CHAPTER 3 TAX PROVISIONS AND CONSIDERATIONS FOR OIL AND GAS PROPERTY PURCHASE AND SALE AGREEMENTS

• Jurisdiction: United States

Oil & Gas Agreements: Purchase & Sale Agreements
(May 2016)
CHAPTER 3
TAX PROVISIONS AND CONSIDERATIONS FOR OIL AND GAS PROPERTY PURCHASE AND SALE AGREEMENTS
John T. Bradford ¹

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JOHN T. BRADFORD is Of Counsel with the energy and natural resource law firm of Liskow & Lewis in Houston, Texas. Mr. Bradford earned his B.S. in Accounting at the University of Illinois in 1977; his J.D. in Law at the University of Illinois College of Law in 1980; and his Master of Laws in Taxation at the University of Houston Law Center in 1991. Mr. Bradford practices energy and natural resources taxation at the state, federal, and international levels. His practice involves advising clients on the tax consequences of their acquisitions, dispositions, joint ventures, financing activities, hedging activities, and day-to-day business operations. He has represented clients before the Internal Revenue Service on audit, administrative appeal, and for private letter ruling requests. He has extensive experience in the energy and natural resources industry, having practiced for more than 18 years as a tax lawyer for Exxon Corporation (now Exxon Mobil Corporation), having worked in energy and natural resource investment banking at JP Morgan Securities, and having most recently advised clients as a principal in KPMG LLP's Washington National Tax practice. Mr. Bradford is a frequent speaker on energy and natural resource taxation matters, having presented to the American Petroleum Institute Federal Tax Forum, the University of Texas Parker C. Fielder Oil and Gas Tax Conference, the Texas Federal Tax Institute, the Rocky Mountain Mineral Law Foundation, the Tax Executives Institute, the American Bar Association Section of Taxation Energy and Environmental Taxes and Banking and Savings Institutions Committees, the Houston Bar Association Tax and Oil and Gas Sections, the Practicing Law Institute, the South Texas College of Law Energy Symposium, KPMG LLP's Global Energy Conference, and the Liskow & Lewis Energy Law Seminar. His articles have been published by The Journal of Taxation, the Rocky Mountain Mineral Law Foundation, the University of Houston Business and Tax Law Journal, Oil, Gas & Energy Quarterly, Oil and Gas Financial Journal, and the KPMG Global Energy Institute. Mr. Bradford has been a guest lecturer on oil and gas taxation at Georgetown University School of Law and currently is Adjunct Professor at the University of Illinois College of Law, where he teaches a seminar class on Energy and Natural Resource Transactions.

Introduction

"It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair. . . ."² Many of us remember this quote from English literature class, but it seems as appropriate in the winter of 2015 -2016 in the oil and gas business as it was in the setting of the Charles Dickens book "A Tale of Two Cities". Oil and gas producers in the United States developed incredible new technology for the production of oil and gas from shale rock formations, which had the ability to unlock massive oil and gas reserves trapped in shale rock here in the United States. Private equity capital and the high yield debt market, with few alternatives as attractive as funding domestic oil and gas exploration, development and production projects, rushed to provide billions of dollars of equity and debt capital to domestic oil and gas companies large and small. The significant increase in the number of operating oil rigs and gas rigs as companies rushed to drill shale oil and gas wells from 2010 through mid-2014 brought incredible prosperity to companies, their employees and their

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contractors involved in shale plays in the Permian Basin and Eagle Ford shale in Texas, the Bakken shale in North Dakota, the Marcellus shale in Pennsylvania, and the Utica shale in Ohio, to name a few. Total oil and gas reserves in the United States for the year 2014 increased nine percent from the year before.³ Television even got back in the action, as the ABC network commissioned stalwart Don Johnson to star in "Blood and Oil" on Sunday nights.

Yes, those were the best of times at $100 per barrel of oil, but the significant increase in United States oil and gas production pushed the Saudi-led Organization of Petroleum Exporting Countries ("OPEC") to take action in the fall of 2014 to preserve market share. As preparation of this article for Rocky Mountain Mineral Law Foundation's presentation on Oil and Gas Purchase and Sale Agreements continues in March of 2016, OPEC producers have opened up the taps full throttle (with conversations beginning on freezing the increases in production), and oil producers now are producing several million barrels a day more of crude oil than world demand requires. Oil prices now trade in a $30 -$40 per barrel range, driving many of those United States shale drillers into significant capital budget reductions, staff reductions, and in some cases, reorganization or liquidation in United States bankruptcy court proceedings. As those in the oil business know all too well, the best of times often leads to the worst of times, but that is why this article is important for those companies that may need to execute one or more oil and gas property purchase and sale transactions in order to restructure their balance sheets and position themselves for the future.

These difficult financial times have caused a number of domestic oil and gas producers to reconsider the size of their oil and gas producing property portfolios. As oil and gas prices have plummeted and favorable price hedges have run off, cash flows from producing operations have decreased and reserve redeterminations have lowered the value of collateral to support term debt, forcing many banks to reduce or eliminate credit to the industry. With public equity markets essentially closed for all but the best of oil and gas investments, many producers are left with no alternative but to raise cash and pay down debt by disposing of some of their domestic oil and gas properties in purchase and sale transactions in an effort to improve their balance sheets and perhaps even preserve their existence. This article will describe the various documents involved in these transactions, explain how those documents work to execute the transfer of ownership of oil and gas properties, and provide guidance and insight into the federal and state tax-related provisions included in those documents and the federal income tax consequences that follow from the execution of these transactions. Key terms in the oil and gas property purchase and sale agreement (the "PSA") will be defined, key provisions in the PSA impacting the

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expected federal income tax results will be identified and explained, and the expected tax results themselves will be detailed.⁴

Background

As mentioned above, current oil and gas property purchase and sale transactions are being driven, at least in part, by the need to shore up the balance sheet by reducing outstanding debt. Other reasons leading a producer to become a seller include a pessimistic view on long-term prices for oil and gas and a determination that future development costs for an oil and gas property will exceed the debt and equity capital available to develop it. Opportunistic purchasers, on the other hand, may have a more optimistic view on long-term oil and gas prices, may have solid balance sheets allowing for additional borrowing for oil and gas property purchases, and may have access to debt and equity capital otherwise not available to the current owner of the oil and gas properties put up for sale.

As a first step in the oil and gas property purchase and sale process, prospective sellers and purchasers may negotiate and then execute a document that may be styled as a "Letter of Intent," a "Term Sheet," or a "Heads of Agreement" (referred to collectively in this article as the "LOI"). The LOI sets out the key business elements of the transaction, including the assets being disposed of and any assets being retained, the purchase price, any required deposit, the effective date for the sale, any special conditions that must be met prior to closing the transaction, the expected closing date, and any "drop-dead" date after which all negotiations are terminated. Typically, a due diligence period is provided during which the prospective purchaser may examine documents related to the oil and gas properties to be disposed of in a physical or electronic

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data room before moving forward with a determination to purchase those properties. Care must be taken in drafting the LOI so that there is no misunderstanding between the parties as to whether all or only some portion of its terms and conditions are binding on the parties. If the LOI is not drafted carefully in this regard, litigation can ensue and the results potentially can be devastating. See, for example, the news reports of the award of over five hundred million dollars to Energy Transfer Partners, L.P. ("Energy Transfer") in its lawsuit with Enterprise Products Partners, L.P. ("Enterprise") in the District Court of Dallas County, Texas, 298th Judicial District over whether the LOI the parties executed regarding the formation of a partnership to build a pipeline was binding. The jury found that it was binding and awarded damages to Energy Transfer after Enterprise entered into a subsequent agreement with another party to build the pipeline. The case is on appeal to the Texas Court of Appeals for the Fifth District, Dallas, Texas.⁵

After the parties set forth their intentions in the LOI, they will begin the negotiation of the PSA (even though due diligence still may be ongoing). The PSA generally will implement the key terms and...