Royalty Underpayment Schemes
Fri April 6, 2020
To begin with, you never want to sign a document unless you have done your research to determine if you are dealing with an “honest” operator. Some oil companies have some beyond-terrible reputations.
Never sign a document unless you fully understand every word in it. Have someone to help you with your lease negotiation. The best way I have seen it is to bypass most of the language in the lease and have a very sharp attorney prepare an addendum for you that overrides the lease. Do not rely on what you are told by the landman or even your neighbor. You can easily be cheated and told you should be thankful for whatever they offer. You never want to lease or sell your mineral rights until you have determined the market the value. Make sure your lease requires the operator to furnish you a copy of the title opinion and a title run sheet too. Make sure you are getting a check in exchange for your signature; otherwise, you could be dealing with a lease flipper who will shop your lease, so they can get the money to pay you and make a huge profit. For the agreement to be binding, consideration must be paid for the lease. Make certain that your lease has audit rights or the oil company might refuse to let you see any support for what they are paying you and what they are deducting from you. Consider a surface use agreement. Your lease should release all depths over 100 feet from the perforations of the pipe.
The main red flag is when the operator is selling to an affiliate. It creates an obvious question: Why is the operator setting up a separate company to sell to itself? Most likely and commonly, the affiliate is selling the production at a higher price than is being paid to the operator, working interest owners and royalty owners who are being cheated. This is a violation of the lease terms and the implied duties of the operator; it is basically a breach of contract, unjust enrichment, and fraud. The operator will finally say that the discrepancy was not fraud, but rather was an accounting error or computer glitch. The way it is working out is the operator can steal from one hundred entities, be sued by a couple of them and settle for much less. The legal system for the operator becomes a profit center. When oil and gas prices are low, it puts pressure on the operator to take more deductions. When the prices are high, it makes it very tempting for the operator to take more than their fair share. When you find that the purchaser is not an affiliate, there is a risk that both the operator and purchaser are owned by the same company, thus moving the profits from one pocket to the other pocket.
In one situation that we ran into a while back, there was a company that had a contract with the operator: He would be the independent purchaser to stop the audit trail and then sell it back at a higher percent, so the operator could sell it at a very high profit.
Additionally, we have a serious problem with NGLs (natural gas liquids). Some or all the states are not requiring the operators to post NGL volumes when they require the posting of gas and oil volumes. They have the information since they want to be paid taxes on the NGL sales. The result is that no NGL royalties are paid to the other owners who are only paid on an unprocessed gas basis and many don’t even know they are due any payment. This can go on for the life of the wells. The courts have known to be corrupt and the state can be in cahoots with the oil companies to steal as much of your mineral rights as possible. Also, the prices for NGLs are not posted to the U.S. Energy Information Administration website which has both the monthly, average prices for both gas and oil. The operator can have a processing agreement with an affiliated processor where they only have a smaller percentage of the NGLs which payment is based on while the processor keeps the rest as profit.
A lot of royalty owners don’t realize that the oilfield is the cash register that has an open drawer to the operator’s pumper or gauger who can simply undermeasure and report the gas, oil and NGL volumes.
We have a concern when a client has a well nearby other wells and production is based on allocation which is manipulated by the operator’s pumper or gauger. We have seen crooked people switch signs on the wells for the diversion of expenses and revenues. Another way is to have two wells with similar names where the long name is owned by the operator; so that, when a short name is used it defaults to the well with a low ownership. It is interesting that the royalty owner can be told that the well has only gas production, but you drive out to the lease, there is a pumping unit going full blast.
We had a gas measurement company to tell us they were going to be required to set the gas meters to where they would start with an undermeasurement of three percent on all wells. When the operator owns many or most of the vendors dealing with their company, you know that is done for a reason. One of the favorites is to put in a line that by-passes the meter which cheats everyone including the taxing authorities. The favorite time to do this is when the well is making its first significant production. Pricing is usually higher in the winter due to demand and lower in the summer which allows an operator to store gas in the summer, be paid by an affiliate when prices are low and be paid much higher prices when the gas is produced from storage. Gas can be mixed with other sources of gas to receive higher payments not passed on the royalty owners. There can be a signing bonus made by the purchaser to the operator which will never be shared with the other owners. Periodically, there can be credits or payments made to the operator by the pipeline carriers.
One of the worst problems now is the operator taking deductions from the revenues which can be very substantial. Many of the deductions can be fabricated and do not even exist. The cost can include, and are not limited to, compressing, dehydrating, marketing, gathering, handling, processing, separating, transportation, and treating.
We had a revenue employee to tell us to close the door and told us if they did not steal a certain amount of money from the royalty owners every month, they would be fired. Another well known operator used to give a bonus to employees who could show him how they were cheating and making the company a profit. A very rich operator had a scheme where he would have their owned salt water trucks to be charged for a significant number of visits to oil wells. We showed the client the worst well and recommended they take over half of the field and operate it themselves. The salt water charges virtually disappeared. The bad operator is probably still doing it. You can have contractual rights and the operator might refuse to allow you in since you are too late in the year; you legally force your way in; and all the audit desks are empty!
Make sure that your lease has a Pugh Clause which spells out what will happen to any portion of your acreage you lease that does NOT either contain a well or is not included within a producing petroleum pool or unit. This prevents the unused acreage from being needlessly tied up to where you cannot lease it later. The Pugh Clause should read something like this: “If at the end of the primary term, a part but not all of the land covered by this lease, on a surface acreage basis, is not included within a unit or units in accordance with the other provisions hereof, this lease shall terminate as to such part, or parts, of the land lying outside such unit or units, unless this lease is perpetuated as to such land outside such unit or units by operations conducted thereon or by the production of oil, gas or other minerals, or by such operations and such production in accordance with the provisions hereof.” The objective is to provide maximum protection for the mineral owner.
When a royalty client calls Malone Petroleum Consulting due to our decades of oil and gas training and experience, our first statement usually is: You do NOT want to do any kind of a royalty audit if your royalty is very small. The reason for that is simply that any benefit or credits would most likely be very small, and you would be better off just enjoying your life and leaving well enough alone. But still, we are always amazed at some of the ingenious ways we discover where the royalty owner is being paid less than the lease allows, and you might owe it to yourself to have a free consultation to explore your options.