Transcript overriding royalty interests: pitfalls, precedent and protection

OVERRIDING ROYALTY INTERESTS:
PITFALLS, PRECEDENT AND
PROTECTION
John K. H. Akers, Jr.
Akers & Associates LLC
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.
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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
OTHER FORMS OF NONOPERATING
INTERESTS

Production Payment (aka Oil Payment)
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Net Profits Interest
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Carried Working Interest
COMMON CHARACTERISTICS OF
NONOPERATING INTERESTS
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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
ORRI
REALTY OR PERSONALTY?
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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
EFFECT OF CLASSIFICATION OF ORRI AS
REALTY OR PERSONALTY
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Statute of Frauds
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Venue
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Recording Statutes
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Applicable Law
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Available Remedies
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.
DURATION OF THE ORRI
Absent Agreement to the Contrary:
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Limited to the term of the lease
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Expiration, surrender or forfeiture of the
lease extinguishes the ORRI
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
CIRCUMSTANCES PERPETUATING ORRI
Fiduciary Relationship
–
Fraud, Bad Faith
JUDICIAL APPROACHES TO “EXTENSION
AND RENEWAL” CLAUSES
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“Oklahoma” Rule
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Definitional Approach
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Rule Against Perpetuities
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 §14.04[11] p. 1433
IMPLIED COVENANTS
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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
ENFORCEMENT OF IMPLIED COVENANTS
BY THE NONOPERATING INTEREST
OWNER
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Grant vs. Reservation
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States Permitting ORRI Owner to Enforce
Implied Covenants Under Lease
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States Limiting Right of Enforcement of
Implied Covenants by ORRI Owner to
Express Provisions in Assignment
INTERPRETATION OF GRANTS AND
RESERVATIONS OF ORRIs
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Plain Meaning of Words
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Lesser Interest Clause in Lease
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Proportionate Reduction Language
JUDICIAL INTERPRETATION OF ORRI
Part 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)
JUDICIAL INTERPRETATONS OF ORRI
Part 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)
JUDICIAL INTERPRETATION OF ORRI
Part 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)
JUDICIAL INTERPRETATIONS OF ORRI
Part 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)
JUDICIAL INTERPRETATION OF ORRI
Part 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)
POOLING AND UNITIZATION OF THE
OVERRIDE
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Is “Unilateral” Pooling or Unitization Provision
Binding on ORRI Owner?
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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)
PROTECTING THE NONOPERATING INTEREST
IN BANKRUPTCY
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11 U.S.C. Section 541(a)-(1)
United States Bankruptcy Code
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Boyd v. Martin Exploration Company, 56 B. R.
776 (E.D. La. 1986)
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Grynberg v. Waltman, 946 P.2d 473 (Colo.
App. 1996)
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“Hybrid” Production Payment
OTHER ORRI ISSUES
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Take-or-Pay Gas Purchase Contract
Settlements
Transamerican Natural Gas v. Finkelstein, 933 S.W. 2d 591
(Tex. App. – San Antonio 1996)
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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.
TAX TREATMENT OF NONOPERATING
INTERESTS
Courtesy Of
Larry C. Bidwell, CPA
6101 W. 38th Ave.
Wheat Ridge, CO 80033
303.422.3070
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
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
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” – nonbusiness 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
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
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 11:59
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.
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 ThirdParty 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.
MATTERS TO BE CONSIDERED IN THE DRAFTING
OF AN ASSIGNMENT OR RESERVATION OF A
NONOPERATING INTEREST
Part 1 of 2
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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
MATTERS TO BE CONSIDERED IN THE DRAFTING
OF AN ASSIGNMENT OR RESERVATION OF A
NONOPERATING INTEREST
Part 2 of 2
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Whether the interest is to be credited with its
proportionate share of advance payments or “takeor-pay” settlement payments from gas purchasers
The right to take production in kind
Pooling and unitization
Reassignment obligation
Bankruptcy considerations
Attorneys fees
IT IS BETTER TO RESERVE THAN
TO RECEIVE.
E. Kuntz