Revenue Accounting Issues For Royalty Owners Donald A

Revenue Accounting Issues For Royalty Owners Donald A. Phend, CPA Phend & Company, LLC 8500 W. Bowles Ave. , Suite 301 Littleton, CO 80123 (303) 298 -7908 Phone (303) 292 -4663 Fax phendcpa@aol. com

Objectives • Gain a basic understanding of how oil and gas is valued for royalty payment calculations. • Basic tips royalty owners can use to determine if deductions are being taken from their royalty payment. • Current issues affecting Colorado Royalty Owners

Accounting Terms – Oil • BBL Barrel – 42 US Gallons • BS&W Basic Sediment and Water, an analysis of contaminants in oil • Gravity Viscosity of oil – higher gravity is thinner and usually more valuable

Accounting Terms - Gas • MCF • MMBTU • Chromatograph Measurement of Volume (1, 000 cubic feet at standard temperature and pressure) Measure of heating content of gas Theoretical content of various liquids (Gallons per MCF)

Accounting Terms – Gas • Pooled Accounting – All wells in pool receive same valuation for gas and liquids – Pool can be various definitions, • Field • Geographic Area • All wells going to a specific plant, etc.

Accounting Terms - Gas • Netback Method – Deductions reduce stated value of gas, rather than being shown as a separate deduction – Example – Sales Price $3. 15 MMBTU – Deductions (0. 15) MMBTU – Netback Price $3. 00 MMBTU – Typically the Netback Price will be shown on royalty check detail

Oil Valuation • First step: measure the oil sold – Run Ticket Method • High and low tank measurements manually recorded when oil is run (sold) into tank truck – LACT Meter (Lease Automatic Custody Transfer) • Automatically records volume transferred (sold) to pipeline connection

Run Ticket

Plumb Bob

LACT Meter

Oil Valuation • Second step: Determine quality of oil – Sample taken (using “oil thief” device) for analysis • Gravity • BS&W- Basic Sediment and Water

Oil Thief

Pricing Calculation • Posted Price – Purchasers publish a daily or monthly field price • Spot Price – Based on market Purchase contract may specify + or – from the above referenced prices

Issue for Royalty Owner • Is the price an arms-length price? • Is posted price (if related party) truly a representative price for that area and time?

Gas Valuation • First step: Measure the gas sold – Paper chart meter – Electronic meter

Paper Chart Meter

Electronic Meter

Gas Valuation • Second Step: Determine quality of gas: – Sample taken for analysis: • BTU Content – Heating content of gas sample • Content Analysis (Chromatograph) – Content of various potential liquids contained in gas sample

Gas Analysis Report Heating Content • MMBTU / MCF 1. 267

Theoretical Liquid Content (Chromatograph) Gallons per MCF • Ethane • Propane • Isobutane • Normal Butane • Isopentane • Normal Pentane • Hexane 3. 382 1. 383 0. 256 0. 486 0. 194 0. 170 0. 342

Physical Flow of Gas and Liquids Wells End User Market Pipeline Gas Plant Gathering System Unprocessed Gas Field Compressor Processed Gas Liquids

Who Processes Gas? • Independent processing companies provide processing for a fee • Some large operators may have their own gas plants

Why Process Gas? • The raw gas at the wellhead may not meet pipeline specifications Too high heating content (MMBTU/MCF ) Impurities (water, CO 2, H 2 S)

Why Process Gas? Additional Revenue • Liquids sell at a premium price. • At times, some liquids command 2 X the price per MMBTU as residue (processed) gas.

Gas Processing Agreement

Gas Processing Agreement • Agreement between Producer (Well Operator) and Processor (Gas Plant) • Defines terms and fees for processing gas • Various types include – Percentage of Proceeds (POP) – Keep Whole – Fixed Fee

Example of POP Contract • Producer receives 80% of sales proceeds for processed gas • Producer receives 60% of sales proceeds for NGLs • Producer pays “gathering fee” of 10 cents MCF • Processor may use “without cost” 3% of producer’s gas for compressor and plant fuel • Producer pays 5 cents/gallon “frac fee”

POP Fees Liquids 40% Processed Gas 20% Wells End User Market Pipeline Gas Plant Gathering System Unprocessed Gas Field Compressor Processed Gas Liquids

Gathering Fees Wells End User Market Pipeline Gas Plant Gathering System Unprocessed Gas Field Compressor Processed Gas Liquids

Fuel (3% of Volume) Wells End User Market Pipeline Gas Plant Gathering System Unprocessed Gas Field Compressor Processed Gas Liquids

Frac Fee (5 Cents / Gallon) Wells End User Market Pipeline Gas Plant Gathering System Unprocessed Gas Field Compressor Processed Gas Liquids

Effect of Netback Method • You can’t see all of the deductions being taken by looking at your revenue check detail. • Some of the deductions may be buried in the “artificial” lower price.

Why is Netback Important? • Producers often use the Netback price they receive from the processors as a starting point to pay royalty. • Note, these deductions may or may not be appropriate to charge to royalty owners. – This is a legal issue, not an accounting issue.

Calculate Theoretical Gallons • • Ethane Propane Isobutane Normal Butane Isopentane Normal Pentane Hexane 3. 382 x 1000 = 1. 383 x 1000 = 0. 256 x 1000 = 0. 486 x 1000 = 0. 194 x 1000 = 0. 170 x 1000 = 0. 342 x 1000 = Gallons 3382 1383 256 486 194 170 342

Why are Theoretical Gallons Important • It is used to allocate the total “Actual Gallons” produced at the plant to each well, to determine payment to producer Actual plant gal X Theoretical Gal Your Well Theoretical Gal All Wells in Plant

Allocation to Well • In other words, if the your well has 5% of the total theoretical plant production of Ethane, it will get credit for 5% of the actual sales of ethane. • Note that this sales value will be net of the 40% POP fee.

Valuation of Ethane • Actual Gallons of Ethane Allocated to your well 3, 111. 44 • Price of Ethane (Gal) $0. 43175 • Gross Value of Ethane to Well $1, 343. 36 • Less POP (40%) (537. 34) • Net Paid Producer 806. 02

Calculate Gross Value

Calculate Net Value

Valuation on Check • Net Value After Deduction • MCF at Wellhead • Calculated Price Per MCF $5, 586. 76 1, 000 $5. 59

Other Issues • Volumetric Loss – Often known as “Fuel Lost and Unaccounted” or “FL&U) – Processor only pays on net volume sold at tailgate of plant – Can be easily calculated

Volumetric Loss • MMBTU at Wellhead • Less MMBTU in All Products • Equals FL&U • Note that liquids are stated in gallons, but there are conversion factors to determine MMBTU content

Volumetric Loss • In this example FL&U was calculated as approximately 22. 85 MMBTU • Expressed in terms of residue gas this is – 22. 85 MMBTU X $5. 59/MMBTU = $127. 72

Summary • • Gross Value Sold at Plant $8, 284. 06 Plus Value of FL&U 127. 72 Value At Wellhead 8, 411. 78 Less – POP – Gathering – Frac – FL&U (2, 401. 34) (100. 00) (195. 96) (127. 72) Net $5, 586. 76 Percentage of Net to Gross 66%

Summary • 10% Royalty Owner Effect • Gross value of 10% • Net Actually Received $841. 18 568. 67 • Royalty Owner’s share of deducts $273. 51

“Keep Whole” Contract • Gas Processor pays Producer for the total MMBTU produced at the wellhead • Price is based on the sales price of residue gas only • Gas Processor keeps the enhanced value of the MMBTU that was converted to liquids

“Keep Whole” Contract • These contracts may also have an allowance for fuel, (for example, 3%) in which case the Gas Processor only pays on a net percentage of the wellhead volume • Other fees may also be charged by Gas Processor

“Keep Whole” Contract • Typically the Producer will begin with the “Keep Whole” amount they receive from the Gas Processor, when beginning to calculate royalty payments • Producer may also add other charges when calculating royalty payment

“Keep Whole” Contract • Effect on royalty owner payments – Royalty owner does not receive benefit for higher value of liquid products – Royalty owner may be receiving payment on a volume net of fuel allowances – Royalty owner may be charged other deductions by the operator – Note that the above items may, or may not, be evidenced on the royalty check detail

Fixed Fee Contract • Gas Processor charges a per unit of volume fee to the producer for providing processing services • Producers may calculate royalty payments net of this fee

Other Issues • Arms-Length Pricing – It is possible for a processing company to sell to a marketing affiliate at a lower than market price, and settle with producer on this basis. – Strategy - request documentation for first armslength sale

Strategies for Royalty Owners • Look for slight variations of price for different wells (if you have more than one well) – This is indicative that various products are being allocated differently based on well’s theoretical content. – While this isn’t proof that netback pricing is occurring, it is at least a place to start.

Strategies for Royalty Owners • If well was involved in a class action settlement, the calculation methodology for “future deductions” may be available in the settlement agreement. • This might be interesting for informational purposes, but you may be bound by the settlement agreement (not intended as legal advice!)

Strategies for Royalty Owners • Request copies of any Gas Processing Agreements and Plant Statements for some sample months • The Plant Statements show basically the same calculations as in the prior example, and if you are good with numbers, you can probably figure it out, or at least make an estimate • Down side is I have found most companies are reluctant to provide this type of info absent legal pressure

Strategies for Royalty Owners • If you know your gas is being processed, and • You have access to index prices in your area for pipeline standard gas • Then you should expect that the blended value you receive should be higher than the pipeline standard gas, due to the enhanced value of the liquids (assuming no deductions)

Strategies for Royalty Owners • Some royalty checks are becoming more descriptive • If they display a column of “Deducts”, ask Royalty Relations Department for an explanation • Also ask them if they use “Netback Pricing” and see if they give you an answer

Strategies for Royalty Owners • Compare notes with friends and neighbors who may have royalties with other companies in the same geographic area • Significant variances in stated prices may merit further investigation