Net Profits Interest 

Net Profits Interest (NPI) is a form of agreement commonly used in oil, gas, and mining, whereby the property owner is entitled to share the profits generated by operations on their property. NPIs differ from royalty interests because the net profit interest is calculated after deducting operating costs so that the property owner receives only the net profits. This guide elaborates on the types, calculations, and examples of NPI to achieve clarity for beginners and seasoned investors. 

What is Net Profits Interest? 

Net Profits Interest is a profit-sharing arrangement between a property owner (or interest holder) and an operator. It is particularly relevant in extractive industries, where operational costs are often high. While the property owner no longer looks forward to receiving a share of gross revenues, he instead enjoys a percentage of the remaining profits after deducting all allowable expenses. 

Key Characteristics of NPI 

• Risk-Sharing: NPI holders benefit only if the operation is profitable; hence, there is a performance-conditional interest. 

• No Operating Role: NPI holders are not involved in running the operation or making operational decisions. 

• Contract-Based: The contract clearly outlines deductions and how the profits will be calculated to avoid disagreements. 

• Commonly in Resource-Based Industries: Most natural resource-based industries, especially oil, gas, and mining. Operational costs or revenues can dramatically vary in such industries. 

In an NPI agreement, the property owner is not involved in operations; on the other hand, he/she benefits financially if the project generates profit. The operator bears the operational costs and risks, while the owner shares in the profits based on the terms agreed upon. 

Understanding Net Profits Interest 

Net Profit Interest is a passive income arrangement that incentivises property owners to lease their assets without taking operational risks.  

Here’s how it works: 

• Leasing of Property: The owner leases a property (e.g., an oil well) to an operator. 

• Revenue Generation: The operator generates revenue by extracting and selling resources. 

• Expense Deduction: Operational costs, including labour, transportation, maintenance, and taxes, are deducted from revenue. 

• Profit Sharing: A predetermined percentage of the remaining profits is paid to the property owner as NPI. 

NPI fundamentally differs from royalty agreements, which are based on gross revenue without regard to operational profitability. 

Types of Net Profits Interest 

The types of Net Profits Interest arrangements vary with industrial needs, tax structures, and operational goals. Here are some of the detailed types: 

1. Standard Net Profits Interest

This is one of the common types of NPI, in which the property owner receives a fixed percentage of the net profits. 

Example: A property owner with a 20% NPI will get 20% of the net profits after all expenses are subtracted from revenue. The percentage does not change regardless of how much money is generated in revenue or profit.  

Best Suited for more straightforward deals in which property owners don’t need to alter their percentage depending on market shifts. 

2. Tiered Net Profits Interest

In a tiered NPI system, the percent returns of the owner depend on profitability levels. 

Example: An NPI might contain 15% of net profits below $10 million and 25% if profits exceed $10 million. 

Best for those projects where profitability differs much over time to motivate both parties to optimize operations. 

3. Convertible Interest

This type allows a royalty interest on gross revenue to be converted into an NPI. 

Example: If a property owner begins with a royalty of 5% of gross revenue, this may be converted into a 20% share of net profits when operations stabilise, and expenses decrease. 

Best For: Situations where front revenue (royalty) is preferred initially, but profit-sharing (NPI) is preferred more in the long term. 

4. Sliding Scale Net Profits Interest

Like tiered NPI, the percentage here depends on external factors such as commodity pricing. 

Example: If oil prices are less than $50 per barrel, the property owner receives 10% of net profits. Prices higher than $70 per barrel receive 30%. 

Best For: Commodity-based industries where market prices significantly affect profitability. 

Calculation of Net Profits Interest 

NPI calculations involve several well-defined steps. Let us break them down for a clear understanding. 

Step 1: Calculate Total Revenue 

Total revenue is the income obtained from selling the resources extracted in the operation. It is calculated as: 

Total Revenue = Quantity Sold x Price per Unit 

Example: 

If an oil operation sells 200,000 barrels at $75 per barrel: 

Total Income = 200, 000 × 75 = US$15,000,000 

Step 2: Net out Operating Costs 

Operating expenses include drilling, labour, maintenance, transportation, taxes, and other expenses required to produce the lease. These reduce total revenue: 

Net Profits = Total Revenue – Total Expenses 

Example: 

Assuming the company’s operational expenses amount to $9 million: 

Net Profits = 15,000,000 – 9,000,000 = US$6,000,000 

Step 3: Determine the NPI Payment 

The final step is to pay the assigned percentage of net profits to the property owner: 

NPI Payment = Net Profits × NPI Percentage 

Example: 

Assume that the percentage of NPI is 25%. Then: 

NPI Payment = 6,000,000 × 0.25 = US$1,500,000 

Examples of Net Profits Interest  

Example 1: Operating an Oil Well 

Case: 

An oil company has an operating well and is ending the year with the following financials: 

Revenue: $18 million (300,000 barrels sold at $60 per barrel) 

Operational Expenses: US$12 million 

NPI Percentage: 15% 

Step-by-Step Calculation: 

Calculate Total Revenue: 

Total Revenue = 300, 000 × 60 = US$18,000,000 

Calculate Net Profits: 

Net Profits = 18, 000, 000 – 12, 000, 000 = US$6,000,000 

Determine NPI Payment: 

NPI Payment = 6, 000, 000 × 0.15 = US$900,000 

Result: 

The owner receives $900,000 from this transaction. 

Example 2: Gas Field Operation 

Case: 

A gas field generates income from natural gas sales at a price of $5 per unit for 4 million units. The cost of the operation is made of $12 million in drilling and transporting. The NPI contract has a 20% percentage. 

Step-by-step calculation 

Calculate Total Revenue: 

Total Revenue = 4,000,000 × 5 = US$20,000,000 

Determine Net Profits: 

Net Profits = 20,000,000 – 12,000,000 = US$8,000,000 

Determine NPI Payment: 

NPI Payment = 8,000,000 x 0.20 = US$1,600,000 

Result: 

The property owner gets $1,600,000. 

Frequently Asked Questions