How large should that shale gas royalty be?
Negotiating from Strength
By
Les. R. Wright and Roy T. Ohner
Question: Is a 20% or 25% or 30% royalty right 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 junck bonds that pay a higher interest rate but much higher risk).
A higher royalty will reduce the profitability of a project to such an extent that it may cause the Oil Company to invest elsewhere. So there has to be a balance.
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.
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 the access to Oil Companies. 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.
So what is a fair royalty?
First, some background…
The following U.S. based oil and gas companies invest in onshore oil and gas leases, and most invest in shale gas leases: Anadarko, Apache, Chevron, ConocoPhillips, EOG, ExxonMobil, Amerada Hess, Marathon, Murphy, Occidental (Oxy) and Shell.
By researching the website of each of these publicly traded companies (the public can purchase their stock) you will quickly learn two things…
1. The profitability of these companies measured in earnings per share, has been INCREASING ranging from 10% to over 100% per year (on average over 50% year on year);
2. Top executive management compensation as reported in annual proxy notices ranges from $10 million per year to over $75 million per year, and about $20 million per year average for the group. So huge pay checks are earned!
Negotiating Strength Number 2.
The Oil Companies are making a lot of money, their executives are multi-millionaires, which means the land owners can easily increase their royalty and NOT materially and adversely affect the Oil Companies profitability or pay to their CEOs. The land owner 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!
Where do Oil Companies invest? Where do those companies want access to oil and gas properties?
Oil Companies regularly invest in both U.S. and international properties. Why? The Oil Companies want to diversify their investment portfolios as well as gain potential access to large oil and gas deposits in foreign lands. But make no mistake…these foreign lands have unique adverse risks…Political Risk…Contract Risk that contracts will be honored the so called sanctity of contract rule. Foreign 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. 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 should have similar Government take.
A review of the above listed Oil Company’s international investments (non U.S.) in oil and gas assets range from 20% to 80% (average of about 60%) of the value of their investment portfolio. So a significant part of these Oil Companies investments and wealth are overseas outside the U.S.
Typical foreign Government (non-U.S.) 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 the big CEO pay packages.
Typical Oil Company investment ROR ranges from 25% to 50% for oil properties and 15% to 40% for gas properties.
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 expect a lower ROR (lower risk – lower reward) than what they are willing to receive internationally, by paying higher royalty rate to land owners. Comparable Government Take in the U.S. is composed of the oil and gas royalty, bonuses and income taxes.
Thus Oil Companies should be willing to accept in the U.S. at least a similar 65% Government Take and ROR’s less than 25%-50% for oil or 15%-40% for gas. Recall – lower risk – lower reward!
Do costs of projects affect investments?...Yes…and here are the typical numbers…
Capital Costs (the development costs like drilling wells, pipelines, processing facilities, tanks, pumps, etc.) for projects vary depending on if the project is onshore, in shallow water or deep-water.
For oil, typical Capital Costs can range from $2.00 per barrel to $10 per barrel of oil for onshore projects; $5-$20/barrel shallow water; $8-$35/barrel deep-water.
In contrast, gas project Capital Costs can range from $0.25 per thousand cubic feet (mcf) to $1.00/mcf for onshore; $0.7-$$2.25/mcf shallow water; $0.75-$$3.00/mcf deep-water.
Similarly, operating or production costs in addition to Capital Costs (so called Operating Costs) can range as follows:
Oil Projects: $2-$7/barrel onshore; $2-$10/barrel shallow water; $8-$40/barrel deep-water
Gas Projects: $0.5-$1.00/mcf onshore; $0/5-$1.25/mcf shallow water; $0.5-$1.10/mcf deep-water.
Combining Capital Costs and Operating Costs gives an indication of the costs of oil and gas projects.
Total Capital Operating Costs Oil Projects ($/barrel) Gas Projects ($/mcf)
Onshore $4-$27 $0.75-$2.00
Shallow water $10-$30 $1.20-$4.00
Deep water $16-$75 $1.25-$4.10
In contrast, the U.S. Energy Information Agency (www.EIA.gov) estimates the following future oil and gas prices:
2009 ‘real prices’ (unescalated prices in 2009 dollars)
Year Oil ($/barrel) Gas($/mcf)
2009 59.04 3.95
2015 86.83 4.66
2025 107.40 5.97
2035 113.70 7.07
And similarly, if prices are escalated per EIA assumptions, the so called ‘nominal’ or ‘money of the day’ price, the prices are:
Year Oil ($/barrel) Gas($/mcf)
2009 59.04 3.95
2015 94.78 5.09
2025 142.05 7.90
2035 181.43 11.28
Comparing the sum of the Capital and Operating Costs with the EIA price projects illustrate the following observations:
1. Oil projects can be very profitable since the anticipated project oil price is much higher than the estimated Capital and Operating Costs
2. In contrast, for gas projects, such projects are generally less profitable but still competitive, especially since gas prices are projected to increase noticeably above the costs.
Negotiating Strength Number 4.
Oil and gas projected prices are anticipated to outpace Capital and Operating Costs, indicating significant profit potential for Oil Companies –which means more value should be transferred to the land owner by way of higher royalty payments.
How is Government Take determined?
Determining Government Take is easily understood by way of example calculations, and while admittedly simplified, illustrates the principles.
Let’s first assess a typical onshore U.S. project for oil and gas…
Assume (‘Before Payout’)
$100 Sales income or revenue from selling oil or gas production
-25 less 25% royalty to the land owner
75 Net
-50 less assumed capital and operating cost deduction
25
-8.75 (less 35% income tax)
16.25 Profit to Oil Company
Government Take = 25 (royalty) 8.75 (tax) = 33.75(% of total revenue); Which in this example is much less than the typical foreign Government Take of 65%.
And on an After Payout basis…
$100 Sales income or revenue from selling oil or gas production
-25 less 25% royalty to the land owner
75 Net
-10 less assumed operating cost deduction, capital is paid out
65
-22.75 (less 35% income tax)
42.25 Profit to Oil Company
Government Take = 25 (royalty) 22.75 (tax) = 47.75(% of total revenue); Which in this example is much less than the typical foreign Government Take of 65%.
Typical Foreign Government (non U.S.) Take calculations are:
Before Payout After Payout
100 Income 100
-25 Royalty -25
75 Net 75
-50 (50% cost recovery -10
Lesser of 50% or
Actual cost)
37.5 Net 65
-28.125 (Assume 75% profit -48.75
Share to Gov’t’;
25% to Oil Co.)
9.4 Net 16.3
Government Take Before Payout = 25 28.135 = 53.125(%)
Government Take After Payout = 25 48.75 = 73.75(%)
As illustrated above, the Foreign Government Take (53.125% to 73.75%) is noticeably higher than the comparable U.S. Government Take (33.75% to 47.75%).
How much higher could the U.S. royalty rate be to equate to the Foreign Government Take (53.125% Before Payout and 73.75% After Payout, or to match the 65% average)?
The answer…
Before Payout After Payout Before Payout After Payout
100 100 100 100 Revenue
-55 -65 -65 -52 Royalty
45 35 35 48 Net
-50 -10 -50 -10 Cost
-5 25 -15 38 Net
0 -8.75 0 -13.3 Tax
-5 16.25 -15 24.7 Profit
53.125% 73.75% 65% 65% Gov’t Take
This simplified theoretical example indicates the land owners royalty could be increased over 50% in order to mimic a Foreign Government Take – in which Oil Companies have regularly accepted!
Negotiating Strength Number 5.
Oil Companies are willing to accept higher Government Takes (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 and market risk environment leads to support of a higher royalty payment to the land owner…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!.
So next time don’t feel bashful about asking for that minimum 35% royalty.
Other options…
If the Oil Company claims cost and price risks are challenging then connect the royalty rate to a sliding scale price…and as an example…
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 $75; 25%
If $75 or greater but less than $100; 30%
If greater than $100; 35%
As for gas (and using Henry Hub published posted prices as the reference price)…
$3.50/mcf; 20%
$3.50-$4.50; 25%
$4.50-$5.50; 30%
Greater than $5.50; 35%
Another option is to preserve the right (but no obligation) to back-in as a paying working interest owner if there is a commercial discovery. An example might be that the land owner has the option to back-in for up to [25%] of the Oil Company’s working interest (for example if the Oil Company has a 50% of 100% working interest, 25% would be .25 x 50% = 12.5% of 100%). If the option is exercised, the land owner is to pay the Oil Company out of the land owners [25%] share of future production until the land owner [25%] ground floor share of back costs are paid in full after which the land owner receives the working interest share and pays its share of 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 a large gain.
Negotiating from Strength
By
Les. R. Wright and Roy T. Ohner
Question: Is a 20% or 25% or 30% royalty right 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 junck bonds that pay a higher interest rate but much higher risk).
A higher royalty will reduce the profitability of a project to such an extent that it may cause the Oil Company to invest elsewhere. So there has to be a balance.
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.
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 the access to Oil Companies. 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.
So what is a fair royalty?
First, some background…
The following U.S. based oil and gas companies invest in onshore oil and gas leases, and most invest in shale gas leases: Anadarko, Apache, Chevron, ConocoPhillips, EOG, ExxonMobil, Amerada Hess, Marathon, Murphy, Occidental (Oxy) and Shell.
By researching the website of each of these publicly traded companies (the public can purchase their stock) you will quickly learn two things…
1. The profitability of these companies measured in earnings per share, has been INCREASING ranging from 10% to over 100% per year (on average over 50% year on year);
2. Top executive management compensation as reported in annual proxy notices ranges from $10 million per year to over $75 million per year, and about $20 million per year average for the group. So huge pay checks are earned!
Negotiating Strength Number 2.
The Oil Companies are making a lot of money, their executives are multi-millionaires, which means the land owners can easily increase their royalty and NOT materially and adversely affect the Oil Companies profitability or pay to their CEOs. The land owner 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!
Where do Oil Companies invest? Where do those companies want access to oil and gas properties?
Oil Companies regularly invest in both U.S. and international properties. Why? The Oil Companies want to diversify their investment portfolios as well as gain potential access to large oil and gas deposits in foreign lands. But make no mistake…these foreign lands have unique adverse risks…Political Risk…Contract Risk that contracts will be honored the so called sanctity of contract rule. Foreign 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. 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 should have similar Government take.
A review of the above listed Oil Company’s international investments (non U.S.) in oil and gas assets range from 20% to 80% (average of about 60%) of the value of their investment portfolio. So a significant part of these Oil Companies investments and wealth are overseas outside the U.S.
Typical foreign Government (non-U.S.) 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 the big CEO pay packages.
Typical Oil Company investment ROR ranges from 25% to 50% for oil properties and 15% to 40% for gas properties.
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 expect a lower ROR (lower risk – lower reward) than what they are willing to receive internationally, by paying higher royalty rate to land owners. Comparable Government Take in the U.S. is composed of the oil and gas royalty, bonuses and income taxes.
Thus Oil Companies should be willing to accept in the U.S. at least a similar 65% Government Take and ROR’s less than 25%-50% for oil or 15%-40% for gas. Recall – lower risk – lower reward!
Do costs of projects affect investments?...Yes…and here are the typical numbers…
Capital Costs (the development costs like drilling wells, pipelines, processing facilities, tanks, pumps, etc.) for projects vary depending on if the project is onshore, in shallow water or deep-water.
For oil, typical Capital Costs can range from $2.00 per barrel to $10 per barrel of oil for onshore projects; $5-$20/barrel shallow water; $8-$35/barrel deep-water.
In contrast, gas project Capital Costs can range from $0.25 per thousand cubic feet (mcf) to $1.00/mcf for onshore; $0.7-$$2.25/mcf shallow water; $0.75-$$3.00/mcf deep-water.
Similarly, operating or production costs in addition to Capital Costs (so called Operating Costs) can range as follows:
Oil Projects: $2-$7/barrel onshore; $2-$10/barrel shallow water; $8-$40/barrel deep-water
Gas Projects: $0.5-$1.00/mcf onshore; $0/5-$1.25/mcf shallow water; $0.5-$1.10/mcf deep-water.
Combining Capital Costs and Operating Costs gives an indication of the costs of oil and gas projects.
Total Capital Operating Costs Oil Projects ($/barrel) Gas Projects ($/mcf)
Onshore $4-$27 $0.75-$2.00
Shallow water $10-$30 $1.20-$4.00
Deep water $16-$75 $1.25-$4.10
In contrast, the U.S. Energy Information Agency (www.EIA.gov) estimates the following future oil and gas prices:
2009 ‘real prices’ (unescalated prices in 2009 dollars)
Year Oil ($/barrel) Gas($/mcf)
2009 59.04 3.95
2015 86.83 4.66
2025 107.40 5.97
2035 113.70 7.07
And similarly, if prices are escalated per EIA assumptions, the so called ‘nominal’ or ‘money of the day’ price, the prices are:
Year Oil ($/barrel) Gas($/mcf)
2009 59.04 3.95
2015 94.78 5.09
2025 142.05 7.90
2035 181.43 11.28
Comparing the sum of the Capital and Operating Costs with the EIA price projects illustrate the following observations:
1. Oil projects can be very profitable since the anticipated project oil price is much higher than the estimated Capital and Operating Costs
2. In contrast, for gas projects, such projects are generally less profitable but still competitive, especially since gas prices are projected to increase noticeably above the costs.
Negotiating Strength Number 4.
Oil and gas projected prices are anticipated to outpace Capital and Operating Costs, indicating significant profit potential for Oil Companies –which means more value should be transferred to the land owner by way of higher royalty payments.
How is Government Take determined?
Determining Government Take is easily understood by way of example calculations, and while admittedly simplified, illustrates the principles.
Let’s first assess a typical onshore U.S. project for oil and gas…
Assume (‘Before Payout’)
$100 Sales income or revenue from selling oil or gas production
-25 less 25% royalty to the land owner
75 Net
-50 less assumed capital and operating cost deduction
25
-8.75 (less 35% income tax)
16.25 Profit to Oil Company
Government Take = 25 (royalty) 8.75 (tax) = 33.75(% of total revenue); Which in this example is much less than the typical foreign Government Take of 65%.
And on an After Payout basis…
$100 Sales income or revenue from selling oil or gas production
-25 less 25% royalty to the land owner
75 Net
-10 less assumed operating cost deduction, capital is paid out
65
-22.75 (less 35% income tax)
42.25 Profit to Oil Company
Government Take = 25 (royalty) 22.75 (tax) = 47.75(% of total revenue); Which in this example is much less than the typical foreign Government Take of 65%.
Typical Foreign Government (non U.S.) Take calculations are:
Before Payout After Payout
100 Income 100
-25 Royalty -25
75 Net 75
-50 (50% cost recovery -10
Lesser of 50% or
Actual cost)
37.5 Net 65
-28.125 (Assume 75% profit -48.75
Share to Gov’t’;
25% to Oil Co.)
9.4 Net 16.3
Government Take Before Payout = 25 28.135 = 53.125(%)
Government Take After Payout = 25 48.75 = 73.75(%)
As illustrated above, the Foreign Government Take (53.125% to 73.75%) is noticeably higher than the comparable U.S. Government Take (33.75% to 47.75%).
How much higher could the U.S. royalty rate be to equate to the Foreign Government Take (53.125% Before Payout and 73.75% After Payout, or to match the 65% average)?
The answer…
Before Payout After Payout Before Payout After Payout
100 100 100 100 Revenue
-55 -65 -65 -52 Royalty
45 35 35 48 Net
-50 -10 -50 -10 Cost
-5 25 -15 38 Net
0 -8.75 0 -13.3 Tax
-5 16.25 -15 24.7 Profit
53.125% 73.75% 65% 65% Gov’t Take
This simplified theoretical example indicates the land owners royalty could be increased over 50% in order to mimic a Foreign Government Take – in which Oil Companies have regularly accepted!
Negotiating Strength Number 5.
Oil Companies are willing to accept higher Government Takes (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 and market risk environment leads to support of a higher royalty payment to the land owner…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!.
So next time don’t feel bashful about asking for that minimum 35% royalty.
Other options…
If the Oil Company claims cost and price risks are challenging then connect the royalty rate to a sliding scale price…and as an example…
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 $75; 25%
If $75 or greater but less than $100; 30%
If greater than $100; 35%
As for gas (and using Henry Hub published posted prices as the reference price)…
$3.50/mcf; 20%
$3.50-$4.50; 25%
$4.50-$5.50; 30%
Greater than $5.50; 35%
Another option is to preserve the right (but no obligation) to back-in as a paying working interest owner if there is a commercial discovery. An example might be that the land owner has the option to back-in for up to [25%] of the Oil Company’s working interest (for example if the Oil Company has a 50% of 100% working interest, 25% would be .25 x 50% = 12.5% of 100%). If the option is exercised, the land owner is to pay the Oil Company out of the land owners [25%] share of future production until the land owner [25%] ground floor share of back costs are paid in full after which the land owner receives the working interest share and pays its share of 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 a large gain.
Comment