The Marcellus, Utica and other Shale gas plays have been an economic boon to landowners, the oil and gas industry, and the states and communities in which production is occurring. The impacts of shale oil and gas development have mostly focused on environmental issues, such as alleged groundwater contamination, local control of oil and gas activities on private land through zoning regulations, and, from the landowner’s perspective, lease validity and royalty calculation and allocation issues. Seemingly lost in the shale gas gold rush is how oil and gas leasing and production activities may affect the value of a mortgage lender’s real estate collateral, or what underwriting, due diligence, and loan documentation policies and strategies mortgage lenders should consider when underwriting, documenting, closing or servicing a mortgage loan where the real estate collateral is or may become subject to an oil and gas lease or production activities.

Four Oil and Gas Underwriting Scenarios

A mortgage lender may be faced with one of four oil and gas underwriting scenarios:

• A proposed mortgage loan where the mortgaged property is not subject to an oil and gas lease
• A proposed mortgage loan where the mortgaged property is subject to an oil and gas lease or oil and gas production activities
• An existing mortgage loan where the borrower seeks the lender’s consent to enter into an oil and gas lease
• An existing loan where the borrower or the lessee under the oil and gas lease seeks a subordination of the lender’s mortgage to the oil and gas lease

Under any of these scenarios, lenders should revisit their loan documentation to address oil and gas issues. If a borrower enters into an oil and gas lease without the lender’s consent, the oil and gas lease would likely violate negative covenants prohibiting or restricting transfers of interests in the mortgaged property. Additional protective measures may include expanding the lender’s real estate collateral to include the borrower’s right to lease land or mineral interests, known as the executive right—an interest in real property that can be severed from other mineral interests. In addition, consider targeted modifications to mortgages, assignments of leases and rents, and environmental indemnity agreements. In Ohio, oil and gas leases enjoy statutory super priority over mortgages (See Ohio R.C. § 1509.31(D)). As a result, a mortgage lender must take special care to protect its collateral because a foreclosure of a prior mortgage will not divest a subsequent oil and gas lease. Each of the underwriting scenarios would result in the lender assuming a different underwriting, due diligence and loan documentation stance.

A Word About Due Diligence

Oil and gas leasing and production activities produce some interesting due diligence issues and considerations for mortgage lenders that may necessitate broadening the scope of a lender’s real estate due diligence, and answering the ultimate question: how much of your client’s money are you willing to spend?

Title

If it becomes necessary to determine a borrower’s estate or interest in the subsurface mineral estate, a separate oil and gas abstract and title opinion would be required and in addition to traditional title insurance costs. Reliance on a title company search and policy only for existing oil and gas leases and pipeline rights-of-way would likely miss older documents of record because title insurance searches typically only cover 60 years of title history.

Survey

Survey due diligence would require knowledge of applicable oil and gas statutes and regulations that mandate minimum drilling setbacks from residential improvements, water sources and wetlands. Not only should an ALTA survey reflect all oil and gas drilling and production improvements on the property, but also the distance of those improvements from houses, wells, wetlands, streams and other protected assets.

Environmental

A water quality test conducted prior to oil and gas drilling activities or prior to loan closing would disclose whether pre-existing conditions have contaminated groundwater and would protect against later claims of contamination from drilling activities. A Phase I environmental site assessment record search would be wise to include a search of governmental records of drilling applications, plans and plats, permits, and notices of violation or remediation orders.

Appraisal

From an income approach, an appraisal of an oil and gas lease requires review and analysis of a well’s production history and production projections among other information specific to the oil and gas industry, which is beyond the scope of a traditional real estate appraisal and the qualifications of real estate appraisers. A comparable sales approach appraisal will likely fail to account for the oil and gas lease because valuation of an income-producing interest is inconsistent with the comparable sales approach. Over time, comparable sales appraisals that include oil and gas leases may develop into a hybrid income/comparable sale model.

Lease Review

The industry oil and gas lease provides the lessee with broad rights to engage in exploration, production and other related activities, including underground gas storage and operating compression facilities. Landowners may alter the terms of an oil and gas lease with an addendum that provides, in part, for terms that protect the surface estate. Confirming important oil and gas lease facts may be aided by additional loan-related documentation.

Oil and gas leasing and production activities present mortgage lenders with a wide variety of issues and concerns that likely are not addressed by current underwriting and due diligence policies or existing loan documents. If a mortgage lender is actively lending in shale plays, it would be wise to consider how oil and gas leasing may affect its collateral and how the value of the collateral may be protected.

Client Alert 2012-288