Why Your Royalty Should Be Based On Gross Proceeds

Oil and Gas Leasing Help
1

The reason your royalty should be based on gross proceeds, with nothing withheld except for taxes is because the ROYALTY owner is not supposed to spend money. Spending money is the job, by definition of the WORKING INTEREST, it's what they do in exchange for a 75% to 85% interest in oil that you the mineral owner already own.

When the lessee/operator asks you to pay post production costs in a lease, he is asking you to spend money. The lessee/operator is asking YOU, the mineral owner to do his (the working interest's) "work", to spend money to capitalize on the production of your minerals. The lessee/producers working interest should be GREATLY REDUCED if you are asked to assume the burdens that rightly belong to the WORKING INTEREST, which is spending money, spending money for gathering, compressing, dehydrating, separating, transporting or marketing. If the operator spends money to buy equipment to carry out these actions, he deducts it from his taxes/ depreciates it as you cannot although you are paying for it.

If you are expected to do the "work" (spending money on the lease) of the working interest, you should be paid like one, considering how little they probably paid you to gain title to your minerals and considering how much of your royalty may go to paying post production costs, it would probably be fair if you had a 10% to 20% working interest in ADDITION to your royalty if they expect you to do their job for them.

For what the mineral owner is giving up in a lease, he should expect a turn key operation, meaning that he should do no "work" which is defined as spending money. The mineral owner/lessor /royalty owners job is to cash checks, not spend money on the lease.

Another reason for the lessee/producer/working interest to want you to pay post production costs is you have no easy way to get an accounting, they take out what they tell you that you owe and all you can do is audit if you have that right in your lease, or sue them, if you are really, really sure you are right and the amount you think you are being cheated out of is greater than the cost of the lawsuit.

Another good reason why your lease should be gross proceeds is because it makes accounting easier. XXX oil was sold at xxx amount times royalty amount - taxes = your royalty. The same may be done with gas and while it could be a little more complicated if divided into it's constituent parts, dry gas, propane, plant products and so forth, it would still be easier to calculate than with post production costs added in. Anything that makes it easier for you to make certain that you are paid correctly is a good thing, isn't it? The lessee / producer/working interest probably wouldn't agree that it would be a good thing that your fifth grader could determine if you were paid correctly.

Let the working interest do his own "work", unless he actually is your brother-in-law and you have a personal stake in making sure he makes more money.

2

I echo your point about getting an accurate accounting or audit. This is the primary reason I ask for this in all my leases. I would be more open to the sharing of post-production costss with smaller operators who are honest and could use a break, but the sheer impossibility of holding them accountable for those costs being reasonable is too daunting for me to stomach.

3

Amen Brother Kennedy!

It's getting harder and harder to get a cost free royalty - the Oil Co.'s act like their entitled to the royalty owner footing his/her portion of the bill!

And I totally agree, from a personal accounting stand point it's a nightmare. You would never be able to allocate expenses to different "enhancements". At least they could send you a "bill" with the deductions broken down, but even then there would still be no accountability as to the validity of the costs.

4

R. W.,

You have a way with words. You tell it like it is. A very good post. Thank you.

Clint Liles

5

For a little while I was OK with my client's agreeing to leases that allowed for deduction of post-production costs if they increased the value of the gas.

Then I realized that my clients would be relying on someone they never met, and over whom they had no control, to decide what was increasing the value of the gas and how much to deduct.

I also decided that it was way too complicated and expensive for most of my clients to oversee. Many of them only had a few acres divided interest, and would never realize enough benefit from a lawsuit to enforce their rights to make it worthwhile.

Then I read this by John McFarland over at Oil and Gas Lawyer Blog a week or so ago. That's when I decided that I was always going to recommend to every one of my clients that they demand no post-production costs.

r w kennedy, you've just given me additional reasons to recommend this to my clients. Thank you.

6


Thanks Kyle, good article
Kyle Nuttall said:

For a little while I was OK with my client's agreeing to leases that allowed for deduction of post-production costs if they increased the value of the gas.

Then I realized that my clients would be relying on someone they never met, and over whom they had no control, to decide what was increasing the value of the gas and how much to deduct.

I also decided that it was way too complicated and expensive for most of my clients to oversee. Many of them only had a few acres divided interest, and would never realize enough benefit from a lawsuit to enforce their rights to make it worthwhile.

Then I read this by John McFarland over at Oil and Gas Lawyer Blog a week or so ago. That's when I decided that I was always going to recommend to every one of my clients that they demand no post-production costs.

r w kennedy, you've just given me additional reasons to recommend this to my clients. Thank you.

7

RWK:

Well said and thanks for the well written follow up. Couldn't agree with you more.

8

Call me an agreeable contrarion.

I DO NOT believe that using the no-deducts clause as described above is the do all, end all, way to go.

Heresy, right.

No. Run with this.

Hopefully you will learn how things really can work, if you have good, really good representation.

If your royalty clause begins similar to "On all gas produced and sold..." then you have just screwed up big time. Here is why. Gas is produced and not sold all the dern time. On production reports to the RRC, there are lots of oil and gas disposition codes. One is for actual sales, one is gas lost to dehydration, but some is for lease operating expense (that one is RRC Disposition Code 1 for natural gas).

So, with the conceptual idea of paying no costs past the wellhead, or gross proceeds at the point of first sale, you have missed the ENTIRE boat on the use of LOE gas. Some natural gas is flared -- your royalty being burned up, some is vented out of the batteries and not measured as vent gas (no meter on a vent). So, we do not account for that. We only want to be paid on gas produced and saved.

If there were an electric line next to the well, when you could run, for example, electric heaters, dehydrators, compressors, etc (although I know of no such animals) then the "no-deducts clause" triggers and you do not pay the cost of electricity or diesel to run the equipment. So, to continue with the premise of not paying for anything to get the gas to market, you should not donate your gas to run equipment without being paid a royalty on that share.

How much is this? Let's look. I picked a gas well @ random that I have an interest in. Over the past 14 production months, the natural gas used for on lease use (Disposition Code 1) averaged appx 1900 mcf per month. Our gas is real rich, so the mmbtu adjustment gives the gas a sales price of about $4.90 over that period of time.

So, being the smart landowner or attorney you are, you have a deducts clause based on gas produced and sold. In this case, with a 25% royalty, you have just shot yourself in the foot to the tune of $2300 per month in royalty. To add insult to injury, you get no tax break on the depletion allowance. You just let them take your money and burn it.

So, that is $2300 per month. Per well. More if gas goes up in price. The lease gas is reported to the RRC, so you CAN verify your check stub. I hope that you have 5 wells that produce for 10 years (remember, it still uses the same vol of gas to run the equipment, so it does not have a decline curve). Therefore, simple math says you lose $11,500 in royalty per month for 120 months. You finish the math.

As an aside, in Texas, you have no implied right to audit and you cannot, unless the lease provides for audit priviledges.

Before anybody starts to think too much, this language (produced and saved) is in EVERY one of my Texas leases -- for YEARS. If you have any bargaining position at all, this will fly. Sometimes, I can keep it in, sometimes it has to get negotiated out. But, without a really, really good royalty clause you have no chance anyway.

End of my story is that if your attorney took someone else's form as their own, without having a history IN the oil business and did not have the intelligence or background to address this little situation, find someone who knows what they are doing for representation.

Look at your attorney prepared lease to see if the "produced and saved" language is in there, rather than "produced and sold."

I will give everybody a chance to catch their breath before I delve into the issue of being paid a royalty on gas exchanged for a thing of value. Another day date, perhaps.

9

Buddy:

This is excellent. Thanks for pointing this out.

As I look at some old leases, I see the "produced and saved" language for oil, but for gas it says "produced and sold or used off the premises, or used in the manufacture of products therefrom". Based on what you are saying for gas, it should say something like "produced and saved, or used in the manufacture of products therefrom." Correct?

Also, some practicalities. If there is meter near the wellhead, would they not have to be drawing gas for dehydration/compression etc BEFORE it hits the meter? Or would they meter the gas used on the lease separately and subtract it off? I'm just wondering what they really do out there in the real world.

10

Dear JW,

A good royalty clause is not just a few sentences. It really has to have on gas, "produced and saved or used" Manufacture of gasoline would probably hurt more than help. We do not want anything in there that could be a limiting factor.

As to the meters, the well site or central processing facility is lousy with them. One at the wellhead, a split (with meter) to the heaters and separators that do things like take out water, constituent heavies and impurities such as sulfur and paraffin to treat the gas so that the buyer will accept your gas into their line. The pipeline does not want and will not accept all these other items in the sales line. If you are a big enough rancher in south Texas, you will even want the right to inspect the meters, so that you can ensure that the plates are not put in backwards and that the meters are calibrated correctly.

The good royalty clauses say "produced and saved or used" and then also defines how the royalty consideration is determined for lease use gas.

11

Excellent point Buddy. The thing is, most mineral owners are having their gas used AND being charged for post production costs over which he can't even determine if he is being charged a fair amount. The guy with three net acres might not find having some lawyer negotiate the kind of lease that you might, cost effective.

Buddy, the numbers you are giving are lease numbers and if the entire lease consists of your property alone, you have the clout to tell them to take a hike, what about the guy with three net acres?

The mineral owner should have the right to determine how royalty should be calculated as the first part of negotiation, after all if the royalty has not yet been set, it could be 1/8th, how could the lessee or his agents say it was unfair?

12

Bob, there is the stickey wicket. At what point do you lose negotiation advantage? Very hard to say. 3 net acres in a drillsite tract might be real important to the operator.

There was a recent negotiation where we knew the lease that the majority mineral owner granted. He always uses the same. So, rather than re-invent the wheel, I told him let's just use Mr. Brown's form. The accounting is already in place on your end to handle his interest. Thing is, you cannot talk to the field guy. You need to talk to the office guy. This is where relationship building works. Where I can say,"Come on, Joe. Cut us some slack and give us what you gave the other guy on the same tract."

The real issue is whether the 3 net mineral acre owner is sophisticated enough to get representation or if it makes monetary sense to his whole transaction.

At the end of the day, it comes down to what you know and how good a negotiator you are. Quick example, the landman popped off and said "We are going to drill a well." I said well, give us a drilling commitment with a liquidated damage provision. You know what? They did. Without the field guy giving us too much information, I would not have thought to demand a drilling obligation.

Buddy

r w kennedy said:

Excellent point Buddy. The thing is, most mineral owners are having their gas used AND being charged for post production costs over which he can't even determine if he is being charged a fair amount. The guy with three net acres might not find having some lawyer negotiate the kind of lease that you might, cost effective.

Buddy, the numbers you are giving are lease numbers and if the entire lease consists of your property alone, you have the clout to tell them to take a hike, what about the guy with three net acres?

The mineral owner should have the right to determine how royalty should be calculated as the first part of negotiation, after all if the royalty has not yet been set, it could be 1/8th, how could the lessee or his agents say it was unfair?

13

I would not sign a lease with post-production expenses. Many of the older wells in the Fayetteville are now losing over 40% of their check to PPE. If you are integrated (pooled) here, the state lease has no PPE....a suit is pending as Chesapeake, biggest scumbags in the patch, have charged expenses anyway, and if you won't pay, they argue your market value is zero...

14

Well, if CHK never does anything to get the minerals out of the ground, of course they have no value. But the whole point of a lease is to get the minerals out of the ground and to market. That should be a fun case for some attorney to take to court. Should settle for a large amount.

I think it's just too complicated for small mineral owners to keep track of and enforce their rights regarding post-production costs. If I were representing lots of people who have hundreds of acres of minerals, I might think differently, but I see loads of people here in West Virginia who have a tenth of an acre, three acres, or even twenty acres, who just won't have the resources to check up on the producer, hire someone who knows how to read the books, get an attorney, and challenge the producer in court. I have to keep it simple for those folks; a percentage of what comes out of the ground.

15

Thank you all for this very informitive discussion! I thought I had all bases covered on my leases and exhibits! More homework to do! Again, thank you!!!

16

Yes Chesapeake is the biggest scumbags in the patch. They will still take deducts even though your lease does not allow for it. You have to sue them to stop it. There are plenty of suits against them for this.

17

As long as these guys are able to pull these shenanigans, which basically shuts the small mineral owners out of the process, they will continue to do it and there will be others to follow. A class action suit with everyone on the list in all the states is probably the only way to get this straightened out. All the while they are able to steal the mineral owner profits and live their lavish life styles.

Mickie Byrd said:

Yes Chesapeake is the biggest scumbags in the patch. They will still take deducts even though your lease does not allow for it. You have to sue them to stop it. There are plenty of suits against them for this.

18

Class action suits are being looked at but are very difficult due to everyone's lease being different. I dont know why the states attorney general does not step in and force these companies to stop screwing all the royalty owner. No reason we should have to spend $100,000 to sue chk who is all lawyered up.

Bigfoot said:

As long as these guys are able to pull these shenanigans, which basically shuts the small mineral owners out of the process, they will continue to do it and there will be others to follow. A class action suit with everyone on the list in all the states is probably the only way to get this straightened out. All the while they are able to steal the mineral owner profits and live their lavish life styles.

Mickie Byrd said:

Yes Chesapeake is the biggest scumbags in the patch. They will still take deducts even though your lease does not allow for it. You have to sue them to stop it. There are plenty of suits against them for this.

19

I wonder how close the lease contracts would have to be? Everybody have the same royalty? Everybody sign the same name to it? It's probably not quite that bad but it's obvious that the courts are favoring the producer.

20

Mr. Kennedy,

I have been told that they have to be the identical lease forms, minus the lessor's name in order to quality as a class action. It is very hard to get a class action these days and the Lessee and the Courts basically look for every reason possible to disqualify the class. While this is possible and has been done, it is very hard to get accomplished.