Working Interest vs. Royalty Ownership

Introduction

We will compare oil and gas working interest and royalty interest side-by-side. Aside from the benefits of owning alternative investments, it is good to understand the value of both oil and gas working interest and mineral ownership.

First, let’s briefly look at the three types of direct ownership in oil and gas.

Three Types of Oil and Gas Ownership

There are three types of ownership in oil and gas exploration and production. An investor can choose when investing in the oil and gas industry to participate as a working interest, or mineral interest owner. Working interest owners have a lease agreement with the mineral owner that grants rights to explore, drill and produce oil and gas from the specified property.

A mineral ownership, or royalty ownership, is recorded and deeded as real property, outlining ownership of all minerals, like oil and gas, below surface. A mineral owner leases the mineral rights to an exploration and production company that is seeking to exploit and produce those minerals such as oil and gas. In exchange the mineral owner receive an up-front payment (lease payment) as well as retains a royalty interest of all future revenue.

The third ownership is overriding royalty interest, which has much of the same benefits as the mineral owner. Nevertheless, an overriding royalty interest owner does not own the mineral rights. Matter fact, an override can only claim the rights to a set ownership interest, agreed to in a lease agreement. Should the agreement expire, so will the ownership of the overriding royalty.

Duration of Interest

Working Interest

Limited to terms set forth in the lease agreement between mineral owner and working interest owner. Typically terminates due to inactivity before lease term expiration, or after a well is no longer economically producing.

Royalty Interest

Minerals can be owned in perpetuity, like any form of real estate. Nevertheless, States such as Louisiana use the Napoleonic Law System that enforce the mineral rights to revert back to the original land owner.

Exploration & Production Costs

Working Interest

Working interest owners are responsible for all exploration costs such as labor, engineering, overhead, rig costs, transportation, casing, and other tangibles, as well as plugging and abandonment.

Royalty Interest

Minerals can be owned in perpetuity, like any form of real estate. Nevertheless, States such as Louisiana use the Napoleonic Law System that enforce the mineral rights to revert back to the original owner.

Tax Benefits

Working Interest

With the U.S. government backing domestic energy production there are significant advantages to oil investments. Intangible drilling costs, which generally constitute 65%-80% of the total drilling cost, is 100% deductible in the year incurred. Tangible drilling costs are also 100% deductible, but must be depreciated of seven (7) years. Also, any income generated through working interest is considered active income and can be offset against other forms of income (wages, interest, and capital gains).

Royalty Interest

Mineral owners receive royalties from producing oil and gas wells. They do not share any exploration or production liabilities, but also are not eligible to any tax benefits taken by working interest owners. All income is treated as ordinary income, and is taxed at the individuals tax rate.

Assignable Interest

Working Interest

In most cases, a working interest can be assigned (transferred or sold) to another party, but the following conditions often apply:

• Lease Terms: The original oil and gas lease may include provisions that restrict or require consent for assignment. For example, the lease may require the lessor’s approval before assigning any interest.
  
• Joint Operating Agreement (JOA): If the working interest is subject to a JOA, it might include restrictions, consent rights, or preferential rights to purchase (also known as right of first refusal) that other parties must be offered before an assignment is finalized.
  
• Regulatory Requirements: Some jurisdictions require that assignments be filed or approved by a state agency (e.g., state oil & gas commission).

Royalty Interest

Mineral rights are real property and freely assignable or divisible. This means oil and gas mineral ownership is transferable, in whole or in part by the mineral owner. Minerals, like real estate, can also be owned in a Self-Directed IRA, and are also eligible for 1031 exchanges as a like-kind asset.