Leasehold royalty owners are exempt from bearing any of the costs of exploring, drilling, equipping, and producing oil or gas from the lease under which their royalty interest is derived (J. S. Lowe, Oil and Gas Law in a Nutshell, 7th Ed., 2019). This is the express purpose of granting an oil and gas lease: to allow the person or entity with the expertise, resources, and money to take financial risk for exploring, drilling, equipping, and producing oil or gas from the leased premises. The owners of royalty rights receive a royalty, ranging from a minimum 1/8th upwards to usually no more than 25%.
Royalty exemption from expenses stops when the oil or gas is severed from the ground at the wellhead. Lowe (2019) explains that “a lessee is obligated to pay all costs of production, but the lessor shares proportionately in costs subsequent to production” (p. 321). When severed at the wellhead, the production stops being part of the real property interest known as mineral rights, and becomes tangible, personal property (Lowe, 2019). Generally, lease royalty is subject the costs of disposing (profitably) of the oil or gas. These are called post-production costs. Unless the lease terms state otherwise, the royalty is subject to its share of post-production costs incurred by the producer (Lessee) for gathering, treating, dehydrating, compressing, transporting, and marketing the oil or gas (Maxwell, Martin, & Kramer, Oil and Gas, 8th Ed., 2007). The royalty owner’s pro rata share of these costs are deducted from their royalties each month and they are paid the balance. That is, unless their lease contains one or more provisions prohibiting the deduction of post-production costs.
Every payer of royalties has the right to interpret the provisions of any lease, based on their right to decide the amount of financial risk they are willing to accept in any given transaction. This includes interpretation of so-called “cost-free” clauses found routinely in modern leases. That said, it’s important for the analyst to learn the difference between a clause restricting the method of calculating royalty, and one exempting the owner from post-production costs.
As a quick reminder, taxes are not considered a post-production cost. Owners of an interest in any part of the production must pay the state-levied severance tax, and county or parish ad valorem (property) taxes.
Example Clause
“Lessor’s royalty shall be calculated free and clear of costs and expenses for exploration, drilling, development and production including, but not limited to, dehydration, storage, compression, separation by mechanical means and product stabilization incurred prior to the production leaving the leased premises or prior to delivery into a pipeline gathering system, whichever occurs first. Lessor’s royalty shall bear its proportionate share of ad valorem taxes and production, severance, or other excise taxes and the actual, reasonable costs incurred by Lessee to transport, compress, process, stabilize or treat the production off the lease premises in order to make the production saleable, increase its value, or get the production to a market. Notwithstanding anything herein to the contrary, Lessor’s share of royalty shall never be based on a figure less than or more than the actual amountrealized by Lessee from the sale of such production.”
Simplified: “Lessor’s royalty shall be free and clear of costs and expenses for exploration, drilling, development and production including, dehydration, storage, compression, separation by mechanical means and product stabilization prior to the production leaving the leased premises or delivery into a pipeline. Lessor’s royalty shall bear its share of ad valorem taxes and production, severance, or other excise taxes and the actual, reasonable costs to transport, compress, process, stabilize or treat the production off the lease premises to make the production saleable, increase its value, or get the production to a market. Notwithstanding anything herein to the contrary, Lessor’s share of royalty shall never be based on less than or more than the actual amount realized from the sale of such production.”
This clause is tricky. “Lessor’s royalty shall be free and clear of costs and expenses for exploration, drilling, development and production including…” does not refer to post-production costs, but rather, the costs of getting the production out of the ground. Royalty is always free and clear of all costs of getting the production to the surface (Lowe, 2019). The clause goes on to say that the Lessor agrees to pay taxes of whatever kind levied against their royalty share. It is only after the statement regarding taxes that the clause states what the Lessor requires concerning post-production costs.
“Lessor’s royalty shall bear its share of…the actual, reasonable costs to transport, compress, process, stabilize or treat the production” means that those specific costs are allowed to be deducted from the Lessor’s royalty. “Off the lease premises” means the costs named are not to be incurred while the production is still on the lease premises, and those costs must be incurred to “make the production saleable, increase its value, or get the production to a market.” The clause ends with a requirement that the Lessor’s share of royalty can never be paid at a price less than, or more than, the actual amount that the Lessee receives from the sale of that production.
This is not a cost-free clause, despite the fact that it begins with language that sounds very much like it will be a cost-free clause. This is an excellent example of why an analyst must take great care in reading, comprehending, and analyzing a clause to understand its true meaning.
Many producers want to exempt owners only from the post-production costs specifically named in a cost-free clause. Since the company must pay the royalty owner’s share of any post-production costs that the lease states the royalty cannot be charged, to pay all of the post-production costs on behalf of this royalty owner instead might cost the company tens of thousands of dollars, or more, over the producing life of the lease. There are, however, certain situations when a cost-free clause may name specific post-production costs and the company may have a policy of exempting the royalty from all post-production costs instead. An example would be a clause that lists a long list of costs from which the royalty must be exempt, but fails to mention one that the purchaser will charge the Lessee and the Lessee will want to pass along to royalties if they are not “exempt from all.”
Company policy will determine if the analyst flags each post-production cost named in such a cost-free clause, or code the lease as “exempt as to all post-production costs”.
The division order analyst and the revenue accountant responsible for wells drilled on, or that include a cost-free lease, should be advised of those costs that the company must bear on behalf of the royalty owner. The division order analyst often relies on the analysis of the provision by the lease analyst in the lease data sheet when creating the initial division of interest for the well that usually must code royalty accounts as exempt or non-exempt from post-production costs. The revenue accountant then relies on the division order analyst to have included in the database division of interest record the post-production cost codes that the revenue accountant must then match to the deductions reflected in the remittance checks from the purchaser of the production or the operator.
Principles of Oil and Gas Lease Analysis: Uncommon Clauses, found for sale in the Oil Patch Press Bookstore, contains more detailed information on cost-free lease clauses and several examples found in actual leases.
