Is the Bank's position in financing oil and gas producers being replaced by marketing affiliates within the industry? More and more oil and gas producers are turning to unconventional funding sources that include pre-paid swaps, strategic alliances, development financing and production payments to finance their exploration and production of additional reserves. This development was prompted when the producers began to view the quality of traditional financing declining in 1993(1). As a result, production payments have recently taken a lead in the producer's sources of capital. A production payment is where a buyer makes an up-front cash payment for titles to reserves to be produced for and delivered to them at a future date. Both independent gas marketers and large diversified organizations that are significant producers themselves are setting up production payments. They are entering these arrangements to lock in margins to retain exposure to upside on sales prices, as well as lock in a firm title to reserves.
In order to understand the threat to banks by the gas/oil intra-industry financing, the logistics of production payments must be explained. Production payments carry both benefits, as well as drawbacks, to both the Producer and the Marketer. It is a matter of whether the advantages outweigh the disadvantages enough for the producers to completely eliminate outside financing for their capital needs.
In many petroleum-producing states, a production payment is characterized as ownership of real property, namely oil and gas reserves. The production payment is separate from the working interest retained by the producer. It is neither a contract right nor a lien in the producer's working interest, but rather a property right. A production payment is non-recourse in nature and is free and clear of all costs and expenses of lease operations and production. Characteristics of the assets associated with the production payment are listed below:
1. Ownership Interest:
A production payment is an ownership interest in oil and gas reserves. It is separate and apart from the working interest from which it is derived. As a result, if the working interest owner/producer were to become insolvent, the production payment should not be part of the bankruptcy estate. Since the production payment is entitled to the first hydrocarbons produced on a daily basis, the estate must first produce and deliver the production payment volumes to the Partnership in order for the estate to realize its share of the hydrocarbons.
2. First Priority Rights:
The first hydrocarbons produced for the producer's interest, on a daily basis, are applied to satisfy the production payment. Since the production payments have substantial reserve coverage, slight variations in production levels or timing have limited impact on the volumes delivered to the production payment owner.
Multiple properties and wells, which may or may not be contiguous, are burdened by the production payment. Regardless of the location of the leases, the production payment represents a single obligation of the aggregate lease to deliver the specified volumes. If one lease were to produce below expectations, incremental volumes may be taken from other leases in order to ensure that the owner of the production payment is kept economically whole.
4. Reserve Coverage:
The volumes of hydrocarbons which are deliverable pursuant to a production payment represents a fraction of the total reserves available from the properties burdened by the production payment.
5. Environmental Claims:
Due to a production payment owner's lack of control over operations or the producer, the production payment owner should not be subject to any environmental claims.
6. Expense Free:
When designing a production payment, the intent is to leave sufficient hydrocarbons for the producer in order to pay projected costs of production. …