Thursday, November 19, 2009

Calculating Royalties

I’ve gotten several questions about how production companies calculate royalties. I have been reluctant to answer this question before because I hate to encourage chicken counting when the eggs are new.  I am not an expert, but I can tell you what I’ve figured out from my own experience.

I have seen statements from six or seven different producers over the years, and each one is different in terms of layout and the level of detail of information disclosed. I have to say that for the average person these statements are poorly organized and hard to decipher. Keep in mind that royalty payments depend on whether or not the owner has a lease and if the section (in Louisiana) has been unitized. I’ll explain what I know using a unitized Louisiana gas example, but remember each situation might be different.

First, you don’t see any royalties from production for two to three months, usually three. The statement usually shows a gross calculation (the whole well) and the net calculation (you as royalty owner). Each monthly statement will cover all of the wells for that operator. Looking at an individual well, you will see the total gross volume of gas produced in the month. Then you will see a commodity price. This price is a weighted average price based on how much gas was produced each day and the wellhead price for that day. The producers usually use a wellhead price to calculate royalties. (I follow the Henry Hub spot price as a proxy for wellhead price, but they are not exactly the same. Wellhead prices depend on well location and a host of other factors, so they are hard to generalize. You can also look at the NYMEX near month contract, which is the most commonly used natgas price. Most importantly, don't fall in love with the prices you've seen over the month.  My experience is that wellhead prices are a little lower than what you are used to seeing.)  What is for sure is that the producer’s hedged prices that they trumpet for investors are what THEY sell the gas for, not the price on which they base royalties.  Multiplying gross production by price, you get gross revenue for that well.

From that amount is deducted state severance tax, which is not a whole lot in LA, and some operating expenses. Usually the operating expenses column is a black box, but sometimes operators break out the expenses. They can include the costs of gathering, processing, treating and transporting the gas. There is no hard and fast rule, but these costs usually amount to 8-15% of gross value. It's a big variable that applies differently to different wells and leases, as some leases do not allow for transportation costs. Even if you don't pay costs, you still pay severance taxes.  Those costs are subtracted from the gross revenue to get the net revenue.

Multiply that net revenue amount by the owner interest – the percentage you own – and you get the net royalty payable.  Before you get too excited about your 20-25% royalty rate, remember that in Louisiana wells are paid out by 640 acre sections. If you have a 25% royalty rate and own 160 acres of the section in question (25%), your applicable interest is 25% of 25%, or 6.25%. If you own that interest 50/50 with your sibling, your net interest is 3.125%, or 0.03125.

Here is a sample calculation using dummy numbers:
250,000 Mcf produced in a month multiplied by an average price of $3.15/Mcf = $787,500 gross revenue. Subtract from that severance taxes and delivery expenses of $78,750, 10% in this example, to get a net revenue amount of $708,750. If your ownership percentage is 3.125%, you are looking at a net royalty amount of $22,148 from that well for the month.

Another thing to keep in mind is that operators often go back and make adjustments on the statements for past months to correct volumes, commodity prices, expenses, etc. using more accurate figures. As a result, after a few months your statement will have lots of strange line items with big positive and negative numbers flying around that might yield an adjustment of $0.43 or something like that. Or it could be a substantial adjustment. It gets very confusing. Usually I find that the adjustments from previous months tend to cut against me, but not always.

Don’t forget taxes. First, let me say, I DO NOT GIVE TAX ADVICE, so please, please, please consult a tax advisor. In January of the following year you will get a 1099 form from the production company stating your net revenue. It might not match your checks because of the timing of the revenue, but it should be close. The IRS gets a copy of this too. Keep two things in mind:

  1. You are entitled to deduct a portion of that revenue as “depletion” expense from your taxes, often 15% is used. That reduces the taxable revenue on which you pay income taxes. It’s like depreciation expenses for businesses.
  2. If you don’t do quarterly estimated tax payments you might want to start. If your taxable income spikes and you haven’t been paying quarterly estimates, you might be penalized (with interest) come April 15.
The only tax advice I will offer other than seek professional advice is this, don’t spend it all in one place. Remember that you will have to pay taxes on it, either quarterly or on April 15. Don’t let it surprise you and bite you in the rear.


Anonymous said...

Robert,you may suggest the use of the NYMEX closing price for a month as a proxy since that information is publicly available. The daily and monthly Henry Hub cash price is not typically available.

Les B

Robert Hutchinson said...

You are right - NYMEX futures definitely easier to follow and better documented. I am a little OCD and record the HH spot and NYMEX prices every day, and I watch how the spread between the two moves around.

I have always found that the commodity prices on the statements end up lower than I expect, so I hate to set false expectations in people's minds. I don't encourage chicken counting before the eggs crack.

By the way, I enjoy reading your posts on GHS.