Several entry points exist for the investor in the oil and gas industry. Each has certain risks and benefits. In this guide we focus on the key methods of investing.
Especially important to oil and gas investors is the way a working interest in oil and gas performs and its interplay with other types of ownership. Investors should also understand how the revenue earned from working interests is determined.
Various Ownership Interests in Oil and Gas
Several types of ownership exist for oil or gas resources below the ground. The owner of the plot of land has mineral rights, but there’s more to the investment picture than that.
The Landowner’s Rights
Usually, oil and gas projects occur on land leased from its owners, who receive royalties based on a certain percentage of oil and gas production. Many mineral owners find themselves in a better position if they lease the land rather than simply sell their mineral rights.
Leases keep the landowner in control of many factors, while providing a form of investment income. The drilling operator must follow the rules in the lease agreement. And the lease agreement is usually good for three to five years. The terms can restrict points of access and outline the allowable work hours. The landowner can then negotiate the terms so that a business or residence on the land isn’t seriously disturbed.
In contrast, some landowners sell their mineral ownership and all rights to the oil or gas outright. This enables the operators to develop the land whenever and wherever they choose. In this case, operators aren’t obligated to ask the landowner when and how their workers may operate and also keep 100% of the revenue (no royalty payments).
Royalty Interest (RI or ORRI)
A landowner might decide to sell the lot to a buyer while keeping a royalty interest for him or herself. As the former seller accrues royalty payments over time from production, the financial rewards can be substantially greater from the compared to the selling price of the mineral rights in the parcel.
Working Interest (WI)
A working interest in oil and gas is a key type of ownership stake — and the primary focus at EnergyFunders. A working interest is basically an owner’s share of the expenses to develop or operate wells. A working interest can be held in various aspects of oil or gas production, such as a lease, well or drilling unit. Generally, the purchase and maintenance of a working interest requires thousands — or even hundreds of thousands — of dollars at the outset. At EnergyFunders, we offer a way to enter this investment sphere for a minimum of just $5,000.
How the Revenue Is Divided
Royalties come out first. The project must pay all:
- Royalty interest: When gas or oil is extracted from the property, the royalty interest owner earns payments, possibly subject to deductions for certain post-production work.
- Overriding royalty interest: These interests last through a specific lease period only. They’re stakes in a portion of the revenue and not in the oil itself. Capital fundraisers and the technicians who perform geological or exploratory work often receive overriding royalty interest, often simply called overrides.
- Non-participating royalty interest: The holder of a non-participating royalty interest has a lower level of rights and duties than the royalty owners and override owners. Selling a non-participating royalty interest can be a method of fundraising. For example, someone with mineral rights could sell fractions of their royalty interests and get a payment for reducing their future royalties.
After paying the various types of royalties, the working interest owners then divide the rest of the revenue. Typically, a number of parties have working interests, and they play distinct roles.
What Are the Types of Working Interests?
A person who operates the drilling equipment holds an operating working interest in the oil or gas. Working interest owners foot the bill for the costs of operations. One of their duties is to pay each royalty owner.
In contrast, a non-operating working interest comprises an ownership interest in the well, lease or other unit of production that doesn’t come with duties to operate the unit.
There’s also the carried working interest, a partnership contract between or among multiple parties with working interest in the well. Parties may share their working interests through joint ventures, wherein a group contributes the necessary financial backing. Financial contributors don’t need to get involved in the daily operations. They can instead fund them up front — and, in return, receive a share in the revenue for oil or gas extracted.
With EnergyFunders, an investor is entitled to pro-rata revenue shares from the production unit, minus the carried working interest we own. (See our Frequently Asked Questions for more details.) For successful well operations, investors with EnergyFunders stand to earn monthly profits over the course of a five-year period.
Net Revenue Interest (NRI)
A net revenue interest is the percent of production revenue that an operator or investor receives. The way to calculate net revenue interest is to start with working interest amount and deduct royalty interests.
Calculating Working Interest in Oil and Gas
Net revenue interest is an investor’s total revenue share. The revenue interest owned by any one party in a drilling lease, well, or other production unit can take some complicated mathematics to figure out. A given unit might have a number of mineral rights and royalty owners with varied shares. Then, there are often a number of working interest holders. And their interests can be on the whole unit, or a fraction.
Imagine a simple scenario in which the holders of royalty rights are entitled, in total, to one fifth of the revenue. This means what’s derived from the production unit after royalties is four fifths, or 80%. If one party holds the whole working interest, that party gets an 80% net revenue interest. But numerous parties can have shares, and all will divide the revenue after royalties are taken out. That means the 80% revenue segment will be divided again, into a number of fractional interests.
What if one party’s share of the geographical area where drilling operations take place is more productive than another part of the land? This difference has no impact on the division of net revenue. Of course, the party’s share would always be based on their fraction of the acreage, not the entire unit. But there’s no extra revenue for one party who happens to have a more productive segment. All entities get an equal part of the revenue from the unit as a whole, based on their set percentage of royalties or working interest.
A Real Life Example
EnergyFunders (investor) bought a lease from the landowner. The landowner retains a 25% royalty interest on the lease. The operator now has a working interest of 100%, meaning they are responsible for 100% of the costs of the well. The lease that they acquired has a 25% royalty interest (RI). This leaves their portion of the net revenue interest at 75%. In summation, in order to have the ability to drill and produce oil on the lease, the operator will pay 100% of every dollar cost incurred and receive 75% of all revenue from the well. The landowner will receive 25% and pay no portion of the costs.
Investment Considerations for Working Interest
To purchase a working interest in gas or oil operations is to become part of a group that puts up the money for drilling operations. Working interests are high-risk investments with strong potential returns.
Investors don’t receive any return on their working interests unless and until the operation begins producing. Although a working interest in a unit currently in production is a safer bet, machinery is not infallible. Wells do run dry. Environmental and compliance issues can get thorny. Setbacks can delay production and the investors’ ROI by months or years.
Unexpected costs can arise in the course of any project. When they do, investors need to keep funding the project accordingly. With no cap on the investment in a working interest, investors could lose more than they contribute. This is why EnergyFunders has a limited liability option for our investors, as noted below.
Tax Considerations for Working Interest
Oil and gas investments offer attractive tax credits and benefits. Energy is a top national interest. To incentivize people to take the risk involved in funding oil and gas production, the government offers tax deductions unparalleled in any other investment class.
While we recommend seeking the advice of an accountant to fully benefit from these tax credits, you can calculate your rough tax savings for oil and gas investments online. Here are the big three deduction avenues:
- The investor receives a deduction for intangible costs. Intangibles represent the lion’s share of operating costs. They include consultancy fees, rented machinery, cement, and other products and processes.
- The investor also receives a deduction on tangible assets. These are assets and benefits that last through the project and can be resold.
- A 15% depletion allowance, to cover the diminution of the reserves in a well, presents continued tax benefits beyond the initial investment year.
Lowering Risks, Increasing Potential Returns in Working Interest
Lucrative investment areas always come with risk. Oil and gas investing is no exception. That said, working with proven operators enhances the prospects for excellent returns over time. EnergyFunders is committed to bringing well-vetted oil and gas investments online to accredited investors. By careful examination of producers and their proposals, we lower risk. We publish detailed project information so investors know precisely how we select opportunities.
Investors choose to become general or limited partners. General partners may deduct their contributions from their active incomes. Limited partners may deduct the investment from their passive income, but enjoy the benefit of limited liability. For more information, refer to our guide on the choice between investing as a general or limited partner.
Become an accredited investor with EnergyFunders and find the optimal blend of opportunities to suit your goals. We invite you to create your account today to view all our vetted oil and gas investments.