Drilling Down: A Deeper Look into the Distressed Oil & Gas Industry Part 2—Treatment of Oil and Gas Interests in Bankruptcy

Contributed by Charles Persons
Today’s blog article, which looks at the treatment of specific oil and gas property interests in the bankruptcy context, is the second in the Weil Bankruptcy Blog series, “Drilling Down,” where we review issues at the intersection of the oil and gas industry and bankruptcy law. In Part One, we provided an overview of the oil and gas industry and a discussion of some of the unique challenges currently facing this sector. In Part Three, we will look at the ability to assume, assign, or reject oil and gas “leases” under section 365 of the Bankruptcy Code. In Part Four, we will dive into how certain financing arrangements specific to the realm of oil and gas may be considered a “disguised financing” vs. a “true sale of interests.” 

Part Two: The Treatment of Oil and Gas Interests in Bankruptcy

In attempting to convert dreams of black gold to hard cash, aspiring capitalists split the property interest in oil into more fragments than the atom or the rainbow.” — Jones v. Salem Nat’l Bank (In re Fallop), 6 F.3d 422, 424 (7th Cir. 1993)

Appearances are not everything in this industry. A person standing on their property in Midland, Texas might look out across the fence and see a typical family home, and a short distance away, a pumpjack moving up and down. The logical presumption might be that the homeowner owns the pumpjack, as well as any crude oil it happens to be pulling out of the ground.
In reality, the homeowner probably has no interest in the pumpjack or the manner in which it is operated, has no right to produce the oil or gas below his feet, and almost certainly owns only a small fraction, if any, of what is being produced in the nearby well. Indeed, the homeowner may have no interest in the minerals under his home at all. The operator of the pumpjack may itself only own a small percentage of the production, having long ago doled out portions of its interest to perhaps dozens of other parties – including owners of a nearby pipeline, parties that provided initial financing for the drilling project, and perhaps even an oilfield services company that maintains the well itself.
Splitting these inherently speculative oil and gas interests by distributing tiny fractions of the production among several (and often dozens) of parties minimizes the risks for all. But this form of risk distribution requires careful consideration in the bankruptcy context of the derivation and type of interest held by a debtor or creditor.
Disparate State Laws Determine How Oil and Gas Interests Are Treated
Before considering specific oil and gas property interests, it is important to remember some ground rules. First, section 541(a) of Bankruptcy Code provides that, upon the commencement of a bankruptcy case, all legal and equitable interests of the debtor become property of the debtor’s bankruptcy estate. However, whether a debtor or creditor has a legal or equitable interest in that property is determined not by the Bankruptcy Code, but by applicable non-bankruptcy law. Unfortunately, to describe oil and gas laws among the states as “disparate” would be a gross understatement. Certain jurisdictions – often jurisdictions for whom the extraction of these precious resources is part of their core identity – elevate interests in minerals, oil, and gas to the status of “real property.” In other jurisdictions, certain oil and gas interests are little more than “personal property” rights, while in other jurisdictions they are a hybrid of real property and personal property.
Overview of Common Oil and Gas Interests and their Treatment in Bankruptcy
Mineral Interest – The “mineral interest” consists of the ownership of the oil and gas in place under a parcel of property, typically in fee simple, and the exclusive rights to explore, drill, and produce that oil and gas from the land. Mineral interests are conveyed by a “mineral deed” after being severed from the surface interests. Though states classify these interests differently, the broad definition of “property of the estate” under section 541 makes these distinctions moot for bankruptcy purposes, and mineral interests held by a debtor – even those that are contingent or non-possessory under state law – are considered property of the estate.
Working Interest – The owner of the mineral interest – often an individual landowner or government entity not in the business of oil and gas drilling – usually prefers that a sophisticated oil and gas exploration and production (“E&P”) company handle the extraction. In such cases, the mineral interest owner grants the exclusive rights to explore, drill, and produce the oil and gas by conveying an “operating interest” or “working interest” to an E&P company. The holder of a working interest in the property must bear the operating expenses associated with exploration, development, and, eventually, production.
Importantly, a working interest does not exist in perpetuity. Instead, the rights conveyed by the working interest typically revert back to the mineral interest owner if certain terms and conditions – usually certain production requirements – are not met. We will review the bankruptcy ramifications of this reversionary interest in Part 3 of this series when discussing working interests in the context of section 365.
Royalty Interests – The owner of a “royalty interest” is entitled to share in a stated portion of gross production, if any, but has no right to enter the land and extract the minerals itself. As such, the royalty interest is a “nonworking” interest – i.e. the holder of a royalty interest is not obligated to pay any of the costs associated with exploration or production. One type of royalty interest commonly dealt with by bankruptcy courts is the royalty interest retained when the mineral interest holder grants a working interest – a “landowner’s royalty interest.” Courts have generally understood that funds held by the E&P debtor that are subject to a landowner’s royalty interest are not property of the estate, as the Debtors are considered to hold only bare legal title, and not an equitable interest in such funds.
Unlike landowner’s royalty interests, which are derived directly from the mineral estate, “overriding royalty interests” (“ORRIs”) are typically carved out of the working interest by a working interest holder. As a general matter, “perpetual ORRIs” last for the life of the lease between the working interest holder and the mineral rights holder, but “term ORRIs” are limited in duration until a specified volume of production or stated value of production is reached.
Net Profits Interests – Similar to ORRIs, “net profits interests” or “NPIs,” are carved out of the working interest, but net profits interests are only payable to the NPI holder out of the profits earned from production over the contractually agreed‑upon time period. NPIs are consistently considered to be personal property interests, rather than real property interests, even in jurisdictions where royalty interests are considered real property interests.
Production Payments – Production payments, like ORRIs, refer “to an interest created out of the lessee’s estate which is a share of the minerals produced from described premises, free of the costs of production at the surface . . . . But a production payment terminates when the lease expires, or sooner if the owner of the interest has received the agreed quantum of production or dollar amount from the sale of production.” Working interest owners have long used production payments as a form of project lending, borrowing capital to finance the exploration and start-up production costs in exchange for a portion of the production. Once the loan is repaid from the production, the interest terminates.
A recent trend has been to refer to production payments as “term ORRIs” because they operate like an overriding royalty interest with a specified term, and the case law on overriding royalty interests is more robust. The Bankruptcy Code definition of “production payment” concurs with this broader definition. However, as we will discuss in Part 4 of this series, this creates an additional layer of complexity, because whether an interest is a true overriding royalty interest or something else depends on the true nature of the particular conveyance that gives rise to the interest.
Because of the disparity among state laws, the Bankruptcy Code attempts to introduce uniformity to the treatment of production payments. For example, section 541(b)(4)(B) of the Bankruptcy Code states that where the assignee of a production payment takes title to that property, the interest conveyed as a production payment ceases to be property of the estate. Unfortunately, the express language of the statute does leave some room for ambiguity, which has led to uncertainty in the bankruptcy context. Specifically, the statute only covers interests borne of production payments made “to an entity that does not participate in the operation of the property . . . .” By its plain language, the statute seems to exclude from property of the estate only the interests of entities that provide financing and nothing more, but production payments can be granted to parties that provide services or conduct operations on the property. Indeed, by negative implication, it might appear that production payments that are granted to parties participating in operations are interests that are property of the estate under section 541(a), though there is no indication that this was the intent of this language.
Understanding the varied oil and gas interests and their derivation is fundamental to understanding the issues facing bankruptcy courts in this area of the law. For instance, as discussed above, the royalty interest is “carved from the working interest in the land . . . .” This fact is important not just for the purposes of identifying the source of the royalty interest, but also for defining the outer limits of the rights conveyed. It is a “venerable principle” of property law that one “may not convey more than he owns.” Thus, if the jurisdiction considers the conveyance of the working interest by the mineral interest holder to be a conveyance of personal property, the royalty interest conveyed from that working interest can only be a conveyance of personal property. While some states consider conveyance of the mineral rights by the original mineral interest a grant of real property, they consider conveyances carved from the resulting working interest—like ORRIs—to be personal property that is contractual in nature. Finally, even in states where the grant of mineral rights is considered a conveyance of a real property interest, that conveyance is sometimes evidenced by an instrument that leaves both parties with material contractual obligations to perform. As a result, bankruptcy courts have struggled to deal with mineral leases on numerous different levels and the struggle will no doubt intensify in the current business climate.