunity to lease these deep rights exists.
The FHOA Lease requires the filing of an amended or replacement caveat 60 days after the end of the primary term to reflect deep rights reversion and the removal of all caveats 60 days after lease termination.
Default - The Crown has the full power of legislative authority in the event that a lessee defaults on its obligations. The default clause in the leases of most sophisticated corporate owners of mineral rights provides for the lease to terminate if the lessee does not commence to remedy the alleged default within 30 days of receipt of a default notice and for the lessor to have the right to take over any well and equipment on the lands. CAPL leases have been ‘bullet-proofed’ by structuring the lease so as to make the lessee’s obligations to the freeholder subject to the default clause and including a judicial ascertainment clause within the default clause. As a result, a freeholder who is forced to go to court to prove a default and wins, still loses - he is stuck with the defaulting company because under the judicial ascertainment clause the lessee has 30 days after the final ruling of the court to commence to remedy the default. The FHOA Lease does not contain a judicial ascertainment clause. In the event that the freehold owner files a notice of default in respect of an alleged default by the oil company-lessee, the lessee has 30 days in which to remedy the alleged default or initiate negotiations to resolve the dispute. If the oil company fails to do either, the freeholder has the right to repossess the leased substances and may elect to acquire all property of the lessee on the owner=s lands free and clear of any claim by the lessee. If the oil company initiates negotiations and these negotiations fail to resolve the dispute within 60 days, the FHOA Lease contains provisions for mediation, binding arbitration, or litigation at the option of the freeholder.
Reporting - The Crown has full access to Board production data and essentially issues invoices to industry operator lessees for royalties due. Most freehold leases, including CAPL leases, contain no specific provisions setting forth what royalty calculation information is to be reported to the freeholder. Some industry operators provide excellent royalty reports; most do not. Frustration with inadequate royalty reporting is one of the most common complaints of freehold owners. The FHOA Lease requires the lessee to provide the freeholder with detailed and understandable reporting.
Applicable Law – In Alberta the Limitation Act bars legal actions founded on events which occurred more than 10 years before the filing of the legal action. The Act also provides for this ultimate bar to be amended by contract.
The FHOA Lease extends the 10-year period to the length of the lease plus 2 years and in no event less than 10 years.
Assignment – CAPL 88 and 91 leases provide that the energy company-lessee can assign all or any part of its interest in the lease to as many parties as it wishes but the freehold owner-lessor can only assign his or her entire interest. Furthermore, the energy company-lessee has no responsibility if its assignee fails to perform.
The FHOA Lease imposes joint and several liability in situations where there are multiple lessees (ie if a judgment is awarded against the lessees and one cannot pay, the other must).
Conduct of Operations - Finding and developing oil and gas is a complex business and it is impossible to draft a lease agreement which addresses all of the possible circumstances which may arise. In the United States, an entire body of law known as the law of implied covenants exists to protect freehold owners in circumstances which were not specifically contemplated in the lease agreement. Most existing Canadian freehold leases, including CAPL leases, contain an ‘Entire Agreement’ clause which specifically denies the existence of any implied covenant or agreement between the freeholder and the oil company-lessee and essentially limits the lessee’s obligations to the freeholder to those obligations specifically set forth in the lease agreement. The obligation of the oil company-lessee in CAPL leases is to conduct its operations in a “diligent, careful and workmanlike manner”.
The FHOA Lease does not contain an Entire Agreement clause and specifically requires the oil company-lessee to carry out its operations in good faith with regard to the mutual interests of the parties to the lease agreement and act as a reasonably prudent operator in protecting the freehold owner-lessor for drainage, fully developing the freeholder’s mineral rights and producing and marketing the leased substances.