Oil & Gas

Published: Sep 26, 2022 | Updated at: Sep 26, 2022

When it comes to mineral rights and mineral interests, there are a lot of terms that get thrown around. Two of the most common terms are “working interest” (WI) and “overriding royalty interest” (ORRI).

But what is working interest? And what is overriding royalty interest? What are the key differences between them?

WI is an ownership interest in mineral lease that gives the owner rights to explore, develop, and produce the minerals. On the other hand, ORRI is a non-operating interest in mineral lease that gives the owner rights to a percentage of production revenue from a well, mine, or other operation.

So, what are the key differences between these two types of interests? Read on to find out!

What Are Mineral Interests?

Mineral interest, working interest (WI), and overriding royalty interest (ORRI) are a types of property that a person owns beneath the surface of the earth. These types of properties can produce revenue for the owner in different ways, including royalty payments, leases, and shut-in payments.

Mineral leases are generally term-limited, giving the company a set amount of time to develop a mineral asset, after which the lease will expire, and they will no longer have the right to extract minerals.

Mineral interests are often separated from surface property by a conveyance or reservation. This means that the person or company who owns a mineral interest may or may not control of the surface depending on if they own the surface rights as well. In addition to being a separate chain of title, mineral ownership is also backed by a chain of titles.

You can acquire mineral interests can in several ways, including through inheritance, purchase, or court order. Each has its own advantages and disadvantages, as well as different risk profiles. You should consult a lawyer if you are unclear about the legal requirements to acquire a mineral interest.

Types of Mineral Interests

There are several different types of mineral interests. These include working interests, royalty interests, and overriding royalty interests.

Working Interest Definition

A WI is a stake in an oil well or gas well. This type of ownership allows the investor to control all decisions from exploration to marketing. However, the investment is much riskier than that of a royalty interest. If you want to become a WI owner, you should understand the nuances of the industry.

In general, oil and gas investment is expensive and risk, so the risk of loss is high. However, WI owners can offset the loss by obtaining other types of income. In addition to this, they may take part in the production decisions and can receive tax incentives, which can be worth between 65% and 80% of the investment.

WIs are divided into two types, including non-operating and operating. Non-operating working interests have limited liability, which means that they may not need to be actively operated.

In contrast, operating interests require the owner to manage the drilling, production, and royalties themselves. A working interest can also be passive, which means that it can be held by individuals or groups of people.

While investing in a working interest can provide significant tax benefits, it also exposes owners to additional liability. Therefore, forming a limited liability company or other types of tax partnership is important. If you decide to invest in a working interest, consider your risk tolerance, and the potential benefits of each option.

Royalty Interest Definition

A royalty interest is a type of ownership interest in a piece of land that has been set aside for future oil and gas production. It can be sold to an individual or a company for a lump-sum payment. It can also sell as a percentage of future royalties. The percentage of royalties will depend on the specifics of the royalty deed.

The most common type of royalty interest is an ownership interest. This means that the owner of the rights retains the right to a percentage of the revenues produced. The royalty owner pays for all production taxes and severance taxes but isn't responsible for exploration or development costs.

A royalty interest may be granted for a certain period of time or an unlimited period. Many mineral owners sell term royalties interests, meaning they remain in effect for a certain number of years, as long as gas or oil is produced. This gives them the advantage of receiving compensation and interest when production stops.

Overriding Royalty Interest Definition

An ORRI is an interest that a company holds in oil and gas properties. These interests are non-operating and expense-free. In exchange for royalty payments, an entity that owns an ORRI will not be responsible for any production, marketing, or distribution costs related to the property.

The issue of ORRIs has occupied the courts for decades. The treatment of these interests varies from state to state. However, in Texas, an overriding royalty interest was upheld by the state's Supreme Court in a 1996 case. With that, a person may have to pay royalties on a portion of the oil and/or gas production.

An ORRI is a royalty that is carved out of a mineral lease. This interest is exclusive to the mineral owner, and it is a form of compensation for the geologist, landmen, engineers, brokers, and others who work on the property. ORRIs are also sold by the operator in order to raise capital for development.  A typical ORRI will last as long as the lease term.

Generally, a lease will have a language that protects the overriding royalty interest of a non-operated party. The language used in a lease is crucial. The terms of an ORRI may be vague, or they may only apply to wells in the covered interval.

WI vs. ORRI

Both WI and ORRI refer to an ownership interest in a lease. While the terms are similar, they differ in important ways.

Costs

A WI bears the cost during the production process, while an ORRI any of the development costs. While both interests come from oil and gas production, overriding royalty interests are often used as an incentive for E&P companies or drilling professionals.

Unlike working interests, overriding royalty interests are not held on the minerals themselves. Instead, the company that makes the final sale receives the royalty interest.

Risks

Also, royalty interests pose lower risks than working interests. In contrast, working interests require continuous input from investors and are subject to larger losses if expenses exceed revenues. Royalty interests, on the other hand, do not require additional funding, and thus, the risk of additional losses is reduced.

Existing vs. Potential Wells

The biggest difference between working interest and overriding royalty interest is the way the royalties are valued. Working interest base value on existing production while overriding royalties' base value on potential wells in addition to existing production.

The latter is riskier because it may disappear much sooner than expected. Consequently, it is important to understand the difference between the two.

Revenue

Another major difference between working interest and overriding royalty is how a royalty is "carved out." In oil and gas leases, a working interest is a portion of the net revenue, whereas an overriding royalty is the full portion. If the working interest is 100%, then the working interest is the majority of the production.

Ownership Interests

In addition to working interests, ownership interests are more complicated. Ownership interests include rights to land used for production. Mineral owners have the right to execute leases and collect bonuses.

In addition, royalty interest owners do not share in rental income. A lease contract will spell out the specific rights of each landowner.

Leases usually have terms and conditions that depend on how much land a drilling company is leasing. The lease will also include conditions that require the drilling company to pay for damages at the end of the term.

Overriding royalty interests are not linked to ownership of the minerals under the ground. Rather, they derive their ownership from the revenue generated from mineral production and lease associated with the mineral interest.

They expire when the lease terminates or production ceases. As a result, overriding royalty interests are a fraction of the total revenues generated by mineral production.

Legislation

Overriding royalty interests have long confounded oil and gas law. In fact, the courts have litigated the issue.

State courts vary in their treatment. This problem has resulted in significant disagreements between oil and gas companies and mineral owners. In Rohe v. Meehan, the Supreme Court of Texas upheld its ruling.

Tax Implications of Owning an ORRI

If you own an ORRI in a property, you should be aware of the tax implications of this property. Treated as investment income, overriding royalties are subject to federal income tax.

However, there are certain tax advantages that you can enjoy if you own oil and gas property. For instance, if you invest in oil and gas, you will be able to claim a depletion allowance of up to 15 percent of the oil and gas income that you earn.

Overriding royalties are a valuable tool for oil and gas companies. They allow investors to take part in mineral production without costs and risks of production. In addition to providing passive income, they also enable owners to enjoy favorable lease terms and can even help fund personal expenses.

Overriding royalties remain undivided and therefore often sold during a time of high activity. If a dried-up well is sitting on a hot shale play, a potential buyer could purchase the ORRI and sell it at a profit during a boom period. Or, if you choose, you can hold the lease until the lease ends.

Overriding royalties are also subject to net investment income surtax. In addition to the royalty payments, you must report lease payments and lease bonuses as other income. As such, these royalties are subject to the same tax rate as other income.

Stay on Top of Mineral Interests

Working interest and overriding royalty interest are two types of mineral rights ownership. The key difference between WI and ORRI is that WI owners have the right to develop and sell the minerals, while ORRI owners do not. ORRI owners only receive a percentage of the revenues generated from the sale of the minerals.

Working interest and overriding royalty interest are two important concepts in oil and gas law. Understanding these concepts is critical for anyone involved in the industry. 

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