Oil and gas exploration and production (“E&P”) companies consume large amounts of capital to fund the exploration, development, and operation of their properties. These companies frequently rely on traditional, reserve-based lending for capital, but as credit markets tighten, E&P companies might look to alternative types of financing, such as production payments and net profits interests (“NPIs”). The proliferation of production payments, coupled with the increasing number of E&P company bankruptcy filings, has led to heightened scrutiny of production payments.
This article begins with a discussion of certain types of oil and gas financing transactions and follows with an evaluation of how such transactions may be treated in bankruptcy. Although production payments are typically excluded from property of a bankruptcy estate, recent challenges to production payments suggest that certain interests could be considered debts rather than conveyances of real property interests, thereby including property interests in the debtor’s bankruptcy estate.
A traditional oil and gas financing structure is a reserve-based loan (“RBL”) secured by the borrower’s oil and gas reserves, under which the borrower can usually borrow up to the amount of the borrowing base. Typically, to determine the borrowing base, the lender evaluates a third-party reserve engineer’s reserve report, which estimates the value of five types of the borrower’s reserves — proved developed producing, proved developed nonproducing, proved undeveloped, probable, and possible — based on certain assumptions for pricing and costs.
The lender evaluates the borrowing base annually or semiannually, redetermining it as necessary. Borrowing base redeterminations can limit a borrower’s access to capital, particularly where a sharp decline in oil prices results in a significant decrease in the reserves’ value and a correspondingly large reduction of the borrowing base. Because the borrower must repay the RBL obligations, the borrower bears the risk that production will not yield sufficient revenues to service its debt.
An overriding royalty interest (“ORRI”) is a share of oil and gas produced at the surface and free of costs of production. It is carved out of the lessee’s working interest and typically lasts for the life of the lease.1 A production payment (or oil payment) is an ORRI that is limited to a specified term.2 A production payment lasts until a specified volume of production is met or a specified value of such production is realized.3 A volumetric production payment (“VPP”) is typically calculated with reference to a specified volume of production, and production is taken in kind, in contrast to traditional production payments, which are calculated with reference to production values and payable in cash.4
Under Texas law, a production payment typically is considered a real property interest.5 Because a production payment is a share of production, payment is due only if oil or gas is produced; the grantor of a production payment has no personal liability if there is no production from which the production payment can be made.6 Accordingly, the buyer of the production payment bears the risk that production will be low or nonexistent.
Like an ORRI or a production payment, a net profits interest (“NPI”) typically is carved out of the working interest.7 An NPI is a percentage of the “net profits” of production, not a fractional share of production free of the costs of production.8 Accordingly, an NPI is payable only if revenues exceed the costs of production. The buyer of an NPI thus bears the risk that production will be insufficient to cover costs.
Typically, an NPI is calculated by deducting specified expenses, such as lease operating expenses, from revenues generated from production, and then multiplying the portion of revenues that exceed the expenses by a specified percentage.9 NPIs usually last for the term of the lease and are payable in cash rather than in kind. Under Texas law, NPIs are generally considered real property interests.10
In bankruptcy, an RBL is treated differently than is a production payment or an NPI. An RBL is treated as a claim secured by the debtor-borrower’s oil and gas reserves, which are property of the debtor’s bankruptcy estate, and the claim is treated in accordance with the priority scheme of the Bankruptcy Code. During the bankruptcy case, the debtor does not necessarily have to make payments on the loan.11
In contrast, production payments and NPIs may not be considered property of a grantor’s bankruptcy estate. If a production payment or an NPI is not considered property of the estate, then revenues attributable to such interests are not property of the estate, and payments to holders of production payments and NPIs continue post-petition. Type of interest involved, terms of the conveyance, and applicable state law are important in determining whether an interest is excluded from property of the estate.
To the extent it is considered a real property interest under applicable state law, an interest should be excluded from the bankruptcy estate under Section 541(a). If a question arises as to whether a production payment is property of the estate under Section 541(a), the production payment may nonetheless be specifically excluded from the estate under Section 541(b)(4)(B), which excludes certain qualifying production payments from the estate.12 The Bankruptcy Code defines “production payment” as a term ORRI contingent on production from particular real property and “from a specified volume, or a specified value, from the liquid or gaseous hydrocarbons produced from such property, and determined without regard to production costs.”13
Traditional production payments and VPPs generally fit the definition of “production payment” under the Bankruptcy Code, but NPIs do not because they are not “determined without regard to production costs.” Nonetheless, if an NPI is considered a real property interest under applicable state law, a court could find that an NPI conveyed prior to bankruptcy is not property of the debtor’s estate.
Notwithstanding the operation of Sections 541(a) and (b) of the Bankruptcy Code, the addition of debt-like features could cause a production payment to be recharacterized as a loan, thereby keeping the production payment in the estate. In ATP Oil & Gas Corporation (“ATP”), ATP asserted that the “economic realities” of the conveyances of certain term ORRIs and NPIs (the “Subject Interests”) were “consistent with a traditional financing arrangement and not a sale or absolute conveyance of a property interest.”14 Accordingly, ATP requested entry of judgments declaring that the conveyances of the Subject Interests constituted “disguised financing arrangements” and that the Subject Interests and any proceeds attributable thereto were property of ATP’s estate.15
In denying a Subject Interest owner’s motion for summary judgment in one proceeding, the court scrutinized various aspects of ATP’s conveyance of the term ORRI and found, among other things, a genuine issue of material fact as to whether the calculation of the term of the ORRI, based on a formula providing a specified return on investment, was consistent with a term ORRI under Louisiana law.16 The court explained:
Increased revenues result in faster repayment and thus lower interest income accrued during the term of the ORRI. The fact that increased revenue from the properties leads to a decrease in [the Subject Interest owner’s] income appears to be at odds with real property ownership.17
Following denial of summary judgment, ATP’s Chapter 11 case converted to a Chapter 7 case, and a trustee was appointed (“Trustee”). The Trustee then amended ATP’s counterclaim to assert, among other things, preference claims against the Subject Interest owners under Section 547 of the Bankruptcy Code. The owners sought dismissal of the Trustee’s preference claims, asserting that the Trustee would be unable to prove the elements of a preference without recharacterizing the Subject Interests as disguised financing transactions.18 In denying dismissal, the court found that the Trustee may be able to prove that payments made on account of the Subject Interests during the 90-day period prior to ATP’s bankruptcy were preferences, regardless of whether the Subject Interests were real property interests or disguised financing transactions.19 Accordingly, the payments made for the Subject Interests during the preference period may be at risk of avoidance as preferences.
Although production payments and NPIs might be less at risk in states where such interests are considered real property, ATP demonstrates that bankruptcy courts may scrutinize such interests to determine whether they should be recharacterized as loans. Buyers of production payments and NPIs should be aware of how such interests may be recharacterized under applicable state law so that they can better evaluate the risk that such interests could be swept into the seller’s bankruptcy estate. Even where a production payment or an NPI is considered real property, the holders of such interests should be aware of the risk that payments on account of such interests could be subject to avoidance as preferences.
Kenric D. Kattner
Kelli M. Stephenson