CHAPTER 4 OVERRIDING ROYALTIES AND LIKE INTERESTS—A REVIEW OF NONOPERATING LEASE INTERESTS
| Jurisdiction | United States |
(Apr 1993)
OVERRIDING ROYALTIES AND LIKE INTERESTS—A REVIEW OF NONOPERATING LEASE INTERESTS
Ireland, Stapleton, Pryor & Pascoe, P.C.
Denver, Colorado
TABLE OF CONTENTS
Page
I. INTRODUCTION
II. OVERVIEW: GENERAL COMPARISON OF OVERRIDING ROYALTIES AND OTHER SPECIAL INTERESTS WITH LESSOR'S ROYALTIES
III. OVERRIDING ROYALTY INTERESTS
A. Definition
B. Manner of Creation; Business Uses
C. Comparison with Lessor's Royalty
IV. PRODUCTION PAYMENTS
A. Minerals Covered; Definition
B. Uses; Manner of Creation
C. Forms of Production Payments
D. Nonrecourse Nature; Scope of Proceeds Covered
E. Comparison with Overriding Royalty and Lessor's Royalty
1. Divisibility
V. NET PROFITS INTERESTS
A. Definition and Essential Attributes
B. Uses
C. Comparison with Overriding Royalty and Production Payment
D. Lack of Clear, Uniform Meaning
E. Need for Definition and for Accounting Procedures
1. Possible Additional Credits
2. Possible Additional Charges
3. Additional Provisions
VI. CARRIED INTERESTS
A. General Definition and Nomenclature
B. Essential Attributes
C. Absence of Uniform Meaning; Variety of Forms and Uses
1. Third-for-a-Quarter Deal
2. Duration
3. Forced Pooling and Unitization
4. Cotenancy: Operations Without Joinder
5. Abercrombie, Herndon, and Manahan Carry Arrangements
6. Caveat
D. Nonconsent Provisions of Joint Operating Agreement—An Illustrative Review of A.A.P.L. Form 610-1989
1. Covered Operations; Allocation of Carry Among Multiple Consenting Parties
2. Recoupment Mechanism and Period
a. Carried Costs and Multiples Thereof
b. Recoupment Income
(1) Deductions from Recoupment Income
C. "Reversion"
3. Limitations of the Scope of Protection Afforded by the Nonconsent Arrangement from Expenses and Liabilities of Carried Operations
a. Limitations Arising from Restrictive Provisions
(1) "Subsequently Created Interests"
(2) Excess Royalty Price Clause
(3) Excess Burden Percentage Clause
b. Limitations Arising from the Form of the Carry Upon the Carried Party's Protection from Third-Party Liability
(1) Retention of Working Interest Title by Nonconsenting Party
E. Comparison of Carried Interests with Other Interests
VII. CONVERTIBLE INTERESTS
A. Introduction
B. Uses
C. Payout Description
D. Form: Automatic or Optional
E. Recordation of Title
F. Time of Assignment
G. Subsequently Created Interests
H. Additional Wells
I. Operating Agreement
VIII. EXTENSION AND RENEWAL CLAUSES—THE PROBLEM OF PRESERVING NONOPERATING INTERESTS
A. Duration of Nonoperating Interests: Their Vulnerability to Elimination
B. Washout Problem
C. Suggested Implied Duty of Operator
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D. Desirability of Specifying Operator's Obligations to Preserve Nonoperating Interest
E. Extension and Renewal Clause
1. Liberal, Protective Construction
2. Narrow, Restrictive Approach
a. New Lease Distinguished from Renewal Lease
b. Washout by Substitution of Mineral Fee Interest for Lease
c. Assignees of Lease; Effect of "Subject To" Clause
3. Further Drafting Suggestions
IX. CONCLUSION
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I. INTRODUCTION
The lessor awaiting payment of his royalty is often not the only person vitally interested in how the fruits of mineral development are accounted for by the parties with the power to conduct lease operations, the working interest owners. Also standing in line are the owners of overriding royalties, who want to be sure that they too are receiving their share of the proceeds or value of production and, possibly, of other lease benefits. Likewise, owners of production payments and net profits interests depend on a proper accounting to ensure that they receive their due. And owners of yet other types of interests that are "convertible" under farmouts or other agreements or that are "carried" for a period of time must look to such an accounting to determine when they may acquire or be saddled with new rights and obligations, respectively. These owners may, for instance, include nonconsent parties who are carried for a time as to various operating costs and burdens under operating agreements, pooling or unitization orders, or other special arrangements.
This paper is intended to complement the discussion presented in other papers at this special institute, which by and large focus on the lessor's royalty, by considering other non-cost-bearing interests that have a stake in lease operations and the marketing of production. The diversity of these other interests mirrors the practice, long endemic to the oil and gas industry, of splitting the incidents of a lease into different bundles of rights and obligations. This is a accomplished through a bewildering variety of arrangements, all designed to shift or share the benefits and/or burdens of mineral development.
Due to the multiplicity of types of nonoperating lease interests and cost/benefit sharing arrangements, the approach pursued in this paper is necessarily selective. The purpose is to identify the salient attributes of certain frequently utilized nonoperating interests carved out of the working interest created by a lease and, by comparing them with the lessor's royalty interest and each other, clarify their most basic special problems and issues. It is hoped that, among other things, this review will provide a vantage point from which the reader may evaluate the degree to which the owners of these special interests may rely on the more developed body of case and statutory law on lessors
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royalties, which is covered in other papers, in order to flesh out the full contours of their own rights.
Following a brief overview comparing them with the lessor's royalty, the paper addresses, in progressively greater detail, overriding royalties, production payments, net profits interests, carried interests, and convertible interests. With respect to carried interests, special attention is devoted to an analysis of the interests of nonconsent parties under joint operating agreements. The paper concludes by examining issues relating to extension and renewal clauses in reservations or assignments of nonoperating lease interests. That review, especially in the wake of several recent cases, illustrates the difficulty of overcoming the fundamental vulnerability which characterizes all these interests.
II. OVERVIEW: GENERAL COMPARISON OF OVERRIDING ROYALTIES AND OTHER SPECIAL INTERESTS WITH LESSOR'S ROYALTIES
Overriding royalties, production payments, net profits interests, carried interests, and convertible interests resemble the lessor's royalty in the following respects:
1. They are interests in, at least, production or the proceeds or value thereof, except that, in the case of carried and convertible interests, they depend upon the realization of a certain level of such proceeds or value in order to mature into other types of interests.
2. Except to the extent that a lease may, as is common, reserve to the lessor a right to take oil in kind, these interests are akin to the lessor's royalty in that they normally do not entitle the owner to market production. Instead, the owner must depend on the marketing decisions of a working interest owner whose economic interest may, in some circumstances (e.g., buyouts, buydowns, or settlements of gas sales contracts), be adverse or divergent.
3. Since the promised benefit usually consists of money from the working interest owner rather than control of the oil and gas produced, the nonoperating interest owner must look for payment to his working interest owner, except to the limited extent that other parties, such as a unit operator, a production purchaser, or other working interest owners, may be committed by a division order, an operating agreement or other contract, or a statute to make payments to pay him.
4. Except to some measure in regard to certain carried interests, these interests are truly nonoperating in nature and do not bear any of the costs, risks, or liabilities of lease operations.
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However, in the following respects, these interests part company from the lessor's royalty interest:
1. Unlike the landowner lessor, whose reversionary mineral interest survives the termination of a lease, these owners depend for the continued existence of their interests upon the lease out of which their interests have been "carved," or upon other leases in which they may have rights by virtue of an extension or renewal clause or a constructive trust.
2. A number of these interests are not entitled to a share of gross production proceeds, but rather depend, for their calculation, on a comparison of production revenues with costs incurred by the burdened working interest. In some cases, such as net profits interests, this comparison is necessary because the interests are entitled only to a share of net revenues. In other cases, as in the case of some carried interests and convertible overrides, this comparison is necessary because the timing of the conversion or reversion of the interests to normal, cost-bearing working interests depends upon a "carrying" party's recovery of various costs or a multiple thereof.
3. Since these interests are created after the lease, they are apt to be more seriously affected by or subject to the complications and limitations of various post-lease agreements and instruments, such as operating, pooling, unitization, and gas balancing agreements and gas sales contracts.
4. Some of these interests, such as production payments and convertible interests, may terminate or change in nature while the lease is still in effect.
5. The covenants implied to benefit lessors may not automatically apply to these interests, reflecting the generally less solicitous attitude taken by courts toward the protection of these interests.
III. OVERRIDING ROYALTY INTERESTS
A. Definition
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