As Oil and Gas Royalty Income Falls, Owners Should Examine Their Leases to Uncover Missing Income Opportunities

Recent turmoil in the oil and gas industry has directly affected royalty owners, most visibly in the form of lower monthly royalty checks. The Saudi-Russia price war resulted in a flooded oil market, and the COVID-19 pandemic and resulting lockdowns have significantly reduced demand for hydrocarbons.

These two events led to lower prices which in turn forced Operators to reduce development activity and shut-in producing wells due to storage constraints and uneconomic pricing.

With their monthly payments dropping, royalty owners should take another look at their leases to be sure the terms are being met and payments from Operators are appropriate. Here are some elements of the lease that should be reviewed:

Price Terms. Many leases have pricing terms that go beyond the standard “market price” received at the wellhead. The pricing terms may include a pre-defined limit, such as 90% of a specific price index such as NYMEX or Houston Ship Channel. Operators may fail to capture these terms when processing revenue distributions. Over time, a significant amount of underpaid royalties may have accumulated.

Lease Fuel. Many oil and gas leases include a “free use” provision that gives the Operator the right to use natural gas produced on the property to power the production equipment and compression, gathering, and transportation from the lease. For leases that contain such a provision, Operators may deduct these volumes from the royalty owners’ share of production. However, if there is no “Free Use” provision, the Operator must pay a royalty on these volumes. Courts have also determined that free use gas must be used on the lease location or in close proximity to support operations; otherwise a royalty must be paid.

Gathering, Processing and Transportation Deductions. Costs related to gathering, processing, and transportation of natural gas can be significant relative to the market price in a depressed market. These costs may virtually eliminate any revenue received from production. The terms of the lease defines how these costs are applied to the royalty owners’ production revenue. Leases may specifically prohibit deducting any costs, while other terms may allow certain costs. Operators may conceal these charges by netting some or all of these costs on a per unit basis against the realized price of oil or gas each month. It is important for royalty owners to understand how gathering, processing and transportation costs are deducted from their portion of production.

Severance Tax Exemptions. Many states provide severance tax exemptions for oil and gas development activity. For example, Texas offers many incentives to reduce or eliminate the severance tax rate if the Operator requests the incentive. The most impactful incentives in Texas include the Enhanced Oil Recovery (EOR), High Cost Gas (HCG), and Inactive Well incentives, which can reduce or eliminate the severance tax rate. Operators may fail to apply the reduced rate to royalty owners, which can result in significant underpaid royalties if undetected overtime.

Shut-in Royalties. In most leases, Operators are required to produce on a lease to maintain an active lease and ensure the lease does not expire; however there are a few exceptions. Shut-in royalties allow the Operator to keep the lease arrangement intact during periods when wells must be shut in for operational reasons, including maintenance, safety and environmental issues, or market constraints. The lease may provide for a minimum royalty if the producing wells on the property(s) are shut-in for reasons outside of the normal production life cycle of the well. For example, if a gas well is drilled at a location where no market currently exists, the royalty owners may be owed a shut-in royalty until production resumes. The specific amount and terms of the shut-in royalty are defined in the lease.

Operators often struggle with processing revenue distributions accurately due to the high volume of properties and variations in ownership and contractual agreements among the properties they operate. Likewise, Operators under significant financial pressure and constraints may fail to recognize one or more of the lease provision issues identified. These errors can accumulate significantly if undetected. If allowed to accumulate, Operators may be unable to pay the underpaid amounts.

Royalty owners should consider establishing a process to monitor royalty payments against market prices and contractual expectations on a monthly or quarterly basis to timely identify potential royalty calculation errors. Periodic audits of royalties can then be employed for Operators or properties with potential royalty calculation errors, allowing for Operators to provide credits and correct the errors so they do not recur.

It is important for royalty owners to identify issues timely due to the statute of limitations enacted by many states on royalty claims. For example, Texas has a four-year statute of limitations and it is the responsibility of the owner to identify any underpayment issues.

To learn more and understand your royalty interests, contact us. We can help determine whether you are missing out on significant amounts due to non-compliance with lease provisions.

Authored by Ben Harwood, CIA.

 

©2020

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Jody Allred

Jody Allred

Partner-in-Charge, Large Market Manufacturing and Distribution Services

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Jody Allred, CPA, CISA, CGMA, has more than 18 years of experience in public accounting, a deep background in both…

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