What to do when your oil and gas operator goes broke

In case you haven’t noticed, the price of oil has fluctuated tremendously in the last couple of years. In 2015, 67 oil and gas companies declared bankruptcy, which represented a 379% increase from 2014. As the price of WTI continues to hover between $40 to $60, bankruptcies will continue in the oil patch. So what happens when royalty owners, working interest owners, and overriding royalty owners receive notice that their operator has gone bankrupt and how can these individuals protect themselves?

What You Should Do Immediately

First, you should go through your seven stages of grief within 48 hours. You can get mad at your operator until the cows come home. But that won’t change the fact that the operator can’t pay their bills. And no amount of “righteous indignation” will change that simple fact.

Second, read the bankruptcy notice that came in the mail. This will include dates for meetings of the creditors, as well as deadlines to file your proof of claim (discussed below). You can call the bankruptcy court if you’d like, but they will not offer you any advice other than “you should talk to a lawyer.” You can also call the Debtor’s attorney, but he represents the Debtor and not you.

Third, you need to gather your paperwork to file your proof of claim. If you are a royalty owner, you should have signed an oil and gas lease. If you are a working interest owner, you should find your assignment of the oil and gas lease. Additionally, before paying royalties, the operator will require you sign a Division Order. Finally, you should obtain a copy of your past royalty checks. You will need all of these before filing your proof of claim.

Fourth, you need to estimate the amount of money owed to you. This can be done by reviewing your prior checks as wells as production history from the Railroad Commission records.

Finally, you need to file a proof of claim with the Bankruptcy Court. For this stage, it is usually best to have an attorney. WARNING: If you fail to file a proof of claim or, alternatively, don’t prove your property right in your proof of claim, you run the risk that you will not be paid a dime.

I heard Texas has a statute to protect royalty owners and working interest owners. Is that true?

Yes, but there are a couple of problems with the statute. Section 9.343 of the Texas Business and Commerce Code grants a security interest/statutory lien in the proceeds of the sales of production to secure the payment of their royalties. This security interest arises automatically and does not require a filing in order to take advantage of the security interest other than filing a proper proof of claim. There are, however, a couple of problems with the statute.

First, the statute refers to itself as both a statutory lien and a security interest. By definition, it cannot be both. This matters because, under Section 545 of the Bankruptcy Code, a statutory lien can be avoided by the Debtor under certain circumstances. There are some commentators that believe 9.343 is a statutory lien that can be avoided in a Chapter 11 Bankruptcy. However, the cases I reviewed suggest this is a security interest and not a statutory lien. See e.g. In re SemCrude, LP 407 B.R. 112, 134 (Bankr. D. Del. 2009), and In re Tri-Union Dev. Corp., 253 B.R. 808, 811 (S.D. Tex. 2000).

Second, how do you trace the proceeds of production? Under Article 9 of the UCC, a security interest in personal property can continue to the proceeds of the personal property as long as the proceeds are “identifiable” or “traceable.” The problem is that the proceeds of the sale of hydrocarbons is cash that will likely end up in a general bank account. As such, the cash may not be identifiable. That said, the way 9.343 is worded, the security interest continues forever, and there is case law to support that the security interest in the cash proceeds will continue indefinitely even if the cash is conveyed to a third party. In re Tri-Union Dev. Corp., 253 B.R. 808, 811 (S.D. Tex. 2000).

So what should a royalty owner/working interest owner do?

Though it seems intuitive, the best way for a royalty owner to protect themselves is to monitor your accounts receivable. If you haven’t received a check in two months, you should figure out why. And if the reason is because the oil company does not have the assets to pay your royalties, you should seriously contemplate speaking with an attorney to file suit for past royalties. If you receive a judgment for unpaid royalties, you can place a lien against their well that may give you a preferential treatment in bankruptcy.

Second, your oil and gas lease should contain a termination clause for non-payment of royalties. Unsurprisingly, oil companies hate these clauses. When I write these clauses, I will give the company a long period of time after notice of termination (90 days) to make payment in full of the royalties. Because this clause should survive the bankruptcy, the Debtor can lose its collateral. This should bring both the Debtor, and the other Creditors, to the table with you.

Edward Wilhelm and Jack Wilhelm provide assistance to royalty owners, working interest owners, and operators with oil and gas properties. Call us today at 512-236-8400.