CHAPTER 12 DIVISION ORDERS: CONTRACT, DISTRIBUTION MECHANISM, AND CURATIVE TOOL
| Jurisdiction | United States |
(May 1983)
DIVISION ORDERS: CONTRACT, DISTRIBUTION MECHANISM, AND CURATIVE TOOL
Clanahan, Tanner, Downing & Knowlton
Denver, Colorado
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TABLE OF CONTENTS
Purposes of Division Orders
Types of Division Orders
Transfer Orders
Division Order Format
Oil Division Orders
Gas Division Orders
Nature and Legal Effects of Division Orders
Division Orders as Contracts
Revocability of Division Orders
Remedies for Non-Payment of Royalties
Distribution Mechanism
Pricing Pitfalls
Division Orders as Curative Tools
Execution of Division Orders
Division Orders' Effects on Lessee's Duties to Lessor
Split-Stream Gas Sales
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Purposes of Division Orders
When an oil and gas lease is executed, the lessor routinely reserves, in the form of a royalty interest, the right to receive a fraction of production from the leased lands. There may be many others who have an interest in production through ownership of overriding royalties, production payments, working interests, etc. Once production commences, all of the owners have a right, under the provisions of the instruments creating their interests, to their share of production. Interest owners who do not receive payment following production are understandably unhappy and may hold the lessee or purchaser of production, if they are not the same, liable for an accounting of the unpaid royalty. Also, when payments are not made the lessee or purchaser of production may incur liability to the various interest owners for conversion of their interest.1 Therefore, to maintain good relations and avoid litigation, it is necessary to devise a safe method for distributing royalty and other payments resulting from production. The party responsible for distribution of payments could attempt to make them without a formal written understanding between the parties by merely examining the relevant instruments affecting title, interpreting those instruments and making the
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payments accordingly. However, this method of distribution carries a considerable risk of error. Instruments affecting oil and gas interests are often extensive and ambiguous. To help minimize the risk of error, the oil and gas industry developed the division order which authorizes and directs payment to the various interest owners, and protects the lessee or purchaser of production from liability for improper payments. The division order is the recognized vehicle to establish the schedule of ownership and, thus, prescribe the payments under producing properties.
The necessary parties to division orders vary depending on the identity of the party responsible for its preparation. The party responsible for making payments on production generally prepares and secures execution of the division order. In many instances, the lessee/operator will enter into an agreement with a purchaser of production which places the obligation for making payments on the purchaser but this obligation may be retained by the lessee. Thus, division orders may be prepared by the lessee for execution by the lessors, by the purchaser of production for execution by both the lessee and lessors, or by an operator of the lease who is neither a lessee nor the purchaser of production.
When the lessee is not an integrated operator who sells directly to the public, a purchaser of production will be involved in marketing the production. In this instance, the lessee and purchaser will enter into an agreement for the purchase and sale of production from the wells, and the agreement
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will not include the interest owners as parties. The purchaser, being a stranger to the oil and gas lease between the lessee and lessors, has no connection with the lessors through either the lease or the agreement for purchase of production. If the purchaser is responsible for making royalty payments, some type of agreement is necessary to create a legal relationship between the lessor and the purchaser. The purchaser's division order which is executed by all interest owners contractually connects such parties.
Another function of division orders is to supplement the lease royalty provisions by providing a more defined method for payment of royalties. The lease royalty provision itself may only provide for payment of royalty in very general terms, whereas the division order may contain specific methods for computing royalty payments. A specific price or price method to be utilized for the products may be established by the division order. In addition, division orders contain terms setting out the time and manner in which royalty payments shall be made and often contain specified terms for the determination of quantity and quality of the products which might, for example, allow deductions for impurities. A provision for deduction of taxes may also be provided. These terms are rarely found in oil and gas leases because they become relevant only if and when production is achieved.
The primary purpose of division orders is to establish a schedule of interest ownership in the production (which forms the basis for payment on production) and insulate the lessee or
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purchaser from liability when payments are made in accord with the division order provisions. To prepare the schedule of ownership, a division order title opinion must first be prepared by either the lessee or purchaser of production. Counsel for either the lessee or purchaser will prepare the division order title opinion from abstracts and other title documents relating to the lands from which production is obtained. An abstract and title opinion updated to the date of first production is highly desirable, if not an absolute requirement, before accurate ownership is assured. The schedule of interest ownership established in the division order title opinion forms the basis for the schedule of ownership in the division order itself. After the curative work indicated in the division order title opinion has been satisfied, a division order will be prepared by the lessee or purchaser who will then forward duplicate originals for execution by all persons holding an interest in the production. Following execution of the division order and its return to the preparer, payments to interest holders are made under the terms of the division order.
Types of Division Orders
Although division orders are typically used for payment of royalties after production has commenced, pre-production division orders for the payment of delay rentals may also be utilized. Delay rental division orders are primarily used where some uncertainty exists regarding the interest ownership in the leased
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lands. Such a division order is executed by interest owners entitled to delay rentals and is a direction to the lessee to make payment of delay rentals in accord with its provisions. The purposes of the delay rental division order are to prevent lease termination for improper payment of delay rentals, and to provide for changes in ownership of and rights to delay rentals after the execution of the original lease.
Where production cannot be marketed immediately and shut-in royalties must be paid, a shut-in royalty division order may also be prepared. Its purpose, like that of the delay rental division order, is to prevent lease termination due to non-payment. Both delay rental and shut-in royalty division orders typically contain a provision that payment pursuant to the provisions of the document will protect and extend the lease as to the executing party's interest.
Production division orders are what are commonly referred to as "division orders." The type of production involved, i.e., gas production versus oil production, accounts for the major distinctions among division orders. Oil division orders and gas division orders vary somewhat in their terms and may have somewhat different legal ramifications. This is particularly true as concerns the division order royalty and revocation provisions. However, the various types of division orders generally contain the same provisions and the contents of division orders tend much more toward uniformity than differentiation.
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Transfer Orders
A transfer order is utilized when a change in ownership of an interest takes place, and provides authorization for a change in the distribution of payments. A typical transfer order sets out the interest which has been transferred, a statement of the effective date of the transfer, authorization to the purchaser/lessee to credit a new owner of the interest, a warranty of ownership and a ratification of the underlying division order. The main function of a transfer order is to provide notice to the lessee or purchaser of production to pay royalties to a different person than that identified in the original division order.
Division Order Format
The format of division orders has changed very little since their inception over eighty years ago. There are several standard provisions in division orders which are listed as follows:
1. A warranty clause which guarantees that the owner's interest is as indicated on the division order.
2. A property and products clause which describes the land covered by the division order and the products affected.
3. The effective date of the division order.
4. A revocability clause which generally allows for the revocation of an oil division order at will by either party. A
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gas division order will frequently omit the revocability clause and may instead contain a clause which states that the division order is effective for a specified period of time, or for the life of a referenced underlying gas purchase contract. A reference to a gas purchase contract may make the gas division order irrevocable, as will be discussed below.
5. A settlement clause which gives directions to the purchaser to credit proceeds from production on the...
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