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When is an oil or gas lease royalty calculated?

For a landowner, securing an oil and gas lease with royalty payment may seem like a great victory. Developing an oil well from exploration to production is an expensive proposition, something few individuals could afford, but once it reaches production, it can seem like free money.

Of course, it is never "free." The recognition of the cost of development and production is why the standard royalty in the U.S. is only one-eighth the value of the oil or gas produced. Most landowners are willing to accept the inherent unfairness, given they are surrendering an irreplaceable resource because without a willing lessee producing the final product, they know their mineral resource is otherwise practically worthless. An important question, however, is at what point in the extraction process is the royalty calculated?

In the U.S., there are two methods of calculation. There is "at the well" method, which values the mineral at the wellhead. This method deducts many of the costs of production and is the method preferred by lessees. The other method is "marketable condition," which demands that the driller bears the marketability costs, which is beneficial to the landowner.

Part of the problem with the "at the well" method is that it allows the oil and gas company a great deal of control in setting the costs of the services, such as the  "compression, gathering, dehydration, treatment, processing, transportation" performed on the gas. With the oil company often performing many of these tasks, they can price these "costs" in such a way as to minimize the actual price "at the well," and therefore the royalty payments.

While a producing well can provide a landowner a valuable source of income for years or decades, you want to be certain you understand how your royalty payments are being calculated. In negotiating an oil and gas lease, you should work with your attorneys to understand how all of these elements may affect how your royalty payment, to ensure you actually receive the benefit of your bargain.

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