The US Mineral Exchange defines mineral interest as “the ownership of all rights to gas, oil, and other minerals at or below the surface of a tract of land.” Mineral interests are divided into three categories – royalty interests, working interests, and overriding royalty interests. Each is defined as follows:

• Royalty Interest – an ownership in production that bears no cost in production. Royalty interest owners receive their share of production revenue before the working interest owners.
• Working Interest – an ownership in a well that bears 100% of the cost of production. Working interest owners receive their share of the profit after (i) royalty owners have received their share and (ii) after all operating expenses have been paid.
• Overriding Royalty Interest (ORRI) – a percentage share of production, or the value derived from production, which is free of all costs of drilling and producing, and is created by the lessee or working interest owner and paid by the lessee or working interest owner.

A royalty interest is created when an exploration and production (E&P) company wants to extract gas, oil, or other minerals from privately held property. In this scenario, the E&P company could purchase the land, but it is generally much cheaper and more feasible to lease the rights to drill on the land. Under this type of agreement, the E&P company pays the landowner an up-front payment, called a lease bonus, as well as a monthly royalty payment – a specified percentage of all revenues generated by the minerals extracted from the land. Although the landowner profits from the drilling efforts on their property, they do not pay any production costs. A royalty interest is paid as long as minerals from the land generate revenue. Generally, if production stops so do royalty payments. Very rarely, however, some contracts specify certain levels of production which must be maintained.

In the aforementioned situation, while landowners have a royalty interest, the E&P company has a working interest. As a result of the leasing agreement, the E&P company acquires the rights to the minerals on the property. This means that they bear the costs of exploration, drilling, and production, but they have rights to future cash flows generated once the wells are completed. The working interest owner must pay royalty interests, overriding royalty interests, and expenses before receiving their share of these cash flows.

Overriding royalty interests are often used as an incentive for those who are affiliated with the drilling process but do not own the minerals or E&P company (a broker or geologist for, example). Owners of ORRI, like royalty interest owners, bear no cost of production but own a portion of the revenues generated by the drilling process. Unlike royalty interest owners, however, ORRI owners do not receive the royalty for the entirety of production; instead, they are bound by explicit leases, outlining the length of time in which the ORRI will be paid.

Current Issues Surrounding Mineral Interests

States also can receive royalties from oil production. Under the Gulf of Mexico Security Act of 2006, Texas, Louisiana, Alabama and Mississippi became part of a revenue sharing program from off-shore drilling royalties in the Gulf of Mexico. In his 2018 budget, however, President Trump has proposed to repeal this act in order to redistribute the funds to taxpayers. The White House believes that this will save approximately $3.6 billion over the next decade, but the proposal has been met with disapproval both from politicians and the oil and gas industry. Next year alone, the royalty disbursement to the four states is expected to total $275 million, which would be directed to support environmental protection, infrastructure improvements, and coastal restorations. It is unclear if this change will be approved, but the four states’ royalties, like many individual royalty interests, are enveloped in uncertainty in the current market.

Valuations of Mineral Interests

Along with the majority of the oil and gas industry, royalties were hit hard as a result of the oil price downturn beginning in 2014. Among other factors, the success of US shale drillers drove the supply of oil up and subsequently forced the oil price to decade-lows. As a result of shrinking margins for E&P companies, oil production drastically decreased. For some, oil production stopped completely and royalty payments were soon to follow. During the oil downturn, many royalty distributions shrank dramatically while others disappeared completely.  Over 120 companies filed for bankruptcy since the crash of commodity prices and most royalty owners were left to fend for themselves while uncertainty encompassed their mineral interests.

Trends in royalty trusts can be indicative of the value of individual royalty interests. Over the past two years, nineteen out of twenty royalty trusts have shown negative price performance. However, when focusing solely on the past year, this number shrinks to three of twenty trusts exhibiting negative price performance. This suggests that royalty trusts are on an upward trend, and by extension that royalty interests are recovering as well.  However, no two royalty trusts are alike. Differences abound in asset mix, asset location, term, and resource mix and the value of royalty interests vary due to these factors.

We will explore the valuation implications of each kind of interest in an upcoming blog post.

We have assisted many clients with various valuation and cash flow issues regarding royalty interests.  Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Our thanks to Paige Klump who drafted and did much of the research for this post in collaboration with our Energy Group.