In the oil and gas industry, royalty interest is of uttermost importance. As an investor, if you have a royalty interest, your only expense is the initial capital investment; you exclude ongoing operating costs.
However, calculating royalty interest for oil wells is not easy. You have to learn and understand formulas and the logic behind royalty interest calculations, to know if you are receiving the right amount of money.
This article provides a simple guide on how royalty interest might be calculated. However, before you calculate your royalty interest, you may have to adjust the calculations based on your state’s oil and gas laws, as well as property rights. Always inquire about how your specific deal will be calculated. This article is for discussion purposes only.
Definition of oil and gas royalty
Primarily, the law allows a mineral owner to receive a small percentage of revenue from oil and well production. This amount is what is known as a royalty interest. The royalty clause in the lease agreement stipulates the amount of interest a drilling company must pay to the mineral rights owner. Note charges and costs other than a tax are not included in the royalty interest.
Oil and gas investment companies calculate royalty interest amount as a percentage of gross production. So, it is advisable that a landowner quote a higher royalty interest before agreeing to a lease agreement. Apart from money, the mineral right owner may choose to receive royalties in the form of oil. However, it is essential to understand the status of the oil and gas market before selecting this option.
Most landowners prefer royalties in the form of cash, partly because the market price for oil and gas are difficult to calculate. As a property owner, you can request for separate payments for your royalties. Still, you can negotiate payment delay penalties, due dates, and interest fees. Note the property owner controls the terms and conditions of the royalty agreement.
How to calculate oil and gas royalties
As aforementioned, the royalty clause in a lease agreement details the amount of revenue a lessor should receive from a drilling company. The process of determining oil and gas royalties is lengthy and complex. While you can do calculations manually, using an oil gas calculator can help speed up the process. You only need to feed in the required figures, and the calculator gives you the estimated royalty amount.
Calculate the owner’s share interest
Typically, oil and gas drilling companies drill from across various properties. So, to determine the owner’s share interest from one property owner, one must take into account the spacing unit.
What is a spacing unit?
A spacing unit is a legally marked piece of land allocated to a well for drilling and production. Some rules and regulations govern spacing units, which show where the boundaries of drilling are situated. A spacing unit comprises several wells. For instance, a particular area can have a spacing unit of 1000 acres, owned by several mineral owners.
An owner’s share interest is the percentage of ownership of this spacing unit. For example, if you own say, 250 acres on a 1000 acre farm, your ownership percentage would be 25%. This is the most straightforward method of determining an owner’s share interest in calculating royalty interest.
Calculating net revenue interest formula
What is net royalty interest?
Net Revenue Interest (NRI) is the amount that remains after deducting royalty interests from working interest. Net revenue is the amount that is shared among the property owners. To determine net revenue interest, multiply the royalty interest by the owner’s shared interest.
For example, if you have a 5/16 royalty, your net royalty interest would be 25% multiplied by 5/16, which equals 7.8125% calculated to four decimal places.
Notably, private oil and gas firms commonly use 1/8 and 5/16 as royalty rate, while companies leasing federal lands pay 1/8 as a royalty rate. Royalty rates for government-owned lands vary from one area to another. For example, the state of Texas charges a royalty interest of 2%.
Calculating royalty
Royalty is equal to net royal interest (INR) multiplied by the well’s revenue. Assuming an oil and gas well makes approximate revenue of $20,000 in October, your royalty income would be $300 that month.
If you cannot determine the exact amount of revenue the well makes in a month, you can find the total revenue estimate by multiplying the well’s total production by the average price. Keep in mind oil and gas production is usually measured in barrels (BBL) or cubic feet (MCF), depending on whether oil or gas is produced.
As an oil & gas investor, it is essential to know how to calculate oil and gas royalties, more so when it comes to pooling agreements.
What is a pooling agreement?
This is a contract by which investors use their shares as a single block to create a voting trust between them and the individual or company they are transferring their voting rights to.
States such as Texas and Oklahoma have mandatory spacing regulations that define the size of spacing unit drilling companies should exploit. Also, the law requires oil and gas drilling companies to lease property of different landowners to create a single unit. However, many property owners prefer voluntary pooling, whereby all owners form a group to lease their land to oil companies, as a unit.
Sometimes, a property owner may opt out of an agreement and refuse to lease a property. This usually makes it hard for the driller to create a single spacing unit, hence interfering with production and the interest of other property owners. Because of this, individual states have enacted mandatory pooling laws that require a landowner to sign a lease agreement with an oil corporation that has already signed lease contracts with other members of the space unit.
What is mandatory pooling?
Mandatory pooling is also called forced pooling. It is a situation where the law requires a mineral owner to participate in oil and gas production unit. Oil gas firms use the pooling technique to organize an oil and gas field. Whether you were forced or willingly signed a lease contract, it is imperative to know your interests’ worth.
The royalties accrued from a spacing unit is usually shared among mineral owners as stated in a pooling agreement. As aforementioned, an individual mineral owners’ royalty is the ratio between the owner’s acreage and total acreage in the spacing unit.
As an investor, royalty interest lets you share in the success of oil and gas production without spending additional costs other than the initial investment. To understand more about oil and gas royalty interest, seek help from industry experts. You can contact United Exploration for more information.
Nothing in this article is to be considered tax or investment advice. Please consult with your attorney and tax professional.
