What is a Royalty Interest?
Royalty interest in the oil and gas industry refers to ownership of a portion of a resource or the revenue it produces. A company or person that owns a royalty interest does not bear any operational costs needed to produce the resource, yet they still own a portion of the resource or revenue it produces.
Breaking Down Royalty Interest
In contrast to a royalty interest, a working interest refers to an investment in an oil and gas operation where the investor does bear some costs for exploration, drilling and production. An investor holding a royalty interest bears only the cost of the initial investment and isn't liable for ongoing operating costs.
Royalty interests are commonly associated with companies that farmout production to larger oil companies to reduce project and financial risk. Farmout agreements work because the farmor usually takes a royalty interest once the field is developed and producing, while retaining the option to convert the royalty back into a specified working interest after paying the drilling and production expenses incurred by the farmee. This type of option is commonly known as a back-in after payout (BIAPO) arrangement.
Royalty interests are favorable for smaller companies that hold ownership rights to developable oil fields but lack the financing or technology to bring these resources into production. Entering into a royalty interest agreement works for all parties involved. The company tasked with bringing the resources into production is entitled under contact to retain a portion of the output for sale on the market. This operator will need to decide for itself whether a particular project will be profitable. In return for access to the oil fields, the producing company pays the field owner a royalty. The owner would not be able to receive this royalty unless the resources are developed, produced and sold, so entering into this agreement is economically profitable for them.
One company that frequently enters into royalty interest arrangements is Kosmos Energy (KOS). For example, Kosmos holds rights to acreage off the coast of Equatorial Guinea, but the costs and risks to develop these resources are high because they are underwater. To help reduce these risks, Kosmos farmed out acreage to Trident Energy in 2018 in return for royalty payments.