The magnitude of the oil and gas royalty
The two main financial incentives offered to a landowner for the lease of their land for oil and gas development are the bonus and the royalty. For a producing well, royalties can be 10 to 20 times the bonus payment in the first year of production.
Oil and gas companies, as an incentive to lease, offer a one-time payment called the bonus. The lessor (landowner) must be careful to not over-emphasize the up- front bonus payment at the expense of the royalty. The lessor should strive to negotiate a balance of the highest bonus payment possible along with the largest royalty rate possible. For a producing well, royalties could easily be 10 to 20 times the bonus payment in the first year of production alone. Private landowners are normally offered the “standard” royalty of 1/8 share of production. The state of Michigan receives 1/6 royalty on all land they lease. In Michigan and all other states that mineral development is occurring, this royalty rate can be negotiated, and in some cases, increased. There are areas in Michigan right now that landowners located in “hot” areas are negotiating royalties as high as 25 percent.
Let’s take a look at a sample well and identify the potential royalties that can be earned. In our example, the Department of Environmental Quality has established a 40-acre drilling unit. In other words, a minimum of 40 acres must be leased in order for the oil and gas production company to obtain the drilling permit. The company has drilled one well and is successful and strikes a geologic formation that produces crude oil. In our example, the well pumps for 200 days per year, produces 25 barrels per day and the oil sells for $60/barrel.
The total revenue from the well is calculated: 25 barrels/day x 200 days x $60/ barrel = $300,000/year gross income from the well. If the landowner is aware that the lease can be negotiated so that he is paid based on gross income instead of net income, the following royalties can be earned based on different royalty rates.
- 1/8 royalty = $37,500/year = $937.50/acre/year (0.125 x $300,000/40 acres)
- 1/6 royalty = $50,100/year = $1,252.50/acre/year
- 3/16 royalty = $56,400/year = $1,410/acre/year
- 0.20 royalty = $60,000/year = $1,500/acre/year
- 0.25 royalty = $75,000 = $1,875/acre/year
The difference in payments to the landowner from negotiating a 1/6 royalty instead of a 1/8 royalty is $157.50/acre in the first year ($1,410 - $1,252.50 = $157.50/acre). Many times, landowners that concentrate only on the bonus payment short change themselves on the long term royalty that is generated. In “hot” areas where the likelihood a producing well will be developed is greater, some landowners negotiate no bonus in favor of a higher royalty payment. Once the production of oil and gas begins, the lease stays in effect and can stay in effect many years. Attempting to re-negotiate the lease after realizing the importance of the royalty is not possible. Wells normally produce at their highest rates the first year and gradually decline. With the advent of new technology, wells can produce more than 30 years.