In today’s market, the use of production payments to fund assets purchases may seem like a wise thing for oil companies looking to buy, but preserve cash on hand, to do. And sellers of these assets should be flexible enough to enter into production payment agreements, especially if they want the transaction to close. However, both parties should be cognizant of potential pitfalls in the drafting of this language in their assignments or Purchase and Sale Agreements, as they may be exposed to unintended consequences, as we see in an appeal to the Supreme Court of Texas titled Apache Deepwater, LLC v. McDaniel Partners, Ltd.

In 1953, four oil and gas leases were assigned. Two of the leases, the Cowden leases, represented 32/64 of the working interest in two Surveys: 36 and 37. The remaining two leases represented 3/64 working interest. The leases all provided for a 1/8 royalty. In the assignment, the Assignor reserved a 1/16 production payment, described by the following equation: “1/16th of 35/64ths of 7/8ths” of the total production from Surveys 36 and 37. “The assignment provided further that the production payment would continue until net proceeds from the reserved interest amounted to $3.55 million and 1.42 million barrels of oil.”

Twenty years later, the Cowden leases expired. Apache acquired the remaining 3/64 working interest that was subject to the production payment. Apache sent a division order to the Assignor’s successor-in-interest, McDaniel, “stating that the production payment reserved in the 1953 assignment should now be 1/16 of 3/64 of 7/8, reflecting the expiration of the Cowden Leases.” McDaniel disagreed, and argued that the production payment should still be calculated using the 35/64 interest. Apache paid on the 3/64 calculation, and McDaniel sued.

The trial court held that “the production payment was reserved from the four leases separately and ‘was thus subject to extinguishment upon expiration of each lease to the extent it existed as a burden against the production attributable to that lease.’” Therefore, Apache’s division order was correct. McDaniel appealed.

The court of appeals held that “the assignment did not authorize Apache to adjust the production payment equation to reflect the effect of an expired lease on the assigned interests. The court reasoned that, even though the production payment was reserved out of the working interest conveyed and lease terminations effectively reduced that working interest, no adjustment could be made to the production payment’s stated equation because the assignment did not contemplate such an adjustment.” Although Apache argued “that had the parties intended for the production-payment calculation to be unaffected by the termination of an underlying lease, an express savings clause or similar provision would have been necessary,” the appellate court disagreed, and sided with McDaniel. Apache appealed this holding to the Texas Supreme Court.

McDaniel argued that the assignment reserved a fixed production payment of 1/16 of 35/64 of 7/8, and the termination of any leases did not affect that calculation. Apache claimed that the production payment was tied to the current working interest, not to the original interest conveyed. Apache pointed to the language in the assignment which provided that “1/16th of 35/64ths of 7/8ths, being one-sixteenth of the entire interest in the production from said lands to which Assignor claims to be entitled under the terms of said respective oil and gas leases.” Apache claimed that “the word ‘respective’ recognize[d] the separate nature of each lease, and the respective burden of the production payment on each.” Apache also looked to the phrase “entire interest in the production,” and concluded “that the language essentially describe[d] how to derive the production payment at any point in time based on the practical effect of the production payment’s burden on each individual lease.” Therefore, because the Cowden leases expired, the working interest was reduced from 35/64 to 3/64, so the production payment was reduced to 1/16 of 3/64 of 7/8.

The Texas Supreme Court, in analyzing the court of appeals’ holding, agreed with the appellate court that production payments have the same basic characteristics as overriding royalty interests. The Court noted that production payments are “a share of production from described premises, free of production costs at the surface, terminating when a given production volume has been paid or when a specified sum from its sale has been realized. […] When, as in this case, the production payment is carved from the lessee’s working interest, it is like an overriding-royalty interest, except for its more limited duration. […] And, like an overriding royalty, ‘anything that terminates the lease necessarily destroys the [production] payment.’ Thus, in the case of a single lease, an overriding royalty (and by analogy a production payment) will not survive termination of the leasehold it burdens unless the parties have expressly agreed otherwise.’”

The Court stated that there were two parts to the production payment: the fractional share of production to be paid and the total amount of money and production to be received. The Court found that the fixed amount was the latter. As to the former, the Court held that “the assignor reserve[d] and except[ed] a ‘production payment interest’ of 1/16 of the entire production from Surveys 36 and 37 to which the assignor is entitled under the four respective oil and gas leases.” Because the production payment was tied to the interests in the particular leases separately, rather than the lands as a whole, if a lease terminates, the equation that calculated the production payment must be adjusted. Further, the Court held that “[t]he assignment neither state[d], implie[d], nor suggest[ed] that the production payment would be unaffected by the termination of the leaseholds from which it was carved […] Absent express language in the assignment to the contrary, we apply the general rule that ‘when an oil and gas lease terminates, the overriding royalty [or similar production payment] created in an assignment of the lease is likewise extinguished.’” Therefore, the Court reversed the ruling of the court of appeals, and found that McDaniel should take nothing.

For us, we now have a clear ruling that states that, just like overriding royalties, if an underlying lease that was subject to a production payment terminates, production payment terminates. And now we have clarity on how we treat production payments that burden several leases. Specifically, if there is no savings language, production payments may be reduced proportionate to the interest that remains. Production payments are still, in my view, a creative way to get a deal done. But be wary of the language used when expressing the payment terms. An operator may unwittingly lower the fractional payments made to it if the Assignee’s interest in the burdened lands change.