Understanding royalty checks from an operator can be a nightmare for many oil and gas owners. A good understanding of these checks is key to comprehending the risks and expectations for future value.
The total check amount is based on several factors:
- The volume of oil and gas production from the wells on an owner’s property.
- Commodity prices for oil and natural gas.
- Various deductions applied due to transportation, marking costs, taxes.
- The owner’s division of interest (also known as percentage/decimal interest), which is a factor of the owner’s share of the drilling unit multiplied by the royalty percentage agreed upon in the lease.
Understanding Production
While the oil and gas production and commodity prices are out of an owner’s control, it is still important to know where these numbers can be found on the royalty checks. Most checks have a “Volume” column, which contains the quantity of oil or natural gas produced during the payment month. Some operators name this volume column “BBL/MCF” which stands for barrels of liquids and million cubic feet. Barrels of liquids are usually oil measurements and million cubic feet is a measurement of natural gas.
Understanding Commodity Prices
Royalty checks also have a column labeled “Price,” in which the operator lists the price at which they sold the oil or natural gas. These sale prices generally track the WTI and nearest gas hub pricing (e.g. Henry Hub), but can vary widely due to the state of nearby pipeline infrastructure and operator agreements with midstream companies. For example, due to the high cost of transporting natural gas from the Permian basin to areas of demand, gas produced there is often “flared” (burned off at the well site) instead of sold.
Understanding Deductions
There are a variety of costs incurred by the operator before the sale to midstream companies, e.g. costs due to basic pre-treatment of the raw oil/gas, transportation or pipeline gathering infrastructure, marketing expenditures.
Of course, there are taxes. These vary by state.
Understanding Division of Interest
An owner’s division of interest (DOI) is calculated by multiplying their share in the drilling unit by the royalty percentage agreed upon in the lease. The formula is (Net Mineral Acres / Unit Acres) × Royalty Interest = DOI.
Drilling unit sizes can vary widely–many new horizontal wells are drilled in 320, 640, 1280-acre units. Assuming an owner has 16 net mineral acres in a 640-acre drilling unit and signs a lease at a 1/4 (25%) royalty, his DOI would be (16 / 640) × 0.25 = 0.00625.
Bringing It All Together With A Formula
Mineral and royalty owners receive a share of gross revenue less allowable deductions like transportation, dehydration, gathering costs, and taxes. The value of a royalty check for a given unit can be calculated using the following formula:
A = Net Mineral Acres Owned in Unit
U = Number of Gross Acres in the Oil and Gas Unit
R = Net Royalty Owed to Mineral or Royalty Owner, including all prior reservations
P = Product price (oil, gas, natural gas liquids)
V = Volume of Certain Product (oil, gas, natural gas liquids)
D = Deductions including Severance Taxes, Transportation, Marketing, Dehydration, etc…
Royalty Revenue = (A / U) × R × (P × V – D)
Solving for R can be difficult, especially in areas where oil and gas have been produced for a long time. Various types of reservations of mineral and royalty interests have been carved out for hundreds of years and these reservations impact the division of interest in a variety of ways.
To solve for R, the following calculation is used:
L = Lease Royalty Burden
V = Variable Royalty Reservation
F = Fixed Royalty Reservation
There are two scenarios where R can be less than L:
- Fixed Royalty Reservation – Where a prior owner reserved a fixed non-participating royalty. Such language would resemble the following: “Grantor reserves an undivided 1/6 interest in and to all oil and gas produced from said Lands…” If there is a Fixed Royalty Reservation, calculate R with this equation: R = L – F
- Variable Royalty Reservation – Where a prior owner reserved a share of the future royalty. Such language would resemble the following: “Grantor reserves one half (1/2) of all the future oil royalty, gas royalty and casing head gas royalty from said Lands…” If there is a Variable Royalty Reservation, calculate “R” with this equation: R = L x V