CHAPTER 1 ROYALTY CONCEPTS AND PRESENT APPLICATIONS TO FEDERAL OIL AND GAS AND COAL LEASES REVISITED—THE SAGA CONTINUES
| Jurisdiction | United States |
(Mar 1988)
ROYALTY CONCEPTS AND PRESENT APPLICATIONS TO FEDERAL OIL AND GAS AND COAL LEASES REVISITED—THE SAGA CONTINUES
O'Connor & Hannan
Denver, Colorado
This paper is intended as a restatement and supplement to Royalty Concepts and Present Applications to Federal Oil and Gas and Coal Leases presented by this author at the Federal Royalty Revolution Oil and Gas and Coal Workshops in October, 1986. The issues discussed in that paper concerning historical development of royalty clauses in oil and gas and coal leases, and in federal leases, will be restated here in modified form. The portion of the discussion relative to current practices in royalty valuation will be restated and updated. The new regulations for valuation are discussed here in a general way, and the reader is referred to other papers presented in this institute for detailed discussion of the new regulations. The discussion presented relative to royalty policy and conflicting theories of royalty application is continued in this paper.
I. HISTORICAL 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. Given that all subsurface substances were owned by the crown, by 1850, the term "royalty" was also used to denote rights pertaining to minerals. The
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particular meaning of "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 arguments exist to the effect that "royalty" interest is in fact a type of rent, and possesses the incidents of a rent, it is generally 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
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. The English Common Law and other legal principals relative to extraction of hard minerals was the only precedent upon which to base drafting and resolution of disputes.4
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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 by the leasees.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 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 to bear the risk of non-discovered wells.
2. Early salt leases simply provided for the land-owner 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
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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, an 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 equitable solution than specifying a price per unit for the lessor's share of production. Value was a substitute for taking in kind.
D. Coal Royalty Clause.
1. 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
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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.
With the 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.
2. Notwithstanding their common beginnings, coal royalty is generally provided for in a way substantially different than oil and gas royalty. To analyze these differences, coal extraction and oil and gas extraction as an industry must first be understood:
— 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 reserves. Whereas, coal companies generally know where the coal is located and the extent of the reserves and, therefore, 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
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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. Conversely, 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.
3. 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
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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 because the value of the surface use was relatively limited in most cases. Because of the possibility of extensive surface disturbance, increasing land values, and development of land for other purposes, surface royalty provisions have become much more common.
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.
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:
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(a) Holders of oil claims 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%. 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
(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
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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, royalty represented a proportionate share of the particular mineral mined or extracted depending on where it was 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...
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