Types of Ownership

This 19-minute video describes the different types of ownership involved in mineral rights and leasing.

Covered in this video:

  • who maintains mineral ownership
  • how ownership type affects your royalty income
  • which ownership types provide for bonus payments
  • how ownership type determines who will pay production costs

 

Transcript

Introduction

Hi, this is Bret from MineralRightsCoach.com. If you’re relatively new to mineral rights leasing you may be confused by the differences between mineral interest, royalty interest, overriding royalty interest and working interest.

If so, you’re not alone. In this video we’ll take a quick look at these related, but distinctly different ownership types.

As you probably know by now, the ownership type greatly affects both your finances and property. Ownership type determines who maintains ownership in the minerals before, during, and after production. It directly affects the amount of your royalty income. And it affects the bonus amount you collect from an operating company.

Also relevant for you, the mineral rights owner, ownership type determines who pays to operate or drill the well, who participates in the lease operating expenses, and what tax advantages you can benefit from.

Now that we’ve discussed why you need to understand ownership types, here’s what you will be learning.

In this video, we’ll discuss:

  • the four primary ownership types
  • additional ownership types you may come across in mineral rights leasing
  • examples of how each of the ownership types fit together in mineral rights leasing

Let’s get started.

Body

The biggest challenge in understanding the oil and gas lease process is in getting a clear focus on the types of ownership and how each participates in the mineral rights and production.

For example, there’s a difference between a mineral owner and a royalty owner. People oftentimes use these interchangeably, which is incorrect.

Folks without a producing oil or gas well will often say “I own the royalty on our land.” What they really mean is they own the mineral rights. When they lease, and then are lucky enough to get an oil or gas well they are royalty owners. Basically their mineral rights interest has been converted to a royalty interest through the legal document of a lease.

That’s in simple terms.

This misstatement of mineral interest vs. royalty interest can cause problems and can cost you money. So it’s good to explore the basic forms of ownership. These terms seem complex, but actually they’re pretty simple. Hopefully this video will clear up any confusion.

These are the four types of ownership we’ll focus on in this video.

The first, Mineral Interest, is the property interest created in oil and gas production after either a sale by mineral deed or an oil and gas lease. The owner of a mineral interest normally has the right of entry and exit to the property, and the right to use as much of the surface as is reasonably necessary for the purpose of conducting exploratory operations like seismic which we touch on in another video, as well as drilling for and producing oil and gas. An individual may own all of the mineral interest or may own a percentage.  Additionally, an individual may own a certain mineral type.

Royalty interest is created by leasing mineral rights. The royalty interest is retained by the owner of the mineral rights when that owner enters into a lease agreement with another party. Since the royalty interest owner is not responsible for the exploration, development, or production of the property, the interest is referred to as non-working interest. One important note about royalty interest – the interpretation of how royalty interest ownership is defined varies from state to state. Check how the interpretation applies in your state. It may make a difference in taxes and other personal financial dealings.

Let’s take a closer look at royalty interest. I mentioned royalty interest is a share in the production of the mineral free of the costs of producing it when and if there is production on the property.  Oil and gas royalties are typically expressed as fractions or percentages and can be created in different ways.  There are landowner’s royalty interests, nonparticipating royalty interests, and overriding royalty interests.

The landowner’s royalty interest is generally retained by the owner at the time the oil and gas lease is negotiated.  It’s the landowner’s compensation for granting the lease.  A 1/8th royalty was standard from the 1920s through the mid 1980s.  Today, many consider a standard royalty to be 3/16th, but prevailing royalty amounts will vary somewhat depending on the level of production in a given area. Use resources like your local royalty owner’s association and NARO message boards to help you determine what an appropriate royalty interest is in your area.

Working interest is created via leasing and is responsible for 100% of the exploration, drilling, development, and operation of a property. The working interest’s share of revenue is the amount that remains after deducting the share of the royalty interest and other non-working interests. If you invest in the stock market and are familiar with what preferred stock is, then think of royalty and other non-working interests as preferred stock – they get paid first – while working interest is common stock, getting paid from what is left over.

Unlike mineral and royalty interests, overriding royalty interests do not constitute an ownership of minerals under the ground. Instead, overriding royalties constitute ownership of a portion of the revenues generated from oil and gas production, free of the costs of production, and the ownership expires when the lease has been abandoned due to the end of production. Overriding royalties are created from the working interest – put another way, overriding royalty interest ‘overrides’ a portion of the working interest.

Let’s take a look at an example. Jake Smith, a land man, secured the leases for a well that Star Energy Company is going to drill. Instead of a cash payment for his services, Jake Smith receives a 1% overriding royalty interest in the well. If the well is successful, then Jake Smith receives 1% of the revenues generated from oil and gas sales.

A quick word about working vs. non-working interests.

The owners of non-working interests, in their simplest form, have no control over the decisions that dictate whether a well will be drilled or abandoned. Since non-working interests typically expire or terminate at the same time as the lease, there are thousands of stories of landmen and geologists who assigned a lease to an operator in exchange for an overriding royalty interest, then watched helplessly as their lease expired, without any effort on the part of the operator to develop it, only to discover that the operator had taken a new lease from the same lessor, covering the same lands, but free and clear of their overriding royalty interest.

Is this fair? Not really! Does it happen? Certainly. Just one more example of how understanding ownership type can greatly affect your bottom line.

So how do ownership interests like mineral interest, royalty interest, and working interest fit together? Let’s sketch it out.

When the owner of a mineral interest leases the interest to an individual or company, the company receiving the lease, the lessee, has a leasehold interest.  Leasehold interests are typically called working interests or operating interests.  In exchange for granting the lease, the lessor typically receives a royalty interest, an initial bonus, delay rental and shut-in royalty.  The lessee has the rights to use the surface of the property to obtain the minerals, the right to incur costs of exploration and production of the minerals and to retain profits subject to the lessor’s retained rights, typically the royalty interest.  The lessor also holds a reverter in the mineral interest.  Upon expiration of the mineral lease, ownership of the minerals revert to the lessor.

Let’s review the four ownership types – mineral interest, royalty interest, overriding royalty interest, and working interest- by summarizing in this table.

  • When it comes to ownership of the actual underground minerals…
  • Ownership of the minerals after production stops remains with…
  • All four interest types generate revenue from well production. Think of it as a pie, and each piece of the pie gets distributed based on the leasing agreement.
  • In the case of collecting upfront bonuses, only the mineral interest owner receives payment.
  • The only interest type which remains in effect after the lease term expires is Mineral Interest.
  • During operations and drilling, the working interest is the only interest type responsible for paying these costs.
  • Likewise, lease operating expenses are also covered by the working interest.
  • Because of the operations perspective, among other reason, the working interest owner receives significant tax advantages.

There are other ownership types which I’ll mention but won’t go too far into. If an individual owns all of the private rights in land including both surface and subsurface rights, he or she is said to own a fee interest.  If only the surface interest is owned, then the individual owns a surface interest. The converse to the surface interest is the mineral interest.

Similar to overriding royalty interest owners, production payment owners also receive money from production going to the working interest under a lease. This terminates, however, when a specified amount of money is earned or number of barrels are produced.

A term mineral interest owner generally holds his interests for a limited period of time or as long as oil or gas is produced from the property, depending on the lease agreement.

For example, you might acquire an undivided 1/4 mineral estate from Sam for 15 years. If at the end of 15 years, no production is obtained, your interest would terminate and title would revert to Sam.

Prior to this termination, Sam is what is called a reversionary interest owner in your 1/4 mineral estate. Such interests may be created by mineral deeds or reservations contained in warranty deeds or other legal documents.

<whiteboard>

  • Owner – Sam
  • Star Energy
  • Sun Energy

Closing

Well, I hope this video’s been helpful, and that you better understand the different types of interest ownership. Be sure to check out our other videos here on MineralRightsCoach.com.

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