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Airport Participation in Oil and Gas Development (2018)

Chapter: CHAPTER THREE Components of an Oil and Gas Lease

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Suggested Citation:"CHAPTER THREE Components of an Oil and Gas Lease." National Academies of Sciences, Engineering, and Medicine. 2018. Airport Participation in Oil and Gas Development. Washington, DC: The National Academies Press. doi: 10.17226/25097.
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Suggested Citation:"CHAPTER THREE Components of an Oil and Gas Lease." National Academies of Sciences, Engineering, and Medicine. 2018. Airport Participation in Oil and Gas Development. Washington, DC: The National Academies Press. doi: 10.17226/25097.
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Suggested Citation:"CHAPTER THREE Components of an Oil and Gas Lease." National Academies of Sciences, Engineering, and Medicine. 2018. Airport Participation in Oil and Gas Development. Washington, DC: The National Academies Press. doi: 10.17226/25097.
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Suggested Citation:"CHAPTER THREE Components of an Oil and Gas Lease." National Academies of Sciences, Engineering, and Medicine. 2018. Airport Participation in Oil and Gas Development. Washington, DC: The National Academies Press. doi: 10.17226/25097.
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Suggested Citation:"CHAPTER THREE Components of an Oil and Gas Lease." National Academies of Sciences, Engineering, and Medicine. 2018. Airport Participation in Oil and Gas Development. Washington, DC: The National Academies Press. doi: 10.17226/25097.
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Suggested Citation:"CHAPTER THREE Components of an Oil and Gas Lease." National Academies of Sciences, Engineering, and Medicine. 2018. Airport Participation in Oil and Gas Development. Washington, DC: The National Academies Press. doi: 10.17226/25097.
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Suggested Citation:"CHAPTER THREE Components of an Oil and Gas Lease." National Academies of Sciences, Engineering, and Medicine. 2018. Airport Participation in Oil and Gas Development. Washington, DC: The National Academies Press. doi: 10.17226/25097.
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Suggested Citation:"CHAPTER THREE Components of an Oil and Gas Lease." National Academies of Sciences, Engineering, and Medicine. 2018. Airport Participation in Oil and Gas Development. Washington, DC: The National Academies Press. doi: 10.17226/25097.
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Below is the uncorrected machine-read text of this chapter, intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text of each book. Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.

22 CHAPTER THREE COMPONENTS OF AN OIL AND GAS LEASE FAA AC 150/5100-20 provides guidance on the extraction of oil and gas at federally obligated airports. The document is a summary of FAA policies, applicable laws and regulations, standards, and obligations, and how they pertain to oil and gas drilling on airport property. Appendix A of the AC provides sample lease provisions that an airport sponsor might include to ensure compliance with federal aid obligations and grant assurances. This chapter takes a broader look at other elements that an airport sponsor might choose to address in a lease to define the leased premises, the term of the lease, forms of payment, assignment restrictions, insurance requirements, financial security, recordkeeping, and cleanup. BACKGROUND ON OIL AND GAS LEASES Oil and gas leases generally follow a format developed historically by the drilling companies and provided to the landown- ers. The advent of horizontal drilling has had a great impact on the standard drilling lease form as new elements need to be considered, such as off-site drilling, water use, and other practices unique to fracking. These items are discussed in more detail below. Nonetheless, the preprinted standard lease form has governed the landowner-driller relationship for years. While modifications and amendments are negotiated based on the circumstances surrounding each parcel of land, the basic terms have remained the same. In fact, some of the terms have been codified in state laws, purportedly to protect the landowner (see discussion of state laws in Appendix A). What makes a lease on airport property different from a lease delivered to a farmer or other landed estate owner? Most significantly, it is the land mass of an airport that makes it a coveted drilling/fracking site. A large airport with oil and gas resources is valuable. First, the developer does not have to aggregate parcels large enough to justify incurring the costs associated with mobilization of a rig crew. Also (while this is not the case at every airport) it is less likely that there will be residential development in close proximity dense enough to raise concerns that usually attenuate drilling operations in such communities. Land use restrictions may also be easier to overcome when dealing with operations within an airport perimeter. On the other hand, as noted in chapter two, the airport drilling process can be complicated by the government oversight involved. All airport operations, drilling or otherwise, are subject to FAA approval and the constraints of the grant assurances governing an airport that receives federal funds. These federal obligations govern the following: • Ensuring that the airport obtains fair market value for its oil and gas reserves; • Ensuring that the revenues remain on the airport; • Compliance with the National Environmental Protection Act; • Compliance with numerous other federal statutes; and • Ensuring that there is no interference with airspace (compliant with Part 77 surfaces) or airport operations.1 INITIAL STEPS IN THE LEASING PROCESS Airport sponsors often know about oil and gas reserves that are economically and technologically recoverable, either because of previous surveys or as a result of developer interest in extraction of the resource. The sponsor can solicit interest in develop- ment by issuing a request for proposals (RFP) or a request for qualifications to qualify bidders and obtain bids for extraction rights. Most oil and gas leases are based on payments of royalties as a percentage of sales, so it is not necessary to establish the market price per Mcf or barrel of oil at this juncture. However, to maximize the bonus payment (an upfront payment of a certain number of dollars per acre), the sponsor may have an appraisal done in advance. The RFP process will help set the market price by virtue of the number of respondents and their financial proposals for bonus payments.2

23 Once a proponent is qualified and selected, lease negotiations begin. The following sections set forth some of the key elements of a lease for counsel and business agents representing an airport. In this discussion, the term airport refers to the airport sponsor, whether an authority or a municipal government entity. The term lessee refers to the company that will under- take drilling or fracking operations.3 KEY ELEMENTS OF A LEASE 1. Define Leased Premises, Drilling Areas, and Formation In many areas where oil or gas deposits exist, there may be multiple subsurface formations at different depths. For instance, in areas where the Marcellus Shale formation exists, deeper formations such as the Utica and the Devonian also will contain extractable reserves. The quality of the minerals may differ among the formations. If the lease does not specify the formations from which the lessee is permitted to drill, the lease will be presumed to cover formations at all depths. Airports negotiating these provisions are advised to be familiar with the exact formations they will be leasing. It is possible to restrict the driller’s rights and negotiate separate leases for different formations; however, it is usually more cost-effective for both parties to allow the extraction of oil and gas from all formations. After all, the airport will receive the royalties from the sale of all those assets, irrespective of the formation from which they are drawn. The following is a sample of lease lan- guage: “Airport grants and leases exclusively unto Lessee all of Airport’s right, title, and interest in all Leased Minerals (and any constituents therefrom) from all formations underlying the Airport Lands.” The perimeter of the leased premises should likewise be described with specificity, identifying the number of acres included in the leased area and including a survey of the perimeter of the property. Maps reflecting the agreed-upon drill plan, pipeline layout, and drill pads, as well as their locations, are included in the ALP and submitted to the FAA for approval.4 The airport is responsible for clearing any title issues. While the airport may own the surface rights, the mineral estate may be affected by previous land grants dating back to the first recorded deed in the United States. Title defects will reduce the bonus payment and revenue share, and may even affect the airport’s ability to participate at all. 2. Natural Gas Storage Underneath Airport Property Ideally, gas storage rights (the right of the driller to store portions of the extracted gas under the airport) are the subject of separate agreements based on separate negotiations. But that might not always be the case; in certain instances the airport will be required to draft a lease that includes storage. Storage imposes added encumbrances and risk on airport land that may require additional fair market value payments to the airport and specific controls and engineering documentation to preclude adverse effects on airport facilities or disruption of current or planned airport development or operations. Usually the basic airport lease does not include storage rights. If separate storage rights are negotiated, the lease would anticipate that and provide for what happens under such circumstances. The Bureau of Land Management recognizes the value of oil and gas storage agreements as a means of conserving excess production to be used in times of increased demand (see 43 CFR 3105.5-2). Generally, storage provisions or agreements require annual or other periodic payments to the lessor. The rates are negoti- ated and may include a flat rate for storage rights or rates calculated on a per acre basis. How the lease is drafted will affect whether storage rights are granted. Likewise, the granting of storage rights may have the intended or unintended effect of extending the term of the lease. For instance, if the granting clause says the grant is for a “term of five (5) years or as long as gas is being produced in paying quantities,” the term is clear (see the next section). If the provision goes on to add, “or as the property continues to be used for the underground storage of gas,” the reference to gas storage will have the effect, intended or otherwise, of extending the term beyond the defined term or the production percent- age term. The suggested approach, to maximize airport revenue and maintain more control of the activities on airport property, is to mandate that if the driller wants to use the property to store gas, it must first get a gas storage lease from the airport.

24 Likewise, it is reasonable to expect that if the airport wishes to develop any of the property for gas storage, it must first offer that right to its lessee before offering it to any third parties. If that right is not exercised and the airport proceeds to grant storage rights to a third party, all three parties will have to cooperate to coordinate their respective activities on the property, with the understanding that the drilling activities will take priority. 3. Lease Term The term of the lease will be negotiable, but a lessee (which may have made substantial upfront bonus payments to gain exclusive drilling rights) is not likely to agree to a term of less than 5 years because of the startup time required to spud (drill) the first well. In fact, the airport may want to specify a time for completion of the first well, as royalty revenues will not flow until the gas flows and is sold. However, the term will not necessarily end at the end of the defined term—the lease will con- tinue as leased minerals are produced in “paying quantities.” That term will, in turn, be subject to further negotiations. Thus, while a fixed term may be specified, the continuation of the drilling process has the effect of extending the term. 4. Bonus Payment To the extent that an airport has verified oil or gas deposits, the right to drill becomes a valuable and highly competitive opportunity, assuming that market conditions support the costs of drilling. Airports can capitalize on this value prospect by obtaining an upfront bonus payment. The amount of the bonus payment may be included in a bid or simply subject to negotia- tion with the successful proponent. The payment is calculated as a per acre amount. Market conditions for the price of gas will be the key factor; for example, while DFW was able to obtain a bid of $10,000 per acre in 2006, Pittsburgh’s 2012 bid was half that. 5. Land Rent for Installation of Pipe and Well Pads Because the extraction of oil and gas entails the installation of well pads and pipelines, the airport usually receives surface rent for each acre or portion of an acre used for such items. Land rent is charged based on the appraised value of the land to ensure that the airport is receiving fair market value as required by Grant Assurance No. 22 (Sustainability). Periodic increases will be required in the same manner as if applied to the ground lease of a vertical development (that is, a building). 6. Shut-in Rights The market price of gas is subject to substantial fluctuation. If the price goes too low, it may become cost-prohibitive for the lessee to continue the drilling operation until the market recovers and the price per Mcf returns to profitable levels. If this occurs, the lessee will preserve, in the lease, the right to shut in one or more wells for a defined period without losing the drilling rights granted in the lease. 7. Royalty Rate The gas lease imposes on the lessee the payment of a royalty for all gas sold from its drilling operations on airport land. The royalty rate and how it is calculated will vary and will most likely be determined in the bid process. The customary royalty in Pennsylvania, for example, is about 16.5%, although the drilling rights at Pittsburgh International Airport were negotiated at 18%. DFW, on the other hand, received its bids during a period when the market price of gas was high; its lease royalty was set at 25%. Royalty rates for oil are similar to those for gas and equally dependent on market prices. It is crucial to clarify whether the royalties will be paid on a gross or net basis. Payment on a net basis means that the amount will be calculated after deducting the costs of production, which could be substantial depending on what is included in those costs. Market conditions will drive whether bidders offer to pay on a net or gross basis, but negotiating payment on a gross basis protects the airport from questionable deductions. Sample lease language to protect an airport would read as follows: The Airport’s [gas] royalty shall never be reduced, either directly or indirectly, by any part of the costs or expense of production, drilling, exploration, permitting, separation, gathering, dehydration, compression, transportation, trucking, processing, treatment, storage, or marketing of the gas or liquid hydrocarbons produced from the Leased Premises or any part of the costs of construction, operation, repair, renovation or depreciation of any plant or other facilities or equipment used in the handling of gas or liquid hydrocarbons …. or impositions.

25 8. Audit Rights Because ongoing airport revenue is based on the royalty streams paid on oil or gas sold, it is imperative to retain audit rights. Such rights allow airport representatives access to the records of account of the lessee with regard to the minerals extracted from the airport property. Penalties for the understatement of sales and reimbursement of audit costs are standard provisions to ensure accurate reporting. 9. Indemnification The process of drilling, especially fracking, has inherent risks and increases the potential for liability for the airport. The impact on the environment, for example, is still uncertain. Claims of water and land contamination arising out of the fracking process abound, but proponents of the process challenge the causal link. Additionally, there have been rig explosions. These are only two examples of possible risks associated with the process and, while insurance requirements are imposed (see Insur- ance Coverage section), potential liability for uninsured or underinsured claims must be addressed. The lease should include provisions whereby the lessee indemnifies the airport, its governing body, elected officials, officers, and employees from liability for damages arising from environmental hazards, personal injury, and other matters. The value of an indemnification is only as strong as the party providing the indemnity, so it is crucial that the selected lessee meet sufficient net worth tests. Special purpose entities created to hold drilling rights must be adequately capitalized or have a guarantor of their indemnifica- tion and other obligations with the requisite net worth. AC 150/5100-20, Table A-1 contains sample environmental indemnification language for inclusion in an airport lease. 10. Restriction on Assignment The process of selecting an exploration and drilling company is an extensive one, and the airport sponsor must undertake significant due diligence to select a financially capable and experienced company. To allow assignment without airport staff oversight would defeat that purpose and potentially allow a winning proponent to profiteer by “flipping” the lease. It is sug- gested that the lease restrict assignment, subletting, or “farming out” without the consent of the airport at its sole discretion. In addition to financial and experiential concerns, airport staff are charged with the safety and security of the airport and its users; allowing access or exploitation by any entity other than the approved driller could compromise those concerns. However, it is reasonable to expect that a collateral assignment of the lease may be required to enhance the lessee’s credit facility. The terms of any document, such as a leasehold mortgage, can be pre-negotiated, so to speak, by including specific mandates and restrictions in the lease regarding the terms and conditions pursuant to which a leasehold mortgage or other security may encumber the leasehold estate. 11. Financial Security For its financial security, the airport should consider obtaining an irrevocable letter of credit, surety bond, or cash deposit to ensure faithful and timely payment of royalties. Performance security can be addressed in a similar manner to ensure the lessee’s performance of the in-term and post-term covenants of the lease, such as removal of equipment and machinery. In the event the lessee’s net worth falls below a certain threshold, the airport should consider imposing similar financial security instruments to ensure completion of any required well plugging and restoration of the airport property to its original condition. These security instruments should be reevaluated every 5 years or so to determine whether they need to be adjusted upward. 12. Insurance Coverage Appropriate insurance coverage is one of the most important protections for the airport. A financially well-established lessee might self-insure to specific retention levels. While there is a reasonable level of risk tolerance associated with a finan- cially viable entity negotiating a level of retention on self-insurance, umbrella coverage is essential, as one incident, even in a location unrelated to the airport, could cause a substantial erosion in the self-insurance level of protection. Furthermore, market conditions or unrelated pressure for the lessee may affect its financial viability. Constant monitoring of the lessee’s financial state is an essential consideration in any self-insured arrangement; for example, with the recent drop in gas prices, many publicly and privately held companies in the industry have sustained a drop in their market capitalization.

26 The airport should be insured at appropriate levels against all risks, including pollution liability, well control, and general liability. For a list of types and levels of coverage, see Appendix B. 13. First Well Spud and Subsequent Wells Once the lease has been fully negotiated and executed, a great deal of work will need to be undertaken to prepare for the spudding of the first well. To ensure the diligent and expedient completion of these preliminary processes (such as permitting and installation of infrastructure), airport staff should consider imposing a deadline by which the first well must be started. While there might be legitimate reasons for delaying the process—such as market conditions that severely negatively affect the price of gas or matters that are force majeure in nature—the decision to grant an extension would rest with the airport. Failure to fulfill this obligation would be grounds for terminating the lease. If the first well is productive and the anticipated return on investment is expected to meet projections, the lessee would ideally be required to continue with the drilling process in accordance with the approved drill plan. 14. Development and Well Spacing The airport’s grant to the lessee ideally sets forth the number of wells to be built on each well pad location. The spacing layout may require FAA review, especially if it affects the ALP. 15. Drilling Restrictions Drill site locations and all surface operations must be limited to areas where the airport anticipates current and future com- patibility. If the airport engages in other active development activities, proper planning will avoid the risk of impeding on such development. Because the gas extraction process involves horizontal drilling, the airport should be able to accommodate the placement of rigs without a negative impact, and the lessee will still be able to draw gas from sites at considerable distances from the well pad. However, placement of the well pad site must include planning for ingress and egress. Other drilling and well pad restrictions should be included to ensure that operations will not create security or environ- mental issues and will be in compliance with the airport’s general rules and regulations. The airport is advised to retain the right to require the lessee to plug and abandon a well if it interferes with the airport’s development or expansion plans. Under these circumstances the airport would be required to pay the lessee the fair market value of the well and its reserves, if any, unless a reasonable relocation accommodation can be made. 16. Right of First Refusal The lease generally restricts assignment of the lease or any of the rights granted thereunder without the airport’s consent. The airport should reserve for itself the right of first refusal to purchase any well that the lessee may elect to sell or transfer. This right would allow the airport to make its own decision on whether to own a particular well and perhaps subcontract out its operations. 17. Well Records—Confidentiality It is important that the airport have access to accurate production information such as drilling records, meter charts, pric- ing, data logs, core samples, and measurements. This information is valuable not only to confirm royalties but to provide airport staff with important information on activities on airport property so they can, for example, track causes of incidents that might lead to liability and enforce the covenants of the lease. The lessee will be rightfully concerned that this information, which is typically deemed confidential, will not be subject to release under state-specific sunshine or right-to-know laws. While such laws may exempt the disclosure of trade secrets, the burden of establishing that the information constitutes a trade secret would fall on the airport or the lessee. Appropriate safe- guards should be negotiated to protect against the release of information the lessee deems confidential and at the same time protect the airport from claims arising out of the violation of applicable state laws. To protect both the airport and the lessee, the former should notify the latter of any right-to-know requests so the lessee can file for injunctive relief or other protection

27 from disclosure. In such a scenario, the lessee should be obligated to indemnify the airport from any liability arising out of a failure to disclose in accordance with the applicable statute. 18. Unitization Often property abutting the airport is part of the same geologic formation in which drilling or fracking operations are set to occur. To the extent that the lessee has made similar arrangements with such abutting landowners, it is economical to unitize the properties so that drilling operations can be conducted from the same rig or rigs. The airport’s lease may grant the lessee the right to unitize portions of the airport that fall within or form a drilling unit to allow the lessee to pool the production from such units. In giving its consent, the airport must ensure that there will be no adverse impact on airport operations. In a unitized pool, the airport lease ideally ensures that the lessee is still required to drill and produce wells, entitling the airport to all royalties, shut-in royalties, delay rentals, or other rentals on the basis of its pro rata share of the unit. The airport is also advised to ensure that its leased acreage represents an adequate share of the total acreage of leased land in the unit, to prevent the dilution of royalty payments to a small percentage of the drilling unit. 19. Termination For the airport, termination is fairly simple: the lease can be terminated if the lessee fails to pay royalties or otherwise breaches its covenants under the lease, and such breach continues beyond applicable notice and cure periods. In some cases the lessee might decide to surrender the lease. This may occur if the lessee does not see any future economic benefit to continuing the drilling process; for example, if the market is in a downturn and depressed prices no longer support the process or if unforeseen conditions in the ground render the process more expensive or more difficult than expected. The lease should clarify that no portion of any bonus payment will be returned under these circumstances. Rather, the payment would be treated as liquidated damages for the airport’s lost opportunity. In the event of termination, the lessee may be entitled to retain previously drilled producing wells and the acreage needed to support the well pad and drainage. However, the lessee shall remain responsible for plugging or abandoning wells and for all cleanup duties imposed by the lease. Force majeure provisions, which are included in most contracts, would suspend the lessee’s performance obligations. The law generally recognizes that inability to perform owing to circumstances beyond the control of a party is best handled by suspending timely compliance. The most common force majeure events are natural disasters and government regulations and proceedings, but the airport lease should also include inability to operate owing to airport operations or delays in FAA approval. 20. Applicable Federal Clauses AC 150/5100-20 includes guidance and provisions for oil and gas leases. On January 29, 2016, the FAA issued a publica- tion titled “Required Contract Provisions for Airport Improvement Programs and for Obligated Sponsors” as part of the Advisory Circular. Most of these provisions are required for Airport Improvement Program contracts and might not apply to all contracts—oil and gas leases are property agreements and can arguably be considered construction contracts. Civil rights provisions, specifically Title VI assurances, should be included, as well as those related to Disadvantaged Business Enterprises, the Fair Labor Standards Act, and the Occupational Safety and Health Act. Various state and local contract requirements also may apply. LEASE ELEMENTS FOR OFF-AIRPORT DRILLING SITUATIONS Directional drilling has seen significant technological advancements over the past 50 years since it was first used. These advancements have made it possible to frack or drill into a shale deposit from great distances. Thus a vertical well on one parcel may be able to laterally reach shale reserves on an adjacent or even nonadjacent property. This method has proved to be a cost-effective way for drillers to reach multiple lateral locations with fewer vertical wells and less surface disturbance (see Figure 7).

28 FIGURE 7 Conventional and Horizontal Drilling. Source: Tom Baker, Dispatch, 2012, http://www.iasparliament.com/current-affairs/gs-i/ shale-gas. These off-site drilling operations have resulted in a pooling of interests among the affected landowners, as discussed in more detail in following sections. For airports, subsurface access to their oil and gas deposits using under-the-fence leases does not involve the same FAA oversight as drilling operations that conduct surface operations on airport property. In fact, the Advisory Circular5 specifically states that a gas lease that does not provide for the use of or access to federally obligated land and only allows subsurface drilling does not require revisions to the ALP; thus, the provisions of the AC would not apply. However, the provisions of the grant assurances that relate to ensuring that the airport receives fair market value are still applicable, as are any relevant Part 77 provisions. To ensure that the airport, as the subsurface mineral estate owner, receives fair market value, the airport would negotiate an under-the-fence lease. This lease would describe a pooling arrangement whereby the oil and gas drawn from airport property would be pooled with that drawn from the property of participating landowners and unitized so that each participant receives a proportionate share of royalties based on the units’ production. It is crucial that airport staff and counsel responsible for negotiating both under-the-fence and surface leases understand how pooling works. Some states have mandatory or forced pooling statutes; knowledge of these laws is required to determine such rights. In a voluntary pooling arrangement, the specific terms are negotiated. Among the key elements of a pooling clause are (1) requiring advance notice to the airport before any integration occurs; (2) requiring the airport’s consent prior to revising the size, shape, or conditions of any unit(s); and (3) including a Pugh clause providing that the lease will terminate in all nonproducing areas when the primary term ends. WRAP-UP Chapter three has presented the important elements to be included in an oil and gas lease. Determination of the extent of a mineral estate and its value is extremely important information for a lease. Most airports interviewed for this synthesis emphasized that oil and gas leases should leave no areas of uncertainty and should address all terms in detail. Once a lease is signed, the airport sponsor’s ability to successfully renegotiate terms is compromised. The next chapter discusses how airports can account for revenue received as bonus and royalty payments. ENDNOTES 1 Some airports have attempted to avoid significant federal oversight by locating drill pads off airport property and drilling horizon- tally under the airport property (see 14 CFR 77, Safe, Efficient Use and Preservation of the Navigable Airspace).

29 2 Bonus payments provide a financial incentive for airports. In the case of DFW, Chesapeake paid the airport approximately $180,000,000 for the exclusive right to drill and frack on DFW land. The calculation was based on $10,000 per acre for 18,000 acres. 3 Additionally, reference is made to the FAA’s Advisory Circular published 3/23/16 titled Guidance on the Extraction of Oil and Gas at Federally Obligated Airports at No. 150/5100-20 (the “Advisory Circular”), which includes recommended lease terms for on-airport oil and gas leases. 4 See Advisory Circular at Section 3.4 5 FAA AC 150/510B-20, Guidance on the Extraction of Oil and Gas at Federally Obligated Airports

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TRB's Airport Cooperative Research Program (ACRP) Synthesis 87: Airport Participation in Oil and Gas Development provides airports with practical considerations and responses involving oil and gas extraction. The report documents lessons learned as energy prices went from their highest levels (in the mid-2000s) to some of their lowest (in 2015 and 2016). It includes a compilation of federal, state, and local regulatory frameworks; available airport oil and gas leases; municipal permits and ordinances; and case examples from targeted interviews with eight airports. As the price of oil and gas has a long history of volatility, a view of the full price cycle has particular utility to airports.

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