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CalAttorney2
CalAttorney2, Attorney
Category: Business Law
Satisfied Customers: 10238
Experience:  I am a businesses law attorney, with experience advising and representing owners and investors.
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This question is best answered by an attorney familiar with

Customer Question

This question is best answered by an attorney familiar with pooling and/or the formation of oil and gas production units. In a typical production unit consisting of six or seven leases covering 160 acres the net revenue interest may vary due to varying
royalty percentages on these leases. If a well is drilled on one of the leases in the production unit how is the net revenue interest determined for the working interest owners who are drilling the well? Would the working interest owners use the net revenue
interest on the lease they are drilling on or some sort a calculated average net revenue averaging net revenue interest for the six leases in the unit to determine their net revenue interest in the well?
Submitted: 1 year ago.
Category: Business Law
Expert:  CalAttorney2 replied 1 year ago.

Dear Customer,

These transactions are commercial contracts - meaning that the parties are free to structure them however they wish.

In general most parties do try to maintain some sort of equity (fairness) between the property owners and will attempt to compensate accordingly:

-Apportionment by property size is common (so a total production unit of 100 acres with 5 equal 20 acre owners would be split evenly; a 100 acre unit with one 50 acre owner and 5 10 acre owners would be split in a 50/10/10/10/10/10 split for profits). But this is not required, if the unit owners come up with a different distribution plan, that is acceptable to them, that will be enforceable between them.

-Pick a distribution schedule that works for each of the owners on a reasonable schedule - this is an investment, so this is going to be looking towards taxable events, quarterly distributions are most common, although bi-annual and annual distributions are not uncommon. If you have regular distributions from the drilling company, you can match those distributions to the unit owner distributions. I do not recommend anything beyond annual distributions as this will make tax reporting unnecessarily complicated (and many owners will want their distributions more regularly in any event).

-If you want to pool royalties and make average distributions (as I noted above, this is a commercial transaction, you can do as you please), you can certainly do this, but it does create more accounting headaches for the individual(s) in charge of this bookwork, and you will also want to ensure that you have an interest bearing account for the royalties that are paid but not yet distributed.

-Prior to division of profits, the property (or properties) that are being drilled on should be compensated for any loss (if this is not already being compensated by the drilling company - something I recommend negotiating for in the first place, but if you don't get that, the property being drilled shouldn't bear the full cost alone), so pre-distribution, that property should be compensated for the cost of having the drilling equipment, etc. on the land. (For most drilling operations, this is a small expense, but for some extractions, this can be significant).

-A reserve should be established to cover any potential loss (it doesn't have to be huge, but a modest reserve isn't a bad idea - you should already be covered by the drilling company's insurance (again something you should negotiate for, if you aren't covered, look into pulling insurance for this operation, it shouldn't be very expensive - this expense should be pre-distribution).

-Make sure to identify who is responsible for this, who is handling the money, what bank is being used, who the signatories are, and how disputes will be resolved (I recommend including a "mandatory mediation" clause prior to litigation - mediation can help resolve most disputes without having to go through the time and expense of litigation).

-Get it all in writing. Not only does this ensure that these things are enforceable if there is a dispute (it is much easier to resolve potential problems when everyone is amicable and talking to one another than when they are upset and angry), but it also helps ensure there is no confusion or ambiguity about what is going on with the investment. I do recommend hiring a lawyer to help you with this (this is what we are trained to do), but it is not required, and getting something written down is better than nothing.