Introduction to Mineral Rights Leasing

This 20-minute video provides a brief introduction to mineral rights leasing.

Covered in this video:

  • How it Starts for You
  • The Lease
  • Negotiating the Lease
  • How to Amenda a Lease

 

Transcript

Introduction

Welcome to the MineralRightsCoach.com video tutorial series. If you’re new to mineral rights leasing, you’ll find this video a useful overview.

I’ll admit, you can find most of this information elsewhere on the Internet. But nowhere can you get a better high level overview of mineral rights leasing, in a shorter amount of time, than here at MineralRightsCoach.com.

Over the next twelve minutes, I’ll walk you through the four major stages in mineral rights leasing – ownership, lease agreements, division orders, and the royalty check.

Knowing which tasks you and the operator are responsible for in each of these stages is critical to successfully leasing your minerals.

Additionally, understanding key differences in the types of compensation you might receive for leasing your mineral rights can have a significant and long-term effect on your income.

You’ll want to watch the entire video, because near end, I’ll highlight helpful web resources you can use to learn more about each stage to ensure you are best prepared for leasing your mineral rights.

Let’s get started.

Body

Let’s frame this entire discussion of mineral rights leasing. To do so, I’m going to highlight the four major stages for mineral owners and then go into more detail as to how each plays out in mineral rights leasing. The four stages include:

  1. Ownership
  2. Leasing
  3. The Division Order
  4. The Royalty Check

Ownership

When it comes to property rights, the United States is special. As an individual, Americans are guaranteed the right to own the minerals beneath the land. No other country allows its citizens to own the minerals beneath the land.

A legally binding mineral title opinion is typically the only document that substantiates mineral ownership. Back in the 17- and 1800′s, when land was originally deeded to individuals, the mineral estate naturally came with the land, and as long as it hasn’t been severed (meaning the land and minerals remain together), stays with the land.

There are three distinct but related aspects of ownership. They are:

  • Legal Description
  • Net mineral acres
  • Ownership Type

Legal Description

There’s a grid system subdividing land in the United States, known as the Public Land Survey System (USPLS). Here’s an example of a legal description using the USPLS

N 1/2 SE 1/4 SW 1/4, S24, T32N, R18E

Descriptions are usually read from front to back.

For example, the description above would be read “The north 1/2 of the southeast quarter of the southwest quarter of section 24, township 32 north, range 18 east.”

However, the easiest way to interpret descriptions is from back to front (or, right to left). To determine where the property is, you break the description down into each of its elements, starting from the back and working your way to the front. An actual exercise in this is outside the scope of this video. Be sure to check out the Overview of the US Public Land Survey System tutorial.

“Net mineral acres” = Amount of Mineral Acres Owned

Number of acres in the property times the interest in the minerals owned by the Lessor.  For example, if the individual owns a ½ mineral interest in a tract of 100 acres, the Lessor owns ½ of 100, or 50 net mineral acres.  The bonus is expressed as a number of dollars per net mineral acre.  If the Lessee is offering a bonus of $100/acre, the offer is to pay the Lessor $100 for each net mineral acre owned by the Lessor.

Ownership Type 

Non-Producing

  • Mineral Interest

Producing

  • Royalty Interest
  • Overriding Royalty Interest
  • Working Interest

I won’t go into detail on the ownership types. For that discussion, you can turn to the video tutorial on Ownership Types here on Mineral Rights Coach.com.

Many of you are probably wondering – What if I only own the minerals, not the surface rights?

Here’s a list of common rights afforded to mineral owners – a sort of Mineral Ownership Bill of Rights. As a mineral owner, you may:

  1. Enter the land to explore, drill, produce and otherwise carry on mining activities.
  2. Lease your mineral rights to another party.
  3. Ownership never ends – continues in perpetuity.

If you had to summarize in one underlying statement, mineral ownership rights are dominant over surface ownership rights.

Without these rights in place, accessing the minerals to meet our nation’s energy needs would be a lot more difficult. Think about it – why would a surface owner who doesn’t own the mineral rights beneath his land allow access to those minerals operating on his land? It’s a potentially toxic situation addressed by putting these rights in place.

Leasing

To bring oil and gas reserves to market, minerals are leased by oil companies through a legally binding contract known as a lease. This arrangement between individual mineral owners and oil companies began prior to 1900 and still thrives today. Before exploration can begin, the mineral owner (lessor) and the oil company (lessee) must agree to certain terms regarding the rights, privileges and obligations of the respective parties during the exploration and possible production stages.

Although there are numerous other important details, the basic structure of the lease is straightforward: in exchange for an up-front lease bonus payment, plus a royalty percentage of the value of any production, the mineral owner grants the oil company the right to drill for a period of time, known as the primary term. If the term of the oil or gas lease extends beyond the primary term, and a well was not drilled, then the Lessee is required to pay the lessor a delay rental. This delay rental could be $1 or more per acre. In some cases, no drilling occurs and the lease simply expires.

The duration of the lease may be extended when drilling or production starts. This enters into the period of time known as the secondary term, which applies for as long as oil and gas is produced in paying quantities.

Bonus vs. Royalty

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. This royalty rate can be negotiated and in some cases increased. There are areas across the US right now that landowners located in “hot” areas are negotiating royalties as high as 25%.

We’ll take a look at how royalty percentage can affect your monthly income in a moment, but before we do that, there’s an important distinction between selling your mineral rights vs. leasing your mineral rights. And it can have a profound impact on your total income.

By selling you get a large up-front payment today, but you also give up the right to receive future lease bonus, or royalty payments; payments that could over the years end up being more than you received for selling them. Just like when you sell your home, you’ll never benefit from that property again.

Leasing your mineral rights – allows you to maintain ownership of your mineral rights. In return, you get a bonus payment which is smaller than if you sold your rights, but you also maintain ownership such that if production commences on your minerals, you’ll receive royalty payments over time.

So why sell? Besides the immediate cash payment, you can reduce paperwork, taxes, and probably most importantly – risk. There’s no guarantee oil or gas will be found in your minerals. What’s more – even if a well is drilled and production commences, oil and gas are depleting assets, meaning they will eventually stop producing as the field becomes depleted. This results in a lower royalty check every month.

Let’s take a look at a sample well and identify the potential royalties that can be earned. In our example, the state 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/yr = $937.50/acre/yr (.125 x $300,000/40 acres)

• 1/6 royalty = $50,100/yr = $1,252.50/acre/yr

• 3/16 royalty = $56,400/yr = $1,410/acre/yr

• .20 royalty = $60,000/yr = $1,500/acre/yr

• .25 royalty = $75,000 = $1,875/acre/yr

The difference in payments to the landowner from negotiating a 1/6 royalty instead of a 1/8 royalty are $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.

The Division Order

Put simply, the Division Order divides up the oil and gas revenue.

It’s a document which sets forth the proportional ownership in what’s produced – whether that be crude oil, natural gas, natural gas liquids, or a combination of these. Sometimes the Division Order is referred to as a division of interest. More often than not, a single well or lease will have multiple owners. It’s not uncommon in fact to have hundreds of parties owning an interest in a single well.

Receiving a division order is a good thing. It means production is starting on your mineral interests and the operator is preparing to distribute a share of the sale revenue to you, the royalty interest owner.

As a mineral rights owner, you can expect to receive a division order through the mail within 3 to 4 months after completion of the well.

The division order describes the property, the tax ID number, and the decimal interest in production owned by the royalty owner according to the title opinion. It also provides that the royalty owner agrees that this is his correct interest and that the company is authorized to make payments to him of that interest until notified otherwise by the royalty owner.

We’re looking at the Model Form Division Order from the National Association of Division Order Analysts. You can download your own copy of NADOA’s Model Form Division Order by clicking the link below.

You’ll notice that at the top of this Division Order, the legal description is listed. You’ll also find the type of interest – whether it be royalty, overriding royalty, or working interest – and the decimal interest. The bottom of the division order is where you include your Tax ID or social security number and signature. Notice that not providing your tax ID or social security number means the operator will withhold 28% of your income for tax purposes. Uncle Sam wants his share- there’s no getting around it.

A word of caution – A Division Order shouldn’t alter the terms of the mineral lease. A Division Order that attempts to amend the terms of the lease is invalid and in some states illegal. There’s a disturbing trend amongst both large and small production companies to amend lease terms with a division order. Perhaps this is because your guard is down, as you believe you’ve already agreed to the terms in the lease, and are now so close to your first royalty check.

Don’t let your guard down. Strike out elements you don’t agree with. When in doubt, talk to a qualified oil and gas attorney before signing your division order.

The Royalty Check 

This brings us to the fourth a final stage in mineral rights leasing – the royalty check.

Royalty statements, also known as check stubs, are the basic accounting documentation mailed to royalty interest holders, usually on a monthly basis.  Royalty statements are often the only connection between a mineral owner and the operator or producer.

There is no standard format for royalty statements.  However, there are a handful of common elements present on a statement. Let’s explore these elements in the context of a sample royalty statement.

Producing Property Identification

For each producing property, there will be identifying numbers, codes, tract numbers, lease names, well names, county and state names – or some combination of these, all of which serve simply to identify the producing entity.  Often owners will have an interest in multiple properties, each of which should be readily identifiable on the statement.

The API number is a unique identifying number for oil and gas wells. These numbers can be as long as 14 digits. The first digits in the API number refer to the specific geographical location of a well while the last digits record the wells operations. When read from left to right the numbers start with the two digit state code, followed by a three digit county code, followed by the five digit unique well identifying number. The 11th and 12th digits represent the sidetrack codes. The original well is usually 00. The 13th and 14th digits represent separate operations from a singe bore hole.

  1. Sale Date: The month and year that the production was sold from the property.
  2. Product Code: identifies which product you’re being paid for.  Possibilities here include oil, natural gas, condensate, and plant products such as NGL’s, etc.  Since each of these are priced independently, each product will be shown as a separate line item.  The actual product name may be spelled out, or identified by a code # or letter, with an associated legend at the bottom of the page.
  3. Volume of the product sold, in BBL or MCF – 1,000 cubic feet. For the month of production listed, this is the amount of product sold, measured in the appropriate unit of measurement.  The reality is that almost every well , from the first day of production, begins its progress on a downward sloping decline curve.
  4. Measure of the heat energy for the product.
  5. Price: This is the price per unit, paid in dollars and cents, upon which your check is calculated.  Oil is priced in $/bbl, natural gas in $/Mcf, and plant products (NGL’s) in $/Gal.  Over the past 15 years or so, the marketing and pricing of oil and gas has moved toward a 30 day pricing model, and away from traditional fixed pricing for longer terms.  The advent of natural gas deregulation combined with the growth of a highly liquid oil and gas futures market has moved the industry in this direction.
  6. Gross Value = volume x price : The total gross value of property prior to deducts/adjustments. Again, for the month of production listed, this is the amount of product produced, multiplied by the price received.
  7. Net Value = price x volume - tax – deduct : The total value of property after deduction of taxes and/allowable deductions.
  8. Decimal Interest: This number represents your ownership interest expressed as a decimal. This decimal interest multiplied by the gross quantity produced results in the amount of production attributable to you. This decimal is calculated based upon the following variables: Your land tract size, your mineral interest percentage, your lease royalty fraction, and the size of the producing unit.
  9. Interest Type: Type of interest owned. WI = working interest, OR = overriding royalty interest, RI = royalty interest
  10. Owner Gross Value – Proportionate ownership share of Gross Value (Payment Decimal x Lease Volume x Price)
  11. Tax Code – state revenue tax
  12. Owner State Tax – your proportionate share of the state revenue tax. Severance tax, conservation tax, oil field cleanup tax, emergency fund tax; each state is free to design their own scheme regarding oil and gas taxation.  Each state varies in their approach, but it’s safe to say that the overall take usually runs in the 5-8% range, regardless of how it is derived.  Severance tax is usually the dominant tax, with lesser taxes often pointed toward environmental cleanup type programs.  Many states offer tax breaks based upon variables such as low flowrate wells, enhanced oil recovery wells, or well in tight formations like shale.
  13. Deductions: The amount of charges taken for property adjustments. Why are there deductions from my royalty statement?  Making the product marketable – that’s the issue at play here.  Crude oil and natural gas, as it’s produced in it’s raw form, is rarely of sufficient quality that it can be marketed for immediate use.  That’s why you may see deductions for marketing.  The theory behind this is that the product has no value at all until it is made marketable.Common line items you may notice on your royalty check stubs include:
    • compression deduction – a charge for compression of gas to a sufficient pressure to enter into a gathering or transportation pipeline
    • dehydration deduction – a charge for dehydration of gas, meaning the removal of water vapor from natural gas
    • gathering deduction – a charge for pipeline gathering of a product to a common sales point
    • processing deduction – a charge for expenses related to further refinement of high BTU natural gas
    • treating deduction – a charge for removing impurities such as co2, nitrogen, or hydrogen sulfide from a hydrocarbon stream
  14. Owner Net Value = Owner Gross Value – Owner Gross Tax – Owner Gross Deductions

Conclusion

That will do it for this overview. As promised, I’m going to call out other resources available on the Internet which you’ll find valuable. The NARO website (NARO-US.org) has a wealth of information, a store where you can purchase books on leasing, and is the best way to connect with other mineral rights owners through a membership.

The Mineral Rights Forum is one of the most active mineral rights leasing forums on the web. It’s also one of the best sources of information for lease rates in specific areas through the US.

I hope this video’s been helpful, and that you have a better understanding of mineral rights leasing and more importantly, know where to go to learn more. I encourage you to watch the other videos here on MineralRightsCoach.com for more information on specific topics, including ownership, leasing, division orders, and the royalty check stub. I go through specific examples and highlight important details which didn’t fit in this high-level overview.

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Are you interested in learning about a particular topic not yet in our library? Leave a comment below and suggest a video topic. Or, simply send me an email at bret@mineralrightscoach.com.

Stay tuned to MineralRightsCoach.com for more tutorials, and best of luck in your mineral rights leasing.