Royalty reserved in an oil and gas lease never bears any part of the costs of exploring, drilling, equipping, and producing a well drilled on it, or on lands with which the lease is pooled The working interest owners bear those costs alone.
Costs incurred after the production is severed at the wellhead are post-production costs. When production is severed at the wellhead it stops being part of the mineral estate and becomes tangible, personal property of those entitled to a share of it. Beyond the wellhead, costs can be incurred for gas production such as fuel, gathering, treating, separating, transportation, and many other services performed to maximize the market value of the gas and to move it to the point of sale. Post-production costs are more limited for oil—but still can be very costly, especially transportation. Trucks can haul oil from the well site holding tanks (if terrain allows) until a pipeline can be laid, but trucking oil is very expensive and curtails production rates.
So who is responsible for bearing these post-production costs? The operator incurs them initially—or the producer selling is share of production to its own contract—but is the royalty owner responsible for any of it? Sometimes yes, sometimes no. It depends on the terms of the lease, the interpretation of those terms by the lease operator’s attorneys, and company policy whether to absorb or pass along certain post-production costs.
Chesapeake, for example, took the position that all post-production costs enhance the value of gas for the royalty owner, therefore, all costs can be deducted proportionately from the royalty regardless of what’s written in the lease. Chesapeake, crushed under the weight of resulting lawsuits, finally emerged from bankruptcy in early 2021.
For the division order analyst, the company’s interpretation of lease terms must be applied, but not all working interest owners bear a joint interest billing (JIB) share of post-production costs not passed on to royalty owners.
A working interest owner and any ORRI owner must bear 100% of the post-production costs attributable to their interest. They also are responsible for 100% of the post-production costs for any lease from which their interest is derived and that lease disallows post-production cost deductions from their royalty. The “cost-free” provision in the lease providing for this transfer is considered an ongoing addition to the signing bonus.
To explain this better, say a lease covers 50% mineral interest in a lease well (one large tract of land, no pooled unit) and is exempt from all post-production costs. It has a 20% royalty rate. The lease is owned by the operator 100%. There are four other partners in the well, each owning a lease covering a part of the remaining 50% mineral interest. None of those leases have cost free provisions. Each of those leases has a 25% royalty rate. Following is the breakdown of responsibility for payment of post-production costs.
The Operator, Company A, must bear 100% of all deductions attributable to 50% of the production (their cost-free lease), for its 80% net working interest, plus the costs attributable to the 20% lease royalty.
Company B owns all of its 20% mineral interest lease as lessee, and the lease allows any post-production costs to be passed on, and deducted from, its 25% royalty. This means that Company B bears only 75% x 20%, or 15%, of the total post-production costs each month for the well. Likewise, Company C owns 100% working interest in its 15% mineral interest lease at 25% royalty rate. Company C bears 75% x 15%, or 11.25% of total post-production costs. Company D owns 100% working interest in the lease covering 10% mineral interest at 25% royalty rate, so Company D bears 75% x 10%, or 7.50% of the total post-production costs. Company E owns 100% working interest in the remaining 5% mineral interest lease with 25% royalty rate. Company E bears 75% x 5%, or 3.75%, of the total post-production costs.
If the division of interest in the database is not coded correctly, to cause post-production costs (deducts) to be allocated properly between all working interest and royalty owners, the final net revenue for Company E (and all of the others) will be incorrect. A common mistake is to distribute cost-free deducts (not passed on to the royalty owner) on a weighted average basis, meaning all working interest owners are coded to bear their proportionate share of the post-production costs that cannot be deducted from the cost free owner.
Using Company E to illustrate, Company E would bear a larger share of total post-production costs than they should. Remember, their royalty owners bear their share of the deducts from the lease, so Companies B, C, D, and E are supposed to bear only their net working interest share of the deducts. If they are miscoded so also bear part of the Operator’s lease 50% share of post-production costs, their net revenue will be drastically reduced by carrying deducts for a lease in which they don’t even own an interest!
To avoid this error, a spreadsheet should be created “burdening” the partners in the well, all of which signed the joint operating agreement (JOA):
Next week’s blog will be “Basic Rules of Unclaimed Property Reporting.”