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Royalties: Gross versus Net

Paul R. Yagelski, Esq.

The term royalty has been defined in the oil and gas industry as “[T]he landowner’s share of production, free of expenses of production.”  Howard R. Williams & Charles J. Meyers, Manual of Oil and Gas Terms § R (Patrick H. Martin & Bruce M. Kramer eds., 2009).  “Expenses of production” relate to the costs of drilling the well and getting the product to the surface, but do not encompass the costs of getting the product from the wellhead to the point of sale, as those costs are termed “post-production costs.”  Although the royalty is not subject to the costs of production, usually it is subject to costs incurred after production; e.g., costs of treatment of the product to render it marketable, costs of transportation to market. Id.; see also George A. Bibikos and Jeffrey C. King, A Primer in Oil and Gas Law in the Marcellus Shale States, 4 Tex. J. OIL, GAS & ENERGY L. 155, 168-69 (2008-2009) (explaining post-production costs and noting that a majority of jurisdictions authorize the deduction of post-production costs in the calculation of royalties).

There are two basic types of royalties; i.e., a net royalty and a gross royalty.  In addition, there is also a “negative royalty.”

A net royalty normally means that post-production costs will be deducted from the royalty owner’s royalty prior to distribution.  A gross royalty normally means that post-production costs will not be deducted from the royalty owner’s royalty prior to distribution.  A “negative royalty” is actually an oxymoron as a royalty, whether net or gross, results in a payment to the royalty owner.  In the case of a “negative royalty,” the deductions for post-production costs are so great that the deduction of post-production costs result in no royalty payment but rather an amount that is owed by the royalty owner to the oil and gas company who will offset this amount against the royalty owner’s future royalty payments.

When talking about a net royalty, the royalty is usually calculated by the net-back method.  The goal of this method is to determine the value of the gas when it leaves the ground “at the wellhead” by deducting from the sale price the cost of getting the natural gas from the wellhead to the market.  In other words, post-production costs are deducted from the sale price.

With a gross royalty, calculations can be done on the basis of what is known as the “first marketable product doctrine.”  Under this method, the lessee/oil and gas company bears all the costs necessary to get the natural gas to the point of sale.  Generally, the lessee is to bear all the costs necessary to market the gas; e.g., post-production costs.

Whether you have negotiated a net royalty or a gross royalty, the language of the royalty clause is very important.  The language can make a difference in the amount of the royalty that the landowner receives.

For example, for net royalties, although there will be deductions, the deductions may be limited in negotiation.  If so, the limitation needs to be stated in the language of the lease.  In addition, the gas upon which the net royalty will be calculated can also make a difference in the amount of the royalty.  In other words, how is oil and gas defined?  What does it include?  Does it include coalbed methane gas, which is not methane gas?  What should also be looked at is whether the royalty clause covers gas produced and saved or does it cover gas produced and sold or is there some other language used?  There is a difference, which can reduce the royalty that is received.  There are other variations.

For gross royalties, it is particularly important that the language of the royalty clause be checked to ensure that the language does not permit post-production deductions.  The landowner may have negotiated a gross royalty, but the language may not indicate that the royalty is in fact a gross royalty.  The language may result in certain deductions, which the landowner never expected as a gross royalty was negotiated.

As to “negative royalties,” if the royalty owner is concerned that deductions will result in a “negative royalty,” language can be inserted into the oil and gas lease to prevent this.

Royalty provisions are very important. The landowner needs to have the oil and gas lease reviewed by an oil and gas lawyer.  We can help you.