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Investing in Royalty Interests in Oil & Gas

Royalty interests provide a proven method for investors to get involved in the oil and gas industry without all the logistical concerns of a working interest. Essentially, an investor who purchases a royalty interest will receive a percentage of the revenue earned from oil extraction by a mining company; the investor is only responsible for the initial cost of purchasing the royalty interest, not future operating costs.

It is important to note that royalty interests generally only offer returns on extracted oil, and not necessarily on other sources of revenue for the company. Bonuses, leasing profits, and other forms of income are usually shared only with investors who have a working interest.

By contrast, a working interest entails continued investment and involvement in the mining company. This ongoing interest offers some advantages: working interests generally entitle the investor to more decision-making power within a company than a royalty interest does. They also offer a share of the total profit produced by a company, not just on mineral extraction. The increased risk, involvement, and expenditure associated with such an investment also results in a larger potential profit.

As such, a royalty interest is best used as a passive investment to diversify one’s financial portfolio, while shielding oneself from some of the risks associated with more involved investment strategies. While the risk of a working investment usually relegates it to large, wealthy investors who are heavily involved in the industry, the limited risk of royalty interests make it a more appropriate investment for smaller scale investors who appreciate the promise of oil and gas investments but don’t necessarily want to become experts in the field.

Oil and gas also constitute hard assets, a fact which many investors find reassuring. While trading on the stock market entails a certain degree of faith in the company one invests in, oil and gas--like gold--are physical resources that have a proven, durable value. They also insulate the investor from the fluctuations of inflation more than other investments; given current trends in the devaluation of the dollar, such hard assets are becoming ever more attractive to those looking to diversify their holdings.

Royalty interests also confer certain tax benefits to an investor. For federal income tax purposes, the IRS has ruled that such interests constitute real property. They can also be used in like-kind exchanges where a royalty interest in one industry can be traded more easily for an interest in another. This being the case, they can often be traded in 1031 exchanges, which defer the tax burden incurred by an investment to a later date.

Royalty interests are usually sold by mineral rights owners who need an up-front quantity of capital for exploration and development. They are thus able to retain control over the administration of a mine while they give up a portion of their long term profits. The royalty interest then becomes a commodity capable of being traded.

The relative ease of acquiring and exchanging royalty interests has recently encouraged a number of investors to emphasize oil and gas in their portfolios. With current advances in hydraulic tracking techniques, large domestic tracts of shale are now able to be profitably mined for oil and natural gas. Though such investments are promising, ongoing regulatory battles have made involved working interests somewhat less attractive, whereas investors with royalty interests have seen more consistent returns and fewer troubles from their investments.

The size of these shale deposits, and the present interest of large mining corporations, promises a solid, long-term value for such investments even beyond the potential royalties they generate. As investors become increasingly interested in these deposits, their tradable value likewise goes up. While royalty interests are generally best viewed as a long-term investment, the current oil boom makes them more attractive as tradable commodities.

Investors need to do careful research into the mine that they plan to invest in, since royalties are, of course, tied to the amount of extractable minerals in the land. As with any investment, investors are also well advised to coordinate with an accountant or financial planner to streamline the transaction and ensure that they reap all the available tax benefits from their interest. However, the promise of steady income from royalty interest makes them a very attractive prospect for a well-diversified financial portfolio.

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