Maximizing Field Value Using a Royalty Rate That Tracks Oil Price

Abstract

David Mercier Abstract High royalty rates, along with low oil price, can make an operation uneconomic creating a lose-lose situation for the royalty owner and producer. For the operator, a high royalty rate has the same effect as higher operating costs. Both the royalty owner and operator have a tremendous incentive to be innovative when negotiating profit distribution splits. Unfortunately neither the royalty owner nor the operator can consistently predict changes in oil price, all we can do is seek the flexibility to survive oil price fluctuations. However, a royalty schedule that tracks oil price, when properly engineered, decreases the likelihood of negative cash flow during a low oil price swing. Introduction Traditionally, many royalty owners have tried to get the highest fixed royalty rate possible thinking a higher rate naturally translates into a higher royalty payment. This approach has resulted in royalties that need to be renegotiated when the oil price goes lower to prevent premature abandonment. Historical crude oil price forecast have been extremely unreliable - Ref 1. Negotiating the highest possible royalty rate the producer will accept should never be the royalty owner's strategy. In any profit sharing agreement the (royalty owner / operator) economic interdependence is large; i.e., a win-lose relationship ultimately ends up lose-lose. Royalty owners' focus should be on maximizing royalty revenue. High royalty rates do not necessarily equate to maximized royalty revenue. Net Profits sharing contracts are progressive systems employed in many places around the world (Ref 2), however, typically, net profit contracts require the royalty (mineral) owner to be constantly evaluating the details of the operation. This continuous auditing, of the operation, is costly for both the mineral owner and operator. One of the worst experiences a working interest owner can have is to see the operator's president driving an expensive car while wondering if the car was paid for out of his net profit's share; that is, because of an accounting error. It has been my experience, when net profits decrease or go negative the (working interest owner / field operator) relationship tends to deteriorate. Not many operators want to have the mineral owner constantly going over their accounting books. Also, net profit contracts, as compared with royalty contracts, expose the mineral owner to increased financial liability - the risk of negative cash flow. Increased financial risk is not bad when it comes with a proportionate amount of increased benefit. Since overseeing a royalty rate schedule requires less administrative overhead than a net profits split, switching from a net profits split to a royalty schedule can potentially increase field value. This paper will present different techniques used to obtain maximum field value while reducing risk. A price sensitive sliding scale lessens risk by reducing operator cash flow variation while lowering the likelihood of field abandonment. Experienced oil investors know that they cannot control oil price swings; however, with this royalty rate that slides with oil price they can control the risk that, in turn, drives the returns. It is common in the United States for owners of oil properties to charge those who recover and sell these resources a royalty expressed as a fraction of the property's gross production. Royalty agreements most commonly observed specify a constant royalty. Two criteria that need to be satisfied when determining a royalty are:equity (Is the royalty rate fair?)Efficiency (Does the royalty rate interfere unduly with the economics of the oil field?). With a fixed royalty rate, the royalty owners total revenue equals the product of royalty rate, oil price, and the total production. Higher royalty rates can lower production, often causing properties to be abandon prematurely. To the producer, increased royalty rates are similar to increased operating costs. P. 159^