Oil and Gas Royalties – Comprehensive Guide

When someone owns the mineral rights to a piece of land, they have ownership of oil and gas beneath the ground.

A mineral owner cannot reasonably extract the oil and gas due to the high cost, so they lease the mineral rights to an oil or gas company. This lease agreement allows the company to extract the oil and gas.

Once the lease is secured, the oil or gas company begins the drilling process. Drilling involves setting up the necessary equipment to create a well that reaches the oil or gas reserves underground. If the company successfully finds oil or gas, they start the extraction process, known as production.

As outlined in the lease agreement, the owner of the mineral rights receives a portion of the revenue from the sale of the oil or gas extracted from their land. This payment is called a royalty.  This is where the term oil and gas royalties comes from.  Once production from a new well has begun, you now have oil and gas royalties.

Oil and Gas Royalties vs Mineral Rights

There is often confusion among mineral owners about what they own. When mineral owners hear “mineral rights” or “oil and gas royalties”, they often think of them as two separate things.   This is not correct.

Oil and gas royalties are simply mineral rights that are currently producing.

When someone says “oil and gas royalties” they are referring to your mineral rights.   These terms are used interchangeably in the industry.

The only difference is that mineral rights may be producing or non-producing.   If your mineral rights are not currently producing, the industry would call them mineral rights.   Once mineral rights start producing, the mineral rights are often then referred to as oil and gas royalties or mineral rights.

The royalty rate you receive in your lease agreement is important.  The reason is that your royalty rate determines what share of oil and gas royalty income you are entitled to.   The higher the royalty rate, the more oil and gas royalty income you will receive.

Oil and gas royalty rates range between 12.5% and 25%.  This is true for all states.

The average oil and gas royalty rate is between 18.75% and 20% in 2024.   However, in the best locations within the Permian basin, a 25% royalty rate is common.

In the past, it was common to see average oil and gas royalty rates of 12.5%.  As mineral owners became more savvy and understood the value of the oil and gas they were leasing, they started pushing for higher royalty rates.  This pushed the average oil and gas royalty rate to around 18.75% today.

Above we explained how oil and gas royalties and mineral rights are both the same thing.  While true, there are a few different types of mineral rights ownership you can have.  These different types of ownership are explained below:

Royalty Interest (RI):   A royalty interest is the most common type of ownership.  A royalty interest is the ideal type of ownership.  It means that you own the underlying mineral rights and the executive rights (the right to lease) together.  A royalty interest is “complete” and means you own all aspects of the mineral rights.

Non-Participating Royalty Interest (NPRI):  If you own an NPRI, it means that you own the underlying mineral rights but you do not own the rights to lease the mineral rights.  This means someone else has the right to lease the mineral rights, but you have the right to collect all royalty income.  While this could decrease the value of your oil and gas royalties, if you are in good area it may not matter.  Once a lease is held by production, the rights to lease do not matter so the value would depends up on the royalty rate that has already been determined.

Executive Rights:  This is the other side of a non-participating royalty interest.  If you own executive rights, it means you do not own the mineral rights, but you have the right to lease those mineral rights and collect a lease bonus.

Note:  There is a natural conflict between an NPRI owner and the person who owns the executive rights.  As an NPRI owner, you hope the lease royalty rate is the highest possible because it will mean more royalty income for you.  However, the executive rights holder would prefer a lower royalty rate because it means a higher lease bonus for them.  If you have an NPRI, it’s common that the royalty rate you get it is low because the person holding executive rights took a lower lease in exchange for more money.  They would not care about a higher lease royalty rate because they do not receive any of the income.

Overriding Royalty Interest (ORRI):  An ORRI is created, or carved out, from an existing lease.  You do not own the mineral rights if you have an ORRI.  In addition, when the underlying lease agreement that created the ORRI expires, so does your ownership.  In good areas, this may not matter as it will be held by production, but this is a risk as ORRI ownership can technically expire or evaporate.   An example would be a company leases mineral rights from you at 18.75%.  They turn around and sell this lease to an operator, but with a 20% royalty.  This means they “carved out” a 1.25% ORRI for themselves.  The operator pays 20%, but the company gets 1.25% as an ORRI as long as that lease produces.

Working Interest (WI):  A working interest is less common.  A working interest is when a mineral owner elects to participate alongside an operator.  This would be similar to becoming a silent investor or partner in the drilling.  The operator makes all decisions and operates, but as a “partner” or working interest owner, you are responsible for your share of the costs.  This means you are on the hook for all expenses regardless of whether there is profit or not.  A working interest can turn into a liability.  Unless you work in the oil and gas industry, understand decline curves and reserves, and have a large amount of cash to adsorb losses, you should immediately sell any working interest you own or may have inherited.  Due to the fact that working interests turn into a liability, mineral buyers are typically cautious about purchasing them.  If your working interest is not cash flow positive, it is highly unlikely you will find a buyer for it.

Do you want to know the average oil and gas royalties per acre?  A lot of mineral owners are trying to determine the average oil and gas royalties per acre, but can’t seem to find an answer.

The Answer:  There is no such thing as the average oil and gas royalties per acre.

Why?  There are many reasons, but it comes down to the following factors:

• Oil & Gas Prices:   The price of oil and gas is fluctuating all the time.  The average oil and gas royalty payments can’t be determined because the underlying value of oil and gas prices is changing constantly.
• Number of Wells:  If you own 20 acres and they drill 6 new wells, the value per acre for your mineral rights will be very different than someone who has 20 acres but only a single well was drilled.  The average oil and gas royalty payments for someone with 6 wells will obviously be way higher than someone with only a single well.
• Location:  The volume of oil and gas produced is going to change dramatically between the Permian basis (West Texas) and someone in another location within Texas.  The average oil and gas royalties generated per acre would be very different between locations.

There are a lot of other reasons why it is impossible to determine the average oil and gas royalties per acre.  Above we highlight just 3 factors that would cause extreme differences in value between properties.  Trying to figure out the average oil and gas royalty payments is effectively impossible.

The Real Question & Answer

The Question:  The real question typically being asked here is, “I have an offer in hand for $X, how can I determine if I am better off accepting this offer or holding and collecting the royalty income.”  The reason mineral owners are trying to determine the average oil and gas royalty payments is to determine if the offer they have in hand is fair.

The Answer: The answer is that an offer you receive will always be for an amount lower than the amount you would receive in royalty income over time.  A mineral buyer is not going to pay you a higher price than what they expect the future production to be.  However, there is nearly always a higher price available if you get competitive bids.

Does this mean you should never sell the mineral rights?  No.

If you ask 10 different mineral buyers what they expect the average oil and gas royalty payments to be over the next 20 years, you will get 10 different answers.  No one has an accurate answer because of the factors described above along with many others.

As a mineral owner, your goal is to find the mineral buyer will to pay the highest price for your oil and gas royalties.  When you take taxes and diversification into account, selling oil and gas royalties makes sense for most mineral owners.

There are many reasons selling royalties is the right move.  You may have heard the common advice to “never sell mineral rights” but this advice is flawed.  It does not take into account taxes or diversifying your overall financial situation.

Taxes and Inherited Basis

Mineral rights taxes are a significant reason to consider selling oil and gas royalties. Royalty income is subject to ordinary income tax, which can be high. Selling your oil and gas royalties can reduce your taxable income and potentially convert future ordinary income into capital gains, which are often taxed at a lower rate.

For those who inherit royalties, the concept of “stepped-up basis” is important. This means the value of inherited royalties is adjusted to the market value at the time of the decedent’s death. For example, if you inherit royalties worth $100,000 that were originally purchased for $20,000, your basis is stepped up to $100,000. Selling soon after inheriting them allows you to minimize tax liability by only paying capital gains tax on any appreciation beyond $100,000.  This often means mineral owners have an effective tax rate below 10% when they sell, and sometimes as low as 5%.

Mineral owners will collect royalty income for years and get taxed at 30%+, effectively giving away money, not realizing that by selling oil and gas royalties they could avoid a huge tax burden.  This is one of the most important reasons to sell oil and gas royalty income.

Diversification

Diversification is crucial in managing investment risk. Oil and gas royalties are subject to market fluctuations, geopolitical factors, and changes in the energy sector. Selling some or all of your royalties allows you to diversify your portfolio by reallocating assets into stocks, bonds, real estate, or other investment vehicles, creating a more balanced and stable portfolio.

Other Reasons to Sell

In addition to taxes and diversification, there are other reasons to sell oil and gas royalties:

1. Immediate Cash Needs: You may need liquidity for personal expenses or unexpected emergencies.
2. Estate Planning: Selling royalties can simplify estate planning and ensure beneficiaries receive cash rather than a potentially volatile asset.
3. Market Conditions: Favorable market conditions might allow you to sell your royalties at a premium.
4. Declining Production: If wells show signs of declining production, selling before revenue drops can maximize returns.

Ultimately, the decision to sell should be based on your financial goals, tax situation, and market conditions. Consulting with financial advisors and tax professionals can help you make an informed choice.

Calculating the value of oil and gas royalties is possible by using a rule of thumb.  When you own oil and gas royalties, you receive payments based on the production and sale of the oil and gas being extracted.  Estimating the value of these royalties can help you make informed decisions about what the potential sales price could be.

A good rule of thumb to calculate the value of oil and gas royalties is to take the average of your royalty income from the three most recent payments. This average gives you a baseline of your current income from the royalties. Once you have this figure, multiply it by a range of 3 to 6 years. This range provides an estimate of the approximate value of your oil and gas royalties.

For example, if your average royalty payment is $1,000 per month, you would calculate the value by multiplying $1,000 by 36 months (3 years) and 72 months (6 years), resulting in a potential royalty value range of $36,000 to $72,000. This method gives you a ballpark estimate of what your royalties might be worth.

While this calculation provides a useful estimate, the only way to know the true value of your oil and gas royalties is to seek competitive bids from multiple buyers by using a mineral rights broker. Market conditions, production rates, and commodity prices can all impact the value of your royalties significantly. By getting bids from mineral buyers, you can better understand what your royalties are worth in the current market and make a well-informed decision about selling or holding onto them.

In summary, to calculate the value of royalties, use recent royalty payments to estimate future income, but always rely on competitive bids for an accurate valuation.

You can use our oil royalty calculator below.  This calculator will show you the estimated value of your royalties.

Investing in oil and gas royalties can be a profitable way to diversify your portfolio and generate passive income, but it requires careful consideration and knowledge of the industry. When looking into oil royalties for sale, there are several key aspects to keep in mind to make informed decisions and avoid potential pitfalls.

First, it’s important to understand decline curves, which show how the production of oil and gas wells decreases over time. These curves help project future cash flow and estimate the long-term value of oil and gas royalties, allowing you to assess the potential return on investment.

Additionally, hiring a landman to run a title search is essential when considering an investment in oil and gas royalties. A landman specializes in researching property titles and verifying ownership of mineral rights, ensuring that the title is clear and you have a rightful claim to the royalties. This step helps prevent legal issues and ensures you receive the income from the oil and gas production on the property.

While investing in oil and gas royalties offers the potential for significant returns, it’s important to exercise caution. The oil and gas market is complex and can be influenced by fluctuations in commodity prices. Investors should have a solid understanding of the oil and gas market and consider consulting with industry experts or financial advisors.

Figuring out how to buy oil and gas royalties can be lucrative, but it requires an understanding of decline curves, proper title verification through a landman, and a cautious approach to market dynamics.

If you have questions about oil and gas royalties, reach out to Mineral Rights Alliance for a free consultation.

Our experienced team is ready to provide valuable insights and guidance tailored to your needs. Whether you’re curious about the value of your royalties, how to sell oil and gas royalties, or want to know more about what is going on with your acreage, our team is standing by ready to assist.