A working interest in oil or gas drilling allows the owner to work on the land and pay a percentage of expenses, proportional to their interest. Investors seek working interests for a share of exploration proceeds, but royalty interests can reduce profits. Investors should ensure a piece of land will produce before purchasing a working interest.
A working interest in an oil or gas drilling operation gives the owner of the interest the right to work on the land where the drilling will take place. The owner of the interest must also pay a percentage of the expenses incurred while working on the land that is equal to the percentage of the interest that he owns. Investors look for a working interest because it also entitles them to a share of the exploration proceeds after paying royalties. If an investor finds the right piece of land, he can earn significant returns on that investment.
Getting involved in oil or gas exploration typically requires a significant amount of wealth from an individual investor. Such investors are drawn to the virtually unlimited earning potential of this lucrative business. However, they must pay for the opportunity to enter this industry. One way an investor can buy is through a working interest, which gives him a share of the profits proportional to the cost of working the land.
For example, suppose an investor pays a 50 percent working interest in land that will be used for oil or gas exploration. This means that the investor pays 50 percent of the expenses related to the drilling. The rest of the expenses would be divided among the other people with labor interests in the land. If the profits start rolling in, the investor with the 50 percent interest will reap 50 percent of the profits, less any royalty payments due.
These royalty interests can significantly reduce the profits earned by those who have other interests. Using the example above, imagine that the initial owner of the land demanded a 10 percent royalty from investors for the right to work the land. Suddenly, the owner of the 50 percent working interest would be entitled to half of the earnings after subtracting 10 percent of the royalty interest, meaning his earnings would drop to 45 percent. This is true even though he still has to pay 50 percent of the expenses.
Since this is the case, an investor should be especially sure that a piece of land will produce large amounts of gas or oil before purchasing a working interest. While the reward potential is great, the risk incurred is just as great. For that reason, investors wishing to play it safe in this industry might prefer to buy a royalty stake.
Smart Asset.
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