What is a Shut-in Royalty?

Natural gas drilling in the Marcellus Shale is taking off. So far in 2010 over 1,200 natural gas wells have been drilled in the Marcellus region of Pennsylvania:

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Despite the recent trend toward lower natural gas prices, the pace of drilling has accelerated and is expected to further increase over the coming years. But while wells are being drilled now, the pipeline infrastructure to transport the gas to consumers is far from complete. Pipeline companies are currently in the process of constructing the gathering lines, but in many cases the wells are completed and capable of production before the pipeline that will connect to the well is in place. The expression used to describe a well that is capable of gas production but is not yet connected to a pipeline is “shut-in.”

The typical oil and gas lease does not include any type of provision specifically stating when the gas company must market the gas that is capable of being produced from a well. However, the lease will in most cases provide for some form of compensation to the landowner during the period when gas is not sold from the leased premises. Various terms have been used to label this payment, but most often this is found in the lease as the “shut-in royalty.”

The concept of a payment for the time from when the well is drilled until the gas is marketed sounds appealing, but in reality the shut-in royalty is often structured as a nominal payment made annually that does not adequately compensate the landowner for the time when royalties are not forthcoming. An additional concern is that the gas company could choose to voluntarily shut-in a well that is connected to a pipeline, thus holding the gas in reserve. From a purely economic standpoint, the decision to hold a well as shut-in may make sense when the price of natural gas is low, particularly if there is reason to believe that the price of gas may significantly increase in the future. However, for a landowner who has been patiently waiting for royalties and finally sees the producing well connected to a pipeline, the prospect of an indefinite postponement of the wealth from royalties can be discouraging.

The time to address these concerns is during gas lease negotiations. One solution is to negotiate for an increased shut-in royalty, though even a substantially larger payment is unlikely to approach the potential royalties. Another possibility is to place a fixed time limit on how long the lease can be maintained in effect solely by payment of the shut-in royalty. Finally, it is generally advisable to include verbiage in the lease placing a duty on the gas company to make a good-faith effort to market gas production from a well within a reasonable time period.

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