Revenue Accounting Issues For Royalty Owners

1. Revenue Accounting IssuesFor Royalty Owners Donald A. Phend, CPA Phend & Company, LLC 8500 W. Bowles Ave., Suite 301 Littleton, CO 80123 (303) 298-7908 Phone (303) 292-4663 Fax phendcpa@aol.com

2. Objectives • Gain a basic understanding of how oil and gas is valued for royalty payment calculations. • Basic tips royalty owners can use to determine if deductions are being taken from their royalty payment. • Current issues affecting Colorado Royalty Owners

3. Accounting Terms – Oil • BBL Barrel – 42 US Gallons • BS&W Basic Sediment and Water, an analysis of contaminants in oil • Gravity Viscosity of oil – higher gravity is thinner and usually more valuable

4. Accounting Terms - Gas • MCF Measurement of Volume (1,000 cubic feet at standard temperature and pressure) • MMBTU Measure of heating content of gas • Chromatograph Theoretical content of various liquids (Gallons per MCF)

5. Accounting Terms – Gas • Pooled Accounting • All wells in pool receive same valuation for gas and liquids • Pool can be various definitions, • Field • Geographic Area • All wells going to a specific plant, etc.

6. Accounting Terms - Gas • Netback Method • Deductions reduce stated value of gas, rather than being shown as a separate deduction • Example • Sales Price $3.15 MMBTU • Deductions (0.15) MMBTU • Netback Price $3.00 MMBTU Typically the Netback Price will be shown on royalty check detail

7. Oil Valuation • First step: measure the oil sold • Run Ticket Method • High and low tank measurements manually recorded when oil is run (sold) into tank truck • LACT Meter (Lease Automatic Custody Transfer) • Automatically records volume transferred (sold) to pipeline connection

8. Run Ticket

9. Plumb Bob

10. LACT Meter

11. Oil Valuation • Second step: Determine quality of oil • Sample taken (using “oil thief” device) for analysis • Gravity • BS&W- Basic Sediment and Water

12. Oil Thief

13. Pricing Calculation • Posted Price • Purchasers publish a daily or monthly field price • Spot Price • Based on market Purchase contract may specify + or – from the above referenced prices

14. Issue for Royalty Owner • Is the price an arms-length price? • Is posted price (if related party) truly a representative price for that area and time?

15. Gas Valuation • First step: Measure the gas sold • Paper chart meter • Electronic meter

16. Paper Chart Meter

17. Electronic Meter

18. Gas Valuation • Second Step: Determine quality of gas: • Sample taken for analysis: • BTU Content – Heating content of gas sample • Content Analysis (Chromatograph) – Content of various potential liquids contained in gas sample

19. Gas Analysis Report Heating Content • MMBTU / MCF 1.267

20. Theoretical Liquid Content (Chromatograph) Gallons per MCF • Ethane 3.382 • Propane 1.383 • Isobutane 0.256 • Normal Butane 0.486 • Isopentane 0.194 • Normal Pentane 0.170 • Hexane 0.342

21. Physical Flow of Gas and Liquids Wells End User Market Pipeline Gas Plant Unprocessed Gas Processed Gas Gathering System Field Compressor Liquids

22. Who Processes Gas? • Independent processing companies provide processing for a fee • Some large operators may have their own gas plants

23. Why Process Gas? • The raw gas at the wellhead may not meet pipeline specifications Too high heating content (MMBTU/MCF ) Impurities (water, CO2, H2S)

24. Why Process Gas? Additional Revenue • Liquids sell at a premium price. • At times, some liquids command 2X the price per MMBTU as residue (processed) gas.

25. Gas Processing Agreement

26. Gas Processing Agreement • Agreement between Producer (Well Operator) and Processor (Gas Plant) • Defines terms and fees for processing gas • Various types include • Percentage of Proceeds (POP) • Keep Whole • Fixed Fee

27. Example of POP Contract • Producer receives 80% of sales proceeds for processed gas • Producer receives 60% of sales proceeds for NGLs • Producer pays “gathering fee” of 10 cents MCF • Processor may use “without cost” 3% of producer’s gas for compressor and plant fuel • Producer pays 5 cents/gallon “frac fee”

28. POP FeesLiquids 40% Processed Gas 20% Wells End User Market Pipeline Gas Plant Unprocessed Gas Processed Gas Gathering System Field Compressor Liquids

29. Gathering Fees Wells End User Market Pipeline Gas Plant Unprocessed Gas Processed Gas Gathering System Field Compressor Liquids

30. Fuel (3% of Volume) Wells End User Market Pipeline Gas Plant Unprocessed Gas Processed Gas Gathering System Field Compressor Liquids

31. Frac Fee (5 Cents / Gallon) Wells End User Market Pipeline Gas Plant Unprocessed Gas Processed Gas Gathering System Field Compressor Liquids

32. Effect of Netback Method • You can’t see all of the deductions being taken by looking at your revenue check detail. • Some of the deductions may be buried in the “artificial” lower price.

33. Why is Netback Important? • Producers often use the Netback price they receive from the processors as a starting point to pay royalty. • Note, these deductions may or may not be appropriate to charge to royalty owners. • This is a legal issue, not an accounting issue.

34. Calculate Theoretical Gallons Gallons • Ethane 3.382 x 1000 = 3382 • Propane 1.383 x 1000 = 1383 • Isobutane 0.256 x 1000 = 256 • Normal Butane 0.486 x 1000 = 486 • Isopentane 0.194 x 1000 = 194 • Normal Pentane 0.170 x 1000 = 170 • Hexane 0.342 x 1000 = 342

35. Why are Theoretical Gallons Important • It is used to allocate the total “Actual Gallons” produced at the plant to each well, to determine payment to producer Theoretical Gal Actual plant gal X Your Well Theoretical Gal All Wells in Plant

36. Allocation to Well • In other words, if the your well has 5% of the total theoretical plant production of Ethane, it will get credit for 5% of the actual sales of ethane. • Note that this sales value will be net of the 40% POP fee.

37. Valuation of Ethane • Actual Gallons of Ethane Allocated to your well 3,111.44 • Price of Ethane (Gal) $0.43175 • Gross Value of Ethane to Well $1,343.36 • Less POP (40%) (537.34) • Net Paid Producer 806.02

38. Calculate Gross Value

39. Calculate Net Value

40. Valuation on Check • Net Value After Deduction $5,586.76 • MCF at Wellhead 1,000 • Calculated Price Per MCF $5.59

41. Other Issues • Volumetric Loss • Often known as “Fuel Lost and Unaccounted” or “FL&U) • Processor only pays on net volume sold at tailgate of plant • Can be easily calculated

42. Volumetric Loss • MMBTU at Wellhead • Less MMBTU in All Products • Equals FL&U • Note that liquids are stated in gallons, but there are conversion factors to determine MMBTU content

43. Volumetric Loss • In this example FL&U was calculated as approximately 22.85 MMBTU • Expressed in terms of residue gas this is • 22.85 MMBTU X $5.59/MMBTU = $127.72

44. Summary • Gross Value Sold at Plant $8,284.06 • Plus Value of FL&U 127.72 • Value At Wellhead 8,411.78 • Less • POP (2,401.34) • Gathering (100.00) • Frac (195.96) • FL&U (127.72) Net $5,586.76 Percentage of Net to Gross 66%

45. Summary • 10% Royalty Owner Effect • Gross value of 10% $841.18 • Net Actually Received 568.67 • Royalty Owner’s share of deducts $273.51

46. “Keep Whole” Contract • Gas Processor pays Producer for the total MMBTU produced at the wellhead • Price is based on the sales price of residue gas only • Gas Processor keeps the enhanced value of the MMBTU that was converted to liquids

47. “Keep Whole” Contract • These contracts may also have an allowance for fuel, (for example, 3%) in which case the Gas Processor only pays on a net percentage of the wellhead volume • Other fees may also be charged by Gas Processor

48. “Keep Whole” Contract • Typically the Producer will begin with the “Keep Whole” amount they receive from the Gas Processor, when beginning to calculate royalty payments • Producer may also add other charges when calculating royalty payment

49. “Keep Whole” Contract • Effect on royalty owner payments • Royalty owner does not receive benefit for higher value of liquid products • Royalty owner may be receiving payment on a volume net of fuel allowances • Royalty owner may be charged other deductions by the operator • Note that the above items may, or may not, be evidenced on the royalty check detail

50. Fixed Fee Contract • Gas Processor charges a per unit of volume fee to the producer for providing processing services • Producers may calculate royalty payments net of this fee