Factors Involved in Establishing Gas and Oil Royalty Rates!
October 18, 2016
The determination of rates for oil and gas royalties is complicated. Influenced by different elements, royalty rates fluctuate from day to day, an important fact for owners of royalties to understand. There is no one set rate, since conditions that dictate oil and gas royalties change depending on the individual arrangements with royalty owners in addition to external influencers.
What Is A Royalty?
In oil and gas production, a royalty is a share of the profit earned from the production of oil or natural gas. Companies that invest in oil and gas production assume the cost of that production and exchange product for profit. A royalty that paid to a royalty owner is the percentage of that profit agreed upon in advance by the royalty owner and the mineral rights owner or lessee.
Contributing Factors for Determining Royalty Rates
Every drilling operation is different, so royalties will differ accordingly. Some of the main considerations when setting royalty rates involves the current demand based on available supply and what the market is paying for it. As most people know, oil and gas markets fluctuate daily; based on this fluctuation and how the market is perceived to behave in the future, such fluctuation can affect royalty rates and what a company will offer to their royalty holders.
Setting of royalty rates involves more than just supply and demand. Another important consideration is the cost of production based on how much production is expected and then actually generated. Oil and gas that requires less complicated efforts to produce may pay higher royalties than if production is more difficult. Land makeup, deposit depth and size, and the process that must be used to produce oil and gas directly affect royalty rates. Companies seek to cover their costs first, then share a portion of their profits with royalty owners. When production is more costly and more challenging due to geological and other factors, royalties are typically less.
Additionally, the product itself also affects royalty rates. Oil and gas royalties differ, as do the royalties of different qualities and consistencies of oil. When combined with the depth of oil and how difficult it is to produce, even the same type of oil can generate different royalties simply due to its location and how all that affects production cost.
Gross and Net Royalties
Another factor in how royalty rates are set and presented is gross royalties and net royalties. A contract may state that the royalty owner will receive gross royalties, which are calculated based on gross revenue before production costs and other capital expenses are subtracted. Other times royalty owners will receive net royalties, which are calculated from net revenue after those costs and expenses are subtracted. Rates are affected in different ways by these different calculations. Either one may be more profitable than the other, based on all factors that contribute to the determination of royalty rates.
What this illustrates is that royalties are fluid, dependent on many factors. Combined, these factors spell a different rate and potentially a different formula for coming up with that rate for each transaction. Oil and gas royalties are generally similar within same geographical regions due to similar situations. Royalty owners can always research what is being paid in their area to get an idea on how their rate might be based, barring any extraneous circumstances!
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