My wife and I have an acre or so mineral interest in Payne County, OK, Section 28-19N-3E (contains 160 acres), and we have received a well proposal from Calyx. Given our relatively small interest, we are considering participating in the well. Apart from having to pay for our share of the estimated cost of the well as laid out in the AFE, what other costs might we have to pay? If we elect to participate, will we receive a more detailed contract that addresses additional cost and liability, etc.?
Most of the discussions I have seen in this forum have been around leasing and not participation. Are we crazy to be thinking about participating? :-)
David
I am very new at a lot of this but there is some great people that can give you advice on it here… What I know is it is a great option if you can and have the cash option to do… It all goes back to higher risk higher reward…
Thanks, Robert. I've learned a lot on this site already. I can handle the risk of the up front cost. I'm just concerned about cost and liability over time.
I have never participated in a well. My wife's uncle did, and his experience was good while the well was producing enough to cover the expenses being charged by the operator. However, as the well became a marginal well, the revenue checks turned into monthly billings. After several months, he first tried to sell his working interest to the operator which, of course, they refused. He then tried to give it to them and they again refused. At that time he was approaching 90 years old, and it is my understanding he simply refused to acknowledge the bills. He died at 93 and I do not know how his estate handled the debt incurred. Mineral owners with leases which are from about 1985 continue to be paid enough for the current operator, a major, to effectively hold the entire 640 acre unit. This is in the heart of the Woodford Shale production in Pittsburg County.
David Sikes presented an excellent session on Working Interest at the 2012 OK-NARO Conference. The gist, in my recollection, was to participate only if you realize fully what you are getting into, and even if you do know, be sure to create an account from the revenues to cover contingencies. He did discuss advantages and disadvantages to the WI.
It is good to remember that all wells become marginal (also called "strippers") and will at some time need to be plugged and the site cleaned up. Unless the working agreement states otherwise, that will be partially your responsibility.
I have never participated in a well. My wife's uncle did, and his experience was good while the well was producing enough to cover the expenses being charged by the operator. However, as the well became a marginal well, the revenue checks turned into monthly billings... Mineral owners with leases which are from about 1985 continue to be paid enough for the current operator, a major, to effectively hold the entire 640 acre unit...
Wesley, thank you very much for sharing your wife's uncle's experiences! It's interesting that a situation like this could exist where it would make financial sense for the operator to keep running the well. I have assumed that the revenues and expenses would be shared in the same proportions between the operator and the participants (those with Working Interest?), i.e. it's never the case that the operator is making money on the well but the participants are not. Of course, I understand that the operator does charge the participants some additional amount for overhead/administration, so I suppose that creates some inequities where the operator can be making money but not the participants. Are there other factors that could throw off the balance between the operator's incentives and the participants'? For example, would the operator ever want to run the well at a loss to offset gains somewhere else?
I don't quite understand this:
Mineral owners with leases which are from about 1985 continue to be paid enough for the current operator, a major, to effectively hold the entire 640 acre unit.
Can you explain that further?
Thanks,
David
PS - Wish I could have seen that session by David Sikes!
If you choose to participate, remember a couple of things:
1) You will need to negotiate and sign a Joint Operating Agreement between you and the Operator. This is usually the barrier to entry for someone that doesn't work in the industry. It is a massive document that intimidates most people.
2) Aside from the AFE cost, there will be the Operator's overhead charge for both the drilling rate and then for the producing rate.
3) You are on the hook for your proportionate share of ALL costs within the Contract Area. If the first well is no good, you get to pay to plug it. If the first well is pretty good, you get to pay for all of the "experiments" the Operator's people want to do to try to get production up (come up hole to try a different formation, re-frac, etc.) If the Operator wants to drill another well, you are on the hook again. Also, what if the rig gets stuck on the first well for a month? Do you have the money to keep up with an expensive rig sitting there for a month trying to get the tool out of the hole? I'll bet the Operator does. These are all things to think about. The AFE cost is the tip of the iceberg.
4) On a positive note, you get to write off the intangible drilling costs on your taxes. Also, since you will most likely take a loss on the investment in the first year, you get to write that down, as well. Make sure you have an accountant that knows a thing or two about the oil & gas game. Once you do this, your TurboTax days are over.
No, you are not crazy to think about doing this. This a sound investment decision. But, you are taking on some risk that would otherwise not be there if you were to just sign an oil and gas lease and take your checks from the Operator.
One other positive thing, David. If the Operator sells out, and you have the right provisions in place, you can elect to sell out with them. This means you can take the big pile of money that they are getting. This is not available if you sign a lease. I know that people on this site say to never sell a mineral interest, but in some cases it makes a lot of sense to do so if that mineral interest is a converted working interest and a whole pile of money is being offered.
You will have received an AFE well cost. You are obligated to pay that amount upon invoice if pooled and elect to participate. That is a Pro Forma cost estimate or "perfect world" is the meaning of Pro Forma. What that means is if everything goes perfect drilling the well that will be the total cost to place the well into production tanks. Rarely do wells not encounter problems and end up costing the "Pro Forma" AFE amount. Sometimes much more is spent, as much as two times the AFE amount you received. Since you were pooled they have to go before the OCC to get any overage costs approved. That will happen as it cost what it cost and drilling is a risky business. After the well is in production into the oil tanks from day one, then you will pay your share of cost to keep the well in operation, That may not be much each month or if a horizontal it may be excessive in some wells. Submersible pumps go out frequently and cost dearly to repair as does bailing sand out from newly fraced wells. Do not be surprised to see costs in the first few months to be very high for operations which you will receive each month a "JIB" or :"Bill" from the operator which you must pay upon receipt basically plus 30 days at most or generally you will be deemed non-consent. I am not going to tell you which to do as I do not know your tax and financial position. If you have high incomes and need the tax deductions you will want to consider participating. If it is savings do not participate as it could clean the savings out unless very large. Basically, if you make 150K per year and are in at 2% or so I would participate. If you make 75K per year and have saved for years take the safe way and get your royalties paid to you risk free. Free is very good unless you are very wealthy individuals. I never understand why some people always get greedy when a freebie royalty check in front of their nose comes in the mail without risk for many years unless they have a large amount of savings like a million plus or high monthly incomes and need the tax deductions available. Check with your CPA he will tell you what to do. If you do not already use a CPA then take the free ride because if your income does not require a CPA to do your taxes then you have no business in oil and gas. It is a high risk versus high reward game and looses far more than it wins for beginners.
I have another concern no one had addressed so far in this thread. My lease form has a strong indemnification clause, so that my savings are protected in the unlikely event of a terrible accident, e.g. somehow the operator is held responsible for the death of a man with high expected future earnings and 29 kids. You know the typical worst-case scenario is one where a huge dollar amount is at stake and the widow sues everyone her lawyer can think of, including me, and the court finds the accident was the fault of the well or operator, and the widow wins a big judgement with punitive damages. In such a horrific scenario, the mineral interest owner (the Royalty Interest owner) would be glad that he was indemnified by the operator. But if the owner of the mineral interest had instead taken a WI or Working Interest, then he needs to be sure his savings are protected. From the little bit of information that I could gather, as a protective measure, a mineral interest owner can transfer the minerals to an LLC, and only the assets in the LLC can be vulnerable to a lawsuit. (But I think there are some tax disadvantages to a two-person LLC, such as payroll taxes being due on the income.) Also he could try to get some kind of commercial insurance - but I had a hard time ascertaining the feasibility of obtaining such a policy and it seemed it would be $10,000 per year if I were even able to obtain it. [I am no expert on this; just want to point out that the exposure to liability is definitely something to take into consideration, and for me is a big concern.]
You will have received an AFE well cost. You are obligated to pay that amount upon invoice if pooled and elect to participate. That is a Pro Forma cost estimate or "perfect world" is the meaning of Pro Forma...
Thanks for the info, Bryan. Is there anyway to cap the loss? Would it be possible (or even make sense) to negotiate upfront a maximum loss after which the interest in the well could revert to the operator or maybe limit my upside in exchange for limiting the downside? A potentially unbounded loss is kind of hard to justify. Could creating an LLC help with this?
... [I am no expert on this; just want to point out that the exposure to liability is definitely something to take into consideration, and for me is a big concern.]
Yes, liability is a concern of mine as well. I would appreciate hearing from others about ways to address indemnification ant liability.
One effective way mineral rights owners avoid paying any share of the cost of drilling/completing any well involving their land is to sign a "farmout agreement" instead of the JOA. Knowledgeable owners sometimes farm out their mineral rights interest "through the tanks" so that the operator (or whoever they farmout to) will pay their share of costs up to the date of first production. When production begins ("through the tanks"), they often sign a lease covering, say, only 1/2 of their mineral rights in the land, reserving a 25% royalty, and agreeing to participate with the other 1/2. Then after that, they only have to pay 1/2 of their share of actual costs, not a share of the "producing overhead rate" each month. The monthly overhead rate can only be charged to signers of a JOA (it's part of the COPAS Exhibit C to the JOA). These landowners become a "tenant in common" with the other partners in the well after it begins to produce.
By farming out, these owners guard completely from having to pay a share of costs if the well is a dry hole (yes, it still happens!!) but maximize their profits. But they are still liable for their share of plugging and abandoning (and any additional costs like workovers) along the way.
The only way to remove all liability for all costs, including tail-end costs, is to sign a lease.
But to avoid getting force-pooled, you should need to try and negotiate something before the OCC issues an order.
Farmout agreements are common, but between oil companies. As a landowner, you'll be asking Calyx to forgo their right to force pool your 1-acre interest instead of getting whatever bonus & royalty rate is approved by the OCC. Instead, you're asking them to increase their recordkeeping costs by adding you as a working interest owner in the well with a tiny share of 100% of well costs. Yes, you will receive the full 1-acre of revenues, but force pooling statutes in Oklahoma require you to pay your share UP FRONT of the "dry hole costs" (cost of drilling the well to casing point, plus plugging costs if the well is a dry hole). They are not required to carry you to payout 100% for those costs--because they have the right to force pool you instead. I would be very surprised if Calyx would be willing to add you as a working interest owner with a JIB working interest of maybe as little as 1/640ths or 0.15625%. For every $1 million of drilling & plugging (if dry hole) cost estimated in the AFE, a 0.15625% WI would have to pay $1,562.50. So the average $2 million dry-hole cost on a vertical/directional well in Oklahoma would require you to pay some $3,125 out of pocket up front and if it's a dry hole you lose every penny of it. If it does get completed (for an additional $1 million to $2 million) it might be a "dog well" that limps for several years before it ever pays back a $7200 investment (if ever, if additional workovers are done interim). This is why investing in oil and gas wells is so risky.