OKLAHOMA SENATE BILL 168 & JUDICIAL DEVELOPMENTS

OKLAHOMA SENATE BILL 168 & JUDICIAL DEVELOPMENTS By Joe G. Anderson NADOA 2014 INSTITUTE

OK SB 168 & JUDICIAL DEVELOPMENTS

Oklahoma s Senate Bill 168 Oklahoma SB 168 has been in place for over 20 years, so why are we still discussing it? Because Operators acquire interests in Oklahoma wells and new Division Order Analysts come into the workplace. All need to understand the unique calculations and payment requirements.

Oklahoma Royalty Payment History Lessor/Lessee Payment Method Tract Allocation Blanchard Decision 1963 Sweetheart Gas Bill 1983 Senate Bill 160 1985 Senate Bill 168 1992

Blanchard Decision Shell v. Corporation Commission 1963 Oklahoma Supreme Court decision interpreted Oklahoma spacing statute as a communitization of the royalty to the extent of 1/8. Royalty owners were due 1/8 of every gas sale regardless of the selling party. Selling working interest owners paid the operator 1/8 of their individual sales and then the operator distributed this money to the royalty owner along with 1/8 of any sales by the operator.

Blanchard Decision, cont. Any portion greater than 1/8 was paid by the WI owner to whom the royalty owner had leased. This additional portion became known as the excess royalty. Problems still existed with underpayment, overpayment, and nonpayment of the excess royalty.

Sweetheart Gas Bill Belief that lack of a gas market for small WI owners caused underpayment and nonpayment of non-selling WI owner s excess royalties. 1983 Legislature passed House Bill 1221 which mandated revenue sharing of gas proceeds in certain situations.

Senate Bill 160 1985 Legislature passed bill which made first purchasers of gas and WI owners jointly liable for remitting all royalties and overriding royalty interests. Litigation ensued regarding constitutionality. No method of payment was outlined in SB 160 to compensate a WI owner having to bear more royalty than they contracted to bear. Multiple interpretations by industry.

Senate Bill 168 Industry and legislature worked to address payment problems during late 80 s & early 90 s Two major components Productions Revenue Standards Act (PRSA) & Natural Gas Market Sharing Act (NGMSA) PRSA became effective July 1, 1993 Oklahoma Statutes 52-570.1, Sections 1-15 NGMSA became effective September 1, 1992 Oklahoma Statutes 52-581.1, Sections 1-10

Natural Gas Market Sharing Act NGMSA eliminated the Sweetheart Gas Bill. This act requires a contract WI owner to ratably share gas production and the resulting revenues with the non-contracted WI owners in the same well who elect to share and who meet certain of the act s requirements.

PRSA Provisions Does not apply to wells under unitized management, such as a fieldwide unit formed for secondary recovery. Each RI owner shall share in all proceeds derived from the sale of gas production without regard to the identify of the producing owners. Each producing owner shall pay or cause to be paid to the Operator the royalty share of its gas sale proceeds, valued according to such producing owner s lease terms or Corporation Commission forced pooling order.

PRSA Provisions, cont. The Operator shall pay or cause to be paid royalty proceeds to each RI owner in the well in accordance with the proportionate royalty share owned by each RI owner. The Operator shall act solely in a ministerial capacity when performing functions on behalf of others pursuant to this act. The Operator shall have discharged its duties to pay royalty proceeds when it remits to the RI owner such royalty proceeds that the Operator has received from a WI owner.

PRSA Provisions, cont. A WI owner shall be responsible for payment and reporting to any Subsequently Created Interest which burdens its working interest. The Operator may pay the Subsequently Created Interests of other WI owners, but is not required to do so.

Alternate Disbursement Procedure As an alternative to the royalty disbursement procedures previously set forth, a producing owner shall have the right to pay or cause to be paid the royalty share of its gas sales from gas produced by such month during any month directly to all RI owners according to their proportionate royalty shares. Such producing owner shall give to the Operator not less than 60 days written notice prior to initiating or terminating this alternate royalty disbursement procedure.

Payment Requirements Proceeds from the sale of oil or gas shall be paid 6 months after the date of 1 st sale Royalty proceeds remitted to the Operator shall be paid thereafter not later than the last day of the 3 rd succeeding month after the end of the month within which production is sold WI owner that pays royalty proceeds to Operator shall not thereafter by liable for such proceeds Operator that pays royalty proceeds received by it as Operator shall not thereafter by liable for such proceeds

Payment Requirements, cont. Proceeds totaling at least $10 but less than $100 may be paid annually. Amounts less than $10 may be held but shall be remitted when production ceases or when payor relinquishes payment responsibility. Proceeds totaling less than $100 but more than $25 shall be remitted monthly if requested by owner. Amounts less than $10 shall be remitted annually if requested by owner.

Late Payment Penalties 12% interest for marketable title, calculated from the end of the month in which production was sold until the day paid 6% interest for unmarketable title, calculated from the end of the month in which production was sold until title becomes marketable Marketability of title is determined in accordance with then current title examination standards of Oklahoma Bar Association

Definitions Proportionate Production Interest (PPI) Interest in production a WI owner is entitled to produce in order to adjust for shifting of royalty burdens among WI owners under the royalty payment provisions of Act PPI is equal to the sum of that WI owner s net revenue interests plus any subsequently created interests as they burden such owner s WI, divided by one minus the royalty share. NRI + SCI / 1 TRS = PPI

PPI used as entitlement factor for gas nominations, instead of working interest Owner s PPI will be less than its WI if the RI burdening its lease is greater than the communitized royalty share. Owner s PPI will be greater than its WI if the RI burdening its lease is less than the communitized royalty share.

Royalty Interest (RI) Entirety of the percentage interest in production or proceeds therefrom reserved or granted by a mineral interest owner exclusive of any interest defined as a WI or a SCI, or otherwise provided or ascribed to a mineral interest owner by statute, rule, order or operation of law Royalty Share Sum of all royalty interests in a well (not including MMS/BIA) Proportionate Royalty Share (PRS) Percentage of the royalty share owned by a RI owner calculated by dividing owner s RI in a well by the royalty share

Royalty Proceeds The share of production or other revenue derived from or attributable to any production of oil and gas attributable to the royalty share, but shall not include payments of bonus, delay rentals, shut-in royalties, or any additional royalty payable to the Commissioners of the Land Office or other governmental entity, pursuant to and valued according to the terms of its oil and gas lease, which is calculated separately from the royalty portion of actual proceeds from the sale of oil and gas.

Subsequently Created Interest (SCI) Any interest carved from a WI other than a RI. This includes overriding royalty interest, net profits interest, Federal or Indian royalty interest, additional value payable to the Commissioners of the Land Office.

Indian Leases If an Indian owner becomes unrestricted (not subject to supervision of BIA), the change can be handled in one of two ways: Take unrestricted Indian owner out of BIA royalty (SCI), and add it to the total unit royalty. This requires recalculation of PPI. Treat unrestricted Indian owner as a SCI separate from BIA. No change to PPI needed.

PPI Calculations Example #1 NRI + SCI / 1 TRS = PPI Royalty Owner 1 (BS) 1/8 x 320/640 =.06250 Royalty Owner 2 (RD) 3/16 x 320/640 =.09375 TOTAL RI.15625 Blue Sky WI 7/8 x 320/640 =.43750 Red Dirt WI 13/16 x 320/640 =.40625 TOTAL NRI.84375 Blue Sky PPI.43750 + 0 / 1 -.15625 =.51852 Red Dirt PPI.40625 + 0 / 1 -.15625 =.48148 TOTAL PPI 1.00000

PPI Calculations Example #2 With ORI s Royalty Owner 1 (BS) 1/8 x 320/640 =.06250 Royalty Owner 2 (RD) 3/16 x 320/640 =.09375 TOTAL RI.15625 ORI 1 (Burdens BS WI) 1/32 x 320/640 =.01563 ORI 2 (Burdens RD WI) 1/16 x 320/640 =.03125 TOTAL ORI.04688 Blue Sky WI (7/8 x 320/640) -.01563 =.42187 Red Dirt WI (13/16 x 320/640) -.03125 =.37500 TOTAL NRI.79687 Blue Sky PPI.42187 +.01563 / 1 -.15625 =.51852 Red Dirt PPI.37500 +.03125 / 1 -.15625 =.48148 TOTAL PPI 1.00000

PPI Calculations Example #3 With BIA Royalty Owner 1 (BS) 1/8 x 320/640 =.06250 BIA Royalty Owner 2 (RD) 1/4 x 320/640 =.12500 TOTAL RI.18750 ORI 1 (Burdens BS WI) 1/32 x 320/640 =.01563 ORI 2 (Burdens RD WI) 1/16 x 320/640 =.03125 TOTAL ORI.04688 Blue Sky WI (7/8 x 320/640) -.01563 =.42187 Red Dirt WI (3/4 x 320/640) -.03125 =.34375 TOTAL NRI.76562 Blue Sky PPI.42187 +.01563 / 1 -.06250 =.46667 Red Dirt PPI.34375 +.12500 +.03125 / 1 -.06250 =.53333 TOTAL PPI 1.00000

Harry: I can t believe we drove around all day, and there s not a single job in this town. There is nothing, nada, zip! Lloyd: Yeah! Unless you want to work 40 hours a week.

PPI Calculations Dumb Problem #1a Lloyd Christmas 3/16 x 160/640 =.04687 Harold Dunne 1/4 x 480/640 =.18750 TOTAL RI.23437 Mary Swanson (Burdens Aspen Expl) 1/16 x 160/640 =.01563 TOTAL ORI.01563 Aspen Exploration WI (13/16 x 160/640) -.01563 =.18750 Providence Energy WI 3/4 x 480/640 =.56250 TOTAL NRI.75000 Aspen PPI Providence PPI NRI + SCI / 1 - TUR = PPI NRI + SCI / 1 - TUR = PPI

PPI Calculations Dumb Problem #1b Lloyd Christmas 3/16 x 160/640 =.04687 Harold Dunne 1/4 x 480/640 =.18750 TOTAL RI.23437 Mary Swanson (Burdens Aspen Expl) 1/16 x 160/640 =.01563 TOTAL ORI.01563 Aspen Exploration WI (13/16 x 160/640) -.01563 =.18750 Providence Energy WI 3/4 x 480/640 =.56250 TOTAL NRI.75000 Aspen PPI.18750 +.01563 / 1 -.23437 =.26531 Providence PPI.56250 / 1 -.23437 =.73469 TOTAL PPI 1.00000

Yeah baby!

PPI Calculations Dumber Problem #2a Austin Powers 1/8 x 80/640 =.01563 Dr. Evil 3/16 x 160/640 =.04687 Mr. Bigglesworth 1/4 x 400/640 =.15625 TOTAL RI.21875 Scott Evil (Burdens VE) 1/16 x 80/640 =.00781 Foxxy Cleopatra (Burdens MTP) 1/32 x 400/640 =.01953 TOTAL ORI.02734 Virtucon Energy WI (7/8 X 80/640)+(13/16 x 160/640) -.00781 =.30469 Ming Tea Production WI (3/4 x 400/640) -.01953 =.44922 TOTAL NRI.75391 Virtucon PPI Ming Tea PPI NRI + SCI / 1 TUR = PPI NRI + SCI / 1 TUR = PPI

PPI Calculations Dumber Problem #2b Austin Powers 1/8 x 80/640 =.01563 Dr. Evil 3/16 x 160/640 =.04687 Mr. Bigglesworth 1/4 x 400/640 =.15625 TOTAL RI.21875 Scott Evil (Burdens VE) 1/16 x 80/640 =.00781 Foxxy Cleopatra (Burdens MTP) 1/32 x 400/640 =.01953 TOTAL ORI.02734 Virtucon Energy WI (7/8 X 80/640)+(13/16 x 160/640) -.00781 =.30469 Ming Tea Production WI (3/4 x 400/640) -.01953 =.44922 TOTAL NRI.75391 Virtucon PPI.30469 +.00781 / 1.21875 =.40000 Ming Tea PPI.44922 +.01953 / 1.21875 =.60000 TOTAL PPI 1.00000

Oklahoma Judicial Developments El Reno Rod, Gun & Development Corporation v. Mack Energy Company Royalty owners alleged they were underpaid on oil, and asserted that Mack sold oil at belowmarket prices to Enerwest, and that Mack and Enerwest were commonly owned and controlled. Royalty owners asserted they should be paid on work-back method under which allowable costs and expenses are deducted from the proceeds of the first downstream, arms-length sale.

El Reno Rod, Gun & Development, cont. District court denied class certification, finding that since the oil from plaintiffs wells was dealt with by Mack in an entirely different way than 90% of the oil attributable to the proposed class, the elements for class certification were not satisfied. Court of appeals confirmed denial of class certification. Source Rocky Mountain Mineral Law Foundation Journal, Vol. 51, No. 1, 2014

Coastal Strategies Income Fund-C v. Mewbourne Oil Company Mewbourne as operator sent Coastal a royalty check. Check was never deposited because it was intercepted by an employee of Coastal who apparently altered the payee on the check and negotiated the check for his own use. Lawsuit ensued whether Mewbourne or Coastal should bear the loss. Trial court determined that Coastal should bear loss if check was delivered to its offices, and Mewbourne should bear loss it if was not delivered.

Coastal v. Mewbourne, cont. Jury found in favor of Mewbourne. Court of appeals rejected contention that Mewbourne owed a fiduciary duty to inspect all deposited royalty checks for alteration or to detect theft, alteration or embezzlement. Source Rocky Mountain Mineral Law Foundation Journal, Vol. 51, No. 1, 2014

Widner v. Enerlex, Inc. Plaintiffs sued Enerlex seeking rescission of mineral deeds. Enerlex offered to purchase Widner s mineral interests for $7,300 and accrued mineral proceeds. Plaintiffs were unaware of $34,413.94 accrued mineral proceeds. Court concluded deeds were procured through false representations and suppression of the whole truth. Court found that Enerlex engaged in constructive fraud, and affirmed the rescission of the deeds. Source Mountain Mineral Law Foundation Journal, Vol. 51, No. 1, 2014

Panola Independent School District No. 4 v. Unit Petroleum Company Royalty owners sought a class action lawsuit against Unit alleging that royalties had been underpaid based upon the deduction of post-production costs (gathering, compression, fuel use, dehydration, marketing). Royalty owners also asserted that Unit did not disclose deductions on the royalty statements. Trial court found that Unit s policy was to deduct the costs from royalty payments unless a lease specifically prohibited the deduction of off-lease costs. Court certified the case as a class action, and Unit appealed.

Panola Independent School District, cont. Appeals court found that claims of force-pooled royalty owners relating to post-production costs differed markedly from the rest of the class. Claims of royalty owners who acquired their interests pursuant to leases require a multiplicity of sub-classes. The trial court s order certifying a class was reversed. Source Rocky Mountain Mineral Law Foundation Journal, Vol. 50, No. 1, 2013