Checks from Drilling May Dry Up Amid Low Gas Prices

Erich Schwartzel        Pittsburgh Post-Gazette     May 22, 2012

Royalty checks that start to arrive when a gas company drills on your property can make for some very profitable envelopes in the mailbox. But the low natural gas prices that have disrupted industry balance sheets in recent months could start to cut into those checks.

Put it this way: You could be having filet mignon when theyre high, and Kraft macaroni & cheese when theyre low, said Craig Tillotson, executive vice president of sales at the Downtown-based Hefren-Tillotson wealth management firm.

Mr. Tillotson is a wealth adviser whose expanding client base includes farmers and landowners signing lucrative leases for their mineral rights in the Marcellus Shale natural gas formation. So-called shaleionaires can take home millions of dollars by signing a lease, but they are now entering an unpredictable market that can cause royalty checks to fluctuate or stop altogether.

The lowest natural gas prices in a decade also have forced a new industry emphasis on lease terms that allow companies to deduct certain well costs from landowner royalty checks.

So far this year, the Pittsburgh regions dominant driller, Range Resources, said it has paid $65 million in royalty payments, which should put the company on pace to match last years total of $166 million. Because it can take months to get gas from the wellhead to market, it can take months for low natural gas prices to be reflected in royalty checks.

Landowners typically make money in two forms when they sign a lease: a per-acre lump sum and then monthly royalty checks once a well is drilled and starts producing. While the lump sums can total millions of dollars for major landowners, the potential for years of royalty checks can add up to even more.

The aggregate of the royalty checks should make the bonus payment appear insignificant, said Kit F. Pettit, an attorney in Pittsburgh who specializes in representing landowners.

If a landowners income were compared to the U.S. Steel building, he said, A bonus payment would fill up the first floor and then a productive horizontal well assuming good natural gas prices would fill up the other 63 floors with royalty payments.

But low prices now threaten to keep many of those 63 floors vacant.

Natural gas has hovered around $2 per Mcf lately the lowest price in more than a decade, and one that makes drilling in parts of the Marcellus Shale unprofitable. Prices have fallen as new shale formations increase the supply of gas, and a lack of infrastructure required to take the gas to market has limited the industrys ability to sell the fuel as quickly as it is produced.

Complicating the value of royalty checks is whether a company can deduct post-production costs from a royalty payment before cutting the check to the landowner a detail often negotiated during a lease signing. Post-production costs can include everything from the cost to compress and process the gas to the cost of the pipelines needed to transport it.

Some companies will even take marketing costs out of the post-production expenses, using the funds to pay for billboards or commercials, but the extent of post-production fees allowed to be deducted varies from lease to lease.

The industry has a precedent for turning to royalty checks to help trim costs.

When the price of gas started to drop in August 2011, Chesapeake Energy saved money by deducting post-production costs from the royalty checks of about 20,000 royalty owners in the Barnett Shale in Texas. The deductions, which affected landowners who didnt have provisions guarding against the practice, slashed royalty checks by about 25 percent.

At the time, the Oklahoma company that is now a big player in the Marcellus Shale said post-production costs can range from 70 cents to $1 per Mcf.

Some leases even include a shut-in clause that allows the company to cap a well for an indefinite amount of time if it decides it cant turn a profit right away.

More recently, some of the gas companies are starting to push back on the shut-in clause, said Mr. Pettit. They want the ability to play the market and resume drilling when prices rebound, he said.

Not even 10 percent of the landowner clients at Hefren-Tillotson are receiving royalties yet because there are so many new wells and the pipeline infrastructure is not yet in place, said Mr. Tillotson.

The Downtown-based firm manages more than $7 billion in total assets and branches throughout Western Pennsylvania, with a new office opening in Greensburg to help accommodate new clients from more rural parts of the state.

Like many businesses along the drilling supply chain, Hefren-Tillotson didnt have shale portfolios as part of its traditional clientele. Executives served the portfolios of small business owners, but expanded into shale investments several years ago when those same business owners started asking questions about lease agreements on land they owned.

Now the firm works with farmers and landowners being offered potentially millions of dollars for an asset that never made them cash before, said Mr. Tillotson.

The concern is in how to invest the lump sums that come with signing a lease, which at thousands of dollars paid per acre can easily add up to millions of dollars. Sometimes a landowners portfolio is invested in energy stocks, said Mr. Tillotson, who sees the sector as a good long-term investment as the demand for energy rises.

There are tax concerns, as well. The new revenue can catapult landowners into an income strata and tax bracket.

If a lease payment pushes yearly income above $385,000, the landowner will pay about 35 percent in federal taxes. The Internal Revenue Service, however, has a ruling that allows landowners to receive lease payments paid out over several years so their incomes dont crack the high tax bracket and force costly payments to the federal government.

The ruling has been used in the past by shale leaseholders and successful court plaintiffs, said Mr. Pettit.


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