Private equity funds have, and will continue to, invest throughout the capital structure of exploration and production (“E&P”) companies. Investors (and sometimes vendors) acquire interests in an E&P company’s production by buying overriding royalty interests (“ORRI”), which can be perpetual or term overrides. Alternatively, investors acquire production payments, which are more closely aligned with debt instruments, as the production payments terminates when a specific amount of money or production has been received by the investor. As oil and natural gas prices remain low (and the leverage of many E&P companies remains high), PE investors may need to protect their investments and mitigate the risks of an operator failing.

In a common ORRI arrangement, the operator of the wells (i.e., the E&P company) will sell the production of the well, comprised of both the working interest owners’ production as well as that of the holders of ORRIs. Such an arrangement can result in one-to-two months’ production proceeds of an ORRI being in the hands of the operator. As an E&P company begins to experience cash flow issues, an attractive source of near-term cash can be the proceeds of production of ORRIs. Such was the case in the bankruptcy of ATP Oil & Gas. At the “first-day” hearing in ATP’s bankruptcy case, there was testimony that up to $23.4 million of production proceeds attributable to ORRIs and net profits interests had been collected and spent by ATP (the operator) on operating costs, rather than being remitted to the holders of the ORRIs and NPIs.

Every holder of an ORRI wants the operator to be successful (resulting in hydrocarbons being produced and the proceeds being remitted to, among others, ORRI holders). Unfortunately, however, situations arise wherein an over-levered operator faces the dilemma of remitting production proceeds to ORRI holders versus making a debt payment to avoid a default (or paying trade creditors to avoid M&M liens, or any number of demands on cash flow). In such a scenario, holders of ORRI want to be protected against proceeds of their production being spent elsewhere.

To ensure that the operator does not comingle ORRI production proceeds with proceeds of working interests, “lose” the funds, or have the funds attached by the liens of a secured bank lender or other creditor, an ORRI holder can direct the first purchaser of production to send the proceeds directly to the ORRI holder by submitting to the first purchaser a division order” signed by the operator. This alerts the first purchaser as to the specified amount of hydrocarbons that are owned by the ORRI holder such that the proceeds of ORRI production will be paid directly to the ORRI holder.

In larger transactions, the ORRI may have numerous participants or be syndicated among of number of investors. In such a transaction, another way to protect against a cash-strapped operator diverting ORRI production proceeds to a party other than the ORRI holders is through an escrow arrangement whereby the operator sells the production of the well (including production of working interests and ORRIs) to the first purchaser, but the proceeds attributable to the ORRI are paid by the first purchaser to an escrow agent (that remits the proceeds to the ORRI holder), rather than to the operator. This relatively simple arrangement minimizes the amount of ORRI production proceeds that flow through the hands of the operator, thereby mitigating the risk of an ORRI holder’s proceeds being diverted to fund the operating expenses of a failing operator, without requiring a division order that directs payments to each of the investor participants.