Each lease contains a royalty clause that allocates to the landowner a certain portion of the substances produced. Economically, it is probably the most important clause to the landowner. The terms of royalty clauses vary greatly from lease to lease. Consequently, this clause should receive close scrutiny by landowners. Here are some potential problems to guard against.
First, determine which costs, if any, can be deducted from the landowner's royalty payment. The costs encountered throughout the exploration, drilling, production and marketing stages are divided into two categories: (1) those borne solely by the oil company (producer) and (2) those shared by the landowner. Generally all expenses encountered up through the production stages are borne solely by the oil company unless the lease states otherwise. Expenses encountered subsequent to production can be either shared or borne solely by the oil company depending on the terms of the lease.
The shared expenses will depend partly upon where the lease fixes the royalty. If the lease is silent on this matter, the royalty is impliedly ascertained "at the well." In such cases, the landowner's royalty payment is free of production costs but bears a proportionate share of certain costs incurred subsequent thereto. If the lease fixes the royalty "in the pipeline," "at the place of sale" or at other delivery points, a different set of costs subsequent to production will be shared but there is no uniformity among the states on this point. These subsequent costs may include such items as compression expenses necessary to make the product deliverable into the purchaser's pipeline, expenses necessary to make the product salable, the expenses used in measuring production, and even transportation costs.
Another problem which the landowner should consider is determining how the royalty payment is valued or received. Three methods generally are used.
The first method is based on the market price or value of the mineral, generally at the mouth of the well. In the past, if there was no market at the well, then the market price prevailing in the field was used. And if there was no field market, then the value was determined by sales of marketing outlets Finally, if there were no comparable sales, the actual or intrinsic value of the substance could be used.
The market price method has been quite popular with landowners because it allows the royalty to follow the recent upward price trend for oil and gas. However, sometimes the prices posted at wells or fields are discriminatorily or artificially set and hence substantially less than the prices paid for comparable oil and gas at other locations. In such cases, it may be possible to get a higher valuation for the royalty payments but only after a difficult burden of proof has been met by the landowner in a judicial proceeding. To avoid such problems, always try inserting some formula for determining how the market price or value will be established. For example, some leases read, "at the highest price (or percentage thereof) posted for a field within 100 miles by any of the seven major oil companies for like grade and gravity on the day the oil is removed."
The second method of evaluating royalty payments is by way of "proceeds." This method ties the value of the royalty to the actual revenue (or sales price) received from the sale of the mineral. As such, the resulting returns may or may not equal the mineral's actual market value as discussed earlier. In the past, royalties based on proceeds were very popular. This method gave greater flexibility to the producer in marketing the product, particularly gas. By committing gas to long-term contracts, the producer could insure the landowner of a constant, dependable royalty income over time. The disadvantage was that the resulting proceeds were not immediately sensitive to a rising market price.
The third method of receiving a royalty is "in kind." This method allows the landowner to take actual possession of his share of the mineral's production before it is ever marketed by the producer. It presents an excellent alternative for dealing with a lease based on "proceeds." By inserting an option to take royalties either "in proceeds" or "in kind," the landowner can get the best of both worlds. Whenever the market price rises above any long-term commitment price, the landowner can take his or her share "in kind" and seek a more lucrative market outlet. Whenever the market price falls below any long-term commitment, the lessor's share can be taken in proceeds. As a general rule, lessees are hesitant about granting an in-kind/in-proceeds option unless the lease is in a major producing field. Otherwise, the cost of storage, accounting, delivery and other associated expenses may prove to be economically unfeasible.
Without belaboring any one point, the following is a list of factors that also might be considered when negotiating a royalty clause.