Bonus Vs. Royalty: Oil And Gas Landowners' Dilemma

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1 Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY Phone: Fax: Bonus Vs. Royalty: Oil And Gas Landowners' Dilemma Law360, New York (June 27, 2013, 12:32 PM ET) -- The primary document which governs the contractual and real property rights, privileges and obligations of the landowner (lessor) and the energy company (lessee) is the oil and gas lease (O&G lease). Before a landowner grants an O&G lease to a lessee, he should carefully consider some key provisions to protect himself and to maximize economic benefit. This article will discuss in greater detail the key provisions in an O&G lease regarding bonus and royalty payments as briefly discussed in "Top Issues Facing Landowners of Oil and Gas," an article previously published by the authors. Douglas C. Atnipp The two critical provisions under an O&G lease that have significant financial impact are the bonus and the royalty provisions. Bonus: Money Now The bonus is the monetary consideration given by the lessee to the lessor for executing an O&G lease. Bonus amounts can vary widely and have reached as high as $25,000 per net mineral acre, depending where the property is located and the competition for O&G leases in the area. Francis R. Bradley The landowner typically wants to negotiate the highest possible bonus, but, as discussed below, it may be worth sacrificing some upfront bonus consideration in exchange for a higher royalty percentage. Gregory C. Cox Calculation of and Factors Affecting Bonus The bonus amount is based on the number of net mineral acres the lessor owns. For example, if the lessor owns an undivided one-half mineral interest in a 20-acre tract of land, the lessor owns 10 net mineral acres in that tract of land. If the bonus agreed on is $1,000 per net mineral acre, the lessor will be entitled to a $10,000 bonus (10 net mineral acres times $1,000 per net mineral acre).

2 Other factors, such as length of the primary term of the proposed O&G lease or nearby production, can affect the bonus amount. A shorter primary term usually suggests a lower bonus amount, whereas a longer primary term usually suggests a high bonus amount. If the minerals are going to be leased for a greater length of time, the landowner should want greater compensation. If there is production in the area, the bonus amount will typically be greater than in the absence of nearby production. A lessor may also want to negotiate a most favored nation provision. The most favored nation provision typically provides that if another landowner within the geographic area (e.g., within a x-mile radius) is offered and paid a higher net mineral bonus amount per acre by the lessor s lessee, the lessee will pay the lessor the difference between the bonus amount, which would have been paid at the higher per-net mineral acre bonus amount and the bonus amount paid. The most favored nation provision provides the lessor some comfort that he is receiving as fair of a deal as his neighbors. When negotiating a most favored nation provision, lessees attempt to limit the geographic area and time frame (e.g., 30 days) as much as possible. Payment: Checks and Drafts Bonuses can be paid by check or cash, but they are typically paid by draft. A draft is an order issued to a bank to pay a party, conditioned on the occurrence of a specified event. As used by a lessee, a draft is an order issued by the lessee or its agent to the lessee s bank to pay the bonus to the lessor. The draft typically provides that the lessee has a period of time (typically 30 to 90 days) from the date its bank receives the draft to honor the draft by directing the bank to pay the bonus amount to the lessor. The draft is typically conditioned upon the lessee s right to approve the O&G lease and to approve the lessor s title to the oil and gas reserves. If the lessee does not approve the O&G lease, or if it determines that the lessor does not have good or marketable title, it can refuse to pay the draft. Several issues, which are beyond the scope of this article, may arise if the lessee refuses to pay a draft. In order to avoid any such issues, the lessor should withhold delivery of the O&G lease to the lessee until either the draft is paid or a check is tendered. Royalty: Money Later The royalty provision of an O&G lease is the percentage share of production, or the value derived from production, which is reserved by the lessor and which is free of the costs of drilling for and producing the hydrocarbons. The royalty provision has the potential to yield the most economic benefit during the life of the O&G lease, and the lessor should negotiate for the highest royalty percentage possible. In many instances, the percentage is driven by market forces, i.e. the percentage for what others in the area are willing to lease.

3 Prior to 30 years ago, the traditional royalty reserved by a landowner in an O&G lease was 1/8. Presently, O&G leases typically provide for a royalty ranging from 1/6 to 1/4 and sometimes more. All other factors being equal, a lessor who negotiates a 1/4 royalty will derive 50 percent more economic benefit than a lessor who negotiates a 1/6 royalty. If the oil and gas reserves appear to be promising, the lessor may want to forgo some bonus consideration up front in exchange for a higher royalty in the long term. In some instances, the lessee will give the lessor a choice. Each lessor s individual circumstances will dictate whether long-term benefits of a higher royalty percentage outweigh a higher current bonus payment. From a financial standpoint, the royalty provision may be the most important provision in the O&G lease to the lessor. A lessor should consider several items when negotiating the royalty provision. Royalty Amount and Type One consideration for the lessor is determining how the royalty payment is valued or received. O&G leases generally provide three methods of royalty payments. The lessor s royalty may be based on the market price of the production. Market price basically means the highest posted field price existing for the field or, in the absence of such information, at a price for a field within the geographic area for like grade and gravity on the day the minerals are removed. The lessor s royalty may be based on proceeds. This method bases the royalty upon the actual revenue derived from the sale of the minerals produced. The lessor may also negotiate the option to receive royalties in kind (i.e., actually receive hydrocarbons). If the royalty is 1/5, and the lessee produces five barrels of oil, the lessor has the option to take one barrel of oil as a royalty. With in-kind royalties, the lessor has the right and option to sell its own share of the production. Lessees are hesitant about granting this option due to the administrative, accounting and logistical issues associated with separating the production. Post-Production Costs Another consideration is expenses that can be deducted from the royalty payments. Expenses incurred through the production stages (e.g., drilling costs, capacity costs, etc.) are borne solely by the lessee. Expenses subsequent to production (i.e., post-production costs) can be either shared or borne solely by the lessee depending on the terms of the O&G lease. The lessor s portion of post-production costs is determined by the size of the royalty. If the royalty is 1/5, the lessor s share of the post-production costs is 1/5.

4 Post-production costs depend partly on where the O&G lease fixes the royalty. The royalty for oil is typically set at the well or at the wellhead. The lessor s royalty payment in those cases is free of production costs, but all post-production costs are shared. If the O&G lease fixes the royalty in the pipeline, at the place of sale or at other delivery points, different post-production costs may be shared. A lessor may wish to negotiate for a provision for reimbursement of post-production costs on a quarterly, semi-annual or yearly basis if post-production costs are deducted from the lessor s royalty. Other Considerations A lessor may also want to consider the following when negotiating a royalty clause: Explicitly provide for: the time, place and frequency of royalty payments and the consequences for missing royalty payments, such as termination of the O&G lease. Place a minimum royalty provision in the O&G lease. A minimum royalty provision provides that unless a certain amount of revenue is received annually from royalties or other sources, such as shut-in royalties, the O&G lease terminates. Determine if and when the lessee should have free use of water or oil and gas produced on the leased land. Determine if and when the lessor should have access to free gas. Many O&G leases allow the lessor the free use of gas for domestic or agricultural purposes. Conclusion: Realize the Complexities and Seek the Advice of Knowledgeable Legal Counsel This article does not attempt to provide a comprehensive discussion of all of the issues a lessor may want to consider when negotiating the bonus and royalty provisions of an O&G lease. It merely highlights a few issues which can have a significant impact on the landowner. Every existing or potential provision in an O&G lease is negotiable. A landowner should seek the advice of knowledgeable legal counsel when negotiating the terms of an O&G lease with a potential lessee. --By Douglas C. Atnipp, Francis R. Bradley and Gregory C. Cox, Greenberg Traurig LLP Douglas Atnipp is co-chairman of Greenberg Traurig s global energy and infrastructure practice, handles a wide range of energy, corporate and finance transactions. Francis Bradley, a shareholder in the firm s Houston office, handles energy finance and energy-related transactions. Gregory Cox is an energy associate in Greenberg Traurig s Houston office. The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its

5 clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. All Content , Portfolio Media, Inc.