PRODUCTION PAYMENTS AND OTHER ENERGY FINANCING ALTERNATIVES
| Jurisdiction | United States |
(Nov 1995)
PRODUCTION PAYMENTS AND OTHER ENERGY FINANCING ALTERNATIVES
Enron Capital & Trade Resources Corp.
Houston, Texas
Outline:
Introduction
1.01. Description of a Production Payment/Term Overriding Royalty Interest
[A] Description
1.02. Benefits and Risks of a Production Payment
[A] Benefits and Risks to the Producer
[1] Benefits to the Producer
[a] Full Operating Control
[b] Limited Recourse
[c] Accounting Treatment
[d] Tax Treatment
[e] Insulation Against Downturn of Prices
[2] Risks to the Producer
[a] Liability Issues
[B] Benefits and Risks to the PP Owner
[1] Benefits to the PP Owner
[a] Ownership of Reserves
[b] Liability Issues
[2] Risks to the PP Owner
[a] Reserve and Title Risks
[b] Operator Risk
[c] Price Risk
1.03. Due Diligence; Documentation
[A] Due Diligence
[B] Documentation
1.04 Other Energy Financing Alternatives
[Page 10B-ii]
[A] Net Profits Interests
[1] Description
[2] Due Diligence
[3] Documentation
[B] Prepaid Gas and Oil Contracts
[1] Description
[2] Due Diligence
[3] Documentation
[C] Development Capital
[1] Development Loans
[a] Description
[b] Due Diligence
[c] Documentation
[2] Partnership Interests
[a] Description
[b] Due Diligence
[c] Documentation
[D] Stock Equity
[1] Description
[2] Due Diligence
[3] Documentation
Conclusion
Bibliography
[Page 10B-1]
Introduction
This article will focus principally upon the production payment as a form of financing in the oil and gas industry, the type of documentation typically used in such transactions and certain legal considerations related to production payment purchases.1 In addition, this article will discuss generally certain other types of funding structures being used in the energy industry, such as net profits interest purchases, prepaid gas and oil contracts, development drilling loans, as well as partnership and other equity investments.
1.01 Description of a Production Payment/Term Overriding Royalty Interest
[A] Description
A production payment or term overriding royalty interest (the "Production Payment") is a non-operating oil and gas property interest that entitles the owner of the interest (the "PP Owner") to a share of the oil and gas produced from the property for a limited period of time free and clear of the costs of production. A Production Payment may be satisfied either by the delivery of a designated volume of hydrocarbons produced, or by the payment of the proceeds of the sale of the PP Owner's share of hydrocarbons produced. The Production Payment seller (the "Producer") receives a cash purchase price at closing and typically the use of the cash proceeds is unrestricted. The proceeds may be used, for example, to acquire properties, explore and develop properties or refinance or retire existing debt. Production Payments are created either by reservation by the Producer of the Production Payment in a transfer of an oil and gas property or by conveyance by the Producer of the Production Payment to a third party.
A number of oil and gas producing states treat Production Payments as present interests in real property.2 A Production Payment essentially is the same as an overriding royalty interest,
[Page 10B-2]
the distinction between the two being only that a Production Payment continues for a specified term or until designated volumes have been received, while an overriding royalty interest typically has a life coextensive with the life of the oil and gas lease from which it is created.3 Clear drafting of a Production Payment sale as a conveyance of oil and gas reserves is critical to avoid any confusion in interpretation that the transaction is merely a contractual obligation either to deliver gas or oil production or to pay an amount based upon proceeds received from hydrocarbons produced.
1.02 Benefits and Risks of a Production Payment
[A] Benefits and Risks to the Producer
[1] Benefits to the Producer
[a] Full Operating Control
Because a Production Payment is a non-operating real property interest, the Producer maintains full operating control of the property. Although the PP Owner may not participate in leasehold operations, some PP Owners may include in the transaction documentation provisions permitting the PP Owner to take over operations with respect to the properties if the Producer defaults or declares bankruptcy.
[b] Limited Recourse
The PP Owner's sole recourse for satisfaction and discharge of the Production Payment is against the reserves attributable to the Production Payment hydrocarbons. If the reserves are depleted prior to the fulfillment of the delivery obligations, the Producer will not be liable if it produced and operated the property in a reasonable and prudent manner and otherwise complied with its agreements with the PP Owner. The Producer does retain exposure to liability to the PP Owner for any breach of covenants and representations made in connection with the Production Payment purchase.
[c] Accounting Treatment
The accounting treatment of mineral interest conveyances is complex and a full discussion of such topic is beyond the scope of this article. Generally, the cash proceeds
[Page 10B-3]
received by the Producer are recorded as deferred revenue, which is recognized as the actual delivery of hydrocarbons occurs. The Producer treats the sale of a volumetric Production Payment as a sale. However, since substantial obligations for future performance are retained by the Producer, no gain is recognized by the Producer upon receipt of the purchase price.4
While the Production Payment remains in effect, the Producer maintains ownership of its interest in the underlying oil and gas leases which is not burdened by the Production Payment. After the Production Payment terminates, the Producer retains ownership of 100% of the remaining reserves and is entitled to all associated upside in the properties.
[d] Tax Treatment
The Production Payment is treated as a loan for federal income tax purposes. As a result, the Producer does not recognize income upon receipt of the purchase price but recognizes income each time it delivers hydrocarbons to the PP Owner as though it sold such hydrocarbons at their then fair market value and used the proceeds of the sale to repay the loan.5
[e] Insulation Against Downturn of Prices
Once the Production Payment is valued and purchased, the Producer is insulated from any downturn in prices that lessen the value of the volumes attributable to the volumetric Production Payment. The PP Owner assumes the risk of future price downturns but may hedge price risk through the use of derivative products such as swaps, options, caps, floors and collars.6 The PP Owner thus can protect itself against the price risk that the fixed price prepaid for the Production Payment volumes is greater than the market price per unit of the volumes upon delivery.
[2] Risks to the Producer
[a] Liability Issues
The Producer continues to bear the burdens and potential liabilities associated with working interest ownership, such as costs of operations, taxes and royalties as well as environmental liabilities.
[B] Benefits and Risks to the PP Owner
[Page 10B-4]
[1] Benefits to the PP Owner
[a] Ownership of Reserves
By purchasing a Production Payment, the PP Owner is entitled to a steady, long-term stream of production. The PP Owner owns reserves in the ground which are severed and distinct from the interest owned by the Producer. As a result, the PP Owner's interest does not form part of the Producer's estate and is not affected by the automatic stay in a Producer's bankruptcy. In 1994, Congress amended Section 541 of the Bankruptcy Code7 to exclude Production Payments transferred pursuant to a written conveyance from the property of a debtor's estate. By colloquy in the Congressional records, the Senate also attempted to expand the amendment to exclude oil and gas leases from property of a debtor's estate.8
[b] Liability Issues
The PP Owner's interest is a passive, non-operating, non-possessory real property interest, and as such, the PP Owner has no obligation to pay the costs of operations with respect to the property such as operating expenses, taxes, royalties and similar burdens. In addition, the PP Owner should not be responsible for other liabilities associated with working interest ownership such as environmental liabilities.
[2] Risks to the PP Owner
[a] Reserve and Title Risks
The PP Owner, as an owner of real property, bears the reserve risk associated with ownership of the Production Payment as well as the risk of title failure of the underlying oil and gas leases. Since the PP Owner retains no control over the operation of the properties and does not participate in any upside in the properties once the Production Payment has terminated, it is not uncommon for a PP Owner to...
To continue reading
Request your trial