Cash In on the Natural Gas Shale Boom

Jeff and Pamela Barnes of Lawrenceville, Pa., work a dairy farm in Tioga County that’s been in Jeff’s family for generations. A year ago, like so many farmers, they were juggling a lot of debt, sometimes scrimping to get by. “Before, if something broke, it was broke. There was no replacing it,” says Pamela. “Before” means before the royalty payments, which can range from $8,000 to $35,000 a month, for the natural gas extracted from the shale thousands of feet beneath the Barneses’ farm—and beneath much of Pennsylvania, New York, West Virginia and parts of Maryland and Ohio—that was deposited nearly 400 million years ago in the Marcellus Formation.

SEE ALSO: Investing in the Natural Gas Shale Boom

Royalties have been coming in for nearly a year, allowing the family to pay off bills, purchase machinery and invest $50,000 in a portfolio of mutual funds. Jeff and Pamela are working with a financial planner and an accountant, discussing, among other things, a college fund for sons Glenn, 7, and Nicolas, 5. “We’re working out a financial road map,” says Pamela. It’s an exercise these farmers, tied to the twice-daily rhythms of milking cows, find unfamiliar. Says Jeff: “We’re in uncharted waters now.”

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That’s true of a lot of Pennsylvania residents, thanks to the shale boom. Since 2008, nearly 3,400 Marcellus Shale wells have been drilled in the state. A landowner with 100 acres of Marcellus Shale rights might expect (but can’t count on) $2 million in royalties over 20 years—on top of lease payments that can run six figures—but the overall wealth generated is much greater. According to one study, a typical well generates about $4 million in economic benefits, including 62 jobs. Shale gas production has grown an average of 48% annually from 2006 through 2010, as extraction has become economical through a combination of horizontal drilling techniques and hydraulic fracturing, in which a high-pressure mix of water, sand and chemicals forces gas out of the rock.

There are other shale boomtowns. In Louisiana, gas from the Haynesville Shale is boosting personal incomes in Shreveport at the fastest rate in the state, and in Texas, some of the Barnett Shale rigs bump right up against backyards in residential Fort Worth. Nor is shale the only path to Mother Earth’s riches. The National Association of Royalty Owners, an advocacy group and information clearinghouse, estimates that more than 12 million Americans receive royalties from oil, gas and other natural resources. But the growth is most evident in the Keystone State, where shale is changing everything.

Energy economy

In bucolic Bradford County, you can’t go far without encountering evidence of the boom. Here, a cluster of trailers in a farmer’s front yard, rented to gas workers from Texas. Lined up on a ridge, some 20 sand and water trucks ready to frack a gas well. Snaking every­where are trenches for gas pipelines and waterlines, while ponds that used to be hayfields dot the landscape, ready to feed millions of gallons of water to thirsty well sites. Traffic periodically comes to a standstill in little towns like Troy and Canton, infuriating residents, to make way for motorcades of wide-load flatbeds hauling well equipment.

Though the markers of a thriving energy economy are everywhere, would-be shalionaires can hit a lot of snags. Angie and Jeff Sechrist have a well in the backyard of their Canton, Pa., farm, another two on a ten-acre parcel six miles down the road, and still another on additional acreage owned jointly with several other landowners. With no pipeline, and no hint of when one might be coming, the backyard well sits idle, not paying a penny. Royalties barely trickle in from the jointly owned property—it’s impossible to forecast how productive any given well will be, or how natural gas prices (recently about $4 per thousand cubic feet) will behave.

But the 10-acre parcel is promising, having brought in more than $75,000, including the lease payment and gas royalties, since January 2009. Without the gas, “we’d be in trouble,” says Angie. “We probably would have sold some of our land for development.” That’s not likely now. While a visitor waits, Angie takes a phone call from someone at Chesapeake Energy. The company just staked out a well on another Sechrist property, and they want Angie to name it. (Most wells in the area carry landowners’ names.)

Getting in on the boom starts when a landman comes knocking. Landmen (who may be women) represent oil-and-gas companies in lease negotiations with landowners. They’ll offer an upfront payment, called a bonus, for the right to drill on a parcel of land, and royalties for gas extracted from the property, calculated as a percentage of the revenues for any gas sold. Pennsylvania, for example, mandates a minimum royalty of 12.5%. Gas companies may assemble many properties into a gas-producing unit, with landowners’ royalties based on their proportional share in the unit.

Negotiations quickly get complicated, and tales of unscrupulous landmen and naïve landowners are legion. Suffice it to say that when offered a “standard” lease and handed a pen, the worst thing to do is sign right away. Better to wait, talk to several gas companies, confer with neighbors and consult an attorney.

Timing is key. Some of the land in the Marcellus region has been leased for generations, with the leases renewed every five or ten years for a few dollars an acre. Extracting the gas didn’t become commercially viable until 2005 and later, as techniques improved. Acreage that might have been leased at $2 an acre in 2000 and $30 an acre in 2005 commanded $2,400 an acre in 2008. Some signing bonuses have reached $7,000 an acre in red-hot Bradford County, with royalties as high as 20%. “We entertained offers for five years,” says Jackie Root, a Tioga County farmer who has become a homegrown gas guru.

When a landman approached the Roots in 2000 with a lease offer of $2 an acre, Jackie first did a little digging, talking with neighbors, tracking seismic testing around the county and snooping at the courthouse to gauge leasing activity. Five years later, after four months of bargaining, Jackie struck a deal that included 35 landowners and 3,800 acres—and, like many in Shale Land, embarked on a second career. Since 2005, R&R Energy Consulting has negotiated many deals for landowner groups.

A standard lease will typically grant permission to the energy company for all manner of things—to run a pipeline through the property, for instance, or to use the land for gas storage. These and similar items should be negotiated separately, with compensation for each. Royalties should not have fees deducted for transportation or other costs. And landowners will want assurance that drinking water will be tested pre- and post-drilling, with any adverse effects remediated. By the time Roger Chilson, a tax preparer in Covington, Pa., finished negotiating a lease for his 10-acre farm, the number of addenda reached 34—and that is typical.

Severed rights

You don’t have to own land in Tioga County—or Louisiana or Texas—to hit a natural-gas jackpot. In parts of the country with a long energy history, it’s common for oil, gas or mineral rights to be “severed” from the land on top, as parents pass the rights on to kids—who divide them up among their heirs—while ownership of the surface takes a different path.

Pam Cooner, 42, an occupational therapist in Houston, has collected about $15,000 in the past year for a fractional ownership of mineral rights in the Eagle Ford Shale, in south Texas. Cooner was surprised when contacted by a landman about the rights. She didn’t know she’d inherited them—as had 13 other distant family members. In August, Cooner got a $400 royalty check for rights on another property, owned jointly with a different, non-family group—again, a total surprise. “Apparently, my great-grandfather went around buying up these [rights], but we never knew we owned them.”

Could you own unclaimed shale royalties? The chances are slim, but it’s not impossible. An energy company will usually succeed in tracking you down if you’ve inherited rights you’re unaware of, but not always. If you have a suspicion, it’s worth quizzing relatives, examining family paperwork and visiting the county courthouse. Finding out who owns the mineral rights for a given piece of land involves a separate title search that might go back 150 years, or to the origin of the county. Compare that with a traditional real estate search going back, say, 60 years. Searches are free at the courthouse. But tracking a complicated chain of title could require a professional abstractor and cost anywhere from a few hundred to several thousand dollars. Eventually, unclaimed royalties are placed in an escrow account with a state’s oil-and-gas commission, or perhaps with the county’s or state treasurer’s unclaimed-property division.

Shalionaires gone wild

For those lucky enough to get in on a gas gold rush, it’s best to have a plan. Everyone in a shale boomtown has a story about an acquaintance or a neighbor who’s gone a little overboard— perhaps with a $70,000 tractor or trips to Vegas or a fancy new house. “These are people who really didn’t have money before,” says financial planner Garrett Hoge, of H Financial Management, in Canonsburg, Pa. “It’s like hitting the lotto.”

Except it’s not. Royalty income doesn’t come with the clockwork regularity of an annuity; it’s about as unreliable as it gets, especially in the Marcellus Shale, where no one knows how productive wells will be, or for how long. What is known is that production typically tapers off quickly—by 50% to 70% in the first year alone and another 20% to 30% in year two, according to EnergyNet, an online auction site for energy rights.

Most of the time, sensible and generous trumps extravagant. Cooner, in Houston, is using shale money to pay off her mortgage and invest in prepaid tuition plans for her two kids. Eldon Cummings, a Tioga County cattle farmer, wants a lasting legacy. He’s setting up a foundation to fund scholarships for area high schoolers and veterans. Cummings, 80, attended the University of Pennsylvania on scholarship after winning an essay contest. “As a kid, I had nothing. I want to ensure that what I get can help the community,” says Cummings, who has also contributed to the Deane Center for Performing Arts in Wellsboro, Pa. Whatever their wish list, Hoge tells clients, “Don’t think you’ll never have to think about money again.”

They’ll have to think about taxes right away, for instance, and estate planning down the road. Many Marcellus beneficiaries leap from the 10% tax bracket to the 35% bracket overnight. Signing bonuses are taxed at rates for ordinary income. So are royalties, although owners can claim a 15% depletion deduction in calculating taxable royalty income because the resource is being used up over time. Some families find that it makes sense to separate royalties from the rest of their finances by means of a trust or a family limited partnership. Legal fees to do so might run $1,500 to $5,000. For others, a will is all that’s needed.

In Pennsylvania, where royalty checks are just starting to flow, it seems premature to ask about the best time to sell one’s mineral rights. Market timing is as risky with mineral rights as it is with stocks or bonds, says Kenny DuBose, a mineral-rights consultant and CEO of MineralWeb.com, a site with how-to articles and a forum for rights owners. Besides, a few thousand feet below the Marcellus Shale lies the Utica Shale, which stretches beneath parts of eight states—another boom in the making.