Lease Contracts & the Overriding Royalty Interest
Leasing your mineral rights to an oil and gas company makes sense if you are smart about executing the deal. As oil lease contracts involve huge dollar volumes, mineral owners may have a lot of concerns that should be thoroughly discussed with qualified legal counsel and addressed in the fine print of the lease contract. The contract should contain details about how your property is developed by the lessee, the lease term (primary and secondary terms, as well as the lease and most importantly, the royalty income you should expect to receive.
In a standard mineral lease contract, the oil and gas development company will offer land owners an interest in the well production. This interest, otherwise known as an overriding royalty interest, entitles the owner to percentage of the production revenue. This interest is not diluted by any of the expenses of production, such as exploration, drilling expenses, or maintenance.
Upside to the Owner
The biggest benefit to the owner of an overriding royalty interest, is that they benefit from oil production without incurring any effort or expense. Oil production can be a huge gamble, as production companies must make a substantial initial investment in exploring and developing the land for drilling. Consider the following costs related to developing the land:
- Production related equipment
- Well site development
- Drilling and completion costs
- Legal and administrative costs
- Salaries and wages of workers
- Geological survey costs
Oil and gas companies have access to far more working capital than the average private property owner, so while the upfront development costs may be staggering, they can afford the risk of investing in hopes of a huge return from production. While the oil company generally gets most of the return from the wells because of their investment in development, the overriding royalty interest incentivizes land owners to allow production on their land.
Pitfalls of the Overriding Royalty Interest
With an overriding royalty interest, many mineral rights owners assume they will start seeing huge royalty checks soon after signing the lease contract. However, it may take months or even years to see any royalties from your wells. It may take a long time for the oil and gas company to determine if drilling will be a profitable endeavor. The lease merely gives them the time to explore the property and make this determination – they cannot be forced to start drilling. For property owners, this means that they may never receive a royalty check if the operator opts to not drill.
Additionally, because the royalty is paid based upon the income from actual production, royalty payments may fluctuate wildly with changes in oil and gas market. Consider for instance, that in October of 2008, oil was selling for a record $148 per barrel, but by 2016, the price had dropped down to just $30 per barrel because of OPEC flooding the oil supply. For royalty interest holders, this means that for the same level of oil production in 2016, they would receive less than ¼ of the royalties they would have received had the oil been extracted in 2008. Timing of oil production can have a huge impact on how much income you can expect from an overriding royalty interest.
A highly-producing well can mean a steady stream of royalty checks to the oil and gas lessor. While leasing your mineral rights is a great option for many landowners, you may also risk tying up the value of your oil in an unfruitful lease contract.