The Case of the Shrinking Royalty Payments
Have you ever sat down and compared your recent oil and gas royalty checks to older ones? In doing so, you’ll notice that the check decreases over time, often dramatically. This is normal. In fact, your checks will steadily decrease, unfortunately. Why is this the case? It’s because wells produce less and less over time. Production follows a declining trend aptly referred to in the industry as a decline-curve.
The above graph represents the average decline curve for wells located in Colorado. Individual wells will vary and there will be some month-to-month variations, but thanks to physics, the overall shape and trend is a certainty.
Why Declines are Unavoidable
Oil wants to flow upwards to the surface. I’ll be honest, this kind of hurts my brain every time I hear it. Not only that, but it is moving through rocks. Mind. Blown. This starts to make sense, however, if we remember two things: (1) Oil is very light – it floats on water after all. (2) The entire weight of the earth‘s surface presses downwards, creating immense amounts of pressure on everything underneath it. Newton’s third law of physics tells us that for every action in nature, there is an equal and opposite reaction. So, there is an equal amount of pressure pushing upwards as downwards in the earth. This upward pressure forces oil and gas to the surface through unbelievably small pores in rocks and other sediment. Oil and gas continue flowing upwards until they either reach the surface or they get stuck by an impermeable rock (in other words a rock that has no pores). When this happens, a reservoir, or pool, of oil and gas forms.
Immense pressure builds up in the reservoir as the trapped oil and gas continue to try and flow upwards. Think of a ballon filled with air. A drill bit puncturing the reservoir is like a pin puncturing a ballon, but instead of the air escaping, it is oil and gas. In the old days, we did not have the technology to stop the oil from rushing out of the well and resulted in the now famous images of a “gushing well” like below.
As oil and gas is extracted, the pressure inside the reservoir decreases. Less upward pressure means less oil and gas being naturally pushed to the surface. The result is declining production. As this pressure decreases, operators may attempt to artificially increase it, usually by injecting gas into the reservoir. If this is unsuccessful and there is not enough natural pressure left in the reservoir to force sufficient amounts of oil and gas to surface, the operator plugs and abandons the well.
Flush Production & Accrued Payments
Owners that had new wells drilled on their minerals may have noticed a larger-than-expected drop-off between their first and second checks. This is because operators often do not pay out royalties immediately after production commences. Each state’s oil and gas commission determines when first payment is due. For example, in Colorado operators must pay royalty owners within 6 months after the first month of production. This means a mineral owner’s first check can actually be for up to 6 months of production. As we know from our study of decline curves above, these first 6 months will also be the highest-producing months of the well’s entire life. We call this initial surge of oil and gas “flush production”. So, an owner’s first check may be several months of flush production and the second for a single month during which significantly less oil is produced. If an operator waited a full 6 months to issue its first check, it would not be uncommon for the second check to be 90% less than the first one!
So there we have it. We solved the case of the shrinking royalty payments. The culprit was physics, who had a little help from his co-conspirator flush production.
