April 30, 2011

Other than the oil and gas lease itself, the division order is undoubtedly the most common legal instrument mineral owners are asked to sign. Mineral owners should know the purpose of a division order, what rights and obligations it imposes on them, and the division order's relation to the oil and gas lease.

First, I should say that the law and practice regarding division orders varies from state to state. I practice in Texas, so what follows relates only to the use of division orders in Texas.

Historically, there has been much controversy and litigation in Texas about division orders and their effect. As a result, in 1991 the Legislature passed a statute governing the use of division orders. The statute was amended in 1995, 1997 and 1999. It is now Chapter 91, subchapter J of the Texas Natural Resources Code, commonly called the Division Order Statute. So the law applicable to division orders in Texas is the court-made law plus the division order statute.

The main purpose of a division order is to protect the payor of the proceeds of production from double liability. The company issuing the division order is requiring the royalty owner to (1) verify that the royalty owner's decimal interest set out on the division order is correct and (2) agree that the company can make payments based on that decimal interest until notified by the royalty owner that the ownership has been changed. By the division order, the royalty owner indemnifies the payor against liability to third parties who claim to own the interest being paid to the royalty owner.

To understand division orders, it is helpful to understand how exploration companies handle royalty payments. When a company decides it wants to drill a well in a particular area, it first hires landmen who investigate the mineral title to the tracts in the area where the well will be drilled and identify the mineral owners of those tracts. The company or its landmen then contact those mineral owners and negotiate oil and gas leases covering their interests. Depending on the complexity of the mineral title, there may be dozens or even hundreds of mineral owners from whom oil and gas leases must be obtained. The company may want to acquire leases in a large area around its proposed drillsite, in order to lock up the minerals in that general area so that additional wells can be drilled if the exploratory well is successful.

After the company has acquired the oil and gas leases in the area it wants to exploit, it picks its initial drillsite and then engages an oil and gas attorney to examine the title to the drillsite tract. The attorney reviews all of the documents gathered by the landmen involving the mineral title to the drillsite tract and then gives an opinion, called a drilling title opinion, to the company. The purpose of the drilling title opinion is to assure the company that it owns oil and gas leases covering 100% of the mineral estate in the drillsite tract. If the drillsite consists of a pooled unit encompassing two or more smaller tracts, the drilling title opinion may cover all of the tracts in the proposed pooled unit. Where the well to be drilled is a horizontal well, the drilling title opinion should cover at least all of the tracts that will be penetrated by the well bore. If the attorney discovers an unleased interest or finds defects in the mineral title that raise questions about the mineral ownership, the company will engage landman to "cure" these title defects prior to the drilling of the well.

Once the drilling title opinion is complete and shows that the company has the drillsite 100% leased, the company drills its well. If it is successful and placed into production, then the company engages an attorney (who may or may not be the same attorney as the one who did the drilling title opinion) to prepare a division order title opinion. The purpose of this second opinion is to tell the company how to pay the royalty owners, based on the record title ownership of the minerals and the oil and gas leases covering the well or pooled unit. The division order title opinion will list each owner of an interest in production and that owner's decimal interest in production, all of which must add up to 100%. Again, if there are issues regarding the correct ownership of any person, the opinion will discuss those issues and what needs to be done to "cure" the problem. Those issues are listed as "requirements" in the opinion. Where there are requirements, those owners affected by the requirements will not be paid until the requirements are cured.  Remember that a title opinion is just that -- an opinion. It is prepared by attorneys skilled in examining titles, but it may be wrong. First, it is based only on the documents provided to the attorney for review. The attorney may not have seen documents that affect the title, or the attorney may have missed provisions in the documents that affect the title.

Based on the division order title opinion, the company then prepares a division order for each owner entitled to payment on production from the well and sends it to the owner. The company personnel who deal with division orders are called division order analysts. When you call a company asking about your royalty payments, you are usually speaking to a division order analyst.  Often, the royalty owner's receipt of a division order is the first indication to the royalty owner that a well has been completed and is producing. Depending on the complexity of the title, there may be a significant time between the completion of the well and the issuance of division orders - sometimes several months.

Problems arose concerning the use of division orders because companies began using them for something other than their original purpose. Many division orders contained provisions speciofying how the oil or gas would be valued for purposes of paying royalties and what deductions could be made from royalty owners' payments. These division-order provisions often conflicted with the terms of the oil and gas leases under which the royalties were being paid. So litigation inevitably resulted. Courts were confronted with how to characterize and enforce signed division orders that conflicted with the terms of the leases.

In Texas, courts have held that division orders are executed without consideration, but that they are an enforceable agreement until they are revoked. A division order can be revoked at any time by either party, after which it has no further effect. So, if a division order provides that royalties shall be paid based on the net proceeds from sale of the production, less all post-production costs incurred by the lessee prior to sale, then the lessee is entitled to pay on that basis as long as the division order is in effect, even if the lease required the lessee to value the production in another way. 

The miss-use of division orders led to the Texas Legislature's passage of the division order statute. Like most legislation, the statute is a compromise. It provides that division orders cannot be used to modify leases, and it gives the companies the right to require execution of a division order, as long as it does not seek to modify the lease. The statute provides that "Any provision of a division order ... which is in contradiction with any provision of an oil and gas lease is invalid to the extent of the contradiction." But it also provides that "A division order may be used to clarify royalty entitlement terms in the oil and gas lease."

The statute then has an odd provision: "With respect to oil and/or gas sold in the field where produced or at a gathering point in the immediate vicinity, the terms 'market value,' 'market price,' 'prevailing price in the field,' or other such language, when used as a basis of valuation in the oil and gas lease, shall be defined as the amount realized at the mouth of the well by the seller of such production in an arm's-length transaction." Texas Natural Resources Code Section 91.403 (h) and (i). When the statute was passed, there had been a lot of litigation about the meaning of the term "market value" when used in the royalty clause of a lease, and lobbyists for the producing companies got this provision added to the statute to try to reduce their exposure to liability for royalty payments under leases requiring them to pay based on "market value." It is hard for me to understand how the Legislature could dictate what the parties intended in a private contract, but that is apparently what they tried to do. I am not aware of any case dealing with this provision of the statute.

The division order statute says that, if a company uses a division order that meets the requirements of the statute, it can refuse to pay the royalty owner until the royalty owner has signed the division order. The statute also adopted an "approved form" of division order - but only for oil royalties. If the payor uses the statutory division order form, it can be sure that it has no liability for failing to pay royalties if the royalty owner refuses to sign it.

The statute also:

Makes clear that a payor of royalties has no obligation to pay if there is a title question about ownership of the royalty.

Provides that royalties must be paid within a certain number of days after production occurs, and sets a statutory rate for interest that must be paid on late royalty payments - 2% above the "Fed Funds" rate. Such a low rate does not give companies much of an incentive to pay royalties on a timely basis.

Producers and purchasers who pay royalties today generally use division order forms that attempt to comply with the division order statute. The National Association of Division Order Analysts has adopted a form of division order that some companies use. But some companies still try to use division orders to alter the terms of the lease.

So, what should a royalty owner do when he/she receives a division order? First, the owner should determine whether the royalty decimal shown on the division order is correct. Sometimes this is a simple matter, but often it is not, especially where pooled units are involved. When companies send out division orders, they make no attempt to explain how the decimal for payment was arrived at, so the royalty owner may have to call the company to find out how the decimal was calculated. Royalty owners should not be bashful about making such calls. Don't sign a division order until you know and agree with how the decimal was calculated and are satisfied that the lease is still in effect. It is sometimes hard to get to the right person with the company who can explain it. Usually, the division order or the accompanying letter has a number to call, or the company may have a royalty owner hotline that can be found on its website.

Second, read and understand the language in the division order. If you don't understand or don't agree with something, don't be bashful about asking questions or making changes. Most companies will take a division order with changes that don't alter its basic purposes.

Third, I recommend that royalty owners always add language to a division order as follows: