OVERRIDING ROYALTY INTERESTS PITFALLS PRECEDENT AND PROTECTION John

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. l l 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 l Production Payment (aka Oil Payment) l Net Profits Interest l Carried Working Interest

COMMON CHARACTERISTICS OF NONOPERATING INTERESTS l l l 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? l l l 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 “postproduction” issues

EFFECT OF CLASSIFICATION OF ORRI AS REALTY OR PERSONALTY l Statute of Frauds l Venue l Recording Statutes l Applicable Law l 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: l Limited to the term of the lease l Expiration, surrender or forfeiture of the lease extinguishes the ORRI

PERPETUATION OF 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 l “Oklahoma” Rule l Definitional Approach l 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 l 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 l Grant vs. Reservation l States Permitting ORRI Owner to Enforce Implied Covenants Under Lease l States Limiting Right of Enforcement of Implied Covenants by ORRI Owner to Express Provisions in Assignment

INTERPRETATION OF GRANTS AND RESERVATIONS OF ORRIs l Plain Meaning of Words l Lesser Interest Clause in Lease l Proportionate Reduction Language

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

JUDICIAL INTERPRETATONS OF ORRI Part 2 of 5 Lease covers 1/4 Mineral Interest: the reservation of an “…overriding royalty of 1/32 nd of 7/8 ths of all oil and gas produced and saved under and by virtue of this oil and gas lease” - reserves an undivided 1/4 of 1/32 nd of 7/8 ths ORRI. Williams v. Sohio Petroleum Company, 151 N. E. 2 d 645, 649 (Ill. App. 1958); Pollock v. Mc. Alester Fuel Co. , 223 S. W. 2 d 813 (Ark. 1949)

JUDICIAL INTERPRETATION OF ORRI Part 3 of 5 Lease covers 7/12 ths Mineral Interest: reservation of “…$15, 000 out of one-eighth (1/8 th) of seven-eighths (7/8 ths) of oil, if as and only when produced, saved and marketed from said land under this lease” - production payment payable out of an undivided 1/8 th of 7/8 ths of production. R. Lacy, Inc. v. Jarrett, 214 S. W. 2 d 692, 693 (Tex. Civ. App. Tex. - Texarkana 1948); Middleton v. Broussard, 504 S. W. 2 d 839 (Tex. 1974)

JUDICIAL INTERPRETATIONS OF ORRI Part 4 of 5 Lease covers 75% Mineral Interest: reservation of a “…Three sixty-fourths (3/64 ths) over-riding royalty out of the Seven -eighths (7/8 ths) working interest” - reserves an undivided 3/64 ths of 7/8 ths ORRI. Fry v. Farm Bureau Oil Co. , 119 N. E. 2 d 749, 751 (Ill. 1954); Barker v. Boyer, 794 P. 2 d 322 (Kan. App. 1990)

JUDICIAL INTERPRETATION OF ORRI Part 5 Reservation of a “ 3 -1/8% of 8/8 ths 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. 3 d 703 (Wyo. 2003)

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

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. 2 d 149 (1951)

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

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

TAX TREATMENT OF NONOPERATING INTERESTS Courtesy Of Larry C. Bidwell, CPA 6101 W. 38 th 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 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.

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

IT IS BETTER TO RESERVE THAN TO RECEIVE. E. Kuntz