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

Oil & Gas SeminarThursday, October 23, 2008

Sponsored by:

Energy Lending

Today vs. Tomorrow

Today vs. Tomorrow

Today

Energy Lending Practices

Competitiveness

Industry

Tomorrow

The “Lending Tree” Model

Portfolio Management

Regulation

New Street

Today


Collateral Evaluation

• The Reserve Report• Title

Risk Evaluation

Covenants

Today


Collateral Evaluation - The Reserve Report

• Advance Policies• Price Deck Cases• One Line Summaries/Decline Curves• Upside• Why different?

Today


Collateral Evaluation – Title

• Bank Standards

• How it is used?

Today


Risk Evaluation – How we do it?

• It’s a Risky Business• The Big Six

• Underwriting Risks

Today


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 KitchensVice President – Energy 17950 Preston Road, Suite 500Dallas, Texas 75252

P: 972.713.1110 F: 214.234.1974M: 940.453.7954

E: [email protected]

Thank you!

Avoiding the A&D Tax Bite and Enhancing Asset Performance

George Barlow, Esq.Dallas, Texas – October 23, 2008

K&L Gates Oil and Gas Symposium

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% Taxes

$1,000,000 $200,000 8% $ 798,542

Benefit to Exchanger, after 5 years $ 199,635

Business or Investment Purpose

Basic 1031 Requirements

There are six tax classes of property:

1) property used in taxpayer’s trade or business;

2) property held for investment

3) property used for vacation purposes

4) property which is used as your principal residence;

5) property fixed and flipped.

6) property held primarily for sale to customers.

Mineral properties fall into 1 and 2, so Section 1031 applies

“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

1031 Eligible?

Coal Lease exceeding 30 years

Fee simple in land Ltr.Rul. 7906061

Quiz Time



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



1031 Eligible?

Limited Oil Payment Overriding Oil and Gas Royalty

Midfield Oil Company v. Commissioner of Internal Revenue, 39 BTA 1154

(1939)

Quiz Time



1031 Eligible?

Oil and Gas Working Interests

Overriding Royalties

Ltr.Rul. 8237017 (See Requirements therein)

Quiz Time



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



1031 Eligible?

Carved-out Oil Payment Rights

Fee interest in ranch

Fleming v. Commissioner of Internal Revenue, 24 TC 818

(1955)

Quiz Time



1031 Eligible?

Interest in producing lease

until exhaustion of deposit

Fee simple in land Rev.Rul 68-331, 1968-1 CB 352

Quiz Time



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



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

Long Term Interests

These Dogs Won’t Hunt…



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)

Short Term, Limited

Some Tax Notes

• Be careful. Get tax and legal advice from experts before you exchange

• Selling a working interest and retaining royalty or surface interests? 1031 trouble.

• Production Payments? Not real estate. Sorry!

• Equipment included in sale? If substantial, may require separate personal property exchange. (Valued over 15% = Substantial)

• Depletion, Depreciation and IDC’s must be recaptured upon SALE unless 1031’ed into “qualified natural resource property”

Basic 1031 Exchange Requirements

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.

Recapture Treatment

• You can exchange mineral property and defer tax on recapture items.

• How? Select replacement property that is “Qualified Natural Resource Property.” (“QNRP”)

• Get tax and legal advice from experts when you are planning an exchange

• Ordinary income treatment of depreciation recapture, depletion recapture, or recapture of IDC.

• Capital Gain on the appreciated value of the property

Basic 1031 Exchange Requirements

Sell or Exchange?

• Does the property qualify for exchange?

• How long was the property held before sale?

• What type of replacement is in view?

• Is the replacement QNRP?

• How much IDC, depletion and depreciation is subject to recapture?

• Is well equipment included in the sale?

• Will I have like-kind equipment in my replacement asset?

Basic 1031 Exchange Questions

Calculating Basis

• Cost to Acquire is the Starting Point

• Add improvements made to the asset

• Subtract recapture items (depletion, depreciation, and IDC’s)

• That is your Basis in the asset (never lower than Zero)

Basis and Gain

Calculating Gain

• Sales Price is reduced by cost of Sale

• Net Sales Price – Basis = Gain

Gain Calculation:

Sale Price

(Adjusted Basis)

Gain

Facts:$500,000 purchase price$100,000 recapture items$25,000 capital improvements$1,000,000 sales price

Taxes:

33% Recapture

$100,000 x 33% = $33,000

15% Fed. Cap Gains

$475,000 x 15% = $71,250

9.3% State Cap Gains

$575,000 x 9.3% = $53,475

Total Taxes Due: $157,725

Adjusted Basis

Purchase Price

(Recapture Items)

+Capital Improvements

Adjusted Basis

$500,000

$100,000

$25,000

$425,000

$1,000,000

($425,000)

$575,000

Calculating Tax on Gain

Total Tax Deferral

Example #1Relinquished Property

Oil and Gas Property $1,000,000Potential Recapture $400,000

Replacement PropertyOil and Gas Property $1,000,000

Full Exchange

Entirely Tax Deferred because the Replacement Property is Qualified Natural Resource Property (QNRP)

Partial Tax Deferral

Example #2Relinquished Property

Oil and Gas Property $1,000,000Potential Recapture $400,000

Replacement PropertyOil and Gas Property $700,000

Land $300,000

Total $1,000,000

Partial Exchange

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

• 180 days to complete exchange• 45 day identification period• COE after October 15th must file extension

Day 0Close ofEscrow

Day 45Identification

Letter Due

Day 180Exchange

Completed

Basic 1031 Timeline

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.

The Exchange Accommodation Titleholder (EAT) will fund your

purchase.

Taxpayer must have WAYS and MEANS to handle the economics of the

exchange.

Common Misconception

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

Service rules that Taxpayer may go “reverse” and “forward” with the same relinquished property.

Reverse Private Ruling 200836024

• First, park the replacement property “RP”. • Identify relinquished property “RQ” - 45 day limit• Sell RQ before 180 day limit

Day 0RP Parked

Before Day 45Identify RQ

Day 180Sell RQ, Exchange

Completed

Basic Reverse 1031 Timeline

I didn’t get enough…

Property “Sold” is valued more than Replacement

Solution: Forward Exchange to get “More”

= $RQ

= $RP

• RQ valued MORE than RP, so… • Identify additional RP before 45 day limit

Day 0RQ Sold

Before Day 45Identify “More” RP

Day 180Buy RP, Exchange

Completed

Now, the Forward Exchange

ForwardExchangeStarts

Taxpayer MAY shift tax on gain to next year.

Reverse Private Ruling 200836024

ForwardExchangeStarts

Unexchanged Gain Recognized under installment sale rules of Sec. 453 of IRC

ReverseExchangeStarts

180 3600

Forward Exchange Blows Up!!

All is not lost….

Exchange still works. . . to the value of $RP

When $RQ is greater than $RP….

Call Any Time

George Barlow, Esq.Senior Account ExecutiveLandAmerica Financial Group, Inc.2651 N. Harwood StreetSuite 260Dallas, Texas 75201

toll free: 866 377-1031 direct dial: 214 855-8425 mobile: 214 675-1031fax: 214 855 8411

e-mail: [email protected]

The Paradigm Shift in the The Paradigm Shift in the Domestic Crude MarketDomestic Crude Market

PricingPricing

Pricing Mechanisms Quality Differentials Regional Markets

NYMEX Monthly Average

$133.4845

$105.4200

$92.9290

$94.6314

$103.7638

$116.6881

$134.0157

$125.4586

$112.4627

$95.3490

$91.7425$85.6583

$79.6263

$75.0000

$85.0000

$95.0000

$105.0000

$115.0000

$125.0000

$135.0000

Sep-07Oct-0

7

Nov-07

Dec-07Jan-08

Feb-08Mar-0

8Apr-0

8

May-08Jun-08

Jul-08

Aug-08

Sep-08

Month

Pri

ce

(U

.S.

$)

NYMEX Monthly Average

Platts PPlus 13 Month Average (10/07 to 10/08)

$4.6960

$4.8400

$3.5828$3.7309

$4.7893

$3.8153

$2.5643

$3.0367$2.8786

$3.6928

$4.2987$4.3558

$3.4430

$2.0000

$2.5000

$3.0000

$3.5000

$4.0000

$4.5000

$5.0000

Month

Pri

ce (

U.S

. $)

PPlus Value

LogisticsLogistics

TransportationTransportation PipelinesPipelines TruckingTrucking RailRail

Credit RequirementsCredit Requirements

SemCrude Bankruptcy Cost of Credit Credit Instruments

Standby Letters of Credit Corporate Guarantee Pre-payments

Spencer FallsSpencer Falls

Founder & PresidentFounder & President

EnMark Services, Inc.EnMark Services, Inc.

1700 Pacific, Suite 45001700 Pacific, Suite 4500

Dallas, Texas 75201Dallas, Texas 75201

Direct: 214.965.9581Direct: 214.965.9581

E-mail: [email protected] E-mail: [email protected]


Sponsored by:

Mineral Lease Agreements – Creative Solutions

Alignment of Interest – Enticing Parties Back to the Table

73

About K&L Gates

Over 1700 Lawyers located in 28 cities on three continents, U.S., Europe and Asia

Client Service Leader Named one of the top 30 law firms in client service as compared with

more than 500 other leading firms by The BTI Consulting Group in its latest national Survey of Client Service Performance of Law Firms.

Technology Leader Received CIO magazine’s annual CIO 100 Award, given to 100

companies that exemplify the highest level of operational and strategic excellent information technology.

Diversity Leader Honored among the best law firms for women by Working Mother

magazine and Flex-Time Lawyers LLC, in the first-ever 2007 Best Law Firms for Women list.

74

75

Three Interrelated Topics For Discussion

Current law and history of “Dominant” and “Servient” Estates

Basics of a Mineral Lease Creative Solutions to Encourage Production in

Today’s Environment of: Harsh reductions in lease bonuses Downward spiral of hydrocarbon prices, and The fact that the major publicly traded players are at

a standstill.

76

History of “Dominant” and “Servient” Estates

In Texas and a number of other jurisdictions, the Mineral Estate is dominant over the surface estate.

Origin in Spanish law – the King held separate ownership of all minerals.

In 1862, the Texas Supreme Court held that the State could use the land in any way it chose in order to get to the minerals.

Texas Constitution of 1866 released all minerals to owners of the soil.

Mineral Estate may be severed, creating separate estates.

77

Accommodation Doctrine/Refinements–Fact-Driven

Texas Supreme Court recognized that the interests of land and surface owners are not always compatible. The “recurring problem of adjusting correlative rights.”

“Reasonable Accommodation Doctrine” -- Getty Oil Operator must conduct activities with due regard for surface estate

owner’s existing use if there were reasonable means available. Only if a reasonable alternative is available consistent with industry

standard, will the Operator be required to consider existing use by surface owner .

The conduct of the Lessee may not destroy or substantially impair the surface owner’s use of the surface – more than slight interference.

Very fact-driven, and involves questions to be resolved by a jury, with competing expert testimony.

78

Encouraging Production -- Resource Plays still offer attractive risk/reward propositions Over the last several years, horizontal drilling in Shale Plays has

had an incredible economic impact. The competition between Operators escalated signing bonuses and

royalty percentages rapidly. Based on recent media hype, the boom is over and the Operators

are not willing to pay the escalated lease bonuses, and most Operators are backing off on leasing activities all together.

When energy prices stabilize, this change in the market place could have a positive impact on economic return on E&P companies operating in Resource Plays. lower cost of leasehold acreage; decreased drilling cost and rig availability; and Valuable Leasehold will most likely expire during the Primary Term.

79

The Mineral Lease

The “Mineral Lease” outlines the rights, privileges and obligations of the gas company, the “Lessee,” and the mineral owner, the “Lessor.”

Regardless of what anyone may tell you, there’s no “standard” lease form being used today. All terms are negotiable. The term “Producer’s 88 form” is common, but there are hundreds of forms with “88” referenced.

80

The Mineral Lease - Conveyance and Contract

The name “Mineral Lease” is somewhat misleading -- the “lease” is more like a transfer deed than a lease. It is both a conveyance and a contract.

It conveys the mineral rights from the Lessor to the Lessee, and is also a contract between the Lessor and the Lessee for the development of the minerals. The Lessee’s interest is similar to a fee-simple determinable, rather than a term for years.

The Lessor gives the Lessee the right to explore and produce oil and gas from the designated property, and in exchange the Lessee agrees to pay the Lessor a one-time cash lease bonus and allocates “royalty interests,” a percentage of oil and gas produced from the property.

81

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.

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Creative Solutions – ORRI

Overriding Royalty: Leverage Drillsite Tract Owners with additional overriding

royalties – e.g. 1% overriding royalty on all natural gas produced from boreholes drilled on the leasehold premises on the first four wells, and 2% on all wells in excess of four.

taking a percentage share of the natural gas produced by an Operator, is not the only means mineral owners have found to derive more income and encourage development of the lease.

Drillsite tracts – Operators have the ability to drill several horizontal wells from one padsite, and this gives added leverage to the owners of the pad site.

83

Creative Solutions – Minimum Royalty

Minimum royalty clause. For owners of tracts within known producing areas.

Regardless of actual production numbers, the lessor will receive a minimum royalty of a certain sum per month beginning approximately one to two years after the start of the lease through the end of the primary term.

Generally available only to a Lessor of large tract, may now be used to encourage Lessor to lease and the development of the lease by the Operator.

Because of the risks and uncertainties inherent in oil and gas exploration, such a penalty would only be negotiated with owners of tracts within known producing areas.

84

Creative Solutions – Most Favored Nation

MFN -- Mineral owners do not want to leave money on the table, and it is hard to anticipate the market for lease bonus and royalty interest, due to their highly volatile nature. No Owner wants to sign a lease for several hundred dollars and suddenly see neighbors sign for several thousand.

Lessee may be able to entice Lessor to accept a reduced bonus if the Lessor is able to protect themselves through the use of a Most Favored Nations Clause.

The Clause will require an Operator to match any increase in bonus or royalty or both paid to other Lessors: (1) within a defined geographic area and (2) within a specified time period [1-yr vs. prior to a well being completed].

Because MFN Clauses are highly favorable to lessors, the Lessee will typically limited as much as possible the geographic area and time period.

85

Royalties - Free Royalty Stipulations of overriding royalty and minimum royalty or a Most Favored Nations Clause

are not the limit to how lessors can retain more income from their royalty fraction. The net revenue interest due a landowner, based upon their royalty fraction, is highly dependent on the deductions and costs assessed against the lessor and the gas purchase agreement negotiated by the operator.

Mineral and royalty owners can expect to always have some costs associated with production, from severance taxes to some costs of transportation. There is no cost free lease.

Many lessors, include clauses within the lease limiting the costs deducted from the royalty or stipulating arms-length gas purchase agreements.

The Lease should specify if Lessor is responsible for transportation, compression, dehydration, marketing and other expenses. Lessee would like to calculate the value of the gas for royalty purposes as near the

“wellhead” as possible. Lessor would like the royalty to be calculated further downstream in order to avoid paying

post production expenses -- and reduce or prevent charges for producing, storing, separating, dehydrating, compressing, and transporting.

“Marketable Condition Rule.”

86

Encouraging Production

All of the foregoing lease terms are designed to protect the interests of the mineral owner, whether by: encouraging production through minimum royalty payments; protecting against the exclusion of the drillsite tract from a

pooled unit through overriding royalties; rewarding those lessors who execute leases with the possibility

of being compensated for rising bonus and royalty amounts in a Most Favored Nation Clause; and

limiting costs and deduction to the royalty fraction.

87

Mineral Lease – Traditional Terms

Habendum Clause

This clause sets time periods, and provide for a primary term and a secondary term.

The “primary term” is the fixed number of years during which the Lessee can maintain its rights without drilling. This term should be clearly stated (typically three (3) years).

Extension Rights of Primary Term – similar economic terms. Mineral Leases will have no force and effect if the primary term has

expired and there is no production from the property.

The “secondary term” is the extended period of time for which rights are granted to the Lessee once production is obtained.

88

Mineral Lease -- Shut-In Royalty Clause

The shut-in royalty allows the gas companies who have drilled a well to hold the lease without actually producing minerals past the primary term.

From the Lessor’s prospective, this clause should have a maximum number of years, i.e., no more than two years past the primary term or two years in the aggregate -- Lessor wants to get the gas to market or have Lessee lose the lease.

Lessee will want the ability to shut in well(s) based on market conditions, and maintain the Lease.

89

Shut-In Royalty Payments

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

90

Mineral Lease -- Mother Hubbard Mother Hubbard Clauses - Used when defining the Lease Property.

Property descriptions found within oil and gas leases can often be vague, indefinite, or fail to adequately cover the entire property the lease was intended to cover. This often happens because the property description is based on the language found in old deeds, or omits small portions that were adjoined at a later date.

These lot and block descriptions lack any definite metes and bounds description, but they are most often deficient because they do not take into account adjacent streets, alleys, and public rights of way.

Strip-and-Gore. The mineral rights beneath public rights of way may belong to the individual lot owners under the doctrine of strip-and-gore. Under Texas law, when a deed conveys land abutting a street, public highway, or railroad right-of-way, title to the center of the street, public highway, or railroad right-of-way also passes by the deed These minerals, as part of a small adjacent piece of property, would also fall under the Mother Hubbard Clause.

91

Pooling

Contractual Pooling Rights -- there is widespread inclusion of pooling clauses in leases.

The pooling language allows the Lessee to “pool” the lease premises with other land, and production from any part of the pooled acreage shall be deemed production to hold each mineral lease.

Pooling language should allow the company to create the most efficient gas units, but not allow excess vertical or horizontal acreage to be held by a well. Anti-dilution – requires a percentage of acreage be

pooled from the Lease – to ensure that Lessor’s share of royalties from production is not diluted by including only a small portion of their land in a large pooled unit.

Pugh Clause – lease segregation when there is a partial pooling.

92

Pugh Clause

The general rule is that a mineral lease is indivisible, and all the property under the lease will be held by production on any part of the lease premises.

A Pugh Clause is intended to prevent the holding of non-producing acreages.

In negotiated Leases, the release language not only include the undrilled acres but also depths below the producing formation. This is referred to as a vertical and horizontal Pugh Clause.

93

Warranty of Title to the Mineral Interest

The warranty clause binds Lessor to defend interest in, or title to the lease premises, should a dispute ever arise over ownership.

Underwriters are universally unwilling to issue title policies for specific mineral estates.

Valuable mineral interests make title disputes much more likely. Many property owners will want the warranty language stricken or at least modified to cover only title defects caused by the Lessor, not those caused by Lessor’s predecessors in title.

94

Force Majeure/Extension of the Primary Term

Due to the substantial lease bonuses recently paid to Lessors, Lessee are relying on claims of “Force Majeure” to extend the Primary Term.

Force Majeure provides an excuse from non-performance caused by circumstances beyond the reasonable control of the Lessee.

Acts of God to acts of government, may qualify for Force Majeure.

If “Force Majeure” is affective to extend the lease, it will only be affective as long as the force majeure event prevents production or operations.

95

Surface Use Implications

Drilling and maintaining a well may involve water use, vehicular access, noise and other negative impacts. Building roads for transportation; Use of fresh water produced for the land; and Location of drill site may damage crops, timber etc.

No duty to restore land, absent contractual agreement.

Absent restrictions in the Lease, the Lessee has the implied right to use as much water that is reasonably necessary to produce the minerals from the Leased Premises.

96

Surface Use Restrictions

If the Lessor doesn’t want a well drilled on its property, the Lease must clearly restrict surface rights or access.

The Lessee will require a provision providing for directional drilling, to provide a subsurface easement for all purposes associated with such horizontal and/or directional wells.

Operators are attempting to include provisions that provide for the continuing right to use and maintain such subsurface easement for so long as Lessee is utilizing a directional wellbore(s) traversing the leased premises either during or after the expiration of the lease.

97

Surface Use Allowed with Restrictions

If you do want wells drilled on your property, then provisions need to be included in the lease or in a side agreement concerning the additional payment for the Pad site(s), damages to be paid for drill sites, roads, pipeline easements and the use of water.

Title Insurance Considerations – T-19 possible coverage to surface owner for damage caused by mineral estate. Underwriters usually require full surface use waiver, designated

drill sites or surface limitations.

98

Expiration of Primary Term

What does the Lease require to extend to Secondary Term? Production in Paying Quantities Operations, Drilling Operations, continuous

Operations Pooling – with production in the pooled unit.

99

Production in paying quantities

Objective Test Qualifying expenses exceed revenue for the lease

Operating and marketing expenses; not capital expenditures For a reasonable, and not arbitrary, period of time;

can range from 4 to 18 months or longer

Subjective Test a “reasonably prudent operator” would, for the

purposes of making a profit and not merely for speculation, continue to operate the well at issue.

100

Lease Provisions – ORRI Pad Site:

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

101

Minimum Royalty

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

102

Most Favored Nations Clauses If within (Specify Time Period) from the date of this Lease, Lessee, its agents,

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

103

Most Favored Nations Clauses

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

104

Mother Hubbard Clause

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

105

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: 214.939.4920E-mail: [email protected]

mailto:[email protected]

NGP

Capital and Sponsorship for the Energy IndustrySince 1988

October 23, 2008

Energy Private Equity: Choosing the Right Partner

CONFIDENTIAL: NOT FOR REPRODUCTION OR DISTRIBUTION

NGP Energy Capital ManagementFounded in 1988, NGP Energy Capital Management is the Premier Investment Franchise in the Energy Industry

1988

2004

2005

2007

NGP INCOME CO-INVESTMENT FUNDS

2005

Strategic Advisory Council

Robert W. JordanJames R. SchlesingerCharles R. Williamson

Pat Wood, III


• Natural Gas Partners Funds – $6.9 billion North American private equity fund complex consisting of nine funds investing primarily within the oil and gas, midstream and oilfield services sectors

• Co-Investment Funds – $100 million and $250 million co-investment funds are yield-oriented vehicles that invest alongside NGP’s private equity funds

• NGP Capital Resources Company (“NGPC”) – Founded in 2004, NGPC is a $500 million publicly-traded business development company that focuses on providing senior debt and mezzanine capital to companies in the energy industry

NGP Energy Capital ManagementNGP has Created a Diverse Group of Energy-Focused Investment Silos


NGP Energy Capital Management

• NGP Energy Technology Partners (“NGP ETP”) – Founded in 2005, NGP ETP is a $148 million private equity fund created to provide growth capital and buyout funding for companies offering technology-related products and services to the oil and gas, power, and alternative energy sectors. NGP Energy Technology Partners II is currently raising a $300 million to $400 million follow-on fund that will execute the same strategy.

• NGP Midstream & Resources, L.P. (“NGP MR”) – Founded in 2007, NGP MR is a $1.4 billion private equity fund concentrating on the energy infrastructure (pipelines and related assets transporting natural gas, crude oil or refined products) and mining and mineral businesses

NGP has Created a Diverse Group of Energy-Focused Investment Silos


Key Attributes

• Private equity firm focused on the energy industry since 1988

• Particular expertise in oil and gas production, midstream and oilfield service companies

• Management has invested as a team for 20 years with no turnover

• Over $6.9 billion of capital and undrawn commitments managed in nine private equity funds

• $3.5 billion invested and committed – 163 transactions in 127 entities

• Gross IRR from inception to June 2008 of 33% using discounted market values

• Premier investment franchise within the energy and limited partner communities

Overview of Natural Gas Partners


Geo

logi

cal &

Geo

phys

ical

Exp

lora

tion

Pro

duct

ion

Tran

spor

tatio

n

Pro

cess

ing

Ref

inin

g

Mar

ketin

gOil and Gas in Place

Upstream – Businesses that find, develop and extract energy resources

Midstream – Businesses that gather, process, store and transfer energy resources

Downstream – Businesses that refine, market and distribute refined energy resources

End User

Midstream DownstreamUpstream

NGP invests in a broad range of sectors within the energy industry



NGP has broad investment experience in the major North American oil and gas basins

Canada20%

Texas28%

Gulf of Mexico3%

Gulf Coast8%

Mid-Continent13%

Rocky Mountains16%

Other 12%

Percent of Total Capital Invested by RegionNovember 1988 – June 2008



Own equity alongside “owner-managers” who: Invest a portion of their liquid net worth to the enterprise Lead a top-tier technical team able to effectively reinvest cash flows Have a proprietary source of transaction flow or other competitive

edge

Invest in companies with ongoing growth opportunities as opposed to project-oriented financings

Fund the start-up of a company where significant opportunity exists

Provide financial and strategic sponsorship to management and access to additional growth capital at the lowest possible cost

Above all else, NGP believes that finding the right people is the most important ingredient for successful investing in the energy industry… NGP tries to align itself with the best managers in the business, and get out of their way

Overview of Natural Gas PartnersThe Governing Principles


Field Production & Optimization

Strategic Direction

Capital Investment Efficiency

Regional Asset Optimization

Area Asset Optimization

NGP Assistance All Other Colors Represent Management FocusS

trat

egic

Dire

ctio

n

Are

a A

sset

Opt

imiz

atio

n

Fiel

d P

rodu

ctio

n &

Opt

imiz

atio

n

Cap

ital I

nves

tmen

t Effi

cien

cy

Stra

tegi

c D

irect

ion

Senior

Seniority Level of

Management

Junior

Traditional Company Management Model

NGP Portfolio CompanyManagement Partnership Model

(flipped on its side)

Senior SeniorNGP Portfolio Company Management Focus

NGP’s Portfolio Company Structure Capitalizes on the Weakness of Traditional Corporate Structures



NGP Applies a “Build-Up” Strategy in the Oil and GasAcquisition and Exploitation Market

0

0.2

0.4

0.6

0.8

1

1.2

Time

Pro

du

ctio

n R

ate

A Seller's Economics

B Value Creation Through Lower Costs

C Value Creation Through Production Enhancements

A

C

B

Original CostEconomic Limit

New CostEconomic Limit

Time of Property Sale



Focus: People and Teams

• Entrepreneurial

• Strong Technical and Practical Experience

• Sound Business Judgment

• Confidence and Leadership Abilities

• Creativity

• Desirous of a Value-Added Partner



Not Necessary

• CEO Experience

• Full Lineup of Technical and Financial Disciplines

• A Deal in Hand

• Pretty PowerPoint Slides



Considerations

• Incentives

• Owner / Manager Contribution Requirements

• Structure and Alignment of Interests

• Ownership / Monitoring Dynamic

• Resources Offered

• Exit Dynamic

Choosing the Right Partner


Always, Always, Always …

•Check References:

Good and Bad Deals

Past and Present Partners



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



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



Contact Info


David Hayes

Natural Gas Partners

[email protected]

972-432-1451

mailto:[email protected]

Case Law Update

Clayton L. FallsAssociateK&L Gates LLP1717 Main Street, Suite 2800Dallas, Texas 75201214.939.4958

124

Significant Texas Supreme Court Case

Coastal Oil & Gas v. Garza Energy Trust

2008 WL 3991029 (Tex. 2008)

Decided August 29, 2008

125


Case Background Coastal located a Well as close to the Plaintiff’s adjoining

property line; Well was within Railroad Commission spacing rules; Costal “fraced” this Well, with the fracing length designed to

reach over 1,000 feet from the Well. Therefore the frac lines extended well into adjoining lease; Coastal proceeded to drain natural gas from neighboring land; Coastal held the Mineral Lease on the Plaintiff’s adjacent Land,

as well.

126


Adjacent Property Owner’s Allegations:

Subsurface trespass through hydraulic fracturing, Implied Mineral Lease Covenants:

Breach of implied covenants to develop, market and protect against drainage

Failure-to-Develop Damages – zero, interest was lost, but net income was increased.

Breach of duty of good faith pooling.

127


Trial Court awarded Plaintiff:

$1.75MM in lost royalties for failure to develop $1MM for bad faith pooling $1MM in lost royalties for subsurface trespass $1.4MM in reasonable attorneys’ fees

128


On Appeal

Highly anticipated decision Tex. Sup. Ct. had never addressed subsurface

trespass in regard to hydraulic well fracing Strong public policy implications

129


Rule of Capture

Permits the owner of a tract to drill as many wells on his land as the Railroad Commission will allow and provides that he is not liable to adjacent landowners whose lands are drained as a result of his operations

130


Court’s Holding Any alleged damages for royalties lost due to

subsurface trespass are precluded by the law of capture. Justification:

Start Drilling! - Operator required to drill to prevent drainage Better left to RRC rather than Juries Difficult to determine value of drained oil and gas No one wanted it.

131


Court’s Holding Cont. Royalty interest owners with reversionary interests

have standing to sue Operators have a duty to protect the leasehold

against drainage Royalty owner’s recourse could be against their Operator Could see additional litigation

Damages valued at royalty lost to Lessor b/c of Lessee’s failure to develop. Could see increased litigation with drop of prices!

132

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: [email protected]

K&L Gates


Sponsored by:

Documents

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