Oil & Gas Seminar
Thursday, October 23, 2008
Sponsored by:
Energy Lending
Today vs. Tomorrow
Today vs. Tomorrow
Today
Tomorrow
 Energy Lending
Practices
 The “Lending Tree”
Model
 Competitiveness
 Portfolio
Management
 Industry
 Regulation
 New Street
Today
Energy Lending Practices
 Collateral Evaluation
• The Reserve Report
• Title
 Risk Evaluation
 Covenants
Today
Energy Lending Practices
 Collateral Evaluation - The Reserve Report
•
•
•
•
•
Advance Policies
Price Deck Cases
One Line Summaries/Decline Curves
Upside
Why different?
Today
Energy Lending Practices
 Collateral Evaluation – Title
• Bank Standards
• How it is used?
Today
Energy Lending Practices
 Risk Evaluation – How we do it?
• It’s a Risky Business
• The Big Six
• Underwriting Risks
Today
Energy Lending Practices
 Covenants – The Normal and Not so Normal
• Loan Policies
• Financial, Affirmative, Negative
• Tailored
• Benefit?
Today
Competitiveness
 Financial Markets
• Capital Costs and Return
• Scale
• New Entry and Alternatives
 Relationship Management
 Structure
Today
Competitiveness
 Financial Markets –What’s going on?
• Capital Costs and Return
• Scale
• New Entry and Alternatives
Today
Competitiveness
 Relationship Management– Big and Small
• Your Expectations
• A Partnership
• Value Added
• Business Model
• Products
• Industry/YB Knowledge
Today
Competitiveness
 Structure– Big and Small again
• Relationship Upside
• Risk Appetite
• Do they get it?
Today
Industry
Where we’re at and where we’re going
• Energy is “Hot”
• The Fundamentals and Complexity
• Main Street
• Wall Street
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
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: Ckitchens@banksov.com
Thank you!
K&L Gates Oil and Gas Symposium
Avoiding the A&D Tax Bite and Enhancing Asset Performance
George Barlow, Esq.
Dallas, Texas – October 23, 2008
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
Sale vs. Exchange
Pick the Winner:

Sell Now, Pay Current Taxes, Reinvest
OR
 Exchange Now, Defer Current Taxes, Reinvest
Sale vs. Exchange $1,250,000 Value
Option
Value to Invest Annual Cash Flow
Discount
rate
Present Value
of Cash Flow
Exchange,
Defer Taxes
$1,250,000
$250,000
8%
$ 998,177
Sell, Pay 20% $1,000,000
Taxes
$200,000
8%
$ 798,542
Benefit to Exchanger, after 5 years
$ 199,635
Basic 1031 Requirements
Business or Investment Purpose

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
“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.
“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
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!
Quiz Time
Relinquished
Property
Replacement
Property
Coal Lease
Fee simple in land
exceeding 30 years
1031 Eligible?
Ltr.Rul. 7906061
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)
Quiz Time
Relinquished
Property
Replacement
Property
1031 Eligible?
Limited Oil Payment
Overriding Oil and
Gas Royalty
Midfield Oil Company v.
Commissioner of Internal
Revenue, 39 BTA 1154
(1939)
Quiz Time
Relinquished
Property
Replacement
Property
1031 Eligible?
Oil and Gas
Working Interests
Overriding
Royalties
Ltr.Rul. 8237017 (See
Requirements therein)
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)
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)
Quiz Time
Relinquished
Property
Replacement
Property
1031 Eligible?
Interest in
producing lease
until exhaustion of
deposit
Fee simple in land
Rev.Rul 68-331, 1968-1
CB 352
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)
Qualifying Mineral Properties
Long Term Interests
Relinquished
Property
Replacement
Property
Reference
Coal Lease
exceeding 30 years
Fee simple in land
Ltr.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 land
Rev.Rul 68-331, 1968-1 CB
352
These Dogs Won’t Hunt…
Short Term, Limited
Relinquished
Property
Replacement
Property
Reference
Limited Oil Payment
Overriding 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 ranch
Fleming 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)
Basic 1031 Exchange Requirements
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”
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.
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.
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.
Basic 1031 Exchange Requirements
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 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?
Basis and Gain
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)
Calculating Gain
•
Sales Price is reduced by cost of Sale
•
Net Sales Price – Basis = Gain
Calculating Tax on Gain
Gain Calculation:
Sale Price
$1,000,000
(Adjusted Basis)
($425,000)
Gain
$575,000
Facts:
$500,000 purchase price
$100,000 recapture items
$25,000 capital improvements
$1,000,000 sales price
Taxes:
33% Recapture
Adjusted Basis
$100,000 x 33% =
Purchase Price
$500,000
(Recapture Items)
$100,000
+Capital Improvements
Adjusted Basis
$25,000
$425,000
$33,000
15% Fed. Cap Gains
$475,000 x 15% =
$71,250
9.3% State Cap Gains
$575,000 x 9.3% =
Total Taxes Due:
$53,475
$157,725
Total Tax Deferral
Example #1
Relinquished Property
Oil and Gas Property
Potential Recapture
Replacement Property
Oil and Gas Property
$1,000,000
$400,000
$1,000,000
Full Exchange
Entirely Tax Deferred because
the Replacement Property is
Qualified Natural Resource
Property (QNRP)
Partial Tax Deferral
Example #2
Relinquished Property
Oil and Gas Property
Potential Recapture
$1,000,000
$400,000
Partial Exchange
Replacement Property
Oil and Gas Property
Land
Total
$700,000
$300,000
$1,000,000
Tax deferred only to value of
QNRP – Ordinary income
recapture to the value of the
land which is Non-QNRP
Basic 1031 Timeline
•
•
•
Day 0
Close of
Escrow
180 days to complete exchange
45 day identification period
COE after October 15th must file extension
Day 45
Identification
Letter Due
Day 180
Exchange
Completed
Basic Property ID Requirements
Identification Rules

3 Property Rule
200% Rule

AND

The 95% Exception

First Identification Rule


3 Property Rule
You may identify not more than three
properties
Another Way to Identify…
200% Rule

You may identify twice the
value of your “Old” property
Sell $2M, Identify $4M
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
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?
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)
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
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.
Common Misconception
The Exchange Accommodation Titleholder
(EAT) will fund your purchase.
Taxpayer must have WAYS and MEANS to
handle the economics of the exchange.
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 Calls are permitted
• O.K. to adjust estimated values of relinquished property
Reverse Private Ruling 200836024
Service rules that Taxpayer may go “reverse”
and “forward” with the same relinquished
property.
Basic Reverse 1031 Timeline
•
•
•
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
I didn’t get enough…
= $RQ
= $RP
Solution: Forward Exchange to
get “More”
Property “Sold” is
valued more than
Replacement
Now, the Forward Exchange
•
•
RQ valued MORE than RP, so…
Identify additional RP before 45 day limit
Day 0
RQ Sold
Before Day 45
Identify “More” RP
Forward
Exchange
Starts
Day 180
Buy RP, Exchange
Completed
Reverse Private Ruling 200836024
Taxpayer MAY shift
tax on gain to
next year.
0
Reverse
Exchange
Starts
Forward Exchange Blows Up!!
180
Forward
Exchange
Starts
360
Unexchanged Gain
Recognized under
installment sale rules
of Sec. 453 of IRC
All is not lost….
When $RQ is greater
than $RP….
Exchange still works
. . . to the value of $RP
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: gbarlow@landam.com
The Paradigm Shift in the Domestic
Crude Market
Pricing



Pricing Mechanisms
Quality Differentials
Regional Markets
NYMEX Monthly Average
NYMEX Monthly Average
$134.0157
$135.0000
$133.4845
$125.4586
$125.0000
$116.6881
Price (U.S. $)
$115.0000
$112.4627
$105.0000
$105.4200
$103.7638
$94.6314
$95.0000
$95.3490
$91.7425
$92.9290
$85.6583
$85.0000
$79.6263
$75.0000
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Platts PPlus 13 Month Average (10/07 to 10/08)
PPlus Value
$5.0000
$4.8400
$4.6960
$4.7893
$4.5000
$4.3558
$4.2987
$4.0000
Price (U.S. $)
$3.8153
$3.7309
$3.6928
$3.5828
$3.5000
$3.4430
$3.0000
$3.0367
$2.8786
$2.5000
$2.5643
$2.0000
0
1/2
10/
07
0
1/2
11/
07
0
1/2
12/
07
1 /1
0
/20
8
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/20
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10/
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Logistics

Transportation



Pipelines
Trucking
Rail
Credit Requirements



SemCrude Bankruptcy
Cost of Credit
Credit Instruments



Standby Letters of Credit
Corporate Guarantee
Pre-payments
Spencer Falls
Founder & President
EnMark Services, Inc.
1700 Pacific, Suite 4500
Dallas, Texas 75201
Direct: 214.965.9581
E-mail: spencer.falls@enmarkservices.com
Oil & Gas Seminar
Thursday, October 28, 2008
Sponsored by:
Mineral Lease Agreements –
Creative Solutions
Alignment of Interest – Enticing Parties Back to
the Table
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.
73
74
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.
75
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.
76
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.
77
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.
78
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.
79
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.
80
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.
81
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.
82
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.
83
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.
84
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.”
85
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.
86
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.
87
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.
88
Shut-In Royalty Payments
 Well must be capable of producing in paying
quantities
 Shut-In for Operations
 Shut-In for Market conditions
89
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-ofway, 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.
90
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.
91
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 nonproducing 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.
92
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.
93
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.
94
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.
95
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.
96
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.
97
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.
98
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.
99
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.
100
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.
101
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.
102
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
103
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.
104
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: julie.lennon@klgates.com
105
N
G
P
Capital and Sponsorship for the Energy Industry
Since 1988
Energy Private Equity: Choosing the Right Partner
October 23, 2008
NGP Energy Capital Management
Founded in 1988, NGP Energy Capital Management is the
Premier Investment Franchise in the Energy Industry
Strategic Advisory Council
Robert W. Jordan
James R. Schlesinger
Charles R. Williamson
Pat Wood, III
1988
2004
2005
2005
NGP INCOME CO-INVESTMENT FUNDS
2007
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
NGP Energy Capital Management
NGP has Created a Diverse Group of Energy-Focused
Investment Silos
• 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 coinvestment 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
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
NGP Energy Capital Management
NGP has Created a Diverse Group of Energy-Focused
Investment Silos
• 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
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Overview of Natural Gas Partners
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
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Overview of Natural Gas Partners
NGP invests in a broad range of sectors within the energy
industry
Oil and Gas
in Place
End
User
Upstream
Upstream – Businesses
that find, develop and
extract energy resources
Midstream
Downstream
Midstream – Businesses that Downstream – Businesses
gather, process, store and
that refine, market and
transfer energy resources
distribute refined energy
resources
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Overview of Natural Gas Partners
NGP has broad investment experience in the major North
American oil and gas basins
Percent of Total Capital Invested by Region
November 1988 – June 2008
Canada
20%
Rocky Mountains
16%
Mid-Continent
13%
Other
12%
Texas
28%
Gulf Coast
8%
Gulf of Mexico
3%
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Overview of Natural Gas Partners
The Governing Principles
 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
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Overview of Natural Gas Partners
NGP’s Portfolio Company Structure Capitalizes on the
Weakness of Traditional Corporate Structures
Traditional Company
Management Model
NGP Portfolio Company
Management Partnership Model
(flipped on its side)
Senior
Strategic
Direction
Seniority
Level of
Management
Capital
Investment
Efficiency
Regional Asset Optimization
Area Asset Optimization
Field Production & Optimization
Junior
Senior
NGP Assistance
NGP Portfolio Company Management Focus
All Other Colors Represent Management Focus
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Senior
Overview of Natural Gas Partners
NGP Applies a “Build-Up” Strategy in the Oil and Gas
Acquisition and Exploitation Market
1.2
A Seller's Economics
B Value Creation Through Lower Costs
1
Production Rate
C Value Creation Through Production Enhancements
0.8
C
0.6
0.4
0.2
Original Cost
Economic Limit
A
New Cost
Economic Limit
B
0
Time of
Property Sale
Time
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Overview of Natural Gas Partners
Focus: People and Teams
• Entrepreneurial
• Strong Technical and Practical Experience
• Sound Business Judgment
• Confidence and Leadership Abilities
• Creativity
• Desirous of a Value-Added Partner
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Overview of Natural Gas Partners
Not Necessary
• CEO Experience
• Full Lineup of Technical and Financial
Disciplines
• A Deal in Hand
• Pretty PowerPoint Slides
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Choosing the Right Partner
Considerations
• Incentives
• Owner / Manager Contribution Requirements
• Structure and Alignment of Interests
• Ownership / Monitoring Dynamic
• Resources Offered
• Exit Dynamic
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Choosing the Right Partner
Always, Always, Always …
•Check References:
Good and Bad Deals
Past and Present Partners
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Choosing the Right Partner
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
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Choosing the Right Partner
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
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Choosing the Right Partner
Contact Info
David Hayes
Natural Gas Partners
dhayes@ngptrs.com
972-432-1451
CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION
Case Law Update
Clayton L. Falls
Associate
K&L Gates LLP
1717 Main Street, Suite 2800
Dallas, Texas 75201
214.939.4958
Significant Texas Supreme Court Case
Coastal Oil & Gas v. Garza Energy Trust
2008 WL 3991029 (Tex. 2008)
Decided August 29, 2008
124
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.
125
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.
126
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
127
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
128
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
129
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.
130
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!
131
K&L Gates
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: clayton.falls@klgates.com
132
Oil & Gas Seminar
Thursday, October 28, 2008
Sponsored by: