The Money: Bonus versus Royalty

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 The real money in an oil and gas leasing transaction is in the royalty.  Almost without exception, the land owner wins by increasing the royalty – regardless of the bonus. For example, consider an oil well similar to the Union Oil - R.J. Newman 9-11 Well Number 1 in the Cold Creek Field in Mobile County.  Over a twenty-two year period between 1978 and 2000, the well produced 993,448 barrels of oil and 108,205 million cubic feet of natural gas.*  Although this was not a remarkable well**, its limited production can serve to demonstrate why royalty is more valuable than bonus.

[*On-line records of the State Oil and Gas Board of Alabama: http://www.ogb.state.al.us/ prod_report.aspx? PERMIT=2461]

 

[**By comparison to the R.J. Newman 9-11 Well No. 1, the Peter Kline well in the Hatter’s Pond Field  has produced 5,756,072 million cubic feet of gas and 1,651,357 barrels of oil between 1974 and today continues to produce. See http://www.ogb.state.al.us/ ogb/permit_bypool.aspx?PERMIT=1978&POOL_ NAME=SMACKOVER-NORPHLET.]

 

 The R.J. Newman 9-11 Well Number 1 was ultimately on an 160 acre drilling and production unit.  For the purposes of this example, assume that the property to be leased is  the 160 acre tract that ultimately becomes the drilling and production unit for a well like the R.J. Newman 9-11 Well.   The typical leasing negotiation would start with a proposed bonus of $25 per acre and a royalty of one-eighth.  In today’s environment, most oil companies that are leasing will authorize their Landmen to give a royalty of one-fifth.  Assume that in the first negotiating round you get the land man to $1000 per acre bonus and three-sixteenths royalty.  Is that a good deal?

 On the bonus side, by going to a bonus $1,000 per acre, you will have negotiated an increase in the total bonus from $4,000 to $160,000, or an increase of $156,000.  The increase in bonus is immediately tangible.  The lure of the bonus, however, frequently is a trap to distract you from pushing the royalty.

 The table set out below shows the lump sum values*** of royalties on the total production from the R.J. Newman 9-11 Well at different royalty fractions:

 

Royalty Fraction

Royalty Value of Total Production

1/8

$7,541,541

3/16

$11,312,311

1/5

$12,066,465

1/4

$15,083,081

 

[***The following figures from www.bloomberg.com (May 19, 2009) were used for oil ($60.30/Bbl) and gas ($3.95/MBTU).  1 Mcf of gas assumed to contain 1 MBTU.  Net present values assume that the escalation of the hydrocarbon prices equals the interest discount rate.]

 

         If you stop at three-sixteenths royalty and $1,000 per acre bonus,  you would have maximized return only if the proposed well turned out to be a dry hole.  That is because you r your client would get to keep the bonus, and no royalties would come into play because the well would be dry.  If the well turned out to be productive,  under almost any scenario you or your client would receive substantially more money if you had negotiated a higher royalty.  Based on the R.J. Newman 9-11 Well profile, you or your client would receive approximately $3,770,000 more in royalty income with an one-fourth royalty than with a three-sixteenth royalty.  That is a lot of money to leave on the table.

         You should research the going bonus and royalties.  Directly ask the landman about the highest bonus and royalty in your area.  Call other landmen and ask them what they have heard.

         If the landman claims that he does not have authority to offer higher terms, ask him or her to go back to the company and get more authority.  If the oil company balks at three-sixteenths on the royalty, ask for a favored nations clause, like the one below (which oil companies have accepted):

         Favored Nation Escalation.  The Bonus and Production Royalty under this Agreement  shall be the greater of the Bonus and/or Production Royalty payable under this Agreement or any higher royalty for such mineral given by Lessee in <Name of County> County, Alabama, paid by Lessee in <Name of County> County, Alabama, or agreed to be paid by Lessee in <Name of County> County, Alabama.

 

         Oil companies disfavor favored nations clauses.  Sometimes an oil company will agree to pay a higher bonus and/or royalty in lieu of agreeing to the favored nations clause.   Other times, the oil company will back away from the deal and come back to you only after it has obtained all the leases that it wants for the play. At that time, it may be willing to give the favored nation clause.  Even if you do not intend to insist on a favored nations clause, asking for it early in the negotiations should not hurt you.  You can always drop your request for the clause.

         You will never know the absolute maximum bonus and royalty an oil company will pay, because those matters are usually kept confidential.  There are some Texas plays where the oil company has paid $28,000 per acre bonus with a twenty-eight percent royalty.  There have been Alabama lease royalty rates as high as forty-seven percent.  Those cases all involved unleased acreage surrounded by good producing wells.

Copyright 2011 by Edward G, Hawkins. All rights reserved.