Oil and Gas Minerals: Royalties When Crypto Mining

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By now, several E&P companies have been in conversations with crypto miners and many more have been hearing and reading about this latest innovation making waves in the oil patch.

At the simplest level, mining for digital coin requires just three things: access to electricity, a bank of specialized mining computers and a connection to the internet.

Given the simplicity, a mining farm can be set up nearly anywhere. Internet and computer access are fairly ubiquitous. So savvy miners seek a competitive advantage in the third piece of the puzzle: lower-cost electricity.

A couple of common targets include sites with excess electricity-generation capacity and oil wells that are producing otherwise uncommercial associated gas.

Finding unused or stranded natural gas makes for a perfect opportunity to bring in a generator and accompanying array of mining computers.

Crypto value

A look at the cryptocurrency business explains the flurry of activity. The market value of Bitcoin is more than $600 billion; Ethereum, more than $307 billion; and a handful of others, more than $300 billion combined, according to Forbes.

It is a complex process by which mining takes place. In short, specialized interconnected computers complete complex transactions, earning crypto coin for the miner.

The digital coins’ rise in value has led to a boom in mining over the years. Bitcoin was worth between $30,000 and $40,000 in late June. In 2018, it was worth less than $3,500.

And, while the value grew, the cost of mining it was virtually unchanged. Miners were able to profit even when Bitcoin was $700.

Since then, their profit margin has merely grown.

The lack of laws

As the combination of crypto coin and oil wells is a nascent industry, using stranded gas in crypto mining creates a number of potential legal issues that are not clearly addressed in current law.

Are royalties owed? Are there tax obligations? Are there permitting and siting requirements? Environmental issues? Is there any regulatory oversight imposed on any piece of the activity? For example, what are the state rules on the sale/transfer of gas to the electricity generator and the sale/transfer of electricity to the mining operation, if any?

A good place to start this analysis is with a careful review of your contractual obligations—e.g., your lease, farmout, development agreements.

As for laws and regulations, we do not expect to see any clear answers in most cases in, at least, the near term.

Exceptions to this are in Wyoming and North Dakota. The former recently passed legislation (HB0189) to exempt from severance tax the natural gas that would otherwise be flared, including when that gas is repurposed for use in crypto mining.

North Dakota passed legislation (SB2328) to provide a tax credit for capture and repurposing of gas that would otherwise be flared.

Lacking more clarity, a further nuanced evaluation should begin by considering three issues raised by this opportunity:

• What is being, or would be, done with the gas in the absence of its use for electricity generation?
• Is the gas a marketable commodity or an unused byproduct?
• What compensation is the well operator receiving from the cryptocurrency mining?

Royalty obligation?

The most direct way to ensure certainty as to the royalty obligation is to secure a written agreement with the mineral owner. Many operators may think they are not in a situation where that is a desirable option. So we turn now to the most common answers.

Nearly all oil and gas development in the U.S. is conducted with an underlying lease agreement. At its core, it allows the operator to extract and sell the hydrocarbons in return for a payment of a percentage of the revenue.

Many modern leases allow the operator to use some of the produced hydrocarbons to generate electricity on site for operations. The scope is often not clearly defined. But it is generally understood to cover reasonable activity that furthers the purpose of the lease: producing and selling the hydrocarbons.

The lease assumes the operator has an appropriate economic incentive to get the hydrocarbons to market.

At the simplest level, mining for digital coin requires just three things: access to electricity, a bank of specialized mining computers and a connection to the internet.

In many U.S. basins, operators are able to readily connect and sell produced gas downstream. When an operator elects to utilize some of that gas to generate electricity for crypto mining, there will normally be an agreement with the mining firm or an agreed contract price that provides the basis for appropriate royalty payments to the mineral owner, subject to any specific terms in the lease.

The latter basis for calculating royalties applies unless the operator is taking the position that the mineral lease is written in a way that supports this gas-fired generation being covered by the operator’s fair-use provision.

In places like the Williston or Permian basins where the primary hydrocarbon is oil, many operators either lack physical takeaway capacity or market prices do not make transportation and treatment economic.

In these cases, repurposing the gas for crypto mining is particularly attractive.

Generally an operator incurs no royalty liability on the volumes of gas produced from wells when the gas is not sold downstream. When the operator allows a third party to capture this unused gas as an environmental-mitigation strategy, it should not incur any new royalty liability.

We would expect this to be particularly true where the operator truly receives no financial benefit—neither via direct payment nor via having a financial interest in the mining venture.

The test

At the same time, crypto mining takes gas that was an unused byproduct and turns it into a product with a market. A thoughtful review of this argument should focus on whether: 

• The gas is now being sold to a third party, in which case the normal terms of the lease will govern royalties due on sale proceeds;
• The gas is truly being captured without compensation to the oil operator as a preferred environmental-mitigation method, in which case good public policy should not impose any new royalty obligation that did not exist when the gas was being vented or flared; or
• The operator is deriving some indirect benefit, such as membership in the mining venture or receipt of a portion of the earned cryptocurrency.

The potential outcome of a legal challenge in this third situation is the most difficult to predict.

The best guidance for the case in which an operator forms a joint venture or owns an equity stake of some sort in the mining enterprise would be the existing jurisprudence on affiliate transactions. This situation is not unlike when an operator enters agreements to sell gas to its gas gathering and/or midstream affiliate.

Here the operator will need to be prepared to explain and defend the economic terms of the transaction, including what the fair value of the gas would be if sold to a different party.

In cases where no value is attributed to gas that would otherwise be vented or flared, the operator would need to demonstrate that the mining project would be uneconomic if not for the gas having no value.

As a result of this volatility and the conversion of currency, any venture that will include a calculation of economic benefit or payment of compensation based on a value of cryptocurrency requires careful and thoughtful drafting.

Coin to USD

Potential complexity arises in those cases where an operator has the opportunity to be compensated by receipt of some portion of the cryptocurrency.

Unlike U.S. dollars, the value of cryptocurrency is extremely volatile. When converting it to USD, the royalty paid to the mineral owner could vary wildly depending on the coin’s value at the time it was posted to the mining company’s account, posted to the operator’s account or sold and converted to U.S. currency.

On June 21, for example, a Bitcoin earned by the miner was worth around $35,000. When transferred to the operator on June 23, it was worth around $29,500. When converted to USD and paid out at the end of the business day June 25, its value was $32,200.

As a result of this volatility and the conversion of currency, any venture that will include a calculation of economic benefit or payment of compensation based on a value of cryptocurrency requires careful and thoughtful drafting.

Conclusion

An operator’s analysis of its obligation to pay royalties starts where nearly all similar questions begin: a careful reading and understanding of the terms of the governing documents and review of applicable statutes and regulations—or lack thereof.

Because stranded gas for crypto mining was not even contemplated when most current leases or other agreements were signed, it is likely that no clear provision will be identified.

As with the evolution of all agreements, it is likely that industry will begin to see documents edited to cover this and related topics.

Meanwhile, leaders in the oil and gas industry find themselves in the familiar position of trying to forge ahead with productive new economic activities while waiting for legislators to catch up and pass (hopefully) thoughtful, helpful law to fill in the gaps, balancing the rights and obligations of the parties involved.

Until then, carefully evaluate the risks and opportunities of this latest exciting chapter in the industry’s ever-evolving history.

Ryan J. Morgan is the energy transactions practice leader for Steptoe & Johnson PLLC. He is based in Charleston, W.Va.