Royalty that slides with oil price can add value to producing fields

David Mercier
California State Lands Commission
Long Beach

Sliding Scale Royalty Rate Sensitivity [142,813 bytes]

Business calls for cooperation when it comes to creating an economic pie and competition when it comes to dividing it up. It is not Leadership Secrets of Attila the Hun or St. Francis of Assisi.¹

In negotiating a profit sharing agreement, the goal is to compete with but not destroy the opposition. If a high royalty rate destroys the pie (or field value), nothing will be left for either producer or royalty owner to capture. This results in a lose-lose situation.

By the same token, it doesn't make sense for the royalty owner to reduce the royalty rate so low, thereby increasing the pie or field value, only to get an extremely small nonequitable slice of a larger pie.

The goal of this article is to differentiate profit sharing negotiations from zero-sum, win-lose games such as football, poker, or chess. The best results are achieved when both parties strive to creatively increase the size of the pie as large as possible while negotiating how it should be divided.

This process of agreeing on a particular royalty scheme that both parties can live with is a difficult but worthy endeavor. It involves both cooperation (brainstorming ideas to increase the size of the pie) and competition (agreeing on how it should be divided).

Royalty calculation

With a fixed royalty rate, the royalty owner's total revenue equals the product of royalty rate, oil price, and the total production. Below is a royalty revenue calculation example:

Assumptions:
Oil price, $14/bbl
Oil production, 3,000 bbl/month
Royalty rate, 16.7%
Royalty revenue = (oil price * oil production * Royalty rate)
= (14.00 * 3,000 * 0.167)
= $7,014/month

Fixed royalty

It is common in the U.S. for owners of oil properties to charge the producer a royalty rate expressed as a fraction of the property's gross production. The most commonly used royalty rate is fixed.

Traditionally, many royalty owners have tried to get the highest fixed royalty rate possible, thinking that a higher rate translates into higher royalty payments. This approach has resulted in royalties that need to be renegotiated when the oil price goes lower to prevent premature abandonment.

In these types of profit-sharing agreements the (royalty owner/operator) economic interdependence is large; i.e., a win-lose relationship ultimately ends up lose-lose. Contrary to popular and maybe intuitive thought, higher royalty rates do not necessarily equate to higher royalty revenue.

High royalty rates, like higher operating costs, along with low oil price can make an operation uneconomic, creating a lose-lose situation for the royalty owner and producer. A higher royalty rate during times of low oil price reduces economically viable field investment. Reduced field investment speeds up the oil production decline rate and may cause premature abandonment.

Fig. 1 [49,606 bytes] was generated assuming an oil price of $14/bbl and an operating cost of $10/bbl. The royalty rate range is 0-25%. This graph shows the effect of a fixed, one-sixth royalty rate at various oil prices. The fixed one-sixth royalty rate intersects the break-even royalty curve at $12/bbl.

It is important to note that when the oil price is less than $12/bbl, with a 16.7% royalty rate, the operation is uneconomic and subject to premature abandonment. Having a royalty rate that significantly interferes with the operation at low oil prices is what the sliding scale royalty was created to avoid. However, there is a point (less than $10/bbl) where even a 0% royalty rate cannot keep the cash flow of the operation positive.

Benefits of flexible royalty

The optimal royalty rate should track oil price; i.e., the royalty rate should be low when oil price is low and vice versa.

A royalty rate that slides with oil price reduces cash flow variation (or risk) and can extend the economic field life. A flexible royalty rate can mitigate the negative impact any tax has on field life by falling as the oil price falls to a point where the field is breaking even.

The ideal royalty, at any oil price, should not discourage the operator from field investment and slow the field's economic growth. By avoiding premature abandonment and reducing the negative effect that royalty rate has on field development, a royalty that tracks oil price increases the field's economic reserves. Both sides can potentially share in the overall gain; enhancing the position of each compared with what would be possible under a fixed royalty policy.

Experienced oil investors know that they cannot control oil price swings; however, with a royalty rate that slides with oil price they can better control oil price volatility risk. A royalty schedule that tracks oil price also decreases the likelihood of negative cash flow during times of low oil price.

Under general conditions, the best royalty rate, for the royalty owner, is one that maximizes royalty revenue by providing an environment in which the producer has an incentive to invest in field development maintaining and/or increasing field oil and gas production.

When oil prices fall to the point where the field is breaking even, higher royalty rates, just like higher operating costs, reduce oil production. Royalty owner revenue drops when an increase in royalty rate does not offset decreased oil production; that is, a higher royalty rate can actually reduce a royalty owner's royalty revenue.

Developing a sliding royalty

A useful tool for developing a royalty rate that slides with oil price is a break-even royalty rate versus oil price graph (Fig. 2 [49,606 bytes]). It is a good starting point for the sliding scale royalty rate design.

This plot shows the break-even royalty rate at a particular oil price that renders the operation profitless to the operator. The break-even royalty rate, for a given oil price, should not be exceeded, except possibly at low oil prices where the operation is unprofitable even at zero royalty.

In the following example, the oil price and operating cost per barrel (an historical or benchmark cost per barrel can be used) are $14/bbl and $10/bbl, respectively. With these assumptions, the break-even royalty rate is 28.57%.

Note that using a benchmark operating cost per barrel does not reward the operator by providing a lower royalty rate for having a higher-than-normal operating cost. The shaded part of Fig. 1 shows the economic part of the graph.

Break-even royalty calculation

Assumptions: Oil price, $14/bbl Operating cost, $10/bbl Break-even royalty rate = ((1 - (operating cost) / (oil price))*100 = 28.57%

Sliding scale design ideas

If we assume that the royalty owner take is 40% of the pretax profits, then the sliding scale royalty rate is calculated using the equation below.

Royalty rate
= ((1 - (operating cost) / (oil price))*100 * 0.40
= 11.43%
Fig. 2 shows the producer's break-even royalty rate along with the royalty rate when the owner's take is 40% of the pretax profits using a maximum royalty rate of 25%. Different curves can be generated with different royalty owner take percentages and operating costs.

The table on p. 93 is a sliding scale royalty rate sensitivity table. Given an oil price (on the left column) and an operating cost (top horizontal row), the applicable royalty rate can be located.

In this table the royalty rate range is 0-25%. Also, a 40% pretax royalty owner take is assumed. Note that if operating cost is $8/bbl and the oil price is $14/bbl, then the applicable royalty rate is 17.14%.

Win-win negotiating issues

One scheme for all leases When negotiating the modification of an existing royalty, the operator should consider putting all offset leases under one royalty scheme. Usually offset leases have different royalty rates that require separate measuring devices and as a result, higher operating cost.

Economic savings can usually be realized in consolidating all leases under one royalty scheme; i.e., where processing and measurement can be combined. Facilities consolidation along with reduced administrative overhead (less accounting required) can increase an operation's profit margin and extend the field's economic life.

Investment vs. lower royalty

One of the best ways for the royalty owner to increase the size of the pie is to make the sliding scale royalty contingent on an additional level of investment in drilling or well work.

Operator commitment to lease well work or drilling is a good negotiating point for both the royalty owner and operator. As such, the royalty owner will probably be willing to accept a reduced royalty rate scheme if the operator will guarantee an additional level of financial commitment (above what is currently planned).

It is important to note that a royalty owner makes additional royalty revenue, even at a lower royalty rate, when the operator's additional oil production exceeds the reduced royalty rate.

How it should work

Traditionally, many royalty owners have tried to get the highest fixed royalty rate possible, thinking that 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.
Under general conditions, the best royalty rate, for the royalty owner, is one that maximizes revenue by providing an environment in which the producer has an incentive to invest in field development and/or increasing field oil and gas production.
Guaranteed investment and consolidation of all leases under one royalty scheme, if engineered properly, can result in a win-win for the royalty owner and operator.
The sliding scale royalty rate reduces the sensitivity (or volatility) of the operator's cash flow with changes in oil price.
In order to keep the royalty rate that slides with oil price applicable through time, the oil price input to the sliding scale equation should be inflation corrected. The producing price index for finished goods, which is not as volatile as most available indexes, seems to work well.

Acknowledgments

Thanks to the State Lands Commission management for approving submission of this article for publication and its ongoing support for new and creative solutions to current problems and opportunities. The views expressed in this article are the author's and do not necessarily reflect commission or staff views.

Reference

Brandenburger, Adam M., Nalebuff, Barry J., and Brandenburger, Ada, Co-opetition, Copyright 1996, American Library Association, Doubleday, ISGN 0385479506.