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Oil & Gas Seminar Thursday, October 23, 2008 Sponsored by:

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1 Oil & Gas Seminar Thursday, October 23, 2008 Sponsored by:

2 Energy Lending Today vs. Tomorrow

3 Today  Energy Lending Practices  Competitiveness  Industry Tomorrow  The “Lending Tree” Model  Portfolio Management  Regulation  New Street

4 Today Energy Lending Practices  Collateral Evaluation The Reserve Report Title  Risk Evaluation  Covenants

5 Today Energy Lending Practices  Collateral Evaluation - The Reserve Report Advance Policies Price Deck Cases One Line Summaries/Decline Curves Upside Why different?

6 Today Energy Lending Practices  Collateral Evaluation – Title Bank Standards How it is used?

7 Today Energy Lending Practices  Risk Evaluation – How we do it? It’s a Risky Business The Big Six Underwriting Risks

8 Today Energy Lending Practices  Covenants – The Normal and Not so Normal Loan Policies Financial, Affirmative, Negative Tailored Benefit?

9 Today Competitiveness  Financial Markets Capital Costs and Return Scale New Entry and Alternatives  Relationship Management  Structure

10 Today Competitiveness  Financial Markets – What’s going on? Capital Costs and Return Scale New Entry and Alternatives

11 Today Competitiveness  Relationship Management– Big and Small Your Expectations A Partnership Value Added Business Model Products Industry/YB Knowledge

12 Today Competitiveness  Structure– Big and Small again Relationship Upside Risk Appetite Do they get it?

13 Today Industry Where we’re at and where we’re going Energy is “Hot” The Fundamentals and Complexity Main Street Wall Street

14 And Finally Tomorrow…  The “Lending Tree” Model  Portfolio Management  Regulation  New Street (Domestic Policy) To Make a Dollar It’s Not Just the MMBTU Foreign Investment Alternative Energy

15 Questions? Contact Any Time Christina Kitchens Vice President – Energy 17950 Preston Road, Suite 500 Dallas, Texas 75252 P: 972.713.1110 F: 214.234.1974 M: 940.453.7954 E: Thank you!

16 Avoiding the A&D Tax Bite and Enhancing Asset Performance George Barlow, Esq. Dallas, Texas – October 23, 2008 K&L Gates Oil and Gas Symposium

17 Basic 1031 Exchange Property Qualifications HELD for productive use in trade or business or for investment. Exchanged for “Like Kind” All real property is “Like Kind” Many, but not all, mineral properties fit in. Tax Deferral Requirements Reinvest all cash Trade = or > in value For FULL Deferral, Replace QNRP with QNRP

18 Sale vs. Exchange Pick the Winner:  Sell Now, Pay Current Taxes, Reinvest OR  Exchange Now, Defer Current Taxes, Reinvest

19 Sale vs. Exchange $1,250,000 Value OptionValue to InvestAnnual Cash FlowDiscount rate Present Value of Cash Flow Exchange, Defer Taxes $1,250,000$250,0008%$ 998,177 Sell, Pay 20% Taxes $1,000,000$200,0008%$ 798,542 Benefit to Exchanger, after 5 years $ 199,635

20 Business or Investment Purpose Basic 1031 Requirements  There are six tax classes of property: 1) property used in taxpayer’s trade or business; 2) property held for investment 3) property used for vacation purposes 4) property which is used as your principal residence; 5) property fixed and flipped. 6) property held primarily for sale to customers.  Mineral properties fall into 1 and 2, so Section 1031 applies

21 “Held” for investment For conventional real estate, NOT held for personal use or resale. For mineral properties, NOT held primarily for sale in a dealer capacity.

22 “Investor” or “Dealer”? Reason, purpose and intent for acquisition? Continuity of sales of leases over time? Income from sale large in proportion to other income? Sufficient assets to develop the lease, or dependent on selling the lease to make a gain? How long was the property held? What was the extent of development activity compared to solicitation of bids for the property? - -From jury instructions in Bunnel v. U. S. (D.C.N.M. 1968) 20 AFTR 2d 5696,68-1 USTC 86,054

23 1031 “Like-Kind” Requirement  We generally know that all US Real Estate is “Like-Kind” 1) Improved Real Estate 2) Unimproved Real Estate 3) Long term leases 4) Qualifying mineral properties, for example A. Royalty property B. Working interests BUT: Not all Mineral properties are Real Estate!

24 Quiz Time Relinquished Property Replacement Property 1031 Eligible? Coal Lease exceeding 30 years Fee simple in land Ltr.Rul. 7906061

25 Quiz Time Relinquished Property Replacement Property 1031 Eligible? Overriding Royalty Interest in oil, gas and mineral rights TIC half interest in unimproved real estate Chricton v. Commissioner of Internal Revenue, 42 BTA 490 (1940)

26 Quiz Time Relinquished Property Replacement Property 1031 Eligible? Limited Oil PaymentOverriding Oil and Gas Royalty Midfield Oil Company v. Commissioner of Internal Revenue, 39 BTA 1154 (1939)

27 Quiz Time Relinquished Property Replacement Property 1031 Eligible? Oil and Gas Working Interests Overriding Royalties Ltr.Rul. 8237017 (See Requirements therein)

28 Quiz Time Relinquished Property Replacement Property 1031 Eligible? Leasehold/Fixed Percentage Leasehold/fixed number of Barrels Bandini Petroleum Co. v Commissioner of Internal Revenue, 10 CCH TCM 999 (1951)

29 Quiz Time Relinquished Property Replacement Property 1031 Eligible? Carved-out Oil Payment Rights Fee interest in ranch Fleming v. Commissioner of Internal Revenue, 24 TC 818 (1955)

30 Quiz Time Relinquished Property Replacement Property 1031 Eligible? Interest in producing lease until exhaustion of deposit Fee simple in landRev.Rul 68-331, 1968-1 CB 352

31 Quiz Time Relinquished Property Replacement Property 1031 Eligible? Production payment (Assignment of Income) Real property interest C.I.R. v. P. G. Lake, Inc., 356 U.S. 260 (1958)

32 Qualifying Mineral Properties Relinquished Property Replacement Property Reference Coal Lease exceeding 30 years Fee simple in landLtr.Rul. 7906061 Overriding Royalty Interest in oil, gas and mineral rights TIC half interest in unimproved real estate Chricton v. Commissioner of Internal Revenue, 42 BTA 490 (1940) Oil and Gas Working Interests Overriding Royalties Ltr.Rul. 8237017 (See Requirements therein) Interest in producing lease until exhaustion of deposit Fee simple in landRev.Rul 68-331, 1968-1 CB 352 Long Term Interests

33 These Dogs Won’t Hunt… Relinquished Property Replacement Property Reference Limited Oil PaymentOverriding Oil and Gas Royalty Midfield Oil Company v. Commissioner of Internal Revenue, 39 BTA 1154 (1939) Leasehold/Fixed Percentage Leasehold/fixed number of Barrels Bandini Petroleum Co. v Commissioner of Internal Revenue, 10 CCH TCM 999 (1951) Carved-out Oil Payment Rights Fee interest in ranchFleming v. Commissioner of Internal Revenue, 24 TC 818 (1955) Production payment (Assignment of Income) Real property interest C.I.R. v. P. G. Lake, Inc., 356 U.S. 260 (1958) Short Term, Limited

34 Some Tax Notes Be careful. Get tax and legal advice from experts before you exchange Selling a working interest and retaining royalty or surface interests? 1031 trouble. Production Payments? Not real estate. Sorry! Equipment included in sale? If substantial, may require separate personal property exchange. (Valued over 15% = Substantial) Depletion, Depreciation and IDC’s must be recaptured upon SALE unless 1031’ed into “qualified natural resource property” Basic 1031 Exchange Requirements

35 1031 hang-ups…  Selling a working interest and retaining royalty or surface interests spells 1031 trouble.  You must sell to relinquish the entire “bundle of sticks.”  Tax Court has ruled that a sale of WI and retention of RI is not a qualifying property for exchange --Crooks v. Commissioner, 92 TC 816 (1989). (Deemed a lease, not a sale, so 1031 not an option)  ALSO, “Bonus Payment” to secure lease is ordinary income, not exchange-eligible.

36 1031 hang-ups… Production Payments? Not real estate. Sorry!  IRC Section 636 sees PP’s as loans.  Some authorities call into question whether PP’s are ever like-kind with other mineral estates.

37 1031 hang-ups…  Equipment included in sale? If substantial, may require separate personal property exchange. (Valued over 15% = Substantial)  Valued over 15% - Must be replaced by “like-kind” personal property  For personal property, like-kind means same SIC class or product category.

38 Recapture Treatment You can exchange mineral property and defer tax on recapture items. How? Select replacement property that is “Qualified Natural Resource Property.” (“QNRP”) Get tax and legal advice from experts when you are planning an exchange Ordinary income treatment of depreciation recapture, depletion recapture, or recapture of IDC. Capital Gain on the appreciated value of the property Basic 1031 Exchange Requirements

39 Sell or Exchange? Does the property qualify for exchange? How long was the property held before sale? What type of replacement is in view? Is the replacement QNRP? How much IDC, depletion and depreciation is subject to recapture? Is well equipment included in the sale? Will I have like-kind equipment in my replacement asset? Basic 1031 Exchange Questions

40 Calculating Basis Cost to Acquire is the Starting Point Add improvements made to the asset Subtract recapture items (depletion, depreciation, and IDC’s) That is your Basis in the asset (never lower than Zero) Basis and Gain Calculating Gain Sales Price is reduced by cost of Sale Net Sales Price – Basis = Gain

41 Gain Calculation: Sale Price (Adjusted Basis) Gain Facts: $500,000 purchase price $100,000 recapture items $25,000 capital improvements $1,000,000 sales price Taxes: 33% Recapture $100,000 x 33% = $33,000 15% Fed. Cap Gains $475,000 x 15% = $71,250 9.3% State Cap Gains $575,000 x 9.3% = $53,475 Total Taxes Due: $157,725 Adjusted Basis Purchase Price (Recapture Items) +Capital Improvements Adjusted Basis $500,000 $100,000 $25,000 $425,000 $1,000,000 ($425,000) $575,000 Calculating Tax on Gain

42 Total Tax Deferral Full Exchange Entirely Tax Deferred because the Replacement Property is Qualified Natural Resource Property (QNRP)

43 Partial Tax Deferral Partial Exchange Tax deferred only to value of QNRP – Ordinary income recapture to the value of the land which is Non-QNRP

44 180 days to complete exchange 45 day identification period COE after October 15th must file extension Day 0 Close of Escrow Day 45 Identification Letter Due Day 180 Exchange Completed Basic 1031 Timeline

45 Basic Property ID Requirements Identification Rules  3 Property Rule  200% Rule  AND  The 95% Exception

46 First Identification Rule 3 Property Rule You may identify not more than three properties

47 Another Way to Identify… 200% Rule  You may identify twice the value of your “Old” property Sell $2M, Identify $4M

48 The 95% Exception  You can bust the three property rule  OR  You can bust the 200% rule  IF YOU PURCHASE 95% OF THE PROPERTY YOU IDENTIFY

49 The Identification Problem in a Nutshell A RECENT OFFERING:  1031-Eligible oil and gas royalty offering consisting of approximately 74,000 acres with 1,450 producing wells, and 573 PUDs in Texas and Wyoming. 70% gas, 17% oil, reserves are estimated at 30 years. 179 new wells per year have been added over the past 5 years by major operators such as BP. Current CF of 8.7%-11.6%.  Say again, how many properties?

50 A Modest Proposal….  ALWAYS use the 200% rule to identify replacement properties.  If the property is valued at more than 200% of the “Old” value:  Acquiring it will be covered by the 95% exception  Failing to acquire it, no exchange – (back to recognition of gain)


52 Reverse Exchanges under Revenue Procedure 2000-37  Provides a “Safe Harbor” for this procedure  New Terms: Exchange Accommodation Titleholder (EAT) Qualified Exchange Accommodation Arrangement (QEAA)  Park EITHER Relinquished or Replacement Property  180-days To Complete  Bona Fide Intent to do an Exchange

53 Why Bother with a Reverse Exchange? 1. Never be without income producing property 2. Don’t miss out on investment because your property has not sold. 3. Worst case: you own two properties but you don’t owe tax yet.

54 The Exchange Accommodation Titleholder (EAT) will fund your purchase. Taxpayer must have WAYS and MEANS to handle the economics of the exchange. Common Misconception

55 Why Reverse Exchanges Work… No requirement for arms-length terms under Rev. Proc. 2000-37 permitted agreement: TP can loan money or guarantee TP or a related party can manage property TP can oversee improvements Parked property can be triple-net leased to TP or related party Fixed or formula price Puts and Call s are permitted O.K. to adjust estimated values of relinquished property

56 Service rules that Taxpayer may go “reverse” and “forward” with the same relinquished property. Reverse Private Ruling 200836024

57 First, park the replacement property “RP”. Identify relinquished property “RQ” - 45 day limit Sell RQ before 180 day limit Day 0 RP Parked Before Day 45 Identify RQ Day 180 Sell RQ, Exchange Completed Basic Reverse 1031 Timeline

58 I didn’t get enough… Property “Sold” is valued more than Replacement Solution: Forward Exchange to get “More” = $RQ = $RP

59 RQ valued MORE than RP, so… Identify additional RP before 45 day limit Day 0 RQ Sold Before Day 45 Identify “More” RP Day 180 Buy RP, Exchange Completed Now, the Forward Exchange Forward Exchange Starts

60 Taxpayer MAY shift tax on gain to next year. Reverse Private Ruling 200836024 Forward Exchange Starts Unexchanged Gain Recognized under installment sale rules of Sec. 453 of IRC Reverse Exchange Starts 180 360 0 Forward Exchange Blows Up!!

61 All is not lost…. Exchange still works... to the value of $RP When $RQ is greater than $RP….

62 Call Any Time George Barlow, Esq. Senior Account Executive LandAmerica Financial Group, Inc. 2651 N. Harwood Street Suite 260 Dallas, Texas 75201 toll free: 866 377-1031 direct dial: 214 855-8425 mobile: 214 675-1031 fax: 214 855 8411 e-mail:


64 The Paradigm Shift in the Domestic Crude Market

65 Pricing   Pricing Mechanisms   Quality Differentials   Regional Markets



68 Logistics  Transportation  Pipelines  Trucking  Rail

69 Credit Requirements   SemCrude Bankruptcy   Cost of Credit   Credit Instruments   Standby Letters of Credit   Corporate Guarantee   Pre-payments

70 Spencer Falls Founder & President EnMark Services, Inc. 1700 Pacific, Suite 4500 Dallas, Texas 75201 Direct: 214.965.9581 E-mail:

71 Oil & Gas Seminar Thursday, October 28, 2008 Sponsored by:

72 Mineral Lease Agreements – Creative Solutions Alignment of Interest – Enticing Parties Back to the Table

73 73 About K&L Gates  Over 1700 Lawyers located in 28 cities on three continents, U.S., Europe and Asia  Client Service Leader  Named one of the top 30 law firms in client service as compared with more than 500 other leading firms by The BTI Consulting Group in its latest national Survey of Client Service Performance of Law Firms.  Technology Leader  Received CIO magazine’s annual CIO 100 Award, given to 100 companies that exemplify the highest level of operational and strategic excellent information technology.  Diversity Leader  Honored among the best law firms for women by Working Mother magazine and Flex-Time Lawyers LLC, in the first-ever 2007 Best Law Firms for Women list.

74 74

75 75 Three Interrelated Topics For Discussion  Current law and history of “Dominant” and “Servient” Estates  Basics of a Mineral Lease  Creative Solutions to Encourage Production in Today’s Environment of:  Harsh reductions in lease bonuses  Downward spiral of hydrocarbon prices, and  The fact that the major publicly traded players are at a standstill.

76 76 History of “Dominant” and “Servient” Estates  In Texas and a number of other jurisdictions, the Mineral Estate is dominant over the surface estate.  Origin in Spanish law – the King held separate ownership of all minerals.  In 1862, the Texas Supreme Court held that the State could use the land in any way it chose in order to get to the minerals.  Texas Constitution of 1866 released all minerals to owners of the soil.  Mineral Estate may be severed, creating separate estates.

77 77 Accommodation Doctrine/Refinements–Fact-Driven  Texas Supreme Court recognized that the interests of land and surface owners are not always compatible. The “recurring problem of adjusting correlative rights.”  “Reasonable Accommodation Doctrine” -- Getty Oil  Operator must conduct activities with due regard for surface estate owner’s existing use if there were reasonable means available.  Only if a reasonable alternative is available consistent with industry standard, will the Operator be required to consider existing use by surface owner.  The conduct of the Lessee may not destroy or substantially impair the surface owner’s use of the surface – more than slight interference.  Very fact-driven, and involves questions to be resolved by a jury, with competing expert testimony.

78 78 Encouraging Production -- Resource Plays still offer attractive risk/reward propositions  Over the last several years, horizontal drilling in Shale Plays has had an incredible economic impact.  The competition between Operators escalated signing bonuses and royalty percentages rapidly.  Based on recent media hype, the boom is over and the Operators are not willing to pay the escalated lease bonuses, and most Operators are backing off on leasing activities all together.  When energy prices stabilize, this change in the market place could have a positive impact on economic return on E&P companies operating in Resource Plays.  lower cost of leasehold acreage;  decreased drilling cost and rig availability; and  Valuable Leasehold will most likely expire during the Primary Term.

79 79 The Mineral Lease  The “Mineral Lease” outlines the rights, privileges and obligations of the gas company, the “Lessee,” and the mineral owner, the “Lessor.”  Regardless of what anyone may tell you, there’s no “standard” lease form being used today. All terms are negotiable. The term “Producer’s 88 form” is common, but there are hundreds of forms with “88” referenced.

80 80 The Mineral Lease - Conveyance and Contract  The name “Mineral Lease” is somewhat misleading -- the “lease” is more like a transfer deed than a lease. It is both a conveyance and a contract.  It conveys the mineral rights from the Lessor to the Lessee, and is also a contract between the Lessor and the Lessee for the development of the minerals. The Lessee’s interest is similar to a fee-simple determinable, rather than a term for years.  The Lessor gives the Lessee the right to explore and produce oil and gas from the designated property, and in exchange the Lessee agrees to pay the Lessor a one-time cash lease bonus and allocates “royalty interests,” a percentage of oil and gas produced from the property.

81 81 Alignment of Interest – Enticing Parties Back to the Table  Creative Solution must be established to resuscitate leasing activities.  An Oil and Gas Lease is a business transaction created to benefit both parties: the oil, gas, or mineral rich Lessor, and the Lessee who possesses both the knowledge, skill set, and resources to properly develop those minerals. New terms have developed to protect both Lessor and Lessee to insure that both parties achieve their goals.  The parties are attempting to navigate these uncertain times by modifying the traditional terms of the Lease.

82 82 Creative Solutions – ORRI  Overriding Royalty:  Leverage Drillsite Tract Owners with additional overriding royalties – e.g. 1% overriding royalty on all natural gas produced from boreholes drilled on the leasehold premises on the first four wells, and 2% on all wells in excess of four.  taking a percentage share of the natural gas produced by an Operator, is not the only means mineral owners have found to derive more income and encourage development of the lease.  Drillsite tracts – Operators have the ability to drill several horizontal wells from one padsite, and this gives added leverage to the owners of the pad site.

83 83 Creative Solutions – Minimum Royalty  Minimum royalty clause.  For owners of tracts within known producing areas.  Regardless of actual production numbers, the lessor will receive a minimum royalty of a certain sum per month beginning approximately one to two years after the start of the lease through the end of the primary term.  Generally available only to a Lessor of large tract, may now be used to encourage Lessor to lease and the development of the lease by the Operator.  Because of the risks and uncertainties inherent in oil and gas exploration, such a penalty would only be negotiated with owners of tracts within known producing areas.

84 84 Creative Solutions – Most Favored Nation  MFN -- Mineral owners do not want to leave money on the table, and it is hard to anticipate the market for lease bonus and royalty interest, due to their highly volatile nature. No Owner wants to sign a lease for several hundred dollars and suddenly see neighbors sign for several thousand.  Lessee may be able to entice Lessor to accept a reduced bonus if the Lessor is able to protect themselves through the use of a Most Favored Nations Clause.  The Clause will require an Operator to match any increase in bonus or royalty or both paid to other Lessors: (1) within a defined geographic area and (2) within a specified time period [1-yr vs. prior to a well being completed].  Because MFN Clauses are highly favorable to lessors, the Lessee will typically limited as much as possible the geographic area and time period.

85 85 Royalties - Free Royalty  Stipulations of overriding royalty and minimum royalty or a Most Favored Nations Clause are not the limit to how lessors can retain more income from their royalty fraction. The net revenue interest due a landowner, based upon their royalty fraction, is highly dependent on the deductions and costs assessed against the lessor and the gas purchase agreement negotiated by the operator.  Mineral and royalty owners can expect to always have some costs associated with production, from severance taxes to some costs of transportation. There is no cost free lease.  Many lessors, include clauses within the lease limiting the costs deducted from the royalty or stipulating arms-length gas purchase agreements.  The Lease should specify if Lessor is responsible for transportation, compression, dehydration, marketing and other expenses.  Lessee would like to calculate the value of the gas for royalty purposes as near the “wellhead” as possible.  Lessor would like the royalty to be calculated further downstream in order to avoid paying post production expenses -- and reduce or prevent charges for producing, storing, separating, dehydrating, compressing, and transporting.  “Marketable Condition Rule.”

86 86 Encouraging Production  All of the foregoing lease terms are designed to protect the interests of the mineral owner, whether by:  encouraging production through minimum royalty payments;  protecting against the exclusion of the drillsite tract from a pooled unit through overriding royalties;  rewarding those lessors who execute leases with the possibility of being compensated for rising bonus and royalty amounts in a Most Favored Nation Clause; and  limiting costs and deduction to the royalty fraction.

87 87 Mineral Lease – Traditional Terms  Habendum Clause  This clause sets time periods, and provide for a primary term and a secondary term.  The “primary term” is the fixed number of years during which the Lessee can maintain its rights without drilling. This term should be clearly stated (typically three (3) years).  Extension Rights of Primary Term – similar economic terms.  Mineral Leases will have no force and effect if the primary term has expired and there is no production from the property.  The “secondary term” is the extended period of time for which rights are granted to the Lessee once production is obtained.

88 88 Mineral Lease -- Shut-In Royalty Clause  The shut-in royalty allows the gas companies who have drilled a well to hold the lease without actually producing minerals past the primary term.  From the Lessor’s prospective, this clause should have a maximum number of years, i.e., no more than two years past the primary term or two years in the aggregate -- Lessor wants to get the gas to market or have Lessee lose the lease.  Lessee will want the ability to shut in well(s) based on market conditions, and maintain the Lease.

89 89 Shut-In Royalty Payments  Well must be capable of producing in paying quantities  Shut-In for Operations  Shut-In for Market conditions

90 90 Mineral Lease -- Mother Hubbard  Mother Hubbard Clauses - Used when defining the Lease Property.  Property descriptions found within oil and gas leases can often be vague, indefinite, or fail to adequately cover the entire property the lease was intended to cover. This often happens because the property description is based on the language found in old deeds, or omits small portions that were adjoined at a later date.  These lot and block descriptions lack any definite metes and bounds description, but they are most often deficient because they do not take into account adjacent streets, alleys, and public rights of way.  Strip-and-Gore. The mineral rights beneath public rights of way may belong to the individual lot owners under the doctrine of strip-and-gore. Under Texas law, when a deed conveys land abutting a street, public highway, or railroad right-of- way, title to the center of the street, public highway, or railroad right-of-way also passes by the deed These minerals, as part of a small adjacent piece of property, would also fall under the Mother Hubbard Clause.

91 91 Pooling  Contractual Pooling Rights -- there is widespread inclusion of pooling clauses in leases.  The pooling language allows the Lessee to “pool” the lease premises with other land, and production from any part of the pooled acreage shall be deemed production to hold each mineral lease.  Pooling language should allow the company to create the most efficient gas units, but not allow excess vertical or horizontal acreage to be held by a well.  Anti-dilution – requires a percentage of acreage be pooled from the Lease – to ensure that Lessor’s share of royalties from production is not diluted by including only a small portion of their land in a large pooled unit.  Pugh Clause – lease segregation when there is a partial pooling.

92 92 Pugh Clause  The general rule is that a mineral lease is indivisible, and all the property under the lease will be held by production on any part of the lease premises.  A Pugh Clause is intended to prevent the holding of non- producing acreages.  In negotiated Leases, the release language not only include the undrilled acres but also depths below the producing formation. This is referred to as a vertical and horizontal Pugh Clause.

93 93 Warranty of Title to the Mineral Interest  The warranty clause binds Lessor to defend interest in, or title to the lease premises, should a dispute ever arise over ownership.  Underwriters are universally unwilling to issue title policies for specific mineral estates.  Valuable mineral interests make title disputes much more likely. Many property owners will want the warranty language stricken or at least modified to cover only title defects caused by the Lessor, not those caused by Lessor’s predecessors in title.

94 94 Force Majeure/Extension of the Primary Term  Due to the substantial lease bonuses recently paid to Lessors, Lessee are relying on claims of “Force Majeure” to extend the Primary Term.  Force Majeure provides an excuse from non-performance caused by circumstances beyond the reasonable control of the Lessee.  Acts of God to acts of government, may qualify for Force Majeure.  If “Force Majeure” is affective to extend the lease, it will only be affective as long as the force majeure event prevents production or operations.

95 95 Surface Use Implications  Drilling and maintaining a well may involve water use, vehicular access, noise and other negative impacts.  Building roads for transportation;  Use of fresh water produced for the land; and  Location of drill site may damage crops, timber etc.  No duty to restore land, absent contractual agreement.  Absent restrictions in the Lease, the Lessee has the implied right to use as much water that is reasonably necessary to produce the minerals from the Leased Premises.

96 96 Surface Use Restrictions  If the Lessor doesn’t want a well drilled on its property, the Lease must clearly restrict surface rights or access.  The Lessee will require a provision providing for directional drilling, to provide a subsurface easement for all purposes associated with such horizontal and/or directional wells.  Operators are attempting to include provisions that provide for the continuing right to use and maintain such subsurface easement for so long as Lessee is utilizing a directional wellbore(s) traversing the leased premises either during or after the expiration of the lease.

97 97 Surface Use Allowed with Restrictions  If you do want wells drilled on your property, then provisions need to be included in the lease or in a side agreement concerning the additional payment for the Pad site(s), damages to be paid for drill sites, roads, pipeline easements and the use of water.  Title Insurance Considerations – T-19 possible coverage to surface owner for damage caused by mineral estate.  Underwriters usually require full surface use waiver, designated drill sites or surface limitations.

98 98 Expiration of Primary Term  What does the Lease require to extend to Secondary Term?  Production in Paying Quantities  Operations, Drilling Operations, continuous Operations  Pooling – with production in the pooled unit.

99 99 Production in paying quantities  Objective Test  Qualifying expenses exceed revenue for the lease  Operating and marketing expenses; not capital expenditures  For a reasonable, and not arbitrary, period of time; can range from 4 to 18 months or longer  Subjective Test  a “reasonably prudent operator” would, for the purposes of making a profit and not merely for speculation, continue to operate the well at issue.

100 100 Lease Provisions – ORRI Pad Site:  Grantor hereby except from this grant and reserves unto itself, its successors and assigns, perpetually and cost free (except only for property taxes and severance taxes applicable solely to the reserved interest) a royalty of 1% of all (8/8ths) of the oil, gas and other minerals produced through the well bores of the first four wells, and 2% of all (8/8ths) of the oil, gas and other minerals produced through the wellbores of all wells in excess of four, that may be drilled and completed from a surface location or locations on the Property; provided, however, that no royalty shall be paid with respect to oil or gas that escapes and is not sold or used due to a blowout.

101 101 Minimum Royalty  Notwithstanding anything contained herein to the contrary, Lessee shall pay to Lessor a minimum royalty during the first _______ months of this Lease equal to $50,000.00 payable as hereinafter provided. If at the end of the ____ month of this Lease, Lessor has not received at least $50,000.00 from the royalties payable to Lessor pursuant to the above provisions of this Paragraph 3 then, commencing with the _________ month of this Lease, and continuing for each month thereafter until Lessor has received a total of $50,000 from sum of (i) all royalties paid to Lessor pursuant to the above provisions of this Paragraph 3 since inception of this Lease and (ii) the additional royalty provided for in this Subparagraph Lessee shall pay to Lessor an amount equal to the lesser of (x) the difference between $20,000.00 and the amount received by Lessor during that month as royalties pursuant to the above provisions of Paragraph 3 of this Lease, and (y) the difference between (a) $50,000.00 and (b) the sum of all of the royalties previously received by Lessor pursuant to this Paragraph 3. All minimum royalty payments shall be paid by the Lessee to the Lessor on or before the 25th of each month.

102 102 Most Favored Nations Clauses  If within (Specify Time Period) from the date of this Lease, Lessee, its agents, partners, subsidiaries, affiliates, or assignees, shall enter into an oil and gas lease on lands in (Name) County, (State), located within (Specify Distance) from any boundary of the lands that are the subject of this Lease (the “Other Lease”), providing for a bonus, on a per-acre basis, greater than the per-acre bonus paid to Lessor for this Lease, and/or a royalty in an amount greater than is provided for in this Lease, then Lessee shall pay to Lessor, as additional bonus for this Lease, an amount equal to the difference, on a per-acre basis, between the amount paid Lessor for executing this Lease and the greater amount determined by the terms of the Other Lease, and/or amend this Lease to provide for Lessor to be paid the greater royalty interest provided for in the Other Lease. Lessees failure to perform the obligations provided for in this provision within (Specify Time Period) of the date on which a greater bonus is paid for or a greater royalty is provided for in the Other Lease, this Lease shall automatically terminate and Lessor shall have no obligation to return any bonus payments or other consideration paid by Lessee to Lessor. For the purposes of this provision, “bonus” shall be deemed to include any cash consideration paid to a lessor, however called or characterized, or any benefit provided the Lessor by Lessee, and “royalty” shall be deemed to include any and all interests in production, however called or characterized in the Other Lease.

103 103 Most Favored Nations Clauses  FAVORED NATIONS: If at any time or times prior to a well being completed on the leased premises, or prior to a well being completed in any pooled or unitized units in which the leased premises are included, Lessee or its assigns shall obtain a lease from or make a contract with a mineral owner under the Leased Premises other than Lessor, then Lessor shall be entitled to any benefits paid for, granted or reserved in such lease or contract which are greater or more favorable than those paid for, granted or reserved in this lease. Lessee shall pay Lessor immediately Lessor’s prorate share of such benefit, including without limitation, bonus, royalty, rental or shut-in payment or any other benefit more favorable to such mineral owner than the payment for or the benefits of this lease. If necessary in the opinion of Lessor, then Lessee shall amend this lease to confer such benefits upon Lessor

104 104 Mother Hubbard Clause  This lease also covers and includes, in addition to that above-described, all land, if any, contiguous or adjacent to or adjoining the land above described and (a) owned or claimed by lessor by limitation, prescription, possession, reversion, or unrecorded instrument or (b) as to which lessor has a preference right of acquisition.

105 105 K&L Gates Julie E. Lennon is a partner in the Dallas office of K&L Gates. Ms. Lennon’s practice is transactional in nature. She focuses on oil & gas transactions and commercial lending, and includes representing lenders and borrowers in oil & gas financing transactions, representing sellers and purchasers in acquisition and divestures of producing property, and representing both landowners and mineral owners in negotiation and drafting oil & gas leases. Ms. Lennon also represents and counsels lenders and borrowers in a variety of real estate financing transactions. Ms. Lennon is admitted to practice in and member of the Texas and Mississippi State Bars. She graduated from the University of Southern Mississippi and received her law degree from the Southern Methodist University, and her masters of law degree from the New York University School of Law. Ms. Lennon also clerked for the Mississippi Supreme Court. Contact Information: Phone: 214.939.4920 E-mail:

106 N G P Capital and Sponsorship for the Energy Industry Since 1988 October 23, 2008 Energy Private Equity: Choosing the Right Partner

107 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION NGP Energy Capital Management Founded in 1988, NGP Energy Capital Management is the Premier Investment Franchise in the Energy Industry 1988 2004 2005 2007 NGP I NCOME C O -I NVESTMENT F UNDS 2005 Strategic Advisory Council Robert W. Jordan James R. Schlesinger Charles R. Williamson Pat Wood, III

108 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION Natural Gas Partners Funds – $6.9 billion North American private equity fund complex consisting of nine funds investing primarily within the oil and gas, midstream and oilfield services sectors Co-Investment Funds – $100 million and $250 million co- investment funds are yield-oriented vehicles that invest alongside NGP’s private equity funds NGP Capital Resources Company (“NGPC”) – Founded in 2004, NGPC is a $500 million publicly-traded business development company that focuses on providing senior debt and mezzanine capital to companies in the energy industry NGP Energy Capital Management NGP has Created a Diverse Group of Energy-Focused Investment Silos

109 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION NGP Energy Capital Management NGP Energy Technology Partners (“NGP ETP”) – Founded in 2005, NGP ETP is a $148 million private equity fund created to provide growth capital and buyout funding for companies offering technology-related products and services to the oil and gas, power, and alternative energy sectors. NGP Energy Technology Partners II is currently raising a $300 million to $400 million follow-on fund that will execute the same strategy. NGP Midstream & Resources, L.P. (“NGP MR”) – Founded in 2007, NGP MR is a $1.4 billion private equity fund concentrating on the energy infrastructure (pipelines and related assets transporting natural gas, crude oil or refined products) and mining and mineral businesses NGP has Created a Diverse Group of Energy-Focused Investment Silos

110 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION Key Attributes Private equity firm focused on the energy industry since 1988 Particular expertise in oil and gas production, midstream and oilfield service companies Management has invested as a team for 20 years with no turnover Over $6.9 billion of capital and undrawn commitments managed in nine private equity funds $3.5 billion invested and committed – 163 transactions in 127 entities Gross IRR from inception to June 2008 of 33% using discounted market values Premier investment franchise within the energy and limited partner communities Overview of Natural Gas Partners

111 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION Geological & Geophysical Exploration Production Transportation Processing Refining Marketing Oil and Gas in Place Upstream – Businesses that find, develop and extract energy resources Midstream – Businesses that gather, process, store and transfer energy resources Downstream – Businesses that refine, market and distribute refined energy resources End User MidstreamDownstream Upstream NGP invests in a broad range of sectors within the energy industry Overview of Natural Gas Partners

112 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION NGP has broad investment experience in the major North American oil and gas basins Canada 20% Texas 28% Gulf of Mexico 3% Gulf Coast 8% Mid-Continent 13% Rocky Mountains 16% Other 12% Percent of Total Capital Invested by Region November 1988 – June 2008 Overview of Natural Gas Partners

113 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION  Own equity alongside “owner-managers” who:  Invest a portion of their liquid net worth to the enterprise  Lead a top-tier technical team able to effectively reinvest cash flows  Have a proprietary source of transaction flow or other competitive edge  Invest in companies with ongoing growth opportunities as opposed to project-oriented financings  Fund the start-up of a company where significant opportunity exists  Provide financial and strategic sponsorship to management and access to additional growth capital at the lowest possible cost  Above all else, NGP believes that finding the right people is the most important ingredient for successful investing in the energy industry… NGP tries to align itself with the best managers in the business, and get out of their way Overview of Natural Gas Partners The Governing Principles

114 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION Field Production & Optimization Strategic Direction Capital Investment Efficiency Regional Asset Optimization Area Asset Optimization NGP Assistance All Other Colors Represent Management Focus Strategic Direction Area Asset Optimization Field Production & Optimization Capital Investment Efficiency Strategic Direction Senior Seniority Level of Management Junior Traditional Company Management Model NGP Portfolio Company Management Partnership Model (flipped on its side) Senior NGP Portfolio Company Management Focus NGP’s Portfolio Company Structure Capitalizes on the Weakness of Traditional Corporate Structures Overview of Natural Gas Partners

115 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION NGP Applies a “Build-Up” Strategy in the Oil and Gas Acquisition and Exploitation Market 0 0.2 0.4 0.6 0.8 1 1.2 Time Production Rate A Seller's Economics B Value Creation Through Lower Costs C Value Creation Through Production Enhancements A C B Original Cost Economic Limit New Cost Economic Limit Time of Property Sale Overview of Natural Gas Partners

116 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION Focus: People and Teams Entrepreneurial Strong Technical and Practical Experience Sound Business Judgment Confidence and Leadership Abilities Creativity Desirous of a Value-Added Partner Overview of Natural Gas Partners

117 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION Not Necessary CEO Experience Full Lineup of Technical and Financial Disciplines A Deal in Hand Pretty PowerPoint Slides Overview of Natural Gas Partners

118 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION Considerations Incentives Owner / Manager Contribution Requirements Structure and Alignment of Interests Ownership / Monitoring Dynamic Resources Offered Exit Dynamic Choosing the Right Partner

119 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION Always, Always, Always … Check References:  Good and Bad Deals  Past and Present Partners Choosing the Right Partner

120 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION Capital Trends Public Equity and Debt Markets are Closed Many Commercial Banks are in Various States of Disarray Hedge Fund and Other Generalist Money Likely Gone Mezzanine Capital is Limited Public Companies are Reducing Spending and Repairing Balance Sheets Assets Coming Available, But Values Impacted by Lower Commodity Prices and Higher Costs of Capital Choosing the Right Partner

121 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION In Conclusion … Private Equity Capital is Available High Quality Entrepreneurs and Value-Added Partners Remain Scarce Don’t Underestimate the Impact of a Bad or Inexperienced Partner Go with Experience Choosing the Right Partner

122 CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION Contact Info Choosing the Right Partner David Hayes Natural Gas Partners 972-432-1451

123 Case Law Update Clayton L. Falls Associate K&L Gates LLP 1717 Main Street, Suite 2800 Dallas, Texas 75201 214.939.4958

124 124 Significant Texas Supreme Court Case Coastal Oil & Gas v. Garza Energy Trust 2008 WL 3991029 (Tex. 2008) Decided August 29, 2008

125 125 Coastal Oil & Gas v. Garza Energy Trust  Case Background  Coastal located a Well as close to the Plaintiff’s adjoining property line;  Well was within Railroad Commission spacing rules;  Costal “fraced” this Well, with the fracing length designed to reach over 1,000 feet from the Well.  Therefore the frac lines extended well into adjoining lease;  Coastal proceeded to drain natural gas from neighboring land;  Coastal held the Mineral Lease on the Plaintiff’s adjacent Land, as well.

126 126 Coastal Oil & Gas v. Garza Energy Trust  Adjacent Property Owner’s Allegations:  Subsurface trespass through hydraulic fracturing,  Implied Mineral Lease Covenants:  Breach of implied covenants to develop, market and protect against drainage  Failure-to-Develop Damages – zero, interest was lost, but net income was increased.  Breach of duty of good faith pooling.

127 127 Coastal Oil & Gas v. Garza Energy Trust  Trial Court awarded Plaintiff:  $1.75MM in lost royalties for failure to develop  $1MM for bad faith pooling  $1MM in lost royalties for subsurface trespass  $1.4MM in reasonable attorneys’ fees

128 128 Coastal Oil & Gas v. Garza Energy Trust  On Appeal  Highly anticipated decision  Tex. Sup. Ct. had never addressed subsurface trespass in regard to hydraulic well fracing  Strong public policy implications

129 129 Coastal Oil & Gas v. Garza Energy Trust  Rule of Capture Permits the owner of a tract to drill as many wells on his land as the Railroad Commission will allow and provides that he is not liable to adjacent landowners whose lands are drained as a result of his operations

130 130 Coastal Oil & Gas v. Garza Energy Trust  Court’s Holding  Any alleged damages for royalties lost due to subsurface trespass are precluded by the law of capture.  Justification:  Start Drilling! - Operator required to drill to prevent drainage  Better left to RRC rather than Juries  Difficult to determine value of drained oil and gas  No one wanted it.

131 131 Coastal Oil & Gas v. Garza Energy Trust  Court’s Holding Cont.  Royalty interest owners with reversionary interests have standing to sue  Operators have a duty to protect the leasehold against drainage  Royalty owner’s recourse could be against their Operator  Could see additional litigation  Damages valued at royalty lost to Lessor b/c of Lessee’s failure to develop.  Could see increased litigation with drop of prices!

132 132 Clayton Falls concentrates his practice in the commercial litigation, product liability, and toxic tort areas. He has represented clients in a broad range of cases as plaintiffs and defendants in both state and federal courts. Mr. Falls handles a variety of cases including claims for breach of contract, breach of fiduciary duty, negligent misrepresentation, fraud, false advertising as well as numerous claims under the Deceptive Trade Practices Act. In addition to his general litigation experience, he has also assisted in the investigation and defense of two separate shareholder derivative suits brought against the companies prior to their highly publicized public sale. Contact Information: Phone: 214.939.4920 E-mail: K&L Gates

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