Last Updated on Working interest refers to an investor’s responsibility for costs related to exploration, drilling, and production of natural resources. A working interest owner participates fully in all profits from the well due to their investment. In contrast, an investor with royalty interests is usually limited to their initial investment, which leads to a lower potential for large profits.
A working interest provides investors with a percentage ownership of the production profits, a right to the drilling activities, and the resources produced. In addition to receiving income from resource production, investors also bear the responsibility for a percentage of the acquisition costs.
In this article, we will talk about different types of working interests, their benefits and disadvantages and how they are calculated and taxed.
What is a Working Interest in Oil and Gas?
With a working interest, oil and gas developers can obtain a lease allowing them to explore, drill and produce oil and gas from a piece of land.
Working interest owners have to contribute a portion of the costs for leasing, drilling, and operating the oil or gas wells. In addition to the royalty payments due on royalty interests, the owner of a working interest receives a corresponding percentage of the revenues from production.
So, if a property has a royalty interest of 20%, the owner of a 100% working interest would be expected to pay 100% of the drilling costs while retaining 80% of the production profits. The remaining 20% is due to the holder of the royalty interest. If there are multiple owners, they share 80% of the profit among themselves according to the size of their investments.
Note that none of the above depends on the productivity of the oil well. One geographic area may be more productive than another, but that will not affect the net revenue division. The calculation is still the same.
In oil and gas production, working interests may be a lease, well, or drilling unit. Purchasing and maintaining one costs thousands or hundreds of thousands of dollars at the outset. A working interest is a substantial upfront investment initially.
Working Interest vs. Mineral Ownership
Working interests and mineral interest ownership are two types of oil and gas rights. Let’s examine the difference between both.
Working interests are a lease agreement that grants oil and gas companies rights to explore, drill, and produce natural resources from a land. Mineral interest ownership is a recorded property document outlining the legal owner of natural resources below surface level.
The mineral owner and the holder of the working interest must adhere to the terms of the lease for it to be effective. An inactive well typically ends the agreement once the well no longer produces oil or gas, or when the lease with the oil and gas companies expires. Like any form of real estate, minerals can be owned forever. Despite this, states such as Louisiana enforce Napoleonic Law that reverts mineral rights to the original landowner. These are just a few of the differences between the two types of ownership rights.
Types of Working Interest
There are 3 main types of working interest:
- Operating working interest – Other working interest owners include the person who runs the operation as an oil or gas investment. The operating working interest owners handle the costs of operations and the payments to holders of royalty interests.
- Non-operating working interest – this type comprises an ownership interest in the well, lease, or other production areas with no responsibility to operate or pay the operation cost of a producing unit.
- Carried working interest – this type comprises a partnership between different parties who own a working interest in a well. Several parties can share their working interests through a joint venture, a partnership in which a group provides the required finance to keep a well functioning. Investors are not required to participate in daily activities. They pay upfront, and when the production starts making profits receive a share of the revenue generated.
How to Calculate Working Interest in Oil and Gas Investments?
To calculate the working interest owned, you have to know the Net Revenue Interest. This interest is the share of production revenue an investor receives after investing in the working interest. To calculate the net revenue interest, you deduct the royalty interests from the total amount generated from production.
To calculate the net revenue of the working interest, you subtract the RI share from the total percentage of the working interest. Then multiply the remaining shares by the sum of the subtraction.
So, for example, a group of people invests in a working interest investment in a well, with the following shares:
- Joe, royalty owner – 15%
- John, working interest – 10%
- Larry, overriding royalty – 5%
- Megan, working interest – 12.5%
- Moe, working interest – 12.5%
- Jack, working interest – 20%
- Joseph, working interest – 10%
- Mary, working interest – 15%
Among these working interests, the total royalty owners amount to 20% (15% + 5%).
Subtract the royalty owners’ percentage from the profits generated by the well.
So, 100% – 20% = 80% left from the 100% profits from the well.
Multiply each investment by the percentage of profit:
- Joe, royalty owner – 15% * 80% = 12% NRI
- John, working interest – 10% * 80% = 8% NRI
- Larry, overriding royalty – 5% * 80% = 4% NRI
- Megan, working interest – 12.5% * 80% = 10% NRI
- Moe, working interest – 12.5% * 80% = 10% NRI
- Jack, working interest – 20% * 80% = 16% NRI
- Joseph, working interest – 10% * 80% = 8% NRI
- Mary, working interest – 15% * 80 = 12% NRI
Aside from the royalty interest owners, the total NRI of the working interest owners is 80%. The formula is the same regardless of the quantity of interest or the number of decimals it contains.
What are the Benefits of Being a Working Interest Owner?
As with all types of investments, there are benefits. The benefits of investing in working interest include:
- If the well becomes a success, profits are likely to be substantial and can last for years.
- Since tax benefits are seen as a loss and losses are considered active income, they can be offset by other income.
- It is an active investment where you take part in production decisions.
- Working interest owners sometimes receive tax incentives. It can be worth around 65% – 80% of the cost of a working interest investment.
Are there any Disadvantages and Risks?
Apart from the benefits, there are also downsides to this type of investment. Here are some risks of taking part in this type of investment:
- Initially, the investment is high since you must pay for the cost of production.
- Due to the high cost of investment, there is a high chance of running at a loss.
- On-the-job calamities, such as employee injury or environmental damage, may place investors at risk.
How is Working Interest Taxed in the Oil and Gas Industry?
For tax purposes, most working interest income is treated as passive income because the investment is part of a partnership and, as such, will generally be taxed.
As a result, the investor has a taxpayer’s liability for investment income tax. Investors must pay the estimated tax based on Internal Revenue Service (IRS) tax rules and rates, as the tax on regular investment income is not automatically withheld. In the United States, the self-employment tax rate is 15.3%.
If an investor receives resources as a gift, such as lease rights to an oil well, these may qualify as taxable income. Working interest investors are eligible for tax benefits based on the operating costs of their investment. These may include tangible drilling costs or intangible drilling costs, such as equipment costs or utility payments.
How Do You Report Working Interest?
Schedule C is used to show the operating expenses, depletion, and gross receipts of working interest. As a working interest owner, you will see your gross receipts. Operating expenses, direct and indirect, should be noted in Schedule C. They include a dry hole, overheads, administrative and legal, taxes, and other operational costs related to oil and gas development.
Although a working interest is exempt from net investment income tax, it is subject to self-employment taxes, as reflected in Schedule SE.
Conclusion
The above is all the necessary information you need to know about investing in a working interest in oil and gas in case you want to become an investor. If you have no trusted broker to negotiate a working interest deal or ask for more information, count on Pheasant Energy. We are industry experts in oil and gas rights with more than 70 years of experience and a trustworthy broker for buyers and sellers of working interests. Get in touch with us today.
FAQ
1. What is the difference between working interest and royalty interest?
Working interests are oil and gas investments that give owners the right to exploit the resources on a property. Royalty interests are the rights belonging to the landowner who leased out the property to the working interest owner.
2. Is a working interest real property?
No! A working interest is an agreement that grants its owner certain rights over a property.
3. Is working interest passive income?
Yes. Holding a working interest in the oil and gas industry may be a passive activity. Sometimes the investors are a group of people, and not all of them are actively involved with the production process.
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