Negotiating from Strength
Question: Is a 20% or 25% or 35% royalty in an oil and gas lease, especially for shale gas, fair to the (i) Oil Company and (ii) fair to the landowner who owns the underlying lease?
Answer: It depends…but generally a 20% to 25% royalty is too low, and here’s why…
Oil Company’s invest in oil and gas properties that will give them a good rate of return (the ‘ROR’, generally reported as after tax and on a ‘nominal’ money of the day basis) on their investment. Similar to the land owner desiring a high interest rate (return on its investment) from the land owner’s savings.
That ROR depends on the risk being taken – higher the risk, higher the expected reward or higher ROR. (Recall a Certificate of Deposit pays a low interest rate because it is a low financial risk compared to junk bonds that pay a higher interest rate but much higher risk).
Negotiating Strength Number 1.
All Oil Companies compete to acquire rights to oil and gas properties, especially shale gas –they desire to sign a lease to obtain legal rights to the land and access to the underlying potential oil and gas minerals that may be on the property. This is called ‘access ‘ – Oil Companies are really in the land business — without land – the oil and gas lease – the Oil Companies cannot obtain access to their objective – oil and gas deposits. No lease – no grease…
Thus the land owner owns a precious prize – the land—there is no other property like it—it is unique. So don’t give away that unique access to any one. Seek a fair payment –the royalty—for the right of access. And with competition for such access at a peak – many Oil Companies chasing the same property—supply and demand will drive the price or royalty up.
Negotiating Strength Number 2.
The Oil Companies are making a lot of money, their staff, management and executives are well paid, which means the land owners can easily increase their royalty and NOT materially affect the Oil Companies profitability and pay to their employees and executives. The landowner is merely transferring some of the wealth or profitability from the Oil Company to the true owner of the minerals, where the real value is located. Recall oil and gas resources are depleting resources…once gone, their gone forever…don’t give it away cheaply!
Oil Companies regularly invest in both U.S. and international (non-U.S) properties. Why? The Oil Companies want to diversify their investment portfolios – just like a personal financial portfolio – as well as gain potential access to large oil and gas deposits in foreign (non-U.S.) lands. But make no mistake…these non-U.S. foreign lands have unique and potentially greater adverse risks…Political Risk…Contract Risk that contracts will be honored the so called sanctity of contract rule. Foreign (non-U.S.) Governments ask and routinely obtain large Government Takes from Oil Companies. Government Take is defined as the total value a Foreign Government receives from Oil Company investors who develop the Foreign Government oil and gas properties. The Government Take can consist of royalties, bonus payments, taxes, profit sharing, service fees, and a host of other value draining items. In comparison, a U.S. landowner is no different than a Foreign Government land owner – and arguably is entitled to similar Government take.
Typical total Government Take exceeds 65%! (This 65% average applies whether the investment is onshore, shallow water or deep-water investments). In other words in excess of two-thirds of the value of foreign oil and gas assets are kept by the Foreign Government with the balance left to the Oil Company to recover its investment costs, operating costs, pay other taxes and the balance left to pay dividends to shareholders and profits and pay employees and executives their pay packages.
Negotiating Strength Number 3.
By investing in U.S. oil and gas properties, where the political and sanctity of contract risk is much lower –as well at the U.S. also being a safe market in which oil and gas can be sold, Oil Company investors in the U.S. should be happy with a lower ROR (lower risk – lower reward) than what they are willing to receive internationally, by paying higher royalty rate to land owners.
Negotiating Strength Number 4.
Oil and gas future prices are anticipated to outpace Capital and Operating Costs, indicating material profit potential for Oil Companies –which means more value should be transferred to the landowner by way of higher royalty payments. Take a look at today’s oil price and the price of gasoline at the pump – most likely they are on an upward trend…
Negotiating Strength Number 5.
Oil Companies are willing to accept higher Government Take (lower reward, or pay higher royalty) in international projects even though the political risk, sanctity of contract and market risk are higher.
A comparable U.S. Government Take in a lower political-contract-market risk environment leads to justification of a higher royalty payment to the landowner…a royalty in excess of 30% (and theoretically in excess of 50%) or agreement to a sliding scale royalty – higher the oil or gas price – greater the royalty! – sharing the pain or gain with the Oil Company.
So next time don’t feel bashful about asking for that minimum [35%] royalty, unadjusted for lease production costs.
A modern-day royalty option to consider…
If the Oil Company argues for lower royalty based on claims that cost and price risks are challenging to prognose, then connect the royalty rate to a sliding scale price…and let all parties ‘share’ in gains and pains, and as examples…
- If the oil price (such as West Texas Intermediate (WTI) published posted prices, as a benchmark) averaged over a six month semi-annual period are:
Less than $50/barrel: the royalty is 20%
If $50/b or greater but less than $65; 25%
If $65 or greater but less than $80; 30%
If greater than $80; 35%
- As for gas (and using Henry Hub published posted prices as the reference price) averaged over a six month semi-annual period are…
Less than $3.50/mcf; the royalty is 20%
If $3.50 or greater but less than $4.50; 25%
If $4.50 or greater but less than $5.50; 30%
If greater than $5.50; 35%
Admittedly sliding scale royalty accounting is more cumbersome…and not as ‘simple’ as a fixed number. Evenso, the high-tech oil and gas industry is accustomed to managing cumbersome issues…be they subsurface risks, above ground risks, regulatory requirements, SAP Accounting practice, probabilistic and deterministic analyses of petroleum whereabouts, and a host of other not so easy matters.
Another option is for the landowner to preserve the right (but no obligation) to ‘back-in’ as a paying working interest owner in the lease if there is a commercial discovery by the Oil Company. A working interest is typically a more valuable interest compared to a royalty interest — though a working interest requires cost and lease operating issues participation. An example is the landowner retains the option to back-in for up to [10%] of the Oil Company’s working interest (for example if the Oil Company has a 50% of 100% working interest, 10% would be 10% x 50% = 5% of 100%). If the option is exercised, the landowner is to compensate the Oil Company for its share of past costs associated with the [5%] back in share, out of the landowners [5%] share of future production value until the landowner’s [5%] share of back costs are paid in full after which the landowner receives the working interest share of income and pays its share of future working interest costs.
A back-in is similar to sharing in a lottery. For example, if Party A purchases a lottery ticket, and Party B has the right but not the obligation to share in half the winnings –if Party A wins – Party B will pay Party A for half of the price of the lottery ticket, thus Party B will have a risk free option to spend very little investment on a half price lottery ticket in exchange for sharing in potentially a large gain.