Item 1. Business.
DESCRIPTION OF THE TRUST
The Mesa Royalty Trust (the "Trust"), created under the laws of the State of Texas, maintains its offices at the office of the Trustee, The Bank
of New York Mellon Trust Company, N.A., (the "Trustee"), 601 Travis Street, Floor 16, Houston, Texas 77002. The telephone number of the Trust is 713-483-6020. The Bank of New York Mellon Trust
Company, N.A., is the successor Trustee from JPMorgan Chase Bank, N.A., formerly known as The Chase Manhattan Bank and is the successor by mergers to the original name of the Trustee, Texas Commerce
Bank National Association.
The
Trustee does not maintain a website for filings by the Trust with the U.S. Securities and Exchange Commission ("SEC"). Electronic filings by the Trust with the SEC are available free
of charge through the SEC's website at
www.sec.gov
.
The
Trust was created on November 1, 1979. On that date, Mesa Petroleum Co., predecessor to Mesa Limited Partnership ("MLP"), which was the predecessor to MESA Inc.,
conveyed to the Trust an overriding royalty interest (the "Royalty") equal to 90% of the Net Proceeds (as defined in the Conveyance and described below) attributable to the specified interests in
properties conveyed by the assignor on that date (the "Subject Interests"). The Subject Interests consisted of interests in certain oil and gas properties located in the Hugoton field of Kansas, the
San Juan Basin field of New Mexico and Colorado, and the Yellow Creek field of Wyoming (collectively, the "Royalty Properties"). The Royalty is evidenced by counterparts of an Overriding Royalty
Conveyance dated as of November 1, 1979 (the "Conveyance"). On April 30, 1991, MLP sold its interests in the Royalty Properties located in the San Juan Basin field to ConocoPhillips,
successor by merger to Conoco Inc. ("ConocoPhillips"). ConocoPhillips sold most of its interests in the San Juan Basin Royalty Properties located in Colorado to MarkWest Energy
Partners, Ltd. (effective January 1, 1993) and Red Willow Production Company (effective April 1, 1992). On October 26, 1994, MarkWest Energy Partners, Ltd. sold
substantially all of its interest in the Colorado San Juan Basin Royalty Properties to BP Amoco Company ("BP"), a subsidiary of BP p.l.c. Until August 7, 1997, MESA Inc. operated the
Hugoton Royalty Properties through Mesa Operating Co., a wholly owned subsidiary of MESA Inc. On August 7, 1997, MESA Inc. merged with and into Pioneer Natural Resources
Company ("Pioneer"), formerly a wholly owned subsidiary of MESA Inc., and Parker & Parsley Petroleum Company merged with and into Pioneer Natural Resources USA, Inc. (successor to
Mesa Operating Co.), a wholly owned subsidiary of Pioneer ("PNR") (collectively, the mergers are referred to herein as the "Merger"). Subsequent to the Merger, the Hugoton Royalty Properties
were initially operated by PNR. Substantially all of the San Juan Basin Royalty Properties located in New Mexico are operated by ConocoPhillips. Effective January 1, 2005, ConocoPhillips
assigned its interest in an immaterial number of San Juan Basin Royalty Properties located in New Mexico to XTO Energy Inc. Substantially all of the San Juan Basin Royalty Properties located in
Colorado are operated by BP. As used in this report, Linn Energy Holdings, LLC ("Linn") refers to the operator of the Hugoton Royalty Properties, ConocoPhillips refers to the operator of the
San Juan Basin Royalty Properties, other than the portion of such properties located in Colorado, and BP refers to the operator of the Colorado San Juan Basin Royalty Properties, unless otherwise
indicated. The terms "working interest owner" and "working interest owners" generally refer to the operators of the Royalty Properties as described above, unless the context in which such terms are
used indicates otherwise.
On
July 18, 2014, PNR entered into a purchase and sale agreement (the "Purchase Agreement") to sell all of its assets in the Hugoton field in Kansas to Linn. The transaction
closed on September 11, 2014. The assets sold to Linn included, among other things, all of Pioneer's producing oil and gas wells, all of its interest in the Satanta gas processing plant and all
other associated infrastructure. In connection with the Purchase Agreement, PNR and Linn also entered into a Transition Services
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Agreement,
dated July 18, 2014, whereby PNR agreed to continue providing operating, certain administrative services, accounting and other services related to the assets in exchange for a
service fee. As a result, PNR continued to act as operator with respect to the Hugoton Royalty Properties through December 31, 2014. Upon expiration of the Transition Services Agreement, Linn
took over as operator of the Hugoton Royalty Properties.
On
May 11, 2016, Linn Energy, LLC ("Old Linn"), LinnCo, LLC ("LinnCo"), an affiliate of Old Linn, and certain of Old Linn's direct and indirect subsidiaries
(collectively with Old Linn and LinnCo, the "Debtors"), filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court
for the Southern District of Texas (the "Court"). The Debtors' Chapter 11 cases were administered jointly under the caption
In re Linn Energy, LLC, et
al.
, Case No. 16-60040.
On
January 27, 2017, the Court entered the
Order Confirming (I) Amended Joint Chapter 11 Plan of Reorganization of Linn Energy, LLC
and its Debtor Affiliates Other Than Linn Acquisition Company, LLC and Berry Petroleum Company, LLC and (II) Amended Joint Chapter 11 Plan of Reorganization of Linn
Acquisition Company, LLC and Berry Petroleum Company, LLC
(the "Confirmation Order"), which approved and confirmed the Amended Joint Chapter 11 Plan of
Reorganization of Linn Energy, LLC and Its Debtor Affiliates Other Than Linn Acquisition Company, LLC and Berry Petroleum Company, LLC (the "Plan"). The Plan became effective on
February 28, 2017 (the "Effective Date").
Pursuant
to the Plan, on the Effective Date, all assets of Old Linn (other than equity interests in Linn Acquisition Company, LLC and Berry Petroleum Company, LLC) were
conveyed to Linn Energy, Inc. (or a subsidiary thereof), and LinnCo, LLC and Linn Energy, LLC were wound down and liquidated. Subsequent to the effectiveness of the Plan, Linn
Energy, Inc. is now the reorganized successor to Old Linn. Under the Plan Supplement, as amended, filed with the Court, the Debtors assumed all executory contracts and unexpired leases with the
Trust and Mesa Operating Limited Partnership as the counterparty.
The
terms of the Mesa Royalty Trust Indenture (the "Trust Indenture") provide, among other things, that: (1) the Trust cannot engage in any business or investment activity or
purchase any assets; (2) the
Royalty can be sold in part or in total for cash upon approval by the unitholders; (3) the Trustee can establish cash reserves and borrow funds to pay liabilities of the Trust and can pledge
the assets of the Trust to secure payment of the borrowings; (4) in January, April, July and October of each year the Trustee will make quarterly distributions of cash available for
distribution to the unitholders; and (5) the Trust will terminate upon the first to occur of the following events: (i) at such time as the Trust's royalty income for two successive years
is less than $250,000 per year or (ii) a vote by the unitholders in favor of termination. Royalty income of the Trust was $1,364,791 and $2,076,841 for the years 2016 and 2015, respectively.
Upon termination of the Trust, the Trustee will sell for cash all the assets held in the Trust estate and make a final distribution to unitholders of any funds remaining after all Trust liabilities
have been satisfied.
Under
the Conveyance, the Trust is entitled to payment of 90% of the Net Proceeds (as defined in the Conveyance), realized from Subject Minerals (as defined in the Conveyance), if and
when produced from the Royalty Properties. See "Description of Royalty Properties." The Conveyance provides for a monthly computation of Net Proceeds. "Net Proceeds" is defined in the Conveyance as
the excess of Gross Proceeds, received by the working interest owners during a particular period over operating and capital costs for such period. "Gross Proceeds" is defined in the Conveyance as the
amount received by the working interest owners from the sale of Subject Minerals, subject to certain adjustments. Subject Minerals mean all oil, gas and other minerals, whether similar or dissimilar,
in and under, and which may be produced, saved and sold from, and which accrue and are attributable to, the Subject Interests from and after November 1, 1979. Operating costs mean, generally,
costs incurred on an accrual basis by the working interest owners in operating the Royalty Properties, including capital and non-capital
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costs.
If operating and capital costs exceed Gross Proceeds for any month, the excess plus interest thereon at 120% of the prime rate of Bank of America is recovered out of future Gross Proceeds prior
to the making of further payment to the Trust. The Trust, however, is generally not liable for any operating costs or other costs or liabilities attributable to the Royalty Properties or minerals
produced therefrom. The Trust is not obligated to return any royalty income received in any period. The working interest owners are required to maintain books and records sufficient to determine the
amounts payable under the Royalty. Additionally, in the event of a controversy between a working interest owner and any purchaser as to the correct sales price for any production, amounts received by
such working interest owner and promptly deposited by it with an escrow agent are not considered to have been received by such working interest owner and therefore are not subject to being payable
with respect to the Royalty until the controversy is resolved; but all amounts thereafter paid to such working interest owner by the escrow agent will be considered amounts received from the sale of
production. Similarly, operating costs include any amounts a working interest owner is required to pay whether as a refund, interest or penalty to any purchaser because the amount initially received
by such working interest owner as the sales price was in excess of that permitted by the terms of any applicable contract, statute, regulation, order, decree or other obligation. Within 30 days
following the close of each calendar quarter, the working interest owners are required to deliver to the Trustee a statement of the computation of Net Proceeds attributable to such quarter.
The
brief discussions of the Trust Indenture and the Conveyance contained herein are qualified in their entirety by reference to the Trust Indenture and the Conveyance themselves, which
are exhibits to this Form 10-K and are available upon request from the Trustee.
The
Royalty Properties are required to be operated by the working interest owners in accordance with reasonable and prudent business judgment and good oil and gas field practices. Each
working interest owner has the right to abandon any well or lease if, in its opinion, such well or lease ceases to produce or is not capable of producing oil, gas or other minerals in commercial
quantities. Each working interest owner markets the production on terms deemed by it to be the best reasonably obtainable in the circumstances. See "Contracts." The Trustee has no power or authority
to exercise any control over the operation of the Royalty Properties or the marketing of production therefrom.
In
1985, the Trust Indenture was amended at a special meeting of unitholders and the Trust conveyed to an affiliate of Mesa Petroleum Co. 88.56% of the original Royalty (such
transfer, the "1985 Assignment"). The effect of the 1985 Assignment was an overall reduction of approximately 88.56% in the size of the Trust, distributable income and related Trust reserves,
effective April 1, 1985. See Note 2 in the Notes to Financial Statements under Item 8 of this Form 10-K.
The
Trust has no employees. Administrative functions of the Trust are performed by the Trustee.
DESCRIPTION OF THE UNITS
Each unit is evidenced by a transferable certificate issued by the Trustee. Each unit ranks equally for purposes of distributions and has one
vote on any matter submitted to unitholders. A total of 1,863,590 units were outstanding at March 31, 2017.
Distributions
The Trustee determines for each month the amount of cash available for distribution for such month. Such amount (the "Monthly Distribution
Amount") consists of the cash received from the Royalty during such month less the obligations of the Trust paid during such month, adjusted for changes made by the Trustee during such month in any
cash reserves established for the payment of contingent or future obligations of the Trust. The Monthly Distribution Amount for each month is payable to unitholders of record on the monthly record
date (the "Monthly Record Date"), which is the close of business on the last business day of such month or such other date as the Trustee
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determines
is required to comply with legal or stock exchange requirements. However, to reduce the administrative expenses of the Trust, under the Trust Indenture the Trustee does not distribute cash
monthly, but rather, during January, April, July and October of each year distributes to each person who was a unitholder of record on one or more of the immediately preceding three Monthly Record
Dates, the Monthly Distribution Amount for the month or months that he was a unitholder of record, together with interest earned on such Monthly Distribution Amount from the Monthly Record Date to the
payment date. Under the terms of the Trust Indenture, interest is earned at a rate of 1
1
/
2
% below the prime rate charged by The Bank of New York Mellon Trust Company, N.A., successor
from JPMorgan Chase Bank, N.A., (as the successor by mergers to the original name of the Trustee, Texas Commerce Bank National Association) or the interest rate which The Bank of New York Mellon Trust
Company, N.A., pays in the normal course of business on amounts placed with it, whichever is greater. Interest income may vary significantly across different payment dates.
As
of December 31, 2016, there were $0 unreimbursed expenses. The terms of the Trust Indenture provide, among other things, that the Trustee may establish cash reserves and borrow
funds to pay liabilities of the Trust and may pledge assets of the Trust to secure payment of the borrowings. During 2011, the Trustee withheld $1.0 million for future unknown contingent
liabilities and expenses in accordance with the Trust Indenture. At any given time, the amount currently reserved for such future unknown contingent liabilities and expenses is included in cash and
short-term investments. For the year ended December 31, 2016, the Trustee increased the reserve for future unknown contingent liabilities and expenses by (i) the amounts received during
the first quarter and third quarter of 2016 related to expense reimbursement cash receipts for previous periods totaling $6,738 and $812, respectively, (ii) a prior period expense refund
received from a vendor in the amount of $101 and (iii) $107,659 of royalty income received from BP in September 2016 after the distribution to unitholders had been announced for the month of
September 2016. Such royalty income was included in the October 2016 distribution to unitholders. For the twelve months ended December 31, 2016, the Trustee decreased the reserve for future
unknown contingent liabilities and expenses for (i) a prior period expense refund received from a vendor in the amount of $101, (ii) the amount of expected expense reimbursement cash
receipts of $812 and (iii) $107,659 of royalty income received from BP in September 2016 after the distribution to unitholders had been announced for the month of September 2016. Such royalty
income was included in the October 2016 distribution to unitholders. As of December 31, 2016, the reserve for unknown contingent liabilities and expenses was $1,000,000 and is included in cash
and short term investments.
For
the year ended December 31, 2015, the Trustee decreased the reserve for future unknown contingent liabilities and expenses by the amount of expected expense reimbursement cash
receipts of $180,864. Additionally, the Trustee increased the reserve for future unknown contingent liabilities and expenses by the amounts received during the twelve months ended December 31,
2015 related to expense reimbursement cash receipts for previous periods totaling $174,126. As of December 31, 2015, the reserve for unknown contingent liabilities and expenses was $993,261,
which was included in cash and short term investments. The Trust has subsequently received $6,739 of the expected expense reimbursement cash receipts as of January 31, 2016, which has increased
the reserve for unknown
contingent liabilities and expenses. The Trustee reserves the right to determine whether or not to release cash reserves in future periods with respect to any unreimbursed expenses.
Liability of Unitholders
In regards to the unitholders, the Trustee is fully liable if the Trustee incurs any liability without ensuring that such liability will be
satisfiable only out of the Trust assets (regardless of whether the assets are adequate to satisfy the liability) and in no event out of amounts distributed to, or other assets owned by, unitholders.
However, under Texas law, it is unclear whether a unitholder would be jointly and severally liable for any liability of the Trust in the event that all of the following conditions
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were
to occur: (1) the satisfaction of such liability was not by contract limited to the assets of the Trust, (2) the assets of the Trust were insufficient to discharge such liability
and (3) the assets of the Trustee were insufficient to discharge such liability. Although each unitholder should weigh this potential exposure in deciding whether to retain or transfer his
units, the Trustee is of the opinion that because of the passive nature of the Trust assets, the restrictions on the power of the Trustee to incur liabilities and the required financial net worth of
any trustee, the imposition of any liability on a unitholder is extremely unlikely.
Federal Income Tax Matters
This section is a summary of federal income tax matters of general application which addresses the material tax consequences of the ownership
and sale of the units. Except where indicated, the discussion below describes general federal income tax considerations applicable to individuals who are citizens or residents of the United States.
Accordingly, the following discussion has limited application to domestic corporations and persons subject to specialized federal income tax treatment, such as regulated investment companies and
insurance companies. It is impractical to comment on all aspects of federal, state, local and foreign laws that may affect the tax consequences of the transactions contemplated hereby and of an
investment in the units as they relate to the particular circumstances of every unitholder.
Each unitholder is encouraged to consult its own tax advisor with respect to its
particular circumstances.
This
summary is based on current provisions of the Internal Revenue Code of 1986, as amended (the "Code"), existing and proposed Treasury Regulations thereunder and current
administrative rulings and court decisions, all of which are subject to changes that may or may not be retroactively applied. Some of the applicable provisions of the Code have not been interpreted by
the courts or the Internal Revenue Service (the "IRS"). No assurance can be provided that the statements set forth herein (which do not bind the IRS or the courts) will not be challenged by the IRS or
will be sustained by a court if so challenged.
In a technical advice memorandum dated February 26, 1982, the National Office of the IRS advised the Dallas District Director that the
Trust is classifiable as a grantor trust and not as an association taxable as a corporation. As a grantor trust, the Trust incurs no federal income tax liability and each unitholder is subject to tax
on the unitholder's pro rata share of the income and expense of the Trust as if the unitholder were the direct owner of a pro rata share of the Trust's assets. In addition, there is no state tax
liability for the period.
The
Trustee assumes that some Trust units are held by a middleman, as such term is broadly defined in U.S. Treasury Regulations (and includes custodians, nominees, certain joint owners,
and brokers holding an interest for a custodian in street name). Therefore, the Trustee considers the Trust to be a non-mortgage widely held fixed investment trust ("WHFIT") for U.S. federal income
tax purposes. The Bank of New York Mellon Trust Company, N.A., 601 Travis Street, Floor 16, Houston, Texas 77002, telephone number 713-483-6020, is the representative of the Trust that will
provide tax information in accordance with applicable U.S. Treasury Regulations governing the information reporting requirements of the Trust as a WHFIT. Notwithstanding the foregoing, the middlemen
holding units on behalf of unitholders, and not the Trustee of the Trust, are solely responsible for complying with the information reporting requirements under the Treasury Regulations with respect
to such units, including the issuance of IRS Forms 1099 and certain written tax statements. Unitholders whose units are held by middlemen should consult with such middlemen regarding the
information that will be reported to them by the middlemen with respect to the units.
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Royalty income, net of depletion and severance taxes, is portfolio income. Subject to certain exceptions and transitional rules, royalty income
cannot be offset by passive losses. Additionally, interest income is portfolio income. Administrative expense is an investment expense.
Generally,
prior to the Revenue Reconciliation Act of 1990, the transferee of an oil and gas property could not claim percentage depletion with respect to production from the property if
it was "proved" at the time of the transfer. This rule is not applicable in the case of transfers of properties after October 11, 1990. Thus, eligible unitholders who acquired units after that
date are entitled to claim an allowance for percentage depletion with respect to royalty income attributable to these units to the extent that this allowance exceeds cost depletion as computed for the
relevant period.
Distributions from the Trust are generally subject to backup withholding at a rate of 28%. Backup withholding will not normally apply to
distributions to a unitholder, however, unless the unitholder fails to properly provide to the Trust his taxpayer identification number or the IRS notifies the Trust that the taxpayer identification
number provided by the unitholder is incorrect.
Generally, except for recapture items, the sale, exchange or other disposition of a unit will result in capital gain or loss measured by the
difference between the tax basis in the unit and the amount realized. Effective for property placed in service after December 31, 1986, the amount of gain, if any, realized upon the disposition
of oil and gas property is treated as ordinary income up to the amount of intangible drilling and development costs incurred with respect to the property and depletion claimed to the extent it reduced
the taxpayer's basis in the property. Under this provision, depletion attributable to a unit acquired after 1986 will be subject to recapture as ordinary income upon disposition of the unit or upon
disposition of the oil and gas property to which the depletion is attributable. The balance of any gain or any loss will be capital gain or loss if the unit was held by the unitholder as a capital
asset, either long-term or short-term depending on the holding period of the unit. This capital gain or loss will be long-term if a unitholder's holding period exceeds one year at the
time of sale or exchange. Under current law, the highest marginal U.S. federal income tax rate applicable to long-term capital gains of individuals is 20%. Moreover, this rate is subject to change by
new legislation at any time. The deductibility of capital losses are subject to certain limitations. Capital gain or loss will be short-term if the unit has not been held for more than one year at the
time of sale or exchange.
Individuals, estates, and trusts with income above certain thresholds are subject under Section 1411 of the Code to an additional 3.8%
taxalso known as the Net Investment Income Tax ("NIIT")on their net investment income. Grantor trusts such as Mesa Royalty Trust are not subject to the NIIT; however, the
unitholders may be subject to the tax. For these purposes, investment income would generally include certain income derived from investments, such as the royalty income derived from the units and gain
realized by a unitholder from a sale of the units.
In general, a unitholder who is a nonresident alien individual or which is a foreign corporation, each a "non-U.S. unitholder" for purposes of
this discussion, will be subject to tax on the gross income (without taking into account any deductions, such as depletion) produced by the Royalty at a rate equal to 30% or, if applicable, at a lower
treaty rate. This tax will be withheld by the Trustee and remitted directly to the United States Treasury. A non-U.S. unitholder may elect to treat the income from the
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Royalty
as effectively connected with the conduct of a United States trade or business under provisions of the Code or pursuant to any similar provisions of applicable treaties. Upon making this
election, a non-U.S. unitholder is entitled to claim all deductions with respect to that income, but he must file a United States federal income tax return to claim these deductions. This
election once made is irrevocable unless an applicable treaty allows the election to be made annually.
The
Code and the Treasury Regulations thereunder treat the publicly traded Trust as if it were a United States real property holding corporation. Accordingly, a non-U.S. unitholder may
be subject to United States federal income tax on the gain on the disposition of his units if he meets certain ownership thresholds.
In
addition, if a foreign corporation elects under provisions of the Code to treat the income from the Royalty as effectively connected with the conduct of a United States trade or
business, the corporation may also be subject to the U.S. branch profits tax at a rate of 30%. This tax is imposed on U.S. branch profits of a foreign corporation that are not reinvested in the U.S.
trade or business. This tax is in addition to the tax on effectively connected income. The branch profits tax may be either reduced or eliminated by treaty. Federal income taxation of a non-U.S.
unitholder is a highly complex matter which may be affected by many considerations. Therefore, each non-U.S. unitholder is encouraged to consult with his own tax advisor with respect to its ownership
of Trust units.
Pursuant
to the Foreign Account Tax Compliance Act (commonly referred to as "FATCA"), distributions from the Trust to "foreign financial institutions" and certain other "non-financial
foreign entities" may be subject to U.S. withholding taxes. Specifically, certain "withholdable payments" (including certain royalties, interest and other gains or income from U.S. sources) made to a
foreign financial institution or non-financial foreign entity will generally be subject to the withholding tax unless the foreign financial institution or non-financial foreign entity complies with
certain information reporting, withholding, identification, certification and related requirements imposed by FATCA. Foreign financial institutions located in jurisdictions that have an
intergovernmental agreement with the United States governing FATCA may be subject to different rules. Foreign unitholders are encouraged to consult their own tax advisors regarding the possible
implications of these withholding provisions on their investment in Trust units.
The Royalty and interest income should not be unrelated business taxable income so long as, generally, a unitholder did not incur debt to
acquire a unit or otherwise incur or maintain a debt that would not have been incurred or maintained if the unit had not been acquired. Legislative proposals have been made from time to time which, if
adopted, would result in the treatment of Royalty income as unrelated business taxable income. Each tax-exempt unitholder is encouraged to consult its own advisor with respect to the treatment of
Royalty income.
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DESCRIPTION OF ROYALTY PROPERTIES
Producing Acreage and Wells as of December 31, 2016
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Producing Acres(1)
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Producing
Gas Wells(1)
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Gross
|
|
Net
|
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Gross
|
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Net
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Hugoton Area (Kansas)
|
|
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99,654
|
|
|
99,413
|
|
|
482
|
|
|
418
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|
San Juan Basin (Northwestern New Mexico and Southwestern Colorado)
|
|
|
40,716
|
|
|
31,328
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|
|
2,546
|
|
|
291
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|
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|
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|
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|
|
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Total
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140,370
|
|
|
130,741
|
|
|
3,028
|
|
|
709
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-
(1)
-
The
Trust does not have a working interest in the producing acres and producing gas wells. The gross and net amounts in the table above represent gross and net
amounts attributable to the working interest owners and are the basis for the Gross Proceeds amounts discussed under "Description of the Trust."
Hugoton Field
The principal property interest conveyed to the Trust accounts was carved out of Linn's working interest in 104,437 net producing acres in the
Hugoton field. The life of the field is expected to extend beyond the year 2041.
The
gas produced from the Hugoton properties is available for sale on the spot market. See "Contracts." Since the Hugoton field gas is sold in the intrastate and interstate markets, it
is subject to state and federal laws and regulations. The Kansas Corporation Commission (the "KCC") is the state regulatory agency responsible for overseeing oil and gas operations in the state of
Kansas. Hugoton field gas is also affected by the rules and regulations of the Federal Energy Regulatory Commission (the "FERC"). See "Regulation and Prices."
San Juan Basin
The Trust's interest in the San Juan Basin was conveyed from PNR's working interest in 31,328 net producing acres in Northwestern New Mexico and
Southwestern Colorado. PNR completed the sale of its underlying interest in the San Juan Basin Royalty Properties to ConocoPhillips on April 30, 1991. Substantially all of the natural gas
produced from the San Juan Basin is currently being sold on the spot market. ConocoPhillips subsequently sold its underlying interest in substantially all of the Colorado portion of the San Juan Basin
Royalty Properties to MarkWest Energy Partners, Ltd. (effective January 1, 1993) and Red Willow Production Company (effective April 1, 1992). On October 26, 1994, MarkWest
Energy Partners, Ltd. sold substantially all of its interest in the Colorado San Juan Basin Royalty Properties to BP. Effective January 1, 2005, ConocoPhillips assigned its interest in
an immaterial number of San Juan Basin Royalty Properties located in New Mexico to XTO Energy Inc. See "Description of the Trust" under Item 1 of this Form 10-K.
Drilling
There were no exploratory wells drilled on the Royalty Properties during 2016, 2015 or 2014.
Reserves
A study of the proved Hugoton Area and San Juan Basin oil and gas reserves attributable to the Trust has been made by DeGolyer and MacNaughton,
independent petroleum engineering consultants, as of December 31, 2016. A copy of this Reserve Report has been filed as an exhibit to this annual
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report
on Form 10-K. DeGolyer and MacNaughton is a Delaware corporation with offices in Dallas, Houston, Astana, Moscow and Algiers. The firm's more than 150 professionals include engineers,
geologists, geophysicists, petrophysicists, and economists engaged in the appraisal of oil and gas properties, evaluation of hydrocarbon and other mineral prospects, basin evaluations, comprehensive
field studies, and equity studies related to the domestic and international energy industry. These services have been provided for over 70 years. DeGolyer and MacNaughton restricts its
activities exclusively to consultation; it does not accept contingency fees, nor does it own operating interests in any oil, gas, or mineral properties, or securities or notes of clients. The firm
subscribes to a code of professional conduct, and its employees actively support their related technical and professional societies. In serving the petroleum industry and financial community, the
firm's experienced staff provides knowledge, independent judgment, integrity, and confidential service to its clients. The firm is a Texas Registered Engineering Firm, No. F-716.
The
Senior Vice President at DeGolyer and MacNaughton primarily responsible for overseeing the preparation of the reserve estimates is a Registered Petroleum Engineer in the State of
Texas with more than 40 years of experience in oil and gas reservoir studies and reserve evaluations. He graduated with a Bachelor of Science degree in Petroleum Engineering from Texas A&M
University in 1974 and he is a member of the International Society of Petroleum Engineers and the American Association of Petroleum Geologists.
The
Hugoton Area and San Juan Basin Reserve Report reflects estimated production, reserve quantities and future net revenue based upon estimates of the future timing of actual production
without regard to when received in cash by the Trust, which differs from the manner in which the Trust recognizes and accounts for its Royalty income.
Estimates
of the gross and net proved reserves, as of December 31, 2016, of the Trust's ownership in the overriding royalty interest are presented below. Total liquid reserves
(condensate and natural gas liquids) are expressed in thousands of barrels (Mbbl) and gas reserves are expressed in thousands of cubic feet (Mcf).
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Net Reserves
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BP
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Conoco
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Linn
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Red Willow
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XTO
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Total
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Proved Developed
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|
|
|
|
|
|
|
|
Oil and Condensate, Mbbl
|
|
|
0
|
|
|
5
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
5
|
|
Natural Gas Liquids, Mbbl
|
|
|
0
|
|
|
198
|
|
|
34
|
|
|
0
|
|
|
1
|
|
|
233
|
|
Gas, MMcf
|
|
|
882
|
|
|
2,543
|
|
|
630
|
|
|
14
|
|
|
15
|
|
|
4,084
|
|
Proved Undeveloped
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Oil and Condensate, Mbbl
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
Natural Gas Liquids, Mbbl
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
Gas, MMcf
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
0
|
|
Total, Proved
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Oil and Condensate, Mbbl
|
|
|
0
|
|
|
5
|
|
|
0
|
|
|
0
|
|
|
0
|
|
|
5
|
|
Natural Gas Liquids, Mbbl
|
|
|
0
|
|
|
198
|
|
|
34
|
|
|
0
|
|
|
1
|
|
|
233
|
|
Gas, MMcf
|
|
|
882
|
|
|
2,543
|
|
|
630
|
|
|
14
|
|
|
15
|
|
|
4,084
|
|
The
estimated future net revenue and standardized measure of future net royalty income discounted at 10 percent attributable to the Trust's overriding royalty interest as of
December 31, 2016, under the economic assumptions furnished by the working interest owners is summarized as follows, expressed in thousands of dollars:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
BP
|
|
Conoco
|
|
Linn
|
|
Red Willow
|
|
XTO
|
|
Total
|
|
Future Net Revenue(1)
|
|
|
1,048
|
|
|
8,471
|
|
|
2,188
|
|
|
16
|
|
|
48
|
|
|
11,771
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
9
Table of Contents
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
BP
|
|
Conoco
|
|
Linn
|
|
Red Willow
|
|
XTO
|
|
Total
|
|
Standardized Measure of Future Net Royalty Income discounted at 10%(1)
|
|
|
723
|
|
|
4,762
|
|
|
1,532
|
|
|
11
|
|
|
29
|
|
|
7,057
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
-
(1)
-
Future
income tax expenses were not taken into account in the preparation of these estimates.
Please
read "Summary Reserve Report from DeGolyer and MacNaughton" attached hereto as Exhibit 99.1 for more information.
The
Reserve Report was delivered to the Trustee on March 10, 2017. Net reserves of the Trust's Royalty are calculated at the aggregate level from the net revenue of each of the
Working Interest Owners. To estimate net gas reserves, the total net revenue is divided by the net value of 1 Mcf of gas. The net value of 1 Mcf of gas is the gas price per Mcf, plus the condensate
value per Mcf of gas, plus the NGL value per Mcf of gas. The net condensate and NGL reserves are calculated by multiplying their respective yields by the net gas reserves. Revenue values used in the
Reserve Report were estimated using the following prices: (1) condensate prices$41.19 per Bbl; (2) NGL prices$14.16 per Bbl for San Juan properties, $11.45 per
Bbl for Hugoton properties; and (3) natural gas prices$2.23 per Mcf for San Juan properties, $2.85 per Mcf for Hugoton properties, with the initial prices also used as weighted
average prices held constant thereafter over the lives of the properties. Estimates of operating expenses were based on current expenses and used for the life of the properties with no increases in
the future based on inflation.
Preparation of Reserve Estimates
For further information regarding the Net Overriding Royalty Interest, the Basis of Accounting and Supplemental Reserve Information, see
Notes 2, 3 and 9, respectively, in the Notes to Financial Statements contained in Item 8 of this Form 10-K.
There
are numerous uncertainties inherent in estimating quantities of proved reserves and in projecting the future rates of production and timing of development expenditures, including
many factors beyond the control of the producer. Reserve data included above and in these reports represent estimates only and should not be construed as being exact. The discounted present values
shown by the reserve
reports should not be construed as the current market value of the estimated gas and oil reserves attributable to the Royalty Properties or the costs that would be incurred to obtain equivalent
reserves, since a market value determination would include many additional factors.
The
Trustee has been advised that each of the foregoing estimates were prepared in accordance with guidelines established by the SEC and the Financial Accounting Standards Board
("FASB"). Accordingly, the estimates are based on existing economic and operating conditions in effect at December 31, 2016, with no provision for future increases or decreases except for
periodic price redeterminations in accordance with existing gas contracts. Actual future prices and costs may be materially greater or less than the assumed amounts in the reserve reports. Because the
reserve reports are limited to proved reserves, future capital expenditures for recovery of reserves not classified as proved are not included in the calculation of estimated future net revenues.
Reserve assessment is a subjective process of estimating the recovery from underground accumulations of gas and oil that cannot be measured in an exact way, and estimates of other persons might differ
materially from those of DeGolyer and MacNaughton. Accordingly, reserve estimates are often different from the quantities of hydrocarbons that are ultimately recovered.
The
Trustee relies on DeGolyer and MacNaughton to prepare the reserve estimates attributable to the Trust's interests in the Royalty Properties. Although the Trustee inquires with the
third-party reserve engineer about the information provided by the working interest owners and the assumptions made and methodologies used by the third-party reserve engineer, the Trustee does not
control the
10
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information
provided by the working interest owners or the assumptions made or methodologies used by the third-party reserve engineer. Accordingly, such information is outside the scope of the
internal controls of the Trust and the Trustee.
As
noted in this report, the Trustee is currently investigating certain payments and differences from original estimates. The Trustee is also reviewing, with the assistance of outside
experts, prior allocations of payments of Royalty income by the working interest owners. Any past practices not consistent with the Conveyance could also cause the basis for the reserve estimates
included above to differ from actual reserve quantities and future net revenues.
Income, Production and Production Prices and Production Costs
Reference is made to "Management's Discussion and Analysis of Financial Condition and Results of OperationsSummary of Royalty
Income, Production, Prices and Costs" under Item 7 of this Form 10-K for information concerning income, production, production prices and costs with respect to the Royalty.
CONTRACTS
Hugoton Field
Natural gas and natural gas liquids produced by Linn from the Hugoton field and attributable to the Royalty accounted for approximately 34% of
the Royalty income of the Trust during 2016.
Linn
has advised the Trust that since June 1, 1995 natural gas produced from the Hugoton field has generally been sold under short-term and multi-month contracts at market
clearing prices to multiple purchasers. During 2016, the primary purchasers were Kansas Gas Service, Continuum Energy Service, LLC and Enterprise Products Operating, LLC. Linn has
advised the Trust that it expects to continue to market gas production from the Hugoton field under short-term and multi-month contracts. Overall market prices received for natural gas from Hugoton
Royalty Properties were lower for the year ended December 31, 2016 as compared to the year ended December, 2015.
In
June 1994, PNR entered into a Gas Transportation Agreement ("Gas Transportation Agreement") with Western Resources, Inc. ("WRI") for a primary term of five years, commencing
June 1, 1995. Thereafter, this contract has renewed on a year to year basis. WRI subsequently assigned its rights and obligations under the Gas Transportation Agreement to Oneok Field Services
("Oneok"), and PNR subsequently assigned its rights and obligations under the Gas Transportation Agreement to Linn. In their termination notice issued May 12, 2015, Oneok noted they were
agreeable to negotiating a new agreement in order to continue to provide gathering and compression service. On January 1, 2016, an affiliate of Linn acquired the gathering line from Oneok.
Oneok will continue to provide compression
under a new Gas Compression Agreement effective January 1, 2016 through December 31, 2018, and then month-to-month thereafter, at a rate of $0.13 per Mcf, to be escalated beginning
April 1, 2017, and annually each April 1 thereafter using the Consumer Price Index. An affiliate of Linn began providing gathering services under a new Gas Gathering Agreement effective
January 1, 2016, under a three year agreement that continues month-to-month thereafter, at a rate of $0.06 per Mcf, to be escalated beginning April 1, 2017, and annually each
April 1 thereafter using the Consumer Price Index.
San Juan Basin
Natural gas, oil, condensate and natural gas liquids produced from the San Juan Basin field and attributable to the Royalty accounted for
approximately 48% of the Royalty income of the Trust during 2016. The majority of gas produced from the San Juan Basin is now being sold on the spot market.
11
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Market for Natural Gas
The amount of cash distributions by the Trust is dependent on, among other things, the sales prices for natural gas produced from the Royalty
Properties and the quantities of gas sold. The Henry Hub Natural Gas Spot Prices were $4.37 per mcf in 2014, decreased to $2.62 per mcf in 2015 and decreased to $2.50 per mcf in 2016 according to the
U.S. Energy Information Administration of the Department of Energy. Due to the seasonal nature of demand for natural gas and its effects on sales prices and production volumes, the amounts of cash
distributions by the Trust may vary substantially on a seasonal basis. Generally, production volumes and prices are higher during the first and fourth quarters of each calendar year due primarily to
peak demand in these periods. Because of the time lag between the date on which the working interest owners receive payment for production from the Royalty Properties and the date on which
distributions are made to unitholders, the seasonality that generally affects production volumes and prices is generally reflected in distributions to unitholders in later periods.
Competition
The production and sale of gas in the Hugoton field and San Juan Basin areas are highly competitive, and the working interest owners'
competitors in these areas include the major oil and gas companies, independent oil and gas companies, and individual producers and operators. There are numerous producers in the Hugoton field and the
San Juan Basin areas. The working interest owners have advised the Trust that they believe that their competitive position in their respective areas is affected by price, contract terms and quality of
service. Linn has also advised the Trust that it believes that its competitive position in the Hugoton field is enhanced by virtue of its substantial holdings and ownership and control of its wells,
gathering systems and processing plant. Market conditions in the San Juan Basin are negatively affected by the fact that most of the gas produced from such areas is transported on one of only two
major pipelines, and the transportation of such gas is generally controlled by a small number of distribution companies.
REGULATION AND PRICES
General
The production and sale of natural gas from the Royalty Properties are affected from time to time in varying degrees by political developments
and federal, state and local laws and regulations. In particular, oil and gas production operations and economics are, or in the past have been, affected by price controls, taxes, conservation,
safety, environmental and other laws relating to the petroleum industry, by changes in such laws and by constantly changing administrative regulations.
FERC Regulation
In general, the FERC regulates the sale of natural gas in interstate commerce for resale and the transportation of natural gas in interstate
commerce by pipelines, but does not regulate natural gas gathering facilities. The FERC adopted regulations resulting in a restructuring of the natural gas industry. The principal elements of this
restructuring were the requirement that interstate
pipelines separate, or "unbundle," into individual components the various services offered on their systems, with all transportation services to be provided on a non-discriminatory basis, and the
prohibition against an interstate pipeline providing gas sales services except through separately-organized affiliates. In various rulemaking proceedings following its initial unbundling requirement,
the FERC has refined its regulatory program applicable to interstate pipelines in various respects, and it has announced that it will continue to monitor these and other regulations to determine
whether further changes are needed. In addition to rulemaking proceedings, the FERC establishes new policies and regulations through policy statements and adjudications of individual pipeline matters.
Further, additional changes to
12
Table of Contents
regulations
may occur based on actions taken by the United States Congress and/or the courts. As to these various developments, the working interest owners have advised the Trust that the on-going and
evolving nature of these regulatory initiatives makes it impossible to predict their ultimate impact on the prices, markets or terms of sale of natural gas related to the Trust.
In
the past, the federal government has regulated the prices at which natural gas could be sold. While sales by producers of natural gas can currently be made at market prices, Congress
could reenact price controls in the future. Deregulation of wellhead natural gas sales began with the enactment of the Natural Gas Policy Act of 1978 and culminated in adoption of the Natural Gas
Wellhead Decontrol Act that removed all price controls affecting wellhead sales of natural gas effective January 1, 1993.
Sales
of crude oil, condensate, and natural gas liquids are not currently regulated and are made at negotiated prices. Nevertheless, Congress could reenact price controls in the future.
Sales of crude oil are affected by the availability, terms and cost of transportation. The transportation of oil in common carrier pipelines is subject to rate and access regulation. The FERC
regulates interstate oil pipeline transportation rates under the Interstate Commerce Act. In general, interstate oil pipeline rates must be just and reasonable and may be derived in a number of ways
including, but not limited to, the FERC's indexing methodology.
As
to these various types of regulation, the on-going and evolving nature of these regulatory initiatives makes it impossible to predict their ultimate impact on the prices, markets or
terms of sale of natural gas related to the Trust.
State and Other Regulation
All of the jurisdictions in which the Trust has an interest in producing oil and gas properties have statutory provisions regulating the
production and sale of crude oil and natural gas. The regulations often require permits for the drilling of wells but extend also to the spacing of wells, the prevention of waste of oil and gas
resources, the rate of production, prevention and clean-up of pollution and other matters. See "ContractsHugoton Field" for a discussion of Linn's allowables in the Hugoton Royalty
Properties.
State
regulation of gathering facilities generally includes various safety, environmental, and in some circumstances, non-discriminatory take and common purchaser requirements, as well
as complaint-based rate regulation. For example, Oklahoma, Kansas and Texas prohibit discriminatory gathering rates.
Natural
gas pipeline facilities used for the transportation of natural gas in interstate commerce are subject to Federal minimum safety requirements. These requirements, however, are not
applicable to,
inter alia
, onshore gathering of gas (i) through a pipeline that operates at less than 0 psig; (ii) through a pipeline that
is not a regulated onshore gathering line (as determined in Section 192.8); and (iii) within the inlets of the Gulf of Mexico, except for the requirements in Section 192.612.
See
49 C.F.R.
§ 192.1(b). We are informed that the Royalty Properties are located in the Hugoton field in Kansas, the San Juan Basin
in New Mexico and Colorado, and the Yellow Creek field of Wyoming. Furthermore, those states have adopted the Federal minimum safety requirements for intrastate pipelines within their borders. The
standards governing pipeline safety have undergone recent changes and it is possible that future changes in the regulations and statutes may occur which may increase the stringency of the standards or
expand the applicability of the standards to facilities not currently covered.
Environmental Matters
The working interest owners' operations are subject to numerous federal, state and local laws and regulations controlling the discharge of
materials into the environment or otherwise relating to the
13
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protection
of the environment. These laws and regulations, including their state counterparts, can impose liability upon the owner, operator or lessee under a lease for the cost of cleanup of
discharged materials or damages to natural resources resulting from oil and gas operations. These laws and regulations may, among other things:
-
-
restrict the types, quantities and concentration of various substances that can be released into the environment in connection with oil and
natural gas drilling and production activities;
-
-
limit or prohibit drilling activities on certain lands lying within wilderness, wetlands and other protected areas; and
-
-
require remedial measures to mitigate pollution from former and ongoing operations, such as requirements to close pits and plug abandoned
wells.
Violations
of environmental laws, regulations, or permits can result in civil and criminal penalties as well as potential injunctions curtailing operations in affected areas. The working
interest owners have advised the Trust that they are not at this time involved in any administrative or judicial proceedings relating to the Royalty Properties arising under federal, state or local
environmental protection laws and regulations or which would have a material adverse effect on the working interest owners' financial position or results of operations. The working interest owners
have also advised the Trust that they maintain insurance for costs of cleanup obligations, but that they are not fully insured against all such risks.
The
following is a summary of the existing laws, rules and regulations to which the operations of the properties comprising the underlying properties may be subject that are material to
the operation of the Royalty Properties.
Hazardous Substances.
The Comprehensive Environmental Response, Compensation and Liability Act, referred to as "CERCLA" or the
Superfund law, and
comparable state laws impose liability, potentially without regard to fault or legality of the activity at the time, on certain classes of persons that are considered to be responsible for the release
of a hazardous substance into the environment. These persons include the current or former owner or operator of the disposal site or sites where the release occurred and companies that disposed or
arranged for the disposal of hazardous substances that have been released at the site. Under CERCLA, these persons may be subject to joint and several liability for the costs of investigating and
cleaning up hazardous substances that have been released into the environment, for damages to natural resources and for the costs of health studies. In addition, neighboring landowners and other third
parties may file claims for personal injury and property damage allegedly caused by hazardous substances or other pollutants released into the environment.
The
properties comprising the Royalty Properties may have been used for oil and natural gas exploration and production for many years. Although the working interest owners believe that
they have utilized operating and waste disposal practices that were standard in the industry at the time, hazardous substances, wastes or hydrocarbons may have been released on or under the
properties, or on or under other locations, including off-site locations, where such substances have been taken for disposal. In addition, the properties comprising the Royalty Properties may have
been operated by third parties or by previous owners or operators whose treatment and disposal of hazardous substances, wastes or hydrocarbons was not under the working interest owners' control. These
properties and the substances disposed or released on them may be subject to CERCLA, federal hazardous waste laws, and analogous state laws. Under such laws, the working interest owners could be
required to remove previously disposed substances and wastes, remediate contaminated property, or perform remedial plugging or pit closure operations to prevent future contamination.
14
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In addition, in the course of the working interest owner's operations, equipment may be exposed to naturally occurring radiation associated with oil and natural
gas deposits, and this exposure may result in the generation of wastes containing naturally occurring radioactive materials, or "NORM." NORM wastes exhibiting trace levels of naturally occurring
radiation in excess of established state standards are subject to special handling and disposal requirements, and any storage vessels, piping and work area affected by NORM may be subject to
remediation or restoration requirements. Because some properties presently or previously comprising the Royalty Properties may have been used for oil and natural gas production operations for many
years, it is possible that the working interest owners may incur costs or liabilities associated with elevated levels of NORM.
Waste Handling.
The federal Solid Waste Disposal Act, as amended by the Resource Conservation and Recovery Act of 1976, referred to as
"RCRA," and
comparable state statutes, regulate the management and disposal of solid and hazardous waste. Some wastes associated with the exploration and production of oil and natural gas are exempted from the
most stringent regulation in certain circumstances, such as drilling fluids, produced waters and other wastes associated with the exploration, development or production of oil and natural gas.
However, these wastes and other wastes may be otherwise regulated by the Environmental Protection Agency (the "EPA") or state agencies. Moreover, in the ordinary
course of oil and gas operations, industrial wastes such as paint wastes and waste solvents may be regulated as hazardous waste under RCRA or considered hazardous substances under CERCLA. It is
possible that certain oil and natural gas exploration and production wastes now classified as non-hazardous could be classified as hazardous wastes in the future.
Water Discharges.
The Federal Water Pollution Control Act, or the Clean Water Act, and analogous state laws, impose restrictions and
strict controls
with respect to the discharge of pollutants, including spills and leaks of oil and other substances, into regulated waters. The Oil Pollution Act of 1990 (the "OPA"), as amended, which amends the
Clean Water Act, imposes strict liability on owners and operators of facilities that are the site of a release of oil into regulated waters. The OPA and its associated regulations impose a variety of
requirements on responsible parties related to the prevention of oil spills and liability for damages resulting from such spills. Spill prevention, control and countermeasure requirements under
federal or state law may require appropriate operating protocols, including containment berms and similar structures, to help prevent or respond to a petroleum hydrocarbon spill, rupture or leak. In
addition, the Clean Water Act and analogous state laws may require individual permits or coverage under general permits for discharges of storm water runoff from certain types of facilities or during
construction activities.
Hydraulic Fracturing.
It is customary to recover oil and natural gas from deep shale, tight sand and coal bed formations through the
use of hydraulic
fracturing, combined with sophisticated horizontal drilling. Conventional hydraulic fracturing techniques are used to increase production in vertical wells. Hydraulic fracturing involves the injection
of water, sand and chemical additives under pressure into rock formations to stimulate gas production. The federal Energy Policy Act of 2005 amended the Underground Injection Control provisions of the
federal Safe Drinking Water Act to exclude certain hydraulic fracturing activities from the definition of "underground injection." At present, hydraulic fracturing is regulated at the state and local
level. Due to public concerns raised regarding potential impacts of hydraulic fracturing on groundwater quality, legislative and regulatory efforts at the federal, state and local level and in some
states have been initiated to require or make more stringent the permitting and compliance requirements for hydraulic fracturing operations. Repeal of the exemption would allow the EPA to promulgate
new regulations. Many states have adopted rules that required operators to disclose chemicals and water volumes associated with hydraulic fracturing. In addition, the EPA has finalized a study of the
potential environmental impacts of hydraulic fracturing activities and issued a report in December 2016. At that time, the EPA concluded that under certain circumstances, the "water cycle" activities
associated with hydraulic fracturing may impact drinking water resources.
15
Table of Contents
Air Emissions.
The federal Clean Air Act, and comparable state laws, restrict the emission of air pollutants from many sources,
including drilling
operations and related equipment, and as a result affect oil and natural gas operations. The EPA has also developed, and continues to give attention to, stringent regulations governing emissions of
toxic air pollutants at specified sources, including oil and gas operations. Air emissions permits may be required for some oil and gas production operations.
Climate Change.
In the recent Congressional session, numerous legislative measures were introduced that would have imposed restrictions
or costs on
greenhouse gas emissions, including from the oil and gas industry. The EPA has determined that greenhouse gases from certain sources "endanger" public health or welfare. As a result, the EPA has begun
to promulgate certain regulations and interpretations that will require new and modified stationary source of greenhouse gases above certain thresholds to report, limit or control such emissions,
including recently adopted rules to control methane emissions. Although subject to legal challenge, the EPA rules promulgated thus far are currently final and effective and will remain so unless
overturned by a court, or unless Congress adopts legislation altering the EPA's regulatory authority. The EPA has also promulgated regulations restricting greenhouse gas emissions, including rules
applicable to the power generation sector and oil refining sector, which may affect demand for oil and gas. In addition, some states have taken or proposed legal measures to reduce emissions of
greenhouse gases. For example, a number of states, including states in which the Royalty Properties are located, have indicated an intent to reduce greenhouse gases through state action or regional
partnerships.
Safety.
The working interest owners are also subject to the requirements of the federal Occupational Safety and Health Act, known as
"OSHA," and
comparable state statutes that regulate the protection of the health and safety of workers. In addition, the OSHA hazard communication standard requires that information be maintained about hazardous
materials used or produced by oil and gas operations and that this information be provided to employees, state and local government authorities and the public.
Item 1A. Risk Factors.
Although risk factors are described elsewhere in this Form 10-K together with specific Cautionary Statements, the following is a summary
of the principal risks associated with an investment in units in the Trust.
Oil and natural gas prices fluctuate due to a number of factors, and lower prices will reduce net proceeds
available to the Trust and distributions to Trust unitholders.
Net proceeds and the Trust's quarterly distributions are highly dependent upon the prices realized from the sale of natural gas and a material
decrease in such prices could reduce the amount of Trust distributions. Natural gas prices can fluctuate widely on a month-to-month basis in response to a variety of factors that are beyond the
control of the Trust and the working interest owners. Factors that contribute to price fluctuation include, among others:
-
-
political conditions worldwide, in particular political disruption, war or other armed conflicts in oil producing regions;
-
-
worldwide economic conditions;
-
-
weather conditions;
-
-
the supply and price of foreign natural gas;
-
-
the level of consumer demand;
-
-
the price and availability of alternative fuels;
16
Table of Contents
-
-
the proximity to, and capacity of, transportation facilities; and
-
-
the effect of worldwide energy conservation measures.
Moreover,
government regulations, such as regulation of natural gas transportation, regulation of greenhouse gas and other emissions associated with fossil fuel combustion, and price
controls, can affect product prices in the long term.
Crude
oil prices have been volatile the last several years and, since the second half of 2014 have declined substantially from historic highs and may remain depressed for the forseeable
future. In 2016, crude oil prices per Bbl ranged from a high of approximately $54.01 to a low of approximately $26.19. The NYMEX crude oil spot prices per Bbl were $53.27, $37.04 and $53.75 as of
December 31, 2014, 2015 and 2016, respectively. The Trust cannot predict the timing or the duration of any economic cycle and, depending on the prices realized, the financial condition of the
Trust could be materially adversely affected. When natural gas prices decline, the Trust is affected in two ways. First, net royalties are reduced. Second, exploration and development activity on the
underlying properties may decline as some projects may become uneconomic and are either delayed or eliminated. The volatility of energy prices reduces the predictability of future cash distributions
to unitholders. Substantially all of the natural gas and natural gas liquids produced from the Royalty Properties are being sold under short-term or multi-month contracts at market clearing prices or
on the spot market.
Any additional decreases in prices of natural gas may materially and adversely affect our cash generated from
operations, results of operations and reduce net proceeds available to the Trust and distributions to Trust unitholders.
During the eight years prior to December 31, 2016, gas prices at Henry Hub have ranged from a high of $8.15 per MMBtu in 2014 to a low of
$1.49 per MMBtu in 2016. On
December 31, 2016, the Henry Hub spot market price of gas was $3.71 per MMBtu. The reduction in prices has been caused by many factors, including increases in natural gas production and
reserves from unconventional (shale) reservoirs, without an offsetting increase in demand. The expected increase in natural gas production, could cause the prices for natural gas to remain at current
levels or fall to lower levels. If prices for natural gas continue to remain depressed for lengthy periods, we may be required to write down the value of our oil and gas properties. In addition,
sustained low prices for gas will negatively impact the value of our estimated reserves and reduce net proceeds and the amount of cash we would otherwise have available to pay cash distributions to
unitholders.
Increased production and development costs for the Royalty will result in decreased Trust distributions.
Production and development costs attributable to the Royalty are deducted in the calculation of the Trust's share of net proceeds. Production
and development costs are impacted by increases in commodity prices both directly, through commodity-price dependent costs such as electricity, and indirectly, as a result of demand-driven increases
in costs of oil field goods and services. Accordingly, higher or lower production and development costs, without concurrent increases in revenues, directly decrease or increase the amount received by
the Trust for the Royalty.
If
development and production costs of the Royalty exceed the proceeds of production from the Royalty Properties, the Trust will not receive net proceeds for those properties until
future proceeds from production exceed the total of the excess costs plus accrued interest during the deficit period. Development activities may not generate sufficient additional revenue to repay the
costs. Accordingly, there may not be sufficient net proceeds to make a particular distribution.
17
Table of Contents
The Trust has established a cash reserve for contingent liabilities and to pay expenses in accordance with
the Trust Indenture, which would reduce Net Proceeds available to the Trust and distributions to Trust unitholders.
The Trust's source of capital is the Royalty income received from its share of the net proceeds from the Royalty Properties. Pursuant to the
Trust Indenture, the Trust may establish a cash reserve through the withholding of cash for contingent liabilities and to pay expenses. In 2011, the Trustee established a cash reserve for contingent
liabilities and expenses in accordance with the Trust Indenture and withheld approximately $83,333 per monthly distribution amount, or up to $250,000 per quarter, until the cash reserve was
$1.0 million, which reduced net proceeds available to the Trust and
distributions to Trust unitholders. For more information, see "Management's Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources" under
Item 7 of this Form 10-K.
Trust reserve estimates depend on many assumptions that may prove to be inaccurate, which could cause both
estimated reserves and estimated future revenues to be too high or too low.
The value of the units of beneficial interest of the Trust depends upon, among other things, the amount of reserves attributable to the Royalty
and the estimated future value of the reserves. Estimating reserves is inherently uncertain. Ultimately, actual production, revenues and expenditures for the underlying properties will vary from
estimates and those variations could be material. Petroleum engineers consider many factors and make assumptions in estimating reserves. Those factors and assumptions
include:
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historical production from the area compared with production rates from similar producing areas;
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the assumed effect of governmental regulation;
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assumptions about future commodity prices, production and development costs, severance and excise taxes, and capital expenditures;
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the availability of enhanced recovery techniques; and
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relationships with landowners, working interest partners, pipeline companies and others.
Changes
in these factors and assumptions can materially change reserve estimates and future net revenue estimates.
The
reserve quantities attributable to the Royalty and revenues are based on estimates of reserves and revenues for the underlying properties. The method of allocating a portion of those
reserves to the Trust is further complicated because the Trust holds an interest in the Royalty and does not own a specific percentage of the natural gas reserves. Ultimately, actual production,
revenues and expenditures for the underlying properties, and therefore actual net proceeds payable to the Trust, will vary from estimates and those variations could be material. Results of drilling,
testing and production after the date of those estimates may require substantial downward revisions or write-off of reserves.
Physical effects of climatic change have the potential to damage the facilities of the working interest
owners, disrupt production activities on the Royalty Properties, and cause the working interest owners to incur significant costs in preparing for or responding to those effects and can adversely
affect Trust distributions as a result.
Scientific studies and government reports, such as those published by the Intergovernmental Panel on Climate Change established by the United
Nations and World Meteorological Organization indicate that climate change could have global, regional or local effects on the severity of weather (including hurricanes, floods and droughts), sea
levels, arability of farmland, and water availability and quality,
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including
predicted effects on areas in which the Royalty Properties are located. If such effects were to occur, exploration and production operations of the Royalty Properties have the potential to
be adversely affected. Potential adverse effects could include damages to the facilities of the working interest owners or disruption of production activities associated with weather related events,
scale-backs in operations on the Royalty Properties due to the threat of such climatic effects, and increases in costs of operation potentially arising from such climatic effects, less efficient or
non-routine operating practices necessitated by climatic effects or increased costs for insurance coverage. Working interest owners may not be able to recover through insurance some or any of the
damages, losses or costs that may result from potential physical effects of climate change and can adversely affect Trust distributions as a result.
The
Trustee relies entirely on reserve estimates and related information prepared by DeGoyler and McNaughton based on information provided by the working interest owners. While the
Trustee has no reason to believe the reserve estimates included in this report are not accurate, to the extent additional information exists that could affect their reserve estimates, the estimated
reserves in these reports could also be too low.
Operating risks for the working interest owners' interests in the Royalty Properties can adversely affect
Trust distributions.
There are operational risks and hazards associated with the production and transportation of natural gas, including without limitation natural
disasters, blowouts, explosions, fires, leakage of natural gas, releases of other hazardous materials, mechanical failures, cratering and pollution. Any of these or similar occurrences could result in
the interruption or cessation of operations, personal injury or loss of life, property damage, damage to productive formations or equipment, or damage to the environment or natural resources, and
associated cleanup obligations. The occurrence of drilling, production or transportation accidents and other natural disasters at any of the Royalty Properties will reduce Trust distributions by the
amount of uninsured costs. These occurrences include blowouts, cratering, explosives and other environmental damage that may result in personal injuries, property damage, and damage to productive
formations or equipment and environmental damages. Any uninsured costs would be deducted as a production cost in calculating net proceeds payable to the Trust.
Most
of the gas produced in the San Juan Basin is transported on one of only two major pipelines in the area, and transportation of this gas is generally controlled by a small number of
distribution companies. Accordingly, any disruptions to transportation lines or increases in transportation costs for production from these properties could also affect the Trust.
Further,
the present value of future net cash flows from proved reserves may not be the current market value of estimated natural gas and oil reserves attributable to the Royalty. In
accordance with SEC requirements, we base the estimated discounted future net cash flows from proved reserves on the 12-month average oil and gas index prices, calculated as the un-weighted arithmetic
average for the first-day-of-the-month price for each month and costs in effect on the date of the estimate, holding the prices and costs constant throughout the life of the properties. Actual future
prices and costs may differ materially from those used in the net present value estimate, and future net present value estimates using then current prices and costs may be significantly less than the
current estimate. In addition, the 10% discount factor we use when calculating discounted future net cash flows for reporting requirements in compliance with the FASB in Accounting Standards
Codification 932 may not be the most appropriate discount factor based on interest rates in effect from time to time and risks associated with us or the natural gas and oil industry in general.
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Terrorism and continued hostilities in the Middle East could decrease Trust distributions or the market price
of the units of beneficial interest of the Trust.
Terrorist attacks and the threat of terrorist attacks, whether domestic or foreign, as well as military or other actions taken in response,
cause instability in the global financial and energy markets. Terrorism and sustained military campaigns could adversely affect Trust distributions or the market price of the units in unpredictable
ways, including through the disruption of fuel supplies and markets, increased volatility in natural gas prices, or the possibility that the infrastructure on which the operators developing the
underlying properties rely could be a direct target or an indirect casualty of an act of terror.
The operators of the working interests are subject to extensive governmental regulation.
Oil and gas operations have been, and in the future will be, affected by federal, state and local laws and regulations and other political
developments, such as price or gathering rate controls and environmental protection regulations. These regulations and changes in regulations could have a material adverse effect on Royalty income
payable to the Trust.
The working interest owners' operations are subject to environmental, health and safety laws and regulations
that may expose the working interest owners to penalties, damages or costs of remediation or compliance which could adversely affect Trust distributions.
The working interest owners' operations are subject to federal, regional, state and local laws and regulations relating to protection of natural
resources and the environment, health and safety aspects of oil and gas operations and waste management, including the transportation and disposal of waste and other materials. These laws and
regulations may impose numerous obligations on such operations, including the acquisition of permits to conduct regulated activities, the incurrence of capital expenditures to mitigate or prevent
releases of materials from facilities, the imposition of substantial liabilities for pollution resulting from operations and the application of specific health and safety criteria addressing worker
protection. Failure to comply with these laws and regulations could
result in restrictions or orders suspending well operations, the assessment of administrative, civil and criminal penalties, the revocation of permits and the issuance of corrective action orders.
There
is inherent risk of environmental costs and liabilities in the oil and gas business as a result of the handling of petroleum hydrocarbons and oilfield and industrial wastes, air
emissions and wastewater discharges related to current operations as well as historical industry operations and waste disposal practices. Some environmental laws and regulations may impose strict
liability, which means that in some situations, the working interest owners could be exposed to liability as a result of conduct that was without fault or lawful at the time it occurred or as a result
of the conduct of, or conditions caused by, prior operators or other third parties. Clean-up costs and other damages arising as a result of environmental laws and costs associated with changes in
environmental laws and regulations could be substantial and could have a material adverse effect on Trust distributions.
Laws
protecting the environment generally have become more stringent over time and are expected to continue to do so, which could lead to material increases in costs for future
environmental compliance and remediation. The modification or interpretation of existing laws or regulations, or the adoption of new laws or regulations, could curtail exploratory or developmental
drilling for oil and natural gas. The working interest owners may not be able to recover some or any of such costs of compliance with these laws and regulations from insurance.
Please
read "BusinessRegulation and PricesEnvironmental Matters" for more information on the environmental laws and government regulations that may be
applicable to the working interest owners' operations.
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Climate change legislation or regulations restricting or regulating emissions of greenhouse gases could
result in increased operating costs and could adversely affect Trust distributions.
The EPA has adopted various regulations under the federal Clean Air Act addressing emissions of greenhouse gases that may affect the oil and gas
industry, including mandatory reporting and emission reduction. Such changes will affect state air permitting programs in states that administer the federal Clean Air Act under a delegation of
authority, including states in which the Royalty Properties are located. Some states have also indicated an intent to regulate or impose restrictions or costs on greenhouse gas emissions or fossil
fuels. The adoption and implementation of any international treaty or of any federal or state legislation or regulations imposing restrictions on emissions of greenhouse gases could require the
working interest owners to incur costs to comply with
such requirements and possibly require the reduction or limitation of emissions of greenhouse gases associated with the working interest owners' operations or could impose costs on other sources of
emissions within the industrial or energy sectors. Such legislation or regulations could adversely affect demand for the production of oil and natural gas and increase operating costs by requiring
additional expenditures to operate and maintain equipment and facilities, inventory emissions, install emissions controls, acquire allowances or pay taxes and fees relating to emissions, which could
adversely affect Trust distributions. Finally, it should be noted that some scientists have concluded that increasing concentrations of greenhouse gases may produce changes in climate or weather, such
as increased frequency and severity of storms, floods, drought and other climatic events, which if any such effects were to occur, could have adverse physical effects on the working interest owners'
operations or physical assets.
Please
read "BusinessRegulation and PricesEnvironmental Matters" for more information on the environmental laws and government regulations that may be
applicable to the working interest owners' operations.
Federal and state legislation and regulatory initiatives relating to hydraulic fracturing could result in
increased costs and additional operating restrictions or delays on the Royalty properties in which the Trust holds an interest.
Hydraulic fracturing is an important and commonly used process in the completion of unconventional natural gas wells in shale and coal
formations, as well as tight conventional formations including many of those Royalty properties in which the Trust holds an interest. This process involves the injection of water, sand and chemicals
under pressure into rock formations to stimulate natural gas production. Some states have adopted and others are considering legislation to restrict hydraulic fracturing. Several states including
those where Royalty properties are located have adopted legislation requiring the public disclosure of hydraulic fracturing chemicals, which could make it easier for third parties opposing the
hydraulic fracturing process to initiate legal proceedings based on allegations that specific chemicals used in the fracturing process could adversely affect groundwater. Further, the EPA has
finalized a study of the impacts of hydraulic fracturing in December 2016. At that time, the EPA concluded that under certain circumstances, the "water cycle" activities associated with hydraulic
fracturing may impact drinking water resources. In addition, any additional level of regulation could lead to operational delays or increased operating costs and could result in additional regulatory
burdens that could make it more difficult to perform hydraulic fracturing and increase our costs of compliance and doing business and required disclosure without protection for trade secret or
proprietary products could discourage service companies from using such products and as a result impact the degree to which some oil and gas wells may be efficiently and economically completed or
brought into production.
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Trust unitholders and the Trustee have no control over the operation or development of the Royalty Properties
and have little influence over operation or development.
Neither the Trustee nor the unitholders can influence or control the operation or future development of the underlying properties. The Royalty
Properties are owned by independent working interest owners. The working interest owners manage the underlying properties and handle receipt and payment of funds relating to the Royalty Properties and
payments to the Trust for the Royalty. The failure of an operator to conduct its operations, discharge its obligations, deal with regulatory agencies or comply with laws, rules and regulations,
including environmental laws and regulations, in a proper manner could have an adverse effect on the net proceeds payable to the Trust.
The
current working interest owners are under no obligation to continue operating the properties. Neither the Trustee nor the unitholders have the right to replace an operator.
The Trustee relies upon the working interests owners for information regarding the Royalty Properties.
The Trustee relies on the working interest owners for information regarding the Royalty Properties. The working interest owners control
(i) historical operating data, including production volumes, marketing of products, operating and capital expenditures, environmental and other liabilities, effects of regulatory changes and
the number of producing wells and acreage, (ii) plans for future operating and capital expenditures, (iii) geological data relating to reserves, as well as related projections regarding
production, operating expenses and capital expenses used in connection with the preparation of the reserve report, (iv) forward-looking information relating to production and drilling plans and
(v) information regarding the Royalty Properties responsive to litigation claims. While the Trustee requests material information for use in periodic reports as part of its disclosure controls
and procedures, the Trustee does not control this information and relies entirely on the working interest owners to provide accurate and timely information when requested for use in the Trust's
periodic reports. Information regarding operations has been subject to errors and adjustments in the past. Accordingly, the Trustee cannot assure unitholders that other errors or adjustments by
working interest owners, whether historical or future, will not affect Royalty income and distributions by the Trust.
Under
the terms of the Trust Indenture, the Trustee is entitled to rely, and in fact relies, on certain experts in good faith. This reliance includes the use of an independent petroleum
engineering consultant to prepare estimates of net proved reserves attributable to the Trust. This independent petroleum engineering consultant in turn relies on information provided to it by the
working interest owners. While the Trustee has no reason to believe its reliance on experts is unreasonable, this reliance on experts and limited access to information may be viewed as a weakness as
compared to the management and oversight of entity forms other than trusts.
The owner of any Royalty Property may abandon any property, terminating the related Royalty.
The working interest owners may at any time transfer all or part of the Royalty Property to another unrelated third party. Unitholders are not
entitled to vote on any transfer, and the Trust will not receive any proceeds of any such transfer. Following any transfer, the Royalty Properties will continue to be subject to the Royalty, but the
net proceeds from the transferred property would be calculated separately and paid by the transferee. The transferee would be responsible for all of the obligations relating to calculating, reporting
and paying to the Trust the Royalty on the transferred portion of the Royalty Properties, and the current owner of the Royalty Properties would have no continuing obligation to the Trust for those
properties.
The
current working interest owners or any transferee may abandon any well or property if it reasonably believes that the well or property can no longer produce in commercially economic
quantities. This could result in termination of the Royalty relating to the abandoned well.
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The Royalty can be sold and the Trust can be terminated.
The Trust will be terminated and the Trustee must sell the Royalty if holders of a majority of the units of beneficial interest of the Trust
approve the sale or vote to terminate the Trust, or if the Trust's royalty income for each of two successive years is less than $250,000 per year. Following any such termination and liquidation, the
net proceeds of any sale will be distributed to the unitholders and unitholders will receive no further distributions from the Trust. We cannot assure you that any such sale will be on terms
acceptable to all unitholders.
Trust assets are depleting assets and, if the working interest owners or other operators of the Royalty
Properties do not perform additional development projects, the assets may deplete faster than expected.
The net proceeds payable to the Trust are derived from the sale of depleting assets. Accordingly, the portion of the distributions to
unitholders attributable to depletion may be considered a return of capital. The reduction in proved reserve quantities is a common measure of depletion. Future maintenance and development projects on
the Royalty Properties will affect the quantity of proved reserves. The timing and size of these projects will depend on the market prices of natural gas. If operators of the Royalty Properties do not
implement additional maintenance and development projects, the future rate of production decline of proved reserves may be higher than the rate currently expected by the Trust. For federal income tax
purposes, depletion is reflected as a deduction. Please see the section entitled "BusinessDescription of the UnitsFederal Income Tax Matters" under Item 1 of this
Form 10-K.
Because
the net proceeds payable to the Trust are derived from the sale of depleting assets, the portion of distributions to unitholders attributable to depletion may be considered a
return of capital as opposed to a return on investment. Distributions that are a return of capital will ultimately diminish the depletion tax benefits available to the Trust unitholders, which could
reduce the market value of the Trust units over time. Eventually, properties underlying the Trust's Royalty will cease to produce in commercial quantities and the Trust will, therefore, cease to
receive any distributions of net proceeds therefrom.
Unitholders have limited voting rights.
Voting rights as a unitholder are more limited than those of stockholders of most public corporations. For example, there is no requirement for
annual meetings of unitholders or for an annual or other periodic re-election of the Trustee. Additionally, Trust unitholders have no voting rights in Linn or ConocoPhillips. Unlike corporations which
are generally governed by boards of directors elected by their equity holders, the Trust is administered by a corporate Trustee in accordance with the Trust Indenture and other organizational
documents. The Trustee has extremely limited discretion in its administration of the Trust.
Unitholders have limited ability to enforce the Trust's rights against the current or future owners of the
Royalty Properties.
The Trust Agreement and related trust law permit the Trustees and the Trust to sue the working interest owners to compel them to fulfill the
terms of the Conveyance of the Royalty.
If the Trustee does not take appropriate action to enforce provisions of the Conveyance, the recourse of a unitholder would likely be limited to bringing a lawsuit against the Trustee to compel the
Trustee to take specified actions. Unitholders probably would not be able to sue the working interest owners directly.
The limited liability of the Trust unitholders is uncertain.
The Trust unitholders are not protected from the liabilities of the Trust to the same extent that a shareholder would be protected from a
corporation's liabilities. The structure of the Trust does not
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include
the interposition of a limited liability entity such as a corporation or a limited partnership which would provide further limited liability protection to Trust unitholders. While the Trustee
is liable for any excess liabilities incurred if the Trustee fails to insure that such liabilities are to be satisfied only out of Trust assets, under the laws of Texas, which are unsettled on this
point, a holder of units may be jointly and severally liable for any liability of the Trust if the satisfaction of such liability was not contractually limited to the assets of the Trust and the
assets of the Trust and the Trustee are not adequate to satisfy such liability. As a result, Trust unitholders may be exposed to personal liability.
The future financial condition of operators of the underlying properties could impede the operation of wells.
The value of the Royalty and the Trust's ultimate cash available for distribution is highly dependent on the financial condition of the
operators of the wells. The ability to operate the underlying properties depends on all operators' current and future financial condition and economic performance and access to capital, which in turn
will depend upon the supply and demand for oil and natural gas, prevailing economic conditions and financial, business and other factors, many of which are beyond the control of such operators.
In
the event of the bankruptcy of any operator of the underlying properties, the Working Interest Owners in the affected properties, creditors or the debtor-in-possession may have to
seek a new party to perform the operations of the affected wells. The creditors or debtor-in-possession may not be able
to find a replacement operator, and they may not be able to enter into a new agreement with such replacement party on favorable terms or within a reasonable period of time.