Some Guides to Proper Loan Selection in Petroleum Production Financing
Authors: Pearson A.J. 
Published: December 2007

PEARSON, A.J., CONTINENTAL ILLINOIS NATIONAL BANK AND TRUST CO. CHICAGO, ILL. MEMBER AIME

Introduction

Banks have been loaning money secured by oil and gas properties since 1928. From a rather slow start bank financing has grown until today many hanks have a significant percentage of their loans secured by oil and gas production.Since 1928 there have been many developments and many changes in oil and gas loans. For example, the advent of proration in the early 1930's made the assignment of runs worthwhile as collateral for bank loans, the development of production payments in the early 1950's opened a new era in financing, etc. More recently, a 1961 press release by the Internal Revenue Service threatened the use of reserved production payments and caused wide concern among prospective sellers, purchasers and banks. Even though the "threat" was rescinded after several months, certain aspects of reserved production payments are still unsettled.

A broad revision of tax policies is to be brought before Congress in 1963. and it is possible that the character of bank financing will be again changed. Even though the present situation is unsettled, a review of the current status of bank financing for the petroleum industry is believed worthwhile - and that is the purpose of this paper.

Types of Loans

Oil and gas loans may be classed as follows:unsecured,production andproduction-payment loans.

Production-payment loans may be further subdivided intoreserved,carved-out anddevelopment production-payment loans.

An unsecured loan may be defined as a loan made on the general credit standing of the borrower. In other words, the borrower pledges no specific asset to secure payment of the note. Although an unsecured loan by definition is not secured by oil and gas properties, many unsecured loans are made to oil companies.

Production loans differ from unsecured loans in that they are secured by the general credit standing of the borrower plus a mortgage (and usually a deed of trust) on oil and gas properties. In addition, they are often further secured by an assignment of the revenue from specific oil and gas properties. In many cases production loans are secured by a mortgage on only one property or group of properties that a company owns. Such loans may be made in conjunction with a purchase, a drilling program, etc.In other cases the production loan will be secured by a mortgage on all the properties that a company owns (or at least all the valuable properties). There are minor differences in the analysis of loan value in these cases.A production payment is an economic interest (created by grant, exception or reservation) which gives its owner the right to a stated percentage of the production (free and clear of all expenses of operating the property), until he has received a specified sum of money (or specified quantities of oil and gas). From tax considerations, a production payment must meet two additional requirements:It must he payable only out of runs accruing to the production-payment interest in the property; i.e., the holder ofthe payment must look exclusively to the proceeds of the sale of production accruing to the payment for its satisfaction and liquidation.The predicted life of the payment must be less than the predicted life of the property.

The production payment gives its owner the right to a stated percentage of the production until he has received a specified sum of money. Usually the payment also provides for recovery ofan amount equivalent to interest at a specified rate,an amount equal to all severance, production, gathering, ad valorem or similar taxes assessed against or paid with respect to the production payment and, sometimes,a limited amount equal to costs of the production-payment owner in closing the transaction.

The percentage of production may vary from property to property or with time as long as it is clearly specified in the original production-payment document.

JPT

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