One of the questions we’ve been getting a lot of recently is: “how are my oil and gas royalties calculated?” There are actually a few different ways to answer this question. The first angle has to do with how a royalty is calculated as part of a drilling unit. Let’s say that you own 50 acres in a 100 acre drilling unit. Your lease probably says you are to earn 1/8 (or 12.5%) of all oil and gas produced from the premises. The premises in this instance is the 100 acre drilling unit, of which you only own 1/2 (50 acres = 1/2 of 100 acres). Therefore, the entire drilling unit will earn 1/8 as a royalty. Because your land is about 1/2 of that 100 acre drilling unit, your royalty would be 1/2 of the 1/8 the entire drilling unit receives. In other words, a 50 acre landowner in a 100 acre drilling unit receives a 1/16 royalty.
Another way to answer the question of “how are my royalties calculated” has to do with other language in the lease allowing the energy company to deduct various costs. Typically, the landowner royalty is calculated as (using the above example) 1/8 of the value of whatever comes out of the well. Older leases might have had some language allowing the energy company to deduct transportation costs, but that language wasn’t very common. That is because older, shallower wells didn’t always need to be treated before it could be put to use. The wells currently being drilled in the Utica play are much deeper, and what comes out of these wells isn’t immediately useful: the gasses and liquids need to be send to a treatment plant. In many cases, energy companies have passed this cost on to the landowner in the form of deductions in the underlying lease. Well-written leases provide for “gross royalty” payments. This allows landowners to escape costs that are associated with “net royalty” payments.
A further complication to “net royalty” language has to do with how companies account for these various deductions. Much has been written about energy companies that sneakily deduct landowner royalty payments in the form of gathering costs, compression costs, transportation costs, and processing fees. Other times, energy companies can simply sell the oil and gas to one of its own subsidiaries at a low cost. This effectively lowers the price at which the landowner’s royalty is calculated while also allowing the subsidiary to later sell it to another entity at a higher price. The methods by which they accomplish this aren’t always readily apparent to landowners, and even savvy accountants.
The good news is that there has been some reporting on such practices, indicating that the public is generally aware of them. Nevertheless, it is a good idea to keep records of whatever statements you might receive as a landowner. Learn what the information on these statements means, and do not hesitate to call the energy company to ask questions. Some landowners may have a term in their lease allowing them to audit the energy companies books, effectively allowing the landowner an opportunity to see just how their royalties are being calculated.
Thankfully, we have yet to see this happen to our clients. Even so, if you believe your royalty is being calculated inappropriately, get in touch with the energy company, study the statements you have been sent, and if you still have questions, please don’t hesitate to contact us.