Royalty and Mineral Rights Issues: A Q&A with Bill Sinclair

About Bill Sinclair

At age 29, Sinclair is one of the youngest members to ever serve on the board of directors of the National Association of Royalty Owners (NARO). He is the founder and chief executive officer of Dallas-based Agelio Networks Inc. (www.agelio.net), which creates software solutions for the oil and gas industry. Most recently, Sinclair developed MineralFile, a Web-based land management and revenue system for mineral owners. Sinclair has been in the software and services business since 1998, and may be contacted at bill@agelio.net or 888-786-2881, extension 705.

Q. What is the National Association of Royalty Owners (NARO) and how does it help mineral and royalty owners?

A. NARO stands for the National Association of Royalty Owners. It is one of the only national organizations promoting the rights, responsibilities and the definitions of citizens who own natural resources in the United States. Founded in 1980, mineral owners across the country rely on NARO to provide them with educational resources that help them make sound decisions about their mineral rights. Currently, NARO has five chartered state organizations, which include NARO-Texas, Oklahoma-NARO, Rockies-NARO, NARO-Arkansas and NARO-Appalachia. All organizations provide education, political action and state conventions that bring together mineral owners and industry experts from across the nation. For more information about NARO, visit www.naro-us.org or call 1-800-558-0557.

 

Q. What are some of the most common royalty-related issues/problems that you see occurring in the industry today?

A. While I’m seeing an improvement in the communication among mineral owners and professionals, the biggest problem is uniformed mineral owners. In many areas, including the Barnett Shale, oil and gas companies have offered thousands of dollars per acre alone for the lease bonus and then very high royalty percentages. Uncertainty often exists as a result of these high sums because many owners do not know the difference between LEASING their mineral rights and SELLING them. If an owner sells his mineral rights, he forfeits the right to ALL future income associated with production. These potential sums of money require the responsibility of the mineral owner to do some background research and to speak with professionals in the industry.

Another issue is that, once production occurs, mineral owners often receive large checks for their bonus money, as well as for the first few checks they receive for royalties. However, royalty owners should be aware that production of oil and natural gas can and most certainly will drop dramatically over time. As a result, royalty check amounts will significantly decrease. Oil and natural gas are, by nature, depleting assets. Most of the recoverable reserves in tight gas plays like the Barnett Shale are usually extracted in the first few years. This is one of the reasons mineral owners need to manage their assets and plan for the checks to get smaller over time. Several software packages can assist mineral owners with managing mineral rights, including my company’s product, MineralFile, which was built exclusively for mineral owners and managers. I cringe when I hear mineral owners speak about their “mailbox” money because these assets and the associated revenue require diligent attention. Just as a retirement fund or real estate portfolio needs diligent management, so does mineral ownership.

Another issue I sometimes see is a lack of communication between oil and gas companies and the community, which includes mineral owners. The industry is incredibly complicated and those who are not immersed in the issues on a daily basis (most people) have difficulty grasping the terminology surrounding oil and gas production. It’s easy to get frustrated with contracts, division orders and negotiations. Although I encourage oil and gas companies to improve communication with their stakeholders, I strongly recommend mineral owners ask questions and continue to ask questions until they get the answers they understand.

 

Q. What is the best piece of advice you would give to a mineral owner who is new to leasing his/her property?

A. The absolute best piece of advice I can give to a mineral owner who is new at leasing property is to get educated about the process and surround yourself with people who have experience in leasing their own assets. No one has to feel like they’re alone in the process and there are several resources in the U.S. that are willing to help mineral owners get their feet wet. The National Association of Royalty Owners (NARO) is a wonderful organization that was founded to help mineral owners make informed decisions about their mineral rights.

In addition, if a mineral owner is a part of a neighborhood where minerals are being leased everywhere, there is power in numbers so I always suggest starting or joining a group and leasing minerals together. Generally, mineral owners will receive a better deal when minerals are leased in a group, plus you’ll instantly be surrounded by others in the same situation.

            If you’re leasing a significant amount of property, I highly recommend hiring a lawyer with expertise in mineral rights leasing. It will be worth the money to have someone in your corner explaining to you your options and leading you through the negotiation process so that you receive the best terms possible.

 

Q. Educating mineral owners about their rights and about how the process works can help foster better business relationships for both the mineral owner and the energy business. What are some of the areas you see about which mineral owners tend to be confused or where misunderstandings often develop?

A. Oil and gas leasing and operating involves so many parts and pieces that it is possible for anyone to scratch his head at any stage of the process. The leasing stage can be daunting for first-time leasing mineral owners and it is important for them to seek legal counsel before agreeing to any of the terms. It’s okay for mineral owners to ask questions until they understand. In turn, it’s imperative that the oil and gas companies make themselves available until all questions have been answered.

            One of reasons that oil and gas production is so difficult for mineral owners to get their arms around is that we don’t see what’s being taken out of the ground. Let’s say you own a gumball machine and you lease it to someone to remove the gumballs. Throughout the process you can physically see how much is being taken out. This is clearly not the case with leasing mineral rights for oil and natural gas, as it goes through pipelines and trucks to reach the markets and refineries. Confusion can arise about the amount of oil or gas being taken from the ground, which directly affects the royalty checks mineral owners receive. This is further confused by the fact that not all companies measure extraction using the same methods.

            One general misunderstanding mineral owners have is why the prices at the gasoline pumps are different than what they’re receiving on their mineral checks. Believe it or not, some people who are not familiar with the energy industry do not realize that “gas,” or gasoline, used in a car is not the same as the natural “gas” coming from the ground.

 

Q. How can landmen work to eliminate some of this confusion or avoid the most common misunderstandings/problems that develop with both mineral and surface owners?

A. It’s important for landmen to understand that people they approach to lease their mineral rights may be skeptical when the landman comes to the door. Many media stories have circulated in the United States about mineral owners who feel they’ve been “scammed” by landmen. While it’s impossible to make everyone happy, landmen can do their best to explain the leasing process and be willing to discuss negotiations that mineral owners may want to include in the lease they’ve been offered. One of the highest compliments a landman can receive is a referral to other mineral owners in the area. If mineral owners have a good experience, they will tell people about it and, if they have a bad experience, they’ll be SURE to tell people about it.

 

Q. Transparency is a hot topic for oil and gas producers, as well as royalty owners. What types of situations in particular need to be addressed and how can they be improved?

A. For the oil and gas industry, transparency means that many of the practices that go between the oil and gas companies and their partners (such as pipeline contracts for instance, which are confidential) should be open records for the public. One of the major complaints I hear is that pipeline companies do not report the prices they paid to the product purchasers to take the gas to market. Royalty owners fear that the prices are significantly higher than what they receive on their checks and, ultimately, there really is no way of knowing for sure.

            Lease bonuses and royalties are also private, and oil and gas companies do not reveal what they’ve paid others for the right to drill on their mineral rights. I’m working to alleviate the mystery behind lease bonuses by asking mineral owners to report the lease bonuses they’ve accepted from oil and gas companies on our Web site, www.mineralplace.com. Here, we attempt to create a bit more transparency behind issues that have been unnecessarily elusive to royalty owners.

            I think greater transparency among these groups would be a real win-win for both mineral owners and oil and gas companies. Mineral owners would have a better understanding of the issues that pertain to them and thus, oil and gas companies would spend less time answering customer phone calls from angry mineral owners claiming they’ve been mistreated.

 

Q. When a mineral owner sits down to do business with a landman, does the mineral owner typically understand that the lease can be negotiable? What parts of the lease are negotiable?

A. Mineral owners need to know that all leases are negotiable. There is no such thing as a standard lease and every provision of a lease can be negotiated. Lease bonus and royalty payments are two of the most commonly negotiated parts of a lease. Surface owners can further protect themselves and their property by adding specific clauses to protect surface assets such as fences, roads, buildings, etc. It’s important when negotiating a lease to consult an attorney who is experienced in dealing with mineral rights and leases.

 

Q. How can people most easily confirm whether they own the mineral rights to their property?

A. One problem that affects mineral owners is proving they own the rights to their minerals. Surface owners may think they own the mineral rights beneath the land they purchased, but many times when people sell the surface, they retain the mineral rights or a portion of them. If you don’t know whether you own the mineral rights beneath your property, you may want to hire a landman to investigate for you or go to the county courthouse yourself and search the property records. When purchasing property, buyers may want their realtors to inquire whether the minerals are being conveyed, in addition to the surface. However, often the seller does not know whether he or she even owns the mineral rights.

            Landmen who approach you to lease your mineral rights have done a bit of background research about the current owner. However, even if you are approached, you may have to verify your ownership of the mineral rights or the lease could be nullified.

 

Q. In the Barnett Shale play in particular, where there are so many small parcels leased out in residential neighborhoods, do you see potential royalty-related problems down the line as these smaller parcels are passed to heirs, divorces occur, etc.?

A. This is a major issue for mineral owners to understand. Smaller mineral estates can become problematic, as they often do not generate enough income for people to keep track of them properly. As mineral rights get divided up amongst heirs, the royalty gets smaller and smaller. This is a problem because often there is no transfer of ownership in the estate, or when a living heir does not properly manage the asset and pay taxes on the minerals, they can be held in suspense. In other words, royalty payments can be “suspended” and retained in an account by the purchaser until there is proof that all taxes have been paid. This is also true when the purchaser does not have the most current address for the royalty owner.

 

Q. What’s the difference between selling and leasing minerals?

A. When a landowner sells his or her mineral rights, they are selling all potential for any lease bonus or royalties from future leasing and drilling operations. When a landowner chooses to lease his or her property, he grants an oil and gas company permission to drill in exchange for an upfront bonus and ultimately a royalty, which is paid when the well begins producing. An alternative to the upfront bonus is a delayed rental, which forces the lessee to make rental payments until the lease begins producing. If the payments are missed, the leased acreage returns to the mineral owner.

 

Q. What’s the difference between an override, working interest and royalty interest?

A. All interests are fractions of the total production of a well. A greater decimal interest will receive a larger share of the income from production. An overriding royalty interest is an interest usually carved out of a working interest. These are often used to compensate people associated with assembling the production package, including landmen, petroleum engineers and prospect hunters. The override terminates when the well is no longer producing.

A royalty interest is one paid to the mineral owner who has leased his mineral interests for production. They do not participate in the drilling costs of a well, including equipment or labor.

A working interest requires the interest owner to participate in the cost of production. The working interest owner assumes some financial risk as there are costs associated with operating even if the well is unsuccessful. However, if the well is successful, the working interest owner typically receives a large percentage of the income.

 

Q. If an owner plans to pass mineral rights to his or her children, what are some options on how to do this?

A. This is unique to each owner’s situation and it’s best to contact a lawyer or estate planning professional to determine the best option for your situation. Some examples include passing the rights on directly, as you would with a house. Some people put their mineralsin trusts or other legal entities for tax purposes.

 

Q. Can you explain to mineral owners why the product price on their royalty checks is different from the prices they see in the newspaper on the various gas markets (NYMEX, WAHA)?

A. After production occurs, the operator sells that production to one or more intermediaries before it reaches one of the markets in North America. That production is then sold to a wholesaler at a price determined by the demand of the buyers (some examples of prices in the various markets can be found here, http://intelligencepress.com/features/intcx/gas/. That price is more than you were paid as a royalty owner because there are costs involved in transporting and marketing that production. When you buy an ear of corn at the grocery store for instance, the price you pay is higher than the farmer received for that same ear. Prices on the various markets can vary based upon supply and demand. When Katrina temporality destroyed refining capacity in the Southern United States (WAHA or the Houston Ship Channel), prices in the area were much higher than those in the Northeast (NYMEX).

 

Q. How can a mineral owner who has just signed a lease verify that he or she is being paid properly for production on his or her property?

A. Before a mineral owner receives any royalty payments, he/she will receive a division order from the operator, which outlines his/her division of interest in the well, in addition to verifying the owner’s tax information. If the owner does not sign and return the division order, he/she may not get paid and even if they do get paid, the operator will withhold the maximum amount for taxes (without a signed division order). As for proper payment, please refer to the next 2 questions.

 

Q. Is there a way for mineral owners to verify whether the production numbers on their property match what are being reported to the state? If the numbers are incorrect, what action should a mineral owner take?

A. Production must be verified from the oil and gas governing body in the state where the well is located. In Texas, the Railroad Commission (RRC) is responsible for regulating oil and gas production (http://webapps.rrc.state.tx.us/PDQ/home.do). Here you can look up the total production for your well(s) by month and verify against what is printed on your check stub. If you multiply the total production by your decimal interest, it should match your share. If the numbers on your check do not match what the operator has reported to the state, your first call should be to the operator to see if he or she can work things out. You can obtain the operator’s contact information from your check, or take a look at www.mineralplace.com, which lists links to royalty owner contact information for the larger operators. The site is a free online community for oil and gas mineral rights owners in the United States to discuss matters related to owning, leasing, accounting, etc. It offers links to various other useful resources, as well as a handy glossary of oil and gas terminology.

            Your second step can be to contact the RRC and tell them about the discrepancy. As a last resort, you may have to ask your legal professional to help. Computer software and Web-based applications are also available that can help you to verify the math on your checks to make sure that all the numbers add up properly.

 

Q. How can a mineral owner determine the decimal interest on his or her division order and can you explain this in layman’s terms?

A. A decimal interest is basically the mineral owner’s share of the well’s total production. If the total production of the well = 1, then your share is going to be some fraction of 1, such as .0377448. This number is derived from your negotiated royalty and your acreage as a percentage of the total unit as established by the Railroad Commission. For example, if the well spacing is set at 40 acres (the size of the unit) and you own 20 acres and a 1/8 royalty, then your decimal interest would be 20/40 X (1/8) = .0625. If you only own three acres, then your interest would be 3/40 X (1/8) = .009375. You would only receive the full 1/8 royalty if you owned all the acreage in the unit. Otherwise, you must factor in your acreage as a percentage of the total AND your royalty to arrive at your interest in the well.