What is a Royalty Interest?

'Royalty interest' in the oil and gas industry refers to ownership of a portion of the resource or revenue that is produced. A company or person that owns a royalty interest does not bear any of the costs of the operations needed to produce the resource, yet the person or company still owns a portion of resource or revenue produced.

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 of the costs for exploration, drilling, and production. An investor that has a royalty interest only bears the cost of the initial investment and isn't liable for ongoing operating costs.

Royalty interests are commonly associated with companies that farmout their production to other 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 oil or gas, with the option to convert the royalty back into a specified working interest in the block after paying for drilling and production expenses that were 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 have ownership rights to the oil fields that hold developable resources but lack the financing or technology to bring these resources to the production phase. Entering into a royalty interest agreement works for all parties involved. The company that is tasked with bringing the resources to production is entitled under contact to retain a portion of the production to sell on the market. This operator will need to decide for themselves if any particular project is profitable or not. In return for access to the oil fields, the producing company pays the field owner a royalty payment. The owner would not be able to receive this royalty interest unless the resources are developed, produced and sold, so entering this agreement is economically profitable for them.

One company that makes frequent use of this type of royalty interest arrangement is Kosmos Energy (NYSE: KOS). Kosmos has rights to acreage off the coast of Ghana, but the costs and risks to develop these resources are high because they are underwater. To help reduce these risks, Kosmos farms out its acreage to third parties like Hess (HES), Tullow Oil and BP and, in return, receives royalty payments from these operators.