5Energy Lending Practices Collateral Evaluation - The Reserve Report TodayEnergy Lending PracticesCollateral Evaluation - The Reserve ReportAdvance PoliciesPrice Deck CasesOne Line Summaries/Decline CurvesUpsideWhy different?
6Energy Lending Practices Collateral Evaluation – Title TodayEnergy Lending PracticesCollateral Evaluation – TitleBank StandardsHow it is used?
7Energy Lending Practices Risk Evaluation – How we do it? TodayEnergy Lending PracticesRisk Evaluation – How we do it?It’s a Risky BusinessThe Big SixUnderwriting Risks
8Energy Lending Practices Covenants – The Normal and Not so Normal TodayEnergy Lending PracticesCovenants – The Normal and Not so NormalLoan PoliciesFinancial, Affirmative, NegativeTailoredBenefit?
9Relationship Management Structure TodayCompetitivenessFinancial MarketsCapital Costs and ReturnScaleNew Entry and AlternativesRelationship ManagementStructure
10Financial Markets –What’s going on? TodayCompetitivenessFinancial Markets –What’s going on?Capital Costs and ReturnScaleNew Entry and Alternatives
11Relationship Management– Big and Small TodayCompetitivenessRelationship Management– Big and SmallYour ExpectationsA PartnershipValue AddedBusiness ModelProductsIndustry/YB Knowledge
12Structure– Big and Small again TodayCompetitivenessStructure– Big and Small againRelationship UpsideRisk AppetiteDo they get it?
13Where we’re at and where we’re going TodayIndustryWhere we’re at and where we’re goingEnergy is “Hot”The Fundamentals and ComplexityMain StreetWall Street
14The “Lending Tree” Model Portfolio Management Regulation And Finally Tomorrow…The “Lending Tree” ModelPortfolio ManagementRegulationNew Street (Domestic Policy)To Make a DollarIt’s Not Just the MMBTUForeign InvestmentAlternative Energy
15Questions? Contact Any Time Christina KitchensVice President – Energy17950 Preston Road, Suite 500Dallas, Texas 75252P:F:M:E:Thank you!
16Avoiding the A&D Tax Bite and Enhancing Asset Performance K&L Gates Oil and Gas SymposiumAvoiding the A&D Tax Bite and Enhancing Asset PerformanceGeorge Barlow, Esq.Dallas, Texas – October 23, 2008
17Basic 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 RequirementsReinvest all cashTrade = or > in valueFor FULL Deferral, ReplaceQNRP with QNRP
18Exchange Now, Defer Current Taxes, Reinvest Sale vs. ExchangePick the Winner:Sell Now, Pay Current Taxes, ReinvestORExchange Now, Defer Current Taxes, Reinvest
19Sale vs. Exchange $1,250,000 Value OptionValue to InvestAnnual Cash FlowDiscount ratePresent Value of Cash FlowExchange, Defer Taxes$1,250,000$250,0008%$ 998,177Sell, Pay 20% Taxes$1,000,000$200,000$ 798,542Benefit to Exchanger, after 5 years$ 199,635
20Basic 1031 Requirements There are six tax classes of property: Business or Investment PurposeThere are six tax classes of property:property used in taxpayer’s trade or business;property held for investmentproperty used for vacation purposesproperty which is used as your principal residence;property fixed and flipped.property held primarily for sale to customers.Mineral properties fall into 1 and 2, so Section 1031 applies
21“Held” for investmentFor 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
231031 “Like-Kind” Requirement We generally know that all US Real Estate is “Like-Kind”Improved Real EstateUnimproved Real EstateLong term leasesQualifying mineral properties, for exampleRoyalty propertyWorking interestsBUT: Not all Mineral properties are Real Estate!Mineral properties that qualify are long term intererests, as a rule.
25Relinquished Property Quiz TimeRelinquished PropertyReplacement Property1031 Eligible?Overriding Royalty Interest in oil, gas and mineral rightsTIC half interest in unimproved real estateChricton v. Commissioner of Internal Revenue, 42 BTA 490 (1940)
26Relinquished Property Quiz TimeRelinquished PropertyReplacement Property1031 Eligible?Limited Oil PaymentOverriding Oil and Gas RoyaltyMidfield Oil Company v. Commissioner of Internal Revenue, 39 BTA 1154 (1939)
27Relinquished Property Quiz TimeRelinquished PropertyReplacement Property1031 Eligible?Oil and Gas Working InterestsOverriding RoyaltiesLtr.Rul (See Requirements therein)
28Relinquished Property Quiz TimeRelinquished PropertyReplacement Property1031 Eligible?Leasehold/Fixed PercentageLeasehold/fixed number of BarrelsBandini Petroleum Co. v Commissioner of Internal Revenue, 10 CCH TCM 999 (1951)
29Relinquished Property Quiz TimeRelinquished PropertyReplacement Property1031 Eligible?Carved-out Oil Payment RightsFee interest in ranchFleming v. Commissioner of Internal Revenue, 24 TC 818 (1955)
30Relinquished Property Quiz TimeRelinquished PropertyReplacement Property1031 Eligible?Interest in producing lease until exhaustion of depositFee simple in landRev.Rul , CB 352
31Relinquished Property Quiz TimeRelinquished PropertyReplacement Property1031 Eligible?Production payment (Assignment of Income)Real property interestC.I.R. v. P. G. Lake, Inc., 356 U.S. 260 (1958)
32Qualifying Mineral Properties Long Term InterestsRelinquished PropertyReplacement PropertyReferenceCoal Lease exceeding 30 yearsFee simple in landLtr.RulOverriding Royalty Interest in oil, gas and mineral rightsTIC half interest in unimproved real estateChricton v. Commissioner of Internal Revenue, 42 BTA 490 (1940)Oil and Gas Working InterestsOverriding RoyaltiesLtr.Rul (See Requirements therein)Interest in producing lease until exhaustion of depositRev.Rul , CB 352
33Relinquished Property These Dogs Won’t Hunt…Short Term, LimitedRelinquished PropertyReplacement PropertyReferenceLimited Oil PaymentOverriding Oil and Gas RoyaltyMidfield Oil Company v. Commissioner of Internal Revenue, 39 BTA 1154 (1939)Leasehold/Fixed PercentageLeasehold/fixed number of BarrelsBandini Petroleum Co. v Commissioner of Internal Revenue, 10 CCH TCM 999 (1951)Carved-out Oil Payment RightsFee interest in ranchFleming v. Commissioner of Internal Revenue, 24 TC 818 (1955)Production payment (Assignment of Income)Real property interestC.I.R. v. P. G. Lake, Inc., 356 U.S. 260 (1958)
34Basic 1031 Exchange Requirements Some Tax NotesBe careful. Get tax and legal advice from experts before you exchangeSelling a working interest and retaining royalty or surface interests? 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”
351031 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.
361031 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.
371031 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 propertyFor personal property, like-kind means same SIC class or product category.
38Basic 1031 Exchange Requirements Recapture TreatmentYou 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 exchangeOrdinary income treatment of depreciation recapture, depletion recapture, or recapture of IDC.Capital Gain on the appreciated value of the property
39Basic 1031 Exchange Questions 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?
40Basis and Gain Calculating Basis Calculating Gain Cost to Acquire is the Starting PointAdd improvements made to the assetSubtract recapture items (depletion, depreciation, and IDC’s)That is your Basis in the asset (never lower than Zero)Calculating GainSales Price is reduced by cost of SaleNet Sales Price – Basis = Gain
41Calculating Tax on Gain Gain Calculation:Sale Price(Adjusted Basis)GainFacts:$500,000 purchase price$100,000 recapture items$25,000 capital improvements$1,000,000 sales price$1,000,000($425,000)$575,000Taxes:33% Recapture$100,000 x 33% = $33,00015% Fed. Cap Gains$475,000 x 15% = $71,2509.3% State Cap Gains$575,000 x 9.3% = $53,475Total Taxes Due: $157,725Adjusted BasisPurchase Price(Recapture Items)+Capital Improvements$500,000$100,000$25,000$425,000
42Total Tax DeferralFull ExchangeEntirely Tax Deferred because the Replacement Property is Qualified Natural Resource Property (QNRP)
43Partial Tax DeferralPartial ExchangeTax deferred only to value of QNRP – Ordinary income recapture to the value of the land which is Non-QNRP
44Identification Letter Due Basic 1031 Timeline180 days to complete exchange45 day identification periodCOE after October 15th must file extensionDay 0Close of EscrowDay 45Identification Letter DueDay 180 Exchange Completed
46First Identification Rule 3 Property RuleYou may identify not more than threeproperties
47Another Way to Identify… 200% RuleYou may identify twice the value of your “Old” propertySell $2M, Identify $4M
48The 95% Exception You can bust the three property rule OR You can bust the 200% ruleIFYOU PURCHASE 95% OF THE PROPERTY YOU IDENTIFY
49The 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?
50A 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% exceptionFailing to acquire it, no exchange – (back to recognition of gain)
52Reverse Exchanges under Revenue Procedure 2000-37 Provides a “Safe Harbor” for this procedureNew Terms:Exchange Accommodation Titleholder (EAT)Qualified Exchange Accommodation Arrangement (QEAA)Park EITHER Relinquished or Replacement Property180-days To CompleteBona Fide Intent to do an ExchangeThe IRS has given us a blueprint for conducting the Reverse Exchange.
53Why Bother with a Reverse Exchange? Never be without income producing propertyDon’t miss out on investment because your property has not sold.Worst case: you own two properties but you don’t owe tax yet.The IRS has given us a blueprint for conducting the Reverse Exchange.
54The Exchange Accommodation Titleholder (EAT) will fund your purchase. Common MisconceptionThe Exchange Accommodation Titleholder (EAT) will fund your purchase.Taxpayer must have WAYS and MEANS to handle the economics of the exchange.First time reversers may think that the Exchange Facilitator has the deep pockets to make all the financial arrangements. Not so!!
55Why Reverse Exchanges Work… No requirement for arms-length terms under Rev. Proc permitted agreement:TP can loan money or guaranteeTP or a related party can manage propertyTP can oversee improvementsParked property can be triple-net leased to TP or related partyEven though the Exchange Company is intricately involved in the exchange, the rules permit the Taxpayer to call the shots.Fixed or formula price Puts and Calls are permittedO.K. to adjust estimated values of relinquished property
56Reverse Private Ruling 200836024 Service rules that Taxpayer may go “reverse” and “forward” with the same relinquished property.First time reversers may think that the Exchange Facilitator has the deep pockets to make all the financial arrangements. Not so!!
57Basic Reverse 1031 Timeline First, park the replacement property “RP”.Identify relinquished property “RQ” - 45 day limitSell RQ before 180 day limitDay 0RP ParkedBefore Day 45Identify RQDay 180 Sell RQ, Exchange Completed
58I didn’t get enough… = $RQ = $RP Property “Sold” is valued more than Replacement= $RQ= $RPSolution: Forward Exchange to get “More”
59Now, the Forward Exchange RQ valued MORE than RP, so…Identify additional RP before 45 day limitDay 0RQ SoldBefore Day 45Identify “More” RPDay 180 Buy RP, Exchange CompletedForwardExchangeStarts
60Reverse Private Ruling 200836024 Taxpayer MAY shifttax on gain tonext year.Forward Exchange Blows Up!!360180ForwardExchangeStartsReverseExchangeStartsAll is not lost! The exchange was partially completed, to the value of the match between RP and RQ.Unexchanged Gain Recognized under installment sale rules of Sec. 453 of IRC
61All is not lost…. When $RQ is greater than $RP…. Exchange still works to the value of $RP
62Call Any Time George Barlow, Esq. Senior Account Executive LandAmerica Financial Group, Inc.2651 N. Harwood StreetSuite 260Dallas, Texas 75201toll free:direct dial:mobile:fax:Again, we thank you for being with us today and hope we get to work together soon.
71Oil & Gas Seminar Thursday, October 28, 2008 Sponsored by:
72Mineral Lease Agreements – Creative Solutions Alignment of Interest – Enticing Parties Back to the Table
73About K&L GatesOver 1700 Lawyers located in 28 cities on three continents, U.S., Europe and AsiaClient Service LeaderNamed 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 LeaderReceived CIO magazine’s annual CIO 100 Award, given to 100 companies that exemplify the highest level of operational and strategic excellent information technology.Diversity LeaderHonored 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.
75Three Interrelated Topics For Discussion Current law and history of “Dominant” and “Servient” EstatesBasics of a Mineral LeaseCreative Solutions to Encourage Production in Today’s Environment of:Harsh reductions in lease bonusesDownward spiral of hydrocarbon prices, andThe fact that the major publicly traded players are at a standstill.
76History 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.
77Accommodation 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 OilOperator 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.
78Encouraging 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; andValuable Leasehold will most likely expire during the Primary Term.
79The Mineral LeaseThe “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.
80The 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.
81Alignment 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.
82Creative 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.
83Creative 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.
84Creative 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.
85Royalties - 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.”
86Encouraging 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; andlimiting costs and deduction to the royalty fraction.
87Mineral Lease – Traditional Terms Habendum ClauseThis 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.
88Mineral 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.
89Shut-In Royalty Payments Well must be capable of producing in paying quantitiesShut-In for OperationsShut-In for Market conditions
90Mineral 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.
91PoolingContractual 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.
92Pugh ClauseThe 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.
93Warranty 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.
94Force 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.
95Surface 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; andLocation 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.
96Surface 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.
97Surface 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.
98Expiration of Primary Term What does the Lease require to extend to Secondary Term?Production in Paying QuantitiesOperations, Drilling Operations, continuous OperationsPooling – with production in the pooled unit.
99Production in paying quantities Objective TestQualifying expenses exceed revenue for the leaseOperating and marketing expenses; not capital expendituresFor a reasonable, and not arbitrary, period of time; can range from 4 to 18 months or longerSubjective Testa “reasonably prudent operator” would, for the purposes of making a profit and not merely for speculation, continue to operate the well at issue.
100Lease 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.
101Minimum RoyaltyNotwithstanding anything contained herein to the contrary, Lessee shall pay to Lessor a minimum royalty during the first _______ months of this Lease equal to $50, payable as hereinafter provided. If at the end of the ____ month of this Lease, Lessor has not received at least $50, 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, 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, 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.
102Most 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.
103Most 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
104Mother Hubbard ClauseThis 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.
105K&L GatesJulie 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:
106N G P Capital and Sponsorship for the Energy Industry Since 1988 Energy Private Equity: Choosing the Right PartnerOctober 23, 2008
107NGP Energy Capital Management Founded in 1988, NGP Energy Capital Management is thePremier Investment Franchise in the Energy IndustryStrategic Advisory CouncilRobert W. JordanJames R. SchlesingerCharles R. WilliamsonPat Wood, III1988200420052005NGP INCOME CO-INVESTMENT FUNDS2007
108NGP Energy Capital Management NGP has Created a Diverse Group of Energy-Focused Investment SilosNatural 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 sectorsCo-Investment Funds – $100 million and $250 million co-investment funds are yield-oriented vehicles that invest alongside NGP’s private equity fundsNGP 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
109NGP Energy Capital Management NGP has Created a Diverse Group of Energy-Focused Investment SilosNGP 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
110Overview of Natural Gas Partners Key AttributesPrivate equity firm focused on the energy industry since 1988Particular expertise in oil and gas production, midstream and oilfield service companiesManagement has invested as a team for 20 years with no turnoverOver $6.9 billion of capital and undrawn commitments managed in nine private equity funds$3.5 billion invested and committed – 163 transactions in 127 entitiesGross IRR from inception to June 2008 of 33% using discounted market valuesPremier investment franchise within the energy and limited partner communities
111Geological & Geophysical Overview of Natural Gas PartnersNGP invests in a broad range of sectors within the energy industryOil and Gas in PlaceGeological & GeophysicalEnd UserExplorationProductionTransportationProcessingRefiningMarketingMidstreamDownstreamUpstreamUpstream – Businesses that find, develop and extract energy resourcesMidstream – Businesses that gather, process, store and transfer energy resourcesDownstream – Businesses that refine, market and distribute refined energy resources
112Percent of Total Capital Invested by Region Overview of Natural Gas PartnersNGP has broad investment experience in the major North American oil and gas basinsPercent of Total Capital Invested by RegionNovember 1988 – June 2008Canada20%Rocky Mountains16%Mid-Continent13%Other12%Texas28%Gulf Coast8%Gulf of Mexico3%
113Overview of Natural Gas Partners The Governing PrinciplesOwn equity alongside “owner-managers” who:Invest a portion of their liquid net worth to the enterpriseLead a top-tier technical team able to effectively reinvest cash flowsHave a proprietary source of transaction flow or other competitive edgeInvest in companies with ongoing growth opportunities as opposed to project-oriented financingsFund the start-up of a company where significant opportunity existsProvide financial and strategic sponsorship to management and access to additional growth capital at the lowest possible costAbove 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
114Management Partnership Model Overview of Natural Gas PartnersNGP’s Portfolio Company Structure Capitalizes on the Weakness of Traditional Corporate StructuresNGP Portfolio CompanyManagement Partnership Model(flipped on its side)Traditional CompanyManagement ModelSeniorStrategic DirectionStrategic DirectionCapital Investment EfficiencySeniorityLevel of ManagementRegional Asset OptimizationStrategic DirectionCapital Investment EfficiencyArea Asset OptimizationArea Asset OptimizationField Production & OptimizationField Production & OptimizationJuniorSeniorNGP Portfolio Company Management FocusNGP Assistance All Other Colors Represent Management Focus
115Overview of Natural Gas Partners NGP Applies a “Build-Up” Strategy in the Oil and GasAcquisition and Exploitation Market1.2A Seller's EconomicsB Value Creation Through Lower Costs1C Value Creation Through Production Enhancements0.8CProduction Rate0.6Original CostEconomic LimitA0.4New CostEconomic LimitB0.2Time ofProperty SaleTime
116Overview of Natural Gas Partners Focus: People and TeamsEntrepreneurialStrong Technical and Practical ExperienceSound Business JudgmentConfidence and Leadership AbilitiesCreativityDesirous of a Value-Added Partner
117Overview of Natural Gas Partners Not NecessaryCEO ExperienceFull Lineup of Technical and Financial DisciplinesA Deal in HandPretty PowerPoint Slides
118Choosing the Right Partner ConsiderationsIncentivesOwner / Manager Contribution RequirementsStructure and Alignment of InterestsOwnership / Monitoring DynamicResources OfferedExit Dynamic
119Check References: Good and Bad Deals Past and Present Partners Choosing the Right PartnerAlways, Always, Always …Check References:Good and Bad DealsPast and Present Partners
120Choosing the Right Partner Capital TrendsPublic Equity and Debt Markets are ClosedMany Commercial Banks are in Various States of DisarrayHedge Fund and Other Generalist Money Likely GoneMezzanine Capital is LimitedPublic Companies are Reducing Spending and Repairing Balance SheetsAssets Coming Available, But Values Impacted by Lower Commodity Prices and Higher Costs of Capital
121Choosing the Right Partner In Conclusion …Private Equity Capital is AvailableHigh Quality Entrepreneurs and Value-Added Partners Remain ScarceDon’t Underestimate the Impact of a Bad or Inexperienced PartnerGo with Experience
122David Hayes Natural Gas Partners firstname.lastname@example.org 972-432-1451 Choosing the Right PartnerContact InfoDavid HayesNatural Gas Partners
123Case Law Update Clayton L. Falls Associate K&L Gates LLP 1717 Main Street, Suite 2800Dallas, Texas 75201
124Significant Texas Supreme Court Case Coastal Oil & Gas v. Garza Energy Trust2008 WL (Tex. 2008)Decided August 29, 2008
125Coastal Oil & Gas v. Garza Energy Trust Case BackgroundCoastal 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.
126Coastal 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 drainageFailure-to-Develop Damages – zero, interest was lost, but net income was increased.Breach of duty of good faith pooling.
127Coastal 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
128Coastal Oil & Gas v. Garza Energy Trust On AppealHighly anticipated decisionTex. Sup. Ct. had never addressed subsurface trespass in regard to hydraulic well fracingStrong public policy implications
129Coastal Oil & Gas v. Garza Energy Trust Rule of CapturePermits 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
130Coastal Oil & Gas v. Garza Energy Trust Court’s HoldingAny 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 drainageBetter left to RRC rather than JuriesDifficult to determine value of drained oil and gasNo one wanted it.
131Coastal Oil & Gas v. Garza Energy Trust Court’s Holding Cont.Royalty interest owners with reversionary interests have standing to sueOperators have a duty to protect the leasehold against drainageRoyalty owner’s recourse could be against their OperatorCould see additional litigationDamages valued at royalty lost to Lessor b/c of Lessee’s failure to develop.Could see increased litigation with drop of prices!
132K&L GatesClayton 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:
133Oil & Gas Seminar Thursday, October 28, 2008 Sponsored by: