What it means
The risk management reference IRMI describes a working interest as a percentage of ownership in a mineral lease granting the right to explore, drill and produce oil and gas from the leased property. Working interest owners bear all the costs and liabilities of leasing, drilling, producing and operating a well.
They share in only part of the production revenue, with the balance going to royalty owners. IRMI gives a simple case: the owner of a 100% working interest in a lease burdened by a landowner royalty of 20% pays 100% of exploration, development and operating costs but is entitled to only 80% of the revenue.
A Texas oil and gas attorney explains where the interest comes from. When a mineral owner grants an oil and gas lease, the lease splits the mineral estate into two parts.
One is the lessee's interest, often called the working interest, and the other is the royalty interest the owner reserves. The lessee's interest is called working because it does the work of exploration and development.
The same source separates working interest from net revenue interest. If a landowner reserves a one-quarter royalty, the lessee has a 75% net revenue interest and a 100% working interest.
Several parties can share a working interest and split the costs, and an operating agreement governs their rights. Tax law treats the interest specially.
Section 469 of the Internal Revenue Code, which limits passive activity losses, says a passive activity does not include a working interest in an oil or gas property that the taxpayer holds directly or through an entity that does not limit the taxpayer's liability. The regulations define a working interest as a working or operating mineral interest in a tract of land.
This entry describes the US treatment as one example, and lease and operating terms control each deal.
In practice
Real-world examples.
Example
A fictional company leases a tract and the landowner reserves a one-quarter royalty. The company holds a 100% working interest and a 75% net revenue interest. It pays all drilling and operating costs.
Example
A fictional investor buys a 20% working interest in a well operated by another company. The investor pays 20% of the costs. The investor receives a matching share of net production.
Example
A fictional well is drilled and comes up dry. The working interest owners still pay the drilling costs. The royalty owner pays no costs.
Formula
Calculation
Net revenue interest = working interest x (1 - royalty rate), when the royalty burdens the lease.
Worked example with assumed figures: a 100% working interest and a 25% royalty.
Net revenue interest = 100% x (1 - 0.25) = 75%.
If the well costs $1,000,000 and sells $2,000,000 of production, the owner pays $1,000,000 and receives 0.75 x $2,000,000 = $1,500,000. The royalty owner receives $500,000 and pays no costs.
Owner's result before other costs = $1,500,000 - $1,000,000 = $500,000.
If the well is dry, the owner still pays the $1,000,000 of costs and receives no revenue, a result of negative $1,000,000. The figures are assumptions for illustration.Case study
Seen in the real world.
This case study is fictional and illustrative. A small exploration company leases 640 acres and agrees to a one-quarter royalty. It holds the whole working interest in the lease. The company sells 40% of its working interest to an investor, who agrees to pay 40% of the costs.
An operating agreement names the company as operator and sets out each party's rights. The well costs $1,000,000. The investor pays $400,000. The well produces $2,000,000 of oil and gas, and the investor's share of the net revenue is 0.40 x 0.75 x $2,000,000 = $600,000.
The investor's result before other costs is $600,000 - $400,000 = $200,000. The company keeps 60% of the working interest, so it pays $600,000 of costs and receives 0.60 x 0.75 x $2,000,000 = $900,000, a result of $300,000. The royalty owner receives $500,000 and pays nothing, and the three shares add up to $600,000 + $900,000 + $500,000 = $2,000,000. Had the well been dry, the investor would have lost the full $400,000.
Watch out
Common mistakes.
- Assuming a working interest owner shares only in profits, when the owner pays costs whether or not the well produces.
- Confusing working interest with net revenue interest, which is the share of production after royalties.
- Treating it like a royalty interest, which carries no cost share.
Questions
People also ask.
What is a working interest?
It is an ownership share in an oil and gas lease with the right to explore, drill and produce. The owner bears the costs and liabilities of operating.
How is it different from a royalty interest?
A royalty owner receives a share of production free of drilling and production costs. A working interest owner pays the costs and receives the remaining share.
Does tax law treat it differently?
Under section 469, a working interest held directly or through an entity that does not limit liability is not a passive activity. The tax rules are detailed, so check current guidance.
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