What is Leasehold Interest?

Posted by CourthouseDirect.com Team - 23 October, 2019


what_is_surface_interestThe array of ownership and leasing agreements surrounding mineral interests can be a bit dazzling. There are so many ways mineral interests can be bought, leased, shared, and otherwise contracted, it can cause confusion even among experienced investors. 

The tangle of ownership and lease-holding also challenges landmen as well as credit and banking professionals. They must unravel the knot when developing deals for oil and gas exploration and production. Verifying levels of ownership is a crucial step for the implementation of new projects and changes to ownership to ensure successful forecasts of revenues and losses now and in the future. 

Understanding leasehold interest provides some illumination into the process of determining operating costs and royalties in the oil and gas industry.

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Defining Leasehold Interest

Leasehold interest is a legal right secured by an individual or corporation to use a specific property for a contracted time period. It can be considered an official claim through a lease arrangement to use an asset.

In general, a leasehold interest is a contract between two parties over a real asset. The owner is the lessor, who agrees to rent the property to the lessee, who is the person receiving the right to use the property. If the time of the lease is limited, it is considered a leasehold. If the time is unlimited, the interest is then called freehold. 

In the real estate or auto industry, a person can gain leasehold interest over a piece of land, a home, or a car. In oil and gas exploration and production, leasehold interest refers to the lease the company enters into with the mineral rights owner. Other names for leasehold interest are working interest and operating interest. Leasehold (working interest) can be broken into one of three types.

  • Operating working interest - held by the person or corporation operating the drilling equipment. The working interest holder pays for the cost of operation, as well as, payment to royalty owners.
  • Non-operating working interest - ownership held by an entity that has an interest in the well, unit of production, or lease without the responsibility for operations. 
  • Carried working interest - a partnership contract between (or among) two or more parties that have a working interest in the well. The parties can share working interest through joint ventures and contribute financial backing without being responsible for daily operations. 

Leasehold interest in oil and gas most often refers to the company leasing the mineral rights and required surface access that assumes the risk of exploration and the expenses of production. 

Mineral Interests, In Brief

The mineral estate is the underground portion of a piece of property where minerals (hopefully) exist that can be mined. Often, the mineral estate is severed from the surface estate and dealt with separately. The mineral interest owner can then sell the mineral interest or lease it to a company in return for royalties on any oil or gas produced from the well.

The mineral estate in Texas is considered the dominant estate, meaning the surface estate is subject to the rights of the mineral interest owner to use the land to access the subsurface content. When mineral interests are leased, the agreement includes access to the surface estate for the purposes of drilling, extraction, and transportation.

Multiple individuals or entities may own shares in a mineral interest, and the ownership benefits may differ depending on the type of ownership. Shares can be transferred by conveyance or reservation, or by inheritance. Each owner of a mineral estate is considered a co-tenant, each of whom has the right to explore and develop minerals. Each is also entitled to sign leases covering their undivided interest.

Every gas or oil lease can reserve different royalties or offer different terms, with co-tenants leasing to one or more lessees, who are then considered to have a leasehold interest. Royalties are the first item to be taken from revenue when it is divided. The project must pay royalty interest, overriding royalty interest, and non-participating royalty interest before working interest owners may split the rest.

Leasehold Interests vs. Other Interests

Beyond leasehold interest, other interests may be owned, leased, or that generate revenue.

  • Royalty interest is the right to share royalties on production but no right to lease the mineral interest or receive any lease-granting bonuses. The royalty recipient has no right of possession or use. Sometimes it is called a non-participating royalty interest although, in truth, all royalty interests are non-participating.
  • Term mineral interest is granted or reserved for a specific period, usually several years.
  • Overriding royalty interest is taken from the working interest. ORI is limited to the term of the lease. Once the lease ends, the ORI ends as well.

As mentioned above, leasehold interest is also known as working interest or operating interest, meaning the owner of the leasehold interest bears all of the cost of exploration and production. However, the leasehold interest only includes a portion of production revenues, whereas royalty interest owners receive production revenue free of production costs.

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Leasehold Interest Can Have Multiple Owners

Leasehold, or working, interest can be owned by more than one party. An original lessee may grant shares of the working interest to others who share the cost of drilling and production. Alternatively, if a tract has multiple lessees, they may come together and agree to joint development. However, Texas law only allows for a single operator of a tract, so the company that performs as an operator usually has an operating agreement with the other leasehold interest owners.

Investment and Tax Considerations for Working Interest Owners

Working interests are high-risk investments because all risk and expense for exploration, drilling, and production are shouldered by the working interest owners. Until the operation begins producing, if it produces, an investor receives no return on the working interest share.

Investing in a well that is already producing can reduce some of the risk, but the well could run dry, or other issues can delay or shut down a project, such as environmental or compliance problems. The delay in revenue return under certain circumstances may take months or years. If there is no cap on investment for a working interest, it’s possible to lose more than you contribute.

As far as taxes are concerned, oil and gas investing often provides tax credits and benefits. The government offers tax incentives to encourage investment in drilling for oil and gas, often better than all other investment tax deductions. For example, as an investor, you may be eligible for deducting intangible costs, tangible assets, and depletion.

Leasehold interest is the share of the mineral estate belonging by contract to a lessor. The leasehold interest owner has the responsibility to pay for exploration, drilling, and production. Any revenue from a well must first pay for royalties before the leasehold interest owner receives any money.

Leasehold interest is a high-risk investment, but there are generous tax incentives for those who decide to share in the risk of producing gas or oil. If you are a gas and oil exploration company, you become a leasehold interest owner when you sign a lease on mineral interests. 

To determine who has the legal right to sign a lease on a mineral estate, visit CourthouseDirect.com to do all your title searches online, and save yourself a trip to the courthouse.

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Topics: Oil and Gas

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