What is Overriding Royalty Interest and How to Value it?

If you have decided to invest in a mineral lease, your timing could not be better. The current slowdown in oil and gas drilling activity during the COVID-19 pandemic provides investors an opportunity to invest in leases at a discount to their future market value. The peak of the shale boom could be ahead of us.

But which type of mineral interest should you invest in — ORRI, RI, WI? The acronym soup can be confusing.

This article explains the overriding royalty interest (ORRI), opportunities to receive a portion of ORRI revenues free of production costs, and how to value, research ownership, and find the best opportunities to buy and sell ORRI interests.

What is an overriding royalty interest in oil and gas?

An overriding royalty interest (ORRI) is an undivided interest in a mineral lease giving the holder the right to a proportional share (receive revenue) of the sale of oil and gas produced. The ORRI is carved out of the working interest or lease.

Now, let’s dig a bit deeper.

When landowners separate subsurface rights from the surface rights of a parcel of land, two mineral estates are created:

1. Working Interest (WI)
2. Royalty Interest (RI)

Oil and gas companies lease subsurface rights from mineral owners through a working interest lease to explore, drill and produce the mineral reserves.

In exchange, a landowner receives a royalty interest in the mineral estate.

Usually, oil and gas companies grant ORRIs to fund operations to investors; and geologists, landmen, and lawyers as compensation for their services.

Unlike a working or royalty interest, an ORRI cannot be fractionalized.

It is an undivided, non-possessory right to a share of the production, excluding the mineral lease’s production costs.

What is the difference between an overriding royalty interest and royalty interest?

Holders of overriding royalty interest, also called the land owner’s interest, have executory rights over the mineral rights.

They may divide the mineral rights and lease them to third parties. They receive a signing bonus, lease payments, and royalty payments on production based on their proportional ownership in the mineral rights in exchange for leasing ownership rights.

The royalty mineral owner retains ownership of the interest after production stops.

Holders of overriding royalty interests have no ownership rights to the minerals under the ground but a non-possessory undivided interest. They have an interest in the working oil or gas lease of the E&P company. This interest gives them the right to royalty payments on the proceeds of selling the oil and gas produced. When the lease expires, the interest reverts to the mineral estate.

What factors determine overriding royalty interest value?

Several factors determine the value of an overriding royalty interest in a working lease. They include:

1. Location – A mineral interest in high producing shale basins will be more valuable.
2. Producing Wells – Producing wells are valued higher than non-producing wells. The life of the producing well should also be considered.
3. Production Levels and Reserves – Wells with high producible reserves generate higher revenues from oil and gas sale. As technology improves, more oil gas companies are increasing their estimates of producible reserves.
4. Oil and Gas Prices – If oil and gas prices decline, revenues will decline, and operations may no longer be economical.

The most important factors in the calculation of overriding royalty interest value are:

1. Lease Terms – Royalty payments in hot shale plays have reached 25 percent, double the average.
2. Working Interest (WI) Value – Since the overriding royalty interest (ORRI) is a portion of the working interest, the WI value is the major determinant of the value of overriding mineral rights. The WI owner incurs all of the costs associated with exploration and development activity. All of the profits (revenues – costs) go to the owner after revenues are paid on any share in the mineral rights leased to third parties.
3. Royalty Interest (RI) Value – The RI holder has the first right to revenues. The ORRI lease holder’s proportional share is based on the WI revenues after the royalty mineral owner receives their share. The RI holder’s share of the working interest is typically 12.5–25 percent of the mineral reserves’ revenue under the WI.

Because overriding royalty interests entitle the holder to a share in the production, not the mineral lease, when the wells are no longer economical to produce, the ORRI lease expires.

How Do Overriding Royalty Interest Payments Work?

The value of an overriding royalty interest is simple to calculate since it is a percent of the working interest lease. The ORRI value is based on production on the acreage leased by the working interest.

Let’s say hotshot geologist is confident a 100,000-acre parcel in the Texas Permian Basin will produce oil.

Big Oil Co. gives him a 5 percent ORRI in exchange for his geology reports. Hotshot geologist’s production share would represent 5 percent of the total production on the net acreage, or revenues on 5,000 net acres.

The revenues from the WI production depend on the price of oil and gas produced from the wells on the subject acreage and the number of reserves. If oil and gas prices decline, but oil and gas companies report higher reserves, the higher reserves could offset any decline in fossil fuel prices.

The working interest holder pays for all costs of production. Although depending on the state in which the wells are drilled, the ORRI royalty payments may be net the post-production costs.

The oil and gas company starts producing the oil and generating revenues of $1 million a month. The ORRI holder, however, will not receive 5 percent of $1 million in revenues. First, Big Oil Co. must pay the royalty interest owner his stake. Let’s say the original mineral estate owner, or landowner, retained a royalty interest of 25 percent (20 percent plus 5 percent in signing bonuses) in the mineral estate.

How to calculate the overriding royalty interest?

The revenue remaining after the RI is paid out of the WI is called the net revenue interest (NRI). If you are the lessor of an ORRI, you will receive your proportional share of the working interest lease based on the net revenue interest (NRI).

NRI = Working Interest — Royalty Interests

The royalty owner receives monthly royalty payments for 25 percent of the monthly proceeds from the sale of $1 million. If the RI is 25 percent, the NRI calculation is:

• 100 — 25 = 75 percent (NRI)
• $1,000,000 — $250,000 = $750,000 (monthly NRI)

A hotshot geologist would then receive monthly royalty checks on 5 percent of the NRI.

• ORRI = NRI * 5 percent
• $750,000 * 0.005 = $3,750

Example of an Overriding Royalty Interest

Grandpa Jones owns 25 percent of the royalty interests on the mineral estate on his tract of land in Oklahoma. Owing to new fracking technology, the oil and gas producer increases production. As the mineral owner, Grandpa Jones’ monthly royalty payments jump ten-fold. He wants to share the mineral wealth with his two grandchildren, who will eventually need money for college and a first home purchase.

Grandpa Jones owns a royalty interest and not a non-participating royalty interest (NPRI)  or ORRI. He has executory powers to divide his RI into more leases. He bequeaths the full RI rights to his son, who also benefits from signing bonuses and rent payments. He then carves out two overriding mineral interests of 6.25 percent for his two grandchildren. In this way, his son maintains executory powers over the royalty rights, while the young grandsons only benefit from production revenues.

ORRI cost deductions

Although the overriding royalty interest holder is not responsible for oil or gas production costs, an ORRI or RI holder may be responsible for post-production costs.

Post-production costs include:

• Processing
• Storage
• Transportation
• Marketing expenses

The issue of whether or not the holders of overriding royalty interests should pay their share of post-production costs has kept courts across the land busy for several decades. The treatment varies from state to state and continues to be contested by the oil and gas industry and mineral owners. In Texas, a 1996 ruling, upheld by a 2015 Texas Supreme Court decision, apportioning a share of post-production costs to the ORRI lessor has prevailed.

We advise having a mineral expert in the relevant states carefully review the contract terms. Inexperienced mineral buyers often turn to online calculators to determine their expected future royalty streams, without checking if the lease includes post-production costs or if a clause has been added excluding these costs.

Overriding royalty interest taxation

Owing to favorable tax treatments, royalty leases, and trusts can provide tax advantages over other investment securities. Depending on the well’s location, royalty income on an overriding royalty lease could be taxed on three levels if the county also imposes a tax.

1. Federal income tax – The overriding royalty interest holder pays taxes on revenues received as royalty payments. ORRI income is treated as investment income and therefore taxed as ordinary income. Oil and gas income investment is taxed at the lower end of the capital gains tax rate. A depletion allowance of up to 15 percent, a depreciation deduction, is another oil and gas production tax advantage.
2. State severance taxes – Both resource producers and royalty interest owners are subject to severance taxes. A severance tax is a tax on the removal of natural resources for sale in another state.
3. County ad valorem taxes – Ad valorem oil and gas taxes are a form of sales tax charged on production (oilfield glossary)

Since overriding royalty interest owners do not share in the production costs, they are not deductible from taxes. In the case post-production costs such as marketing expenses are deducted from royalty payments, these expenses are deductible.

How to search for inherited ORRI

If you want to research the land title of a tract of land, detailed records are kept of all land transactions in the local land titles office. If you want to find out if you inherited your father’s overriding royalty interests, the search process is more complicated.

1. Land titles search – In the case of inheritances, lawyers often file mineral deeds in the land titles office of the local county clerk’s office as part of the estate probate process. However, no law requires the registration of mineral deeds.
2. Mineral Registries – In many states, public or private mineral deed registries are maintained. This is often the first place an oil and gas company will look when seeking to lease your mineral rights. They will send a letter to the last known address. It is well worth your while to do a mineral deed search and ensure your records and current address are up-to-date.

Should you buy or sell ORRI?

Overriding royalty interests are an important financing tool for oil and gas companies involved in the exploration and development of oil gas and mineral interests. For investors, they provide an opportunity to participate in mineral production without incurring the costs.

Why might you want to invest in ORRI?

If you are seeking to buy overriding royalty interests, you have not missed the shale boom. Only about 20 percent of recoverable unconventional reserves with production potential have been tapped. It’s a good time to buy if you are:

• Looking to buy low at current undervalued prices.
• Adjacent to properties in which oil and gas companies are actively taking an interest.
• Seeking passive income through royalty payments.
• Searching for more favorable leasing terms, potentially double the 12.5 percent average in productive shale basins.
• Wanting to meet personal expenses but do not want to miss out on future income potential in mineral development.

Why sell your ORRI?

Since the ownership of overriding royalty interests is broad and extends beyond the typical investor base, owners have diverse reasons to sell.

Remember, an overriding royalty interest is an undivided interest, so the owner cannot divide the mineral rights and sell them.

It’s a good time to sell if you are:

• Seeking to sell inherited ORRI or other mineral interests while exploration and production activity is high. Your old dried-up well may now be sitting on a hot shale play.
• Holding a lease that will soon expire and want to sell while the interest still holds value.
• A professional granted royalty interests in exchange for work and want to sell while demand is high.
• Wanting to use the proceeds from the sale of oil and gas to meet financial goals such as a home mortgage or college education for children.
• Looking to sell or swap them to consolidate royalty interests in a particular basin or on a tract of land.

Conclusion

Now that you understand the opportunity and how to value an overriding royalty interest, how do you determine the opportune time to buy or sell? Which basins and parcels will provide the most upside?

You may decide to sell the mineral rights on your father’s land, only to later find out that an oil company is buying up rights at a premium on adjacent lands. The answer depends on the past, current, and future value of mineral rights and those on surrounding tracts, as well as dozens of other factors.

A broker or other mineral rights contract specialist can help you determine the true value of mineral rights and the options and best time to monetize them.

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