COLUMN-Oil and gas leases place lenders at risk-Chris Kimmerle

- - Chris Kimmerle is a Reuters market analyst. The views
expressed are his own.
By Chris Kimmerle
NEW YORK, Oct 28 (Reuters) - As the United States continues
to deal with the aftermath of the collapsed real estate bubble
and the associated erosion of home values, there may be an
unrecognized exposure for real estate lenders resulting from
the rapid expansion of oil and gas development.
The risk is in states such as Colorado, New York, Ohio and
Pennsylvania as well as in the urban, suburban and exurban
areas of Denver, Fort Worth and Pittsburgh, and involves the
decline in real estate values that follows the severance of
surface and mineral rights on mortgaged properties.
Many lenders may not be aware of their exposure to
properties with drilling leases, a risk that may be tremendous
but unquantifiable.
There have been tens of thousands of oil and gas leases
executed during the shale revolution, and the footprint of the
industry continues to grow as exploration and production (E&P)
companies move their operations from dry gas to liquid
hydrocarbon-rich shale plays.
In theory, the risk to the lender is minimal. Borrowers are
required to gain the prior approval of lenders before executing
mineral leases. However, many borrowers are unfamiliar with the
terms and conditions contained in their loan agreements. And
rapid advances in extraction technology are redefining the
risks to the surface estates of properties already in mortgage
portfolios.
Simply, who wants to buy a property with a gas well 200
feet from the front door, a noisy compressor in the back yard
or a small tank farm in the front yard? Or, more importantly,
the uncertainty associated with a property at risk of
development at some time in the future.
Think coal mining and mountain top removal. Before the
1970s no one envisioned that advances in technology and
changing economics would permit the removal of hundreds of feet
of earth and rock from the top of a mountain to gain access to
the underlying coal seam -- or that shale would be mined from
open pit operations to recover oil.
MINERAL OWNERSHIP
In contrast to standard global practice, mineral ownership
in the United States is vested in landowners, not the
government. State and local laws govern property ownership and
use except in cases where the mineral estate is on federal
lands.
As a rule, the owner of real estate holds title to both the
surface and underlying mineral estates. However, the surface
ownership may be severed from the mineral at any time through a
sale, lease, gift or bequest.
POTENTIAL PROBLEM ON LENDER BALANCE SHEETS
In theory, a property owner must secure a lender's prior
written consent before selling or transferring all or any part
of a property used to secure a mortgage loan.
In reality, the property owner may not be aware of their
obligation to the lender and not gain prior approval of a
lease. Loan service companies receiving lease approval requests
may not be competent or prepared to allocate the resources
required to fully understand or assess the risk associated with
an oil and gas transaction. What's more, the economic impact of
oil and gas development may shift over time due to rapid
advances in technology.
Once executed, a mineral lease is filed with the local
county and may not be discovered by the lender until it
initiates a property foreclose. At that point, the value of the
underlying asset may be less than the outstanding principal and
interest due under the mortgage obligation.
THE OIL AND GAS LEASE
Under the terms of a standard oil and gas lease, E&P
companies gain an unfettered and exclusive right "as may be
necessary or convenient" to explore, develop, produce, measure,
transport and market production from the leasehold, and "from
adjoining lands". These rights survive the term of the
agreement and "run as long as operations are continued" -- in
essence an open-ended agreement.
Lessors also provide E&P companies with an unrestricted
right to construct and use roads, electric power and telephone
facilities, as well as the pipelines, compressors and
collection facilities required to recover hydrocarbons from the
leasehold and neighboring properties.
The shale gas revolution has been driven by a rapid
evolution of well-development technology including horizontal
drilling and hydraulic fracking. And standard-form oil and gas
lease provisions permit deployment of future technological
advances regardless of their impact on the surface owner.
Other lease provisions permit not only the unrestricted
consumption of oil and gas recovered from the leased property
but also unlimited access to non-domestic water sources free of
cost. And well drilling and completion operations can consume
millions of gallons of water.
Upon hydrocarbon depletion, the lessee has the right to
construct and operate an underground storage field, including
surface facilities such as compressors, processing equipment
and tanks.
The primary term of a lease often runs for five years and
renews, at the option of the lessee, in perpetuity provided
payments are made or as long as operations are conducted on the
leasehold.
In essence, the standard-form oil and gas lease gives the
E&P company an unrestricted right to the hydrocarbon-related
mineral estate, unfettered use of surface and minimal
obligation to return the surface, other than the drill pad
itself, to its pre-development condition upon termination of
the lease.
This is not much comfort to a lender who may unwittingly
see its asset value evaporate due to fracking fluid
contamination, damage to ponds and streams, loss of
recreational value, or impairment of other
quality-of-life-related issues such as noise and line-of-sight
issues.
THE RISK TO REAL ESTATE VALUES
The open question centers on the impact an oil and gas
lease exerts on the market value of a piece of mortgaged real
estate.
In the Greater Green River basin of Wyoming, gas
development has been associated with the disturbance of
wildlife habitat as well as light, noise and air-quality
issues. The area southwest of Pinedale, Wyoming resembles a
checkerboard of well pads connected by service roads and
gathering lines that are visible in Google Earth satellite
images.
Suburban neighborhoods around Fort Worth, Texas have been
centers of ongoing complaints associated with gathering system
compressor emissions and noise.
In the Delaware Valley of eastern Pennsylvania and New
York, there is a growing sensitivity to the risks associated
with the surface disposal of fracking fluids and an emerging
concern surrounding the cutting of hardwood forests to
accommodate drill pads, access roads, and gas gathering
systems.
These are all quality-of-life issues that have the
potential to drive prospective buyers away from properties
exposed to the real or perceived risks of oil and gas
development, exposing lenders to an erosion of real estate
prices and declining asset values.
Dirk Dieterich of Western Royalties offers his clients a
possible solution -- the incorporation of a restrictive
"non-development" lease clause. Under non-development
provisions, E&P companies are permitted to recover oil and gas
from the leasehold but are prohibited from disturbing the
surface for drill pads, access roads, gathering systems or
storage field operations.
It is now time for real estate lenders to reexamine their
exposure to oil and gas leases. Going forward, lenders may want
to consider requiring non-development lease provisions for
urban, suburban and exurban properties as well as property
where oil and gas development may conflict with other land
uses.