CHAPTER 1 ROYALTY CONCEPTS AND PRESENT APPLICATIONS TO FEDERAL OIL AND GAS AND COAL LEASES

• Jurisdiction: United States

Federal Royalty Revolution--Coal
(Nov 1986)
CHAPTER 1
ROYALTY CONCEPTS AND PRESENT APPLICATIONS TO FEDERAL OIL AND GAS AND COAL LEASES
Dante L. Zarlengo
Cogswell and Wehrle
Denver, Colorado

I. Historic Development of the Royalty Clause.

A. In general.

The term "royalty" appeared in common law history as early as 1400. It had the general meaning of a right or privilege retained by the crown; by 1580 the term was used chiefly to denote rights pertaining to minerals. The particular meaning of a "royalty" as a right retained by a landowner under a lease in return for the privilege of working a mine had appeared by the year 1829.¹ Although there are arguments to the effect that "royalty" interest is in fact a type of rent and possesses the incidents of a rent, it might generally be stated that royalty at common law was in fact that portion of minerals due the crown at the mine in return for the privilege of extraction.²

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1. The impact of common law on the drafting of oil and gas leases cannot be overstated. Early drafters and courts had little or no knowledge of the physical properties of oil or gas and in particular of its fugacious nature.³ The impact of the common law on coal leases was also substantial, in that law relative to extraction of hard minerals was the only precedent upon which to base drafting and resolution of disputes.⁴

B. Oil royalty clause.

The original oil royalty clauses provided only for payment of royalty in kind as follows:

"Rental, one-eighth of all oil as collected from the springs in barrels furnished or paid for the lessees."⁵

Later leases in use in Nacogdoches County, Texas provided for royalty on one-twelfth "...part of all products of said lands in the way of minerals or oil that may thereafter be saved, procured or found upon said lands...free of any expense to the party of the first part..."⁶

1. Landowners seldom had the money or the faith to test the productivity of their holdings, and it was inevitable that consideration for the privilege of exploration and

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production would be a portion of the product obtained. Again, the influence of the common law where the crown would retain a portion of the product obtained was controlling, especially since early lessees did not desire to be burdened with buying the land or bear the risk of non-discovered wells.

2. Early salt leases simply provided for the landowner to retain sufficient salt for his own use, limited to every twelfth barrel obtained. These salt leases were also a forerunner to early oil leases. Royalty was payable only in kind consistent with the common law theory of the crown retaining a portion of production.⁷

C. Natural gas.

Originally, no royalty was payable on natural gas, as it was thought to be valueless. When it was determined that royalty should be paid on natural gas, the obvious problem developed, in that the traditional way of paying royalty in kind would be difficult if not impossible to implement. Only a few early oil and gas leases provided for payment of royalty in kind on natural gas. Instead, early leases simply provided that the landowner would be paid a flat rate for every quantum of natural gas produced.⁸ As the value of natural gas became more apparent, a percentage of "value" was paid to the landowner as a more practical solution than taking production in kind. Value was a substitute for taking in kind.

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D. Coal royalty clauses.

1. The difference between coal extraction and oil and gas extraction as an industry should first be understood. The primary differences are:

— Oil and gas operations are more exploration oriented. The oil company does not know where deposits of oil and gas are located or the extent of the deposits or reserves. Coal companies generally know where the coal is located and the extent of the reserves. Little exploration takes place.

— Oil and gas production can generally be obtained quickly. It is promptly sold in the open market under short term contracts. A coal mine, however, may take as long as ten years or longer to develop. Coal is generally sold under long term contracts entered into prior to opening of the mine, and extending for the life of the mine.

— Oil and gas is fugacious and may move from one property to another. Coal does not move, so there are no problems regarding protection from drainage or density of drilling.

— Oil and gas operations have minimal effect on surface use compared to coal operations which are usually highly disruptive to the surface.

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2. As a result of the foregoing differences, several clauses relating to coal royalties developed, which are not found in oil and gas leases. These include:

(a) Minimum Annual Royalty. Minimum annual royalty insures the lessor a stipulated minimum income from the extraction of coal. Because there is little doubt as to location and existence of the coal deposit, some guaranteed minimum income from the coal deposit is appropriate.

(b) Advanced Royalty. Advanced royalty may often be provided in a coal lease. This is simply a means of insuring royalty payable to a particular landowner prior to the time that the mine reaches his particular tract of land. Because of the length of time required to open and develop a coal mine, coal leases are for much longer terms (anywhere from 20 to 40 years). Therefore, it may be years before a coal lessor will receive actual production royalties. Advance royalties compensate for this delay.

(c) Surface Royalties. Historically, these were not used as the value of the surface use was relatively limited in most cases. With increasing land values and land development for other purposes, surface royalty provisions have become much more common.

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3. Traditionally, coal royalty was calculated on the basis of a fixed number of cents per ton for coal mined and sold from the premises.⁹ As in early gas royalty clauses, the purpose was to fix a particular value for the landowner's share of coal mined since it would not be practical for the landowner to take his share of production in kind.¹⁰ For years, inflation in the price of coal was minimal and this provided a stable means to calculate the costs and expenses associated with the coal mining process, so a fixed royalty was equitable to both parties. the With increase in coal value and production in recent years, royalty is now stated as a percentage of the value of the coal mined. Again, the value concept was implemented to substitute for the landowner taking his particular share of production in kind.

E. Summary.

Historically, royalty clauses in oil and gas and coal leases were based upon the original common law concept that the landowner or mineral owner would be compensated for the privilege of exploring and extracting minerals, by reserving a proportionate share of the product mined. Later, concepts of computing royalty as a percentage of "value" substituted for the basic idea of royalty in kind.

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II. Evolution of Royalty Payable on Federal Oil and Gas and Coal Leases.

A. Oil and Gas.

1. Three types of leases are set forth in the original text of the Mineral Leasing Act of February 25, 1920 (the "Act") as follows:

(a) Holders of oil leases under the Mining Law of 1872 had the right to exchange unpatented mining claims for leases or prospecting permits. Leases obtained by the holders of these mining permits paid royalty of 12 1/2% of "all the oil or gas produced, except oil or gas used for production purposes on the claim, or unavoidably lost..." A lease was issued upon the payment of royalty to the United States of an amount equal to "the value at the time of production of 1/8 of the oil or gas already produced except oil or gas used for production purposes on the claim, or unavoidably lost...."¹¹

(b) Agricultural entrymen who eventually acquired a preferential right to a permit and lease paid royalty under their leases based upon "12 1/2 percentum as to such areas within the permit as may be included within the discovery lease to which the permitee is entitled under Section 14 hereof."¹²

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(c) As to oil and gas leases acquired by the permit method, a royalty was specified on one-quarter of the property in the amount of "5 percentum in amount or value of the production." Royalty was paid on the remainder of land in the amount of "12 1/2 percentum in amount or value of the production..."¹³

Congress appears to have adopted the basic concept of royalty compensation historically used in fee leasing, that is, that royalty represented a proportionate share of the particular mineral mined or extracted as and where mined and extracted. As such, the Department recognized in an early decision that oil or gas used for production purposes or unavoidably lost was not subject to royalty because, as stated, the government as lessor was entitled to its proportionate share of the mineral as mined. Computation of Royalty under Section 15, Act of February 25, 1920, 15 L.D. 283 (1925). Recent court decisions have ratified this concept of royalty management through the present day.¹⁴

— The Right of Way Leasing Act of May 21, 1930 continued this concept by providing royalty on right of way leases in the amount of "12 1/2 percentum in amount of value of the production."¹⁵

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— The same language contained in the original Act was incorporated in the Act of March 4, 1931 which amended Section 17 to authorize unitization of leasehold interests.¹⁶

— The Act of August 21, 1935 made extensive changes to the leasing procedures. Royalty in every case was based upon "an amount or value of production."¹⁷

2. The current language which appears in federal oil and gas leases was specified in the Act of August 8, 1946 which contained extensive modifications to the Act. It provides that royalty will be calculated on "amount or value of production removed or sold from the lease."¹⁸ No apparent explanation exists for the...