Legal Definitions - carried interest

Carried Interest

In the context of oil and gas exploration and production, a carried interest refers to a fractional ownership stake in an oil or gas well where the owner is not responsible for some or all of the initial, significant costs associated with exploring, drilling, and completing the well. Essentially, another party, typically the "working interest" owner, covers these substantial upfront expenses on behalf of the carried interest owner.

The owner of a carried interest typically receives a share of the revenue from any oil or gas produced (often in the form of royalties) once production begins. However, they do not bear the financial risk of the initial development phases. This "carry" usually continues until the working interest owner has fully recovered their investment in the well, and sometimes even until they have received a multiple of their initial costs. After this point, the carried interest owner might then begin to share in the operational costs, or their interest might convert to a different type of ownership.

• Example 1: A Landowner's Deal

  Imagine a farmer, Mr. Henderson, who owns land with significant mineral rights. An oil company, "Deep Earth Drilling," approaches him, believing there's a large oil reserve beneath his property. Mr. Henderson wants to benefit from potential production but lacks the millions of dollars required to explore and drill a well himself. Deep Earth Drilling offers him a 5% carried interest in the proposed well. This means Deep Earth Drilling will bear all the costs of exploration, drilling, and bringing the well into production. If the well is successful, Mr. Henderson will receive 5% of the revenue from the oil produced, without having paid any of the initial development costs. Deep Earth Drilling will continue to cover all costs until they have recouped their entire investment, after which Mr. Henderson's 5% share of revenue would continue, potentially with a different cost-sharing arrangement for ongoing operations.

  How this illustrates "carried interest": Mr. Henderson holds a fractional interest (5%) in the well. He is "carried" through the expensive initial phases (exploration, drilling, completion) as Deep Earth Drilling covers these costs. He receives royalties from production without upfront investment, and his interest is free of these costs until Deep Earth Drilling recovers its investment.

• Example 2: Expert Contribution

  A highly respected petroleum geologist, Dr. Anya Sharma, identifies a promising but challenging geological formation that major oil companies have overlooked. She presents her detailed analysis and proprietary seismic data interpretation to "Frontier Energy Ventures," a smaller exploration company. Frontier Energy Ventures agrees to fund the drilling based on Dr. Sharma's expertise. In exchange for her intellectual contribution and the use of her data, Dr. Sharma is granted a 2% carried interest in any successful wells drilled in that formation. Frontier Energy Ventures will pay all costs to drill and complete the wells. Dr. Sharma will receive 2% of the production revenue, but only after Frontier Energy Ventures has recovered 150% of its initial drilling and completion costs. Until then, she bears no financial risk or cost burden for the drilling operations.

  How this illustrates "carried interest": Dr. Sharma holds a fractional interest (2%) in the wells. Her interest is "carried" because Frontier Energy Ventures pays all the exploration and drilling costs. She benefits from production revenue without contributing capital, and her carry continues until Frontier Energy Ventures has recovered a multiple of its investment.

• Example 3: Joint Venture Incentive

  Two oil companies, "Giant Resources" and "Small Scale Explorers," decide to form a joint venture to develop a new offshore block. Giant Resources is a much larger company with extensive capital and advanced drilling technology, while Small Scale Explorers has valuable local permits and a strong understanding of regional geology but limited funds for a large offshore project. To incentivize Small Scale Explorers' participation and leverage their local knowledge, Giant Resources offers them a 10% carried interest in the initial exploratory well. Giant Resources will fund 100% of the costs for drilling and testing this first well. If the well proves commercially viable, Small Scale Explorers will then begin to contribute their 10% share of costs for subsequent development wells and ongoing operations, but only after Giant Resources has recouped all its investment in the initial well.

  How this illustrates "carried interest": Small Scale Explorers holds a fractional interest (10%) in the initial well. They are "carried" through the expensive exploratory phase, meaning Giant Resources covers all the costs. They receive the benefit of potential discovery without initial financial outlay, and their cost-free period lasts until Giant Resources recovers its investment.