What Is Overriding Royalty Interest?
There are multiple ways to invest in the oil and gas industry. You don’t necessarily need to buy mineral rights or lease land to extract crude oil or natural gas. One way to invest in a mineral interest is to have an overriding royalty interest.
This article will explain what overriding royalty interest is and how it differs from other mineral interests, particularly royalty interest. It will also detail regulations and taxes regarding this kind of interest. Lastly, you’ll learn whether investing in it is worth it.
What is Overriding Royalty Interest?
An overriding royalty interest (abbreviated as ORRI) is a type of mineral interest that is undivided and gives the holder the right to earn a portion of revenue from the production and sale of the mineral. This share is paid after the royalty interest holder has been paid their share.
ORRI is typically created out of the working interest, and the lessee assigns it.
To better understand ORRI, it’s best to recap mineral interests and talk about the different types of mineral interests.
A mineral interest is an economic interest in subsurface mineral extraction, production, and sale. There are three mineral interests: working interest, royalty interest, and ORRI.
Working interest grants the party access to extract and sell minerals, whereas the royalty interest belongs to the mineral owner who leases the land. The working interest party bears all the costs.
ORRI is created out of working interest and is undivided and non-possessory.
Usually, oil and gas companies with a working interest sell ORRI to investors to get funds for operations or assign it to parties as compensation for their service (for example, a lawyer or landman).
Overriding Royalty Interest vs. Royalty Interest
While ORRI also earns its holder a portion of the profits from the sale of minerals, it’s markedly different from royalty interest.
Royalty interest owners are mineral rights owners or landowners with executive powers over mineral rights. They can lease the land and the minerals to oil and gas companies and, in return, receive royalties, bonuses, and other compensations.
On the other hand, an ORRI holder does not own the land or the minerals in it. In other words, they may receive royalties from revenue, but they don’t have any ownership of the minerals.
Their interest is basically in the lease. Once the lease expires, ORRI automatically ends as well.
Also, ORRI is non-divisible, meaning it cannot be fractionalized further, unlike royalty interests that may be divided among different parties.
In terms of hierarchy, royalty interest supersedes overriding royalty interest in that the former is paid before the latter.
Factors That Impact Overriding Royalty Interest
A multitude of factors influences ORRI. However, its value mainly depends on working interest and royalty interest.
As ORRI is part of the working interest, it depends on the extent of the working interest. For instance, if the working interest is 75 percent, ORRI would make up a percentage of whatever this 75 percent comes out to.
As royalty interest owners have first rights to profits, ORRI is only paid after the royalties are paid to the mineral owners.
Then, there are other factors like the production rate, the market’s mineral prices, and the well’s production life.
It’s essential to be clear on the reserves left and production capacity when buying ORRI. Of course, a high producing well would result in higher royalties.
The location of the field or well also matters. If it’s located in a high-yield area with lots of untapped results and long lease duration, the ORRI payments could be consistent for the foreseeable future.
How to Calculate Overriding Royalty Interest?
Calculating overriding interest is not that difficult once you’ve adjusted the revenue for cost and other royalties (that go to the royalty interest holder).
Suppose a crude oil well’s monthly production revenue comes to $500,000. The royalty interest is 20 percent, and the ORRI for a landman is 5 percent.
To calculate ORRI payment, you need to calculate net revenue interest (NRI), which is working interest minus royalty interest.
NRI = WI – RI = 100 – 20 = 80
When applied to the revenue:
500,000 – 20% = 400,000
The ORRI would come out of the NRI.
400,000 x 5% = 20,000
What Taxes Apply?
ORRI payments are also subject to the same taxes as royalty payments paid to mineral owners. The earnings from ORRI are considered income by the federal government.
If you’re in a state where income tax is applicable, the state would also tax your earnings from ORRI.
In addition, federal and state governments also collect severance taxes from all parties with a mineral interest, including overriding royalty holders. The severance tax rates and regulations may vary from state to state.
On top of federal and state taxes, ORRI holders may also be liable to ad valorem taxes (a type of sales tax charged by local counties).
Is It Worth Investing in?
Overriding royalty interest can be a worthy investment if the oil or natural gas well has a high yield and reserves for many years. It can be a profitable investment, especially when oil and gas prices are high.
Most exploration and production companies invite investors to buy ORRI to fund operations. Depending on the percentage of ORRI and the field yield, your investment may be recovered in a couple of years.
That said, it’s best to consult a professional and assess the lease to see how the lease terms may impact your returns. Keep in mind that ORRI also depends on royalty interest.
Overriding royalty interest let’s third parties earn a portion of revenue without owning the land or bearing the production costs. ORRI can be bought with monetary investment or services rendered for the companies operating in the field.
It can be a worthy investment if done right. It’s best to invest in ORRI for producing wells because returns depend on production. Investing in this interest for a non-producing well would not make sense as you don’t know when profits may start.
As always, it’s best to educate yourself and speak with a professional before signing anything.