OVERRIDING%20ROYALTY%20INTERESTS:%20PITFALLS,%20PRECEDENT%20AND%20PROTECTION

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OVERRIDING ROYALTY INTERESTS PITFALLS,
PRECEDENT AND PROTECTION

• John K. H. Akers, Jr.
• Akers Associates LLC

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OVERRIDING ROYALTY INTEREST (ORRI)

• A nonoperating, nonpossessory interest in gross
  production from an oil and gas lease which
  attaches when the oil or gas is reduced to
  possession at the surface.
• Created by conveyance or reservation
• Carved out of the working interest in the lease
• Limited in duration to the term of the burdened
  lease
• Free and clear of drilling, completing and
  operating costs

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OTHER FORMS OF NONOPERATING INTERESTS

• Production Payment (aka Oil Payment)
• Net Profits Interest
• Carried Working Interest

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COMMON CHARACTERISTICS OF NONOPERATING INTERESTS

• Carved out of working interest in an oil and gas
  lease
• Limited to the term of the burdened lease
• Only payable out of production from the burdened
  lease
• Nonpossessory in nature
• Does not bear costs of drilling, developing and
  operating the lease

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ORRI REALTY OR PERSONALTY?

• ORRI is considered a real property interest in
  most jurisdictions
• Personal property in Kansas and Oklahoma
• Often defined as interest in real property with
  regard to matters related to the leasehold and as
  a personal property interest for
  post-production issues

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EFFECT OF CLASSIFICATION OF ORRI AS REALTY OR
PERSONALTY

• Statute of Frauds
• Venue
• Recording Statutes
• Applicable Law
• Available Remedies

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THE WASHOUT

• A washout is the elimination of the
  nonoperating interest as a result of a surrender
  of the burdened lease by the lessee and the
  subsequent reacquisition of a lease on the same
  lands by the lessee or its agent with the
  intention of taking the lease free of the
  nonoperating interest.

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DURATION OF THE ORRI

• Absent Agreement to the Contrary
• Limited to the term of the lease
• Expiration, surrender or forfeiture of the lease
  extinguishes the ORRI

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PERPETUATION OF ORRI

• ORRI owner has no recourse against a lessee who
  takes a new lease on the same premises before
  expiration of the burdened lease if
• 1. No extension or renewal clause
• 2. No Fraud or Bad Faith
• 3. Lessee not contractually obligated to keep
  original lease in force
• 4. Lease contains a provision permitting
  surrender or abandonment at election of lessee

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CIRCUMSTANCES PERPETUATING ORRI

• Fiduciary Relationship
• Fraud, Bad Faith

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JUDICIAL APPROACHES TO EXTENSION AND RENEWAL
CLAUSES

• Oklahoma Rule
• Definitional Approach
• Rule Against Perpetuities

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RULE AGAINST PERPETUITIES SAVINGS CLAUSE

• Any other provision hereof to the contrary
  notwithstanding, any overriding royalty
  interest/production payment/net profits interest
  granted/reserved in this assignment shall, in
  any event, terminate one day prior to the
  expiration of 21 years after the death of the
  survivor of all descendants of Joseph P. Kennedy,
  father of the late President of the United
  States, who are living on the Effective Date of
  this assignment.
• Hubert Taylor, Creation and Conveyance of
  Oil and Gas Leasehold Burdens, 31 Rocky Mr. Min.
  L. Inst 14.0411 p. 14-33

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IMPLIED COVENANTS

• The implied covenants that apply to the
  contemporary oil and gas leases are
• Covenant of Reasonable Development
• Covenant to Protect Lease from Drainage
• Covenant of Further Exploration
• Covenant to exercise Due Diligence in Marketing

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ENFORCEMENT OF IMPLIED COVENANTS BY THE
NONOPERATING INTEREST OWNER

• Grant vs. Reservation
• States Permitting ORRI Owner to Enforce Implied
  Covenants Under Lease
• States Limiting Right of Enforcement of Implied
  Covenants by ORRI Owner to Express Provisions in
  Assignment

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INTERPRETATION OF GRANTS AND RESERVATIONS OF ORRIs

• Plain Meaning of Words
• Lesser Interest Clause in Lease
• Proportionate Reduction Language

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JUDICIAL INTERPRETATION OF ORRIPart 1 of 5

• The reservation a 1/8th of 8/8ths Overriding
  Royalty Interest (without reference to leases or
  lands) -
• reserves an undivided, net 1/8th of 8/8ths ORRI.
• Downen Enterprises v. Gem Oil Gas Co., 476 N.E.
  2d 42, 43 (Ill. App. 5 Dist. 1985) Wolter v.
  Equitable Resources Energy Co., 979 P. 2d 948
  (Wyo. 1999)

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JUDICIAL INTERPRETATONS OF ORRIPart 2 of 5

• Lease covers 1/4 Mineral Interest
• the reservation of an overriding royalty of
  1/32nd of 7/8ths of all oil and gas produced and
  saved under and by virtue of this oil and gas
  lease - reserves an undivided 1/4 of 1/32nd of
  7/8ths ORRI.
• Williams v. Sohio Petroleum Company, 151 N.E. 2d
  645, 649 (Ill. App. 1958) Pollock v. McAlester
  Fuel Co., 223 S.W. 2d 813 (Ark. 1949)

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JUDICIAL INTERPRETATION OF ORRIPart 3 of 5

• Lease covers 7/12ths Mineral Interest
• reservation of 15,000 out of one-eighth
  (1/8th) of seven-eighths (7/8ths) of oil, if as
  and only when produced, saved and marketed from
  said land under this lease - production payment
  payable out of an undivided 1/8th of 7/8ths of
  production.
• R. Lacy, Inc. v. Jarrett, 214 S.W. 2d 692, 693
  (Tex. Civ. App. Tex. - Texarkana 1948) Middleton
  v. Broussard, 504 S.W. 2d 839 (Tex. 1974)

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JUDICIAL INTERPRETATIONS OF ORRIPart 4 of 5

• Lease covers 75 Mineral Interest
• reservation of a Three sixty-fourths (3/64ths)
  over-riding royalty out of the Seven-eighths
  (7/8ths) working interest - reserves an
  undivided 3/64ths of 7/8ths ORRI.
• Fry v. Farm Bureau Oil Co., 119 N.E. 2d 749, 751
  (Ill. 1954) Barker v. Boyer, 794 P. 2d 322 (Kan.
  App. 1990)

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JUDICIAL INTERPRETATION OF ORRIPart 5

• Reservation of a 3-1/8 of 8/8ths overriding
  royalty in a Federal-form assignment of a 20
  working interest in a Federal oil and gas lease
  is ambiguous due to lack of clarity and
  incompleteness of expression and will be
  proportionately reduced if extrinsic evidence
  shows that such was the intent of the parties.
• Wadi Petroleum, Inc. v. Ultra Resources, 65 P. 3d
  703 (Wyo. 2003)

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POOLING AND UNITIZATION OF THE OVERRIDE

• Is Unilateral Pooling or Unitization Provision
  Binding on ORRI Owner?
• Union Pacific Resources Company v. Hutchinson,
  990 S.W. 2d 368 (Tex. App Austin 1999)
• Wolter v. Equitable Resources Energy Co., 979
  P.2d 948 (Wyo. 1999)
• Harvey v. Moncrief, 816 P.2d 97 (Wyo. 1991)

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CLAUSE LIMITING ENFORCEMENT OF IMPLIED COVENANTS

• Development of, and operations on the premises,
  if any, and the extent and character thereof, as
  well as the preservation or forfeiture of the
  leasehold, shall be solely at the will of said
  assignor/assignee or its successors or assigns,
  and, upon termination of the leases covering the
  lands above described, for any cause whatsoever,
  there shall be no further liability hereunder.
• 2 Williams Meyers, Oil and Gas Law, 429 p.
  489 (2003) citing Bond v. Midstates Oil Corp. 53
  So. 2d 149 (1951)

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PROTECTING THE NONOPERATING INTEREST IN BANKRUPTCY

• 11 U.S.C. Section 541(a)-(1)
• United States Bankruptcy Code
• Boyd v. Martin Exploration Company, 56 B. R. 776
  (E.D. La. 1986)
• Grynberg v. Waltman, 946 P.2d 473 (Colo. App.
  1996)
• Hybrid Production Payment

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OTHER ORRI ISSUES

• Take-or-Pay Gas Purchase Contract Settlements
• Transamerican Natural Gas v. Finkelstein, 933
  S.W. 2d 591 (Tex. App. San Antonio 1996)
• Liens
• DeMac Drilling, Inc. v. Shomake, 713 P.2d 480
  (Kan. App. 1986) Cities Service Oil Company v.
  Pubco Petroleum Corp., 497 P. 2d 1368 (Wyo. 1972)
• AEC Industries, LLC v. Survivor Oil, Inc.

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TAX TREATMENT OF NONOPERATING INTERESTS

• Courtesy Of
• Larry C. Bidwell, CPA
• 6101 W. 38th Ave.
• Wheat Ridge, CO 80033
• 303.422.3070

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SCENARIO 1 (ORRI)

• Landman takes lease for 10,000 bonus payment.
  Turns lease to Operator for 30,000 cash and
  reservation of 5 ORI.
• Tax Consequence
• A. IRS Determination Sublease transaction
• B. 30,000 in ordinary income to Landman (FICA?)
• C. 10,000 cost reallocated to retained
  override - recovered through cost depletion or
  percentage depletion over producing life of
  property
• D. Production income from ORI IS non-business
  income and not subject to FICA

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SCENARIO 2 (PP)Part 1 of 2

• Landman takes lease for 10,000 bonus payment.
  Makes incidental sale to Operator for 30,000
  and reservation of 500,000 production payment
  payable out of 5 of gross production. Lease
  becomes productive on or before October 15 of the
  year following the sale of the lease.
  Engineering establishes that a substantial
  portion of recoverable reserves in lease will
  remain after payout of production payment

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SCENARIO 2 (PP)Part 2 of 2

• Tax Consequence
• A. IRS determination Sale Transaction
  financing agreement mortgage
• B. 500,000 production payment is discounted
  back to present value
• (1) 100,000 difference is considered interest
  non-business income to Landman, interest
  deduction for Operator
• (2) Landman has capital gain of 420,000 (maximum
  15 tax rate) paid on installment basis over the
  life of the Production Payment

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SCENARIO 3 (PP)

• Same as Scenario 2, except lease does not become
  productive on or before October 15 of the year
  following the sale of the lease.
• Tax Consequence
• A. IRS Determination Sublease transaction
• B. 30,000 in ordinary income to Landman (FICA?)
• C. 10,000 cost reallocated to retained
  override - recovered through cost depletion or
  percentage depletion over producing life of
  property
• D. Production income from ORI non-business
  income and not subject to FICA

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SCENARIO 4 (PP)

• Same as Scenario 3 except there is a high
  probability that the well will be drilled and
  completed on lease before October 15 of the year
  following the sale of the lease and that a
  substantial portion of recoverable reserves in
  the lease will remain after payout of the
  production payment.
• Tax Consequence Hold off filing tax return
  until 1159 p.m. on October 15 of the year
  following sale of the lease - pray for miracle
  resulting in Scenario 2, otherwise see Scenario 1
  and 3 and move on.

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TAX WARNING

• A landman, purchasing leases in his or her own
  name, for the benefit of a Third-Party in
  exchange for a day rate or fee and an ORI in the
  leases he or she acquires, must have a written
  agreement with the Third-Party setting forth the
  terms of the agreement. Otherwise, the IRS can
  define any bonus payments reimbursed to the
  landman by the Third-Party as income to the
  landman under Tax Scenario 1.

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MATTERS TO BE CONSIDERED IN THE DRAFTING OF AN
ASSIGNMENT OR RESERVATION OF A NONOPERATING
INTERESTPart 1 of 2

• Description of the interest
• Limitations
• Calculating the interest
• Expenses borne by the interest
• Application to extensions, renewals and new
  leases
• Express obligations with regard to the drilling,
  development, continuing exploration and marketing
• Express provision granting the interest owner the
  right to enforce any or all implied covenants
  under the burdened lease

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MATTERS TO BE CONSIDERED IN THE DRAFTING OF AN
ASSIGNMENT OR RESERVATION OF A NONOPERATING
INTERESTPart 2 of 2

• Whether the interest is to be credited with its
  proportionate share of advance payments or
  take-or-pay settlement payments from gas
  purchasers
• The right to take production in kind
• Pooling and unitization
• Reassignment obligation
• Bankruptcy considerations
• Attorneys fees

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IT IS BETTER TO RESERVE THAN TO RECEIVE.

• E. Kuntz