Malone Petroleum Consulting



Oil and Gas Royalty Audit

Oil and Gas Royalty Audit

Mineral rights owners receive monthly royalty payments when an oil company extracts oil and/or gas from wells they drill on their property. The payments should be a fixed percentage of the market value of the oil and/or gas or the proceeds from selling it.

This is a list of key items from standard check details that are presented in the order that are usually on the check detail: production date, owner’s decimal, Btu factor, well production volume, price, well gross value, well taxes, well deductions, well net value, owner gross value, owner taxes, owner deductions, and owner net value.

Under Natural Resources Code Section 91.504, a royalty owner is entitled to request information from the payor concerning his/her royalties. 

When you sign a lease, it would be intelligent and wise to seek legal oil and gas expertise to prepare and negotiate your lease. Make certain you have audit rights included in the lease. The purpose and need for an oil and gas audit of oil and gas royalties is to verify that all the production and sales have been correctly measured, accounted for and allocated. Keep in mind that the lease is based upon what should be for mutually beneficial needs and benefits for both parties – not just one party which is usually the oil company using their on lease document.

In accounting for the production, there can be complexities involved in oil and gas lease and differences in leases from other landowners. Words written in a lease can easily be interpreted different ways which can cause significant disparities in calculated royalties. Leases can have unaccustomed terms that simply will not fit the operator’s typical data-processing features and are not within the scope of the reporting capability.

An oil and gas royalty audit is to determine if the operator is in compliance with the relevant provisions of the agreement and is paying the proper amount of money. It is obviously a good business practice to audit because an underpayment can happen easily and go undetected unless an audit is conducted in order to discover any underpayments. The audit gives peace of mind that everyone is playing by the same rules. Consistent royalty oversight helps maintain trust between the parties. Business practices and technologies develop and change over time; it essential to monitor and manage those changes. The audit is part of the compliance policy of auditing valuable agreements and revenues. The audit provides increased transparency between the parties that can be used to preclude significant disagreements. We even like to recommend that the Operator is asked to perform a self-audit in advance to uncover underpayments. If our audit findings exceed a given threshold, we believe the audit fees should be paid by the operator. An obvious objective is to maintain a good working relationship between all parties and have the royalty owner become a wiser and more informed entity in a very complicated industry. This means that future reporting will reflect a more proper accounting of the due royalties. Deductions taken are allowed under the agreement terms and conditions.

Producers in the oil and gas industry have an implied duty and responsibility to perform as a “reasonably prudent operator” under all circumstances. However, some producers fail to obey some express and implied covenants in their leases, operating agreements and unit agreements. There is a risk that some operators routinely underpay oil and gas revenues and royalties by deducting unreasonable marketing costs, transportation or are selling the oil and gas below market value to one of their subsidiary companies. Sometimes the producer allocates certain costs against your royalty payments that are absolutely prohibited by either law or contract. This results in significant underpayments being made to the royalty owner.  Some producers have been known to not pay royalties for months or years since no one is the wiser. Producers, knowing they can be or will be audited, encourages them to comply with the reporting and payment obligations which in turn can boost confidence in the overall handling and reporting. The audit assures the operator is compliant with all terms and is calculating, reporting and paying royalties completely and accurately.

Too frequently, oil and gas royalty audits reveal oil and gas drilling companies are using transactions between affiliated companies, deductions for costs of transportation, processing and marketing in order to drive down the amount of royalty mineral owners are entitled to.

There are red flags that cause concern, for instance,

  1. when the operator will not accept calls or reply to calls,
  2. when the operator has a very bad reputation,
  3. when there is a high turnover of employees with honor and ethics
  4. (search the internet as follows: “oil company name” + lawsuit); how many hits did you get?)

The audit process usually begins by reviewing the lease terms followed with a visit to the oil field, where the team obtains an in-depth understanding of the production process. The knowledge obtained at the field is then matched to the records, where the appropriate supporting documentation is obtained. It is determined on a test basis, the accuracy and validity of four components (volume determination, price determination, ownership percentage, and deductions) used by the operator to compute royalties due the royalty owner.

Most of the common royalty oil and gas audit findings are:

  • Amounts - quantities, prices or values are misreported or underreported
  • Arm’s length transaction failure for: oil, gas and liquids volumes, pricing and sales
  • Clerical errors, faulty systems, input errors and omissions, mathematical errors
  • Contract interpretation of the lease and misunderstandings
  • Contract breached intentionally by not adhering to the contractual requirements
  • Deductions charged that are not allowed per the lease; deductions inflated
  • Duplicate deductions
  • Gas allocation errors, gas measurement errors
  • Inaccurate payment computation
  • Ownership percentage is wrong
  • Not paid for natural gas liquids
  • Paying royalties based on the weighted average price instead of the actual price received
  • Payment based on the initial transaction’s sale price instead of the actual sales price.
  • Sale of the asset to another operator causing a loss of consistent information and application
  • Side agreements with related third parties to the disadvantage of the payees
  • Oil and gas sold at reduced prices to subsidiaries or limited partnerships; full value recoup later
  • Wells when visited have bypass pipes that route the production around the meter entirely

The lease should have audit rights and a clause where any operator who refuses to allow a properly noticed audit should be considered in default and should have a termination of the lease. Obviously, audit rights extend to electronic and digital versions of all financial records. State Law has held that you have the responsibility to make sure you are being paid correctly.  If you fail to act timely within the four-year statute of limitations applicable to suits on a written contract, you risk being barred from receiving any entitled recoveries that are contractually due. If the audit can prove the operator fraudulently concealed its failure to pay royalties correctly and that the royalty owner had no reason, in the exercise of reasonable diligence, to discover the underpayment until a point in time (less than four years) prior to his filing of suit. It can be argued that the royalty owner should discover that it was paying royalties incorrectly because they could have found out by reviewing records at the Texas General Land Office. However, the royalty owner might not have had any reason to look at those records. Otherwise, royalty owners who realize too late that they have been underpaid for years—or who inherit a lease from an ailing parent who never bothered to check their statements are simply out of luck.

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