How Royalties are Calculated

Oil and gas leases contain a royalty clause. A royalty is the landowner's share of the gross production, which is free of the costs of production. It is probably the most important part of the lease to the landowner. Landowners can have problems understanding how the royalty is determined.

There are certain costs in drilling and producing a paying oil or gas well. The costs are divided between the production company and the landowner. The production company bears the exploration, production, and marketing costs unless there is a clause in the lease that states differently. Expenses that occur after production can be borne by the production company or shared by the production company and the landowner.

The royalty clause can specify that the royalty be established at the well, which means that the landowner's royalty payment is free of production costs. The landowner's royalty can also bear a share of the costs that occur after production. If the lease reads that the royalty is fixed in the pipeline or at the place of sale or at some other delivery point, then a new set of costs occur and are part of the deductions from the royalty. It will be the costs after the oil or gas has been extracted at the well.

There are three methods generally used for computing and establishing the royalty payment and how it is valued. The first method is market price and value of the oil or gas. Sometimes the market price at the well in the field is used as the prevailing price. Landowners usually have been taking the field price at the well because it allows the price to rise as the price of crude oil and gas rises. Some leases have royalty clauses that state that the royalty is set at the highest price or percentage posted for fields within one hundred miles by any major oil company for similar grades and gravity on the day that the oil is removed.

The second method ties the royalty to actual revenue received from the sale of the oil or gas. In this case, the royalty received may or may not be equal to the actual market price of the oil or gas. This method of computing royalty is used mainly with gas royalties. The production company can and has committed to long-term contracts and the royalty, in that case, is more dependable. Unfortunately, in a rising market, the production company cannot be flexible with set in place long-term contracts.

Another method of commuting royalty is the "in-kind." The landowner takes possession of the oil or gas produced for the landowner's share of the oil or gas production before the oil or gas is marketed by the production company. The landowner can insert a clause in the lease to take royalty either "in kind" or "in proceeds." This clause allows the landowner more flexibility and a higher royalty based on decisions of the market.

The landowner is subject to taxes on the royalty from the production company. The taxes are federal taxes and state taxes on the royalty. The landowner can also be subject to the cost of moving the oil or gas from the well to the refinery and storage tanks.

Royalty interests on a lease can be sold in part or in the entirety by the landowner. A royalty can be split among several persons, such as surviving relatives and family for the life of the lease.

A sample clause from a standard lease is as follows

"Royalties payable to Lessor are (a) on oil, and on condensate saved at the well, one-eighth of that produced and saved from said land, the same to be delivered at the well or to the credit of Lessor in the pipe line to which the wells are connected. Lessee may from time to time purchase any such royalty oil or condensate in its possession, paying market price therefore prevailing for the field where produced for oil or condensate of like kind and gravity on the date of purchase. (b) On gas, including casting head gas or other gaseous substances, produced and saved from said land (1) when sold by Lessee, one-eighth of the net proceeds realized there from by the Lessee computed at the mouth of the well or (2) when used by Lessee in the manufacture of gasoline or other products, so manufactured, plus one-eighth of the net proceeds realized by the Lessee from sale of the residue gas computed at the mouth of the well, or (3) when 'used by Lessee off said land for any other purpose, the market value, computed at the mouth of the well, of one-eighth of the gas so used.

An example of how royalty is determined:

The typical fractions used in oil and gas leases can also be expressed in percentages such as 1/16 = 6.25%, 1/8 = 12.5%, 1/7 = 14.29%, 5/32 = 15.63%. The current trend is to counter the lease royalty offer with what the landowner considers a fair percent of the 100%.