Volumetric production payments allow producers to monetise future production and also provide some advantages to investors. Notably, because a volumetric production payment, or VPP, shields the investor from bankruptcy risk of the issuer, VPPs are a particularly useful means for issuers with relatively high credit risk to monetise production.

In addition, the US federal income tax treatment of VPPs as a loan allows the issuer to avoid recognising taxable income in connection with the issuance of a VPP and also makes VPPs attractive investments to a broad spectrum of potential buyers, including foreign or tax exempt investors.

Further, with proper analysis, the VPP can be structured to maximise the protection for the purchaser that the production will occur as scheduled and the producer will meet operating commitments.

What is a volumetric production payment?

A VPP is a property interest that entitles the holder to a share of the minerals or hydrocarbons produced from the property for a fixed term. Generally, the VPP is granted in exchange for a single upfront cash payment and conveys the right to receive specified amounts of production from the property, on either a daily or monthly basis, without reduction for any related production costs or production taxes.

The holder may receive a return on its investment in the VPP only from the specified amounts of periodic production, if and when produced, and the holder generally has no recourse against the issuer or any other assets of the issuer for production deficiencies. Because the volume of production to be conveyed under the terms of the VPP is fixed, the VPP effectively provides a hedge against volatility in the price of the commodity as well as interest rates.

Bankruptcy law treatment

Under the US Bankruptcy Code section 514(b)(4), a VPP is treated as a conveyance of property that removes the interest in production from the issuer’s estate. Accordingly, if the grantor files bankruptcy, the holder of a VPP is not a creditor of the bankrupt grantor (because it owns the production attributable to the VPP) and is entitled to receive the production notwithstanding the automatic stay.

However, if the issuer files for bankruptcy, enforcement of covenants or rights to collateral with respect to the VPP may be stayed. In recent bankruptcy filings of ATP Oil & Gas Corporation, challenges to the validity of dollar-dominated production payments (which are protected under the same Bankruptcy Code section as VPPs) and net profits interest have been filed. Each of these is likely to fail.

Federal income tax treatment

Under the Internal Revenue Code, VPPs generally are treated as non-recourse debt secured by the burdened property, and not as a depletable economic interest in the underlying property. VPPs will be treated as debt for federal income tax purposes if they convey the right to a specified share of the production from minerals in place (if, as, and when produced), or the proceeds from such production.

The VPP may burden more than one mineral property, but the holder may look only to the production from such burdened properties for payments under the agreement. At closing, the VPP must have an expected economic life of shorter duration than the economic life of one or more of the mineral properties burdened thereby.

Neither the Internal Revenue Code nor the Treasury Regulations provide guidance regarding how much shorter the VPP’s duration must be relative to the economic life of the burdened property. However, the Internal Revenue Service has issued guidance that, to obtain an advance ruling that a contract is a production payment that should be treated as a loan, the taxpayer must show that it is reasonably expected, at the time the right is created, that it will terminate upon the production of not more than 90% of the reserves then known to exist at the burdened property and the present value of the production expected to remain after the right terminates is 5% or more of the present value of the entire burdened property.

The general rule that VPPs are treated as loans for federal income tax purposes is, however, subject to a significant exception. Even if the criteria above for classification as debt are present, a VPP is not treated as debt if the proceeds of the production payment are carved out for exploration and development of the burdened property. Expenditures for the exploration and development of burdened property include expenditures to ascertain the existence, location, extent or quality of a deposit of mineral or incident to and necessary for the preparation of the deposit for production.

Such expenditures do not include costs relating primarily to production of the mineral. The proceeds of a VPP will be treated as carved out for exploration and development only to the extent the proceeds are required to be used or pledged for use in future exploration or development of the burdened property and may not be used for the exploration or development of any other property or for any other purpose.

When a VPP is properly treated as a loan for federal income tax purposes, the producer does not recognise any taxable income when the VPP is sold. For federal income tax purposes, the producer continues to be treated as the owner of the burdened properties and, as the production occurs and is delivered to the holder of the VPP, the producer is treated as having sold the production for its fair market value and applied the proceeds to repay principal and interest due to the holder. The purchaser of the VPP is treated as making a non-recourse loan to the producer, secured by the burdened property. Thus, it is not the holder of an economic interest in the burdened property and is not entitled to depletion deductions. Instead, the purchaser treats the payments received under the VPP as return of capital and interest.

VPPs generally are treated as contingent payment debt for federal income tax purposes. Accordingly, the issuer generally is required to provide a schedule of projected payments with interest paid at a rate equal to the yield on a comparable non-contingent debt instrument. Then, as payments are made each period, the amounts accrued are adjusted for any differences between actual payments and the projected payment schedule. A net positive adjustment is treated as additional interest for the year. A net negative adjustment first reduces the interest accrued on the VPP for the current year, then is treated as an ordinary loss to the extent of interest previously accrued on the VPP, and any excess adjustment is carried forward to future years. If any net negative adjustment remains at the time of a sale or retirement of the VPP, it is treated as a reduction in the proceeds received.

Treatment of a VPP as a loan for federal income tax purposes generally is favourable for both foreign and tax-exempt holders. Generally, foreign investors prefer not to be treated as engaged in a US trade or business, which subjects them to federal income tax and also requires them to file US tax returns. The ownership of debt of a US issuer alone, however, generally will not cause foreign investors to be treated as engaged in a U.S. trade or business. Instead, the interest income is subject to 30% withholding, unless an exemption or lower rate of withholding applies under the Internal Revenue Code or applicable treaty.

In addition, foreign persons generally are not subject to US tax on gain on the sale of debt issued by US persons, but the exemption does not apply to gain on interests in US real property. As discussed above, the Internal Revenue Code treats VPPs as mortgage loans, which generally are not treated as US real property interests.

However, the Treasury Regulations under Internal Revenue Code Section 897 provide that a VPP will be treated as an interest in US real property when it conveys a right to share in the appreciation in value of the mineral property. Specifically, a production payment that conveys a right to a specified amount of oil or gas, including a percentage of production, is treated as conveying a right to share in the value of the property.

Accordingly, if a VPP were treated as an interest in US real property, a foreign seller would be subject to 10% withholding on gross sale proceeds and the gain on the sale of a VPP would be subject to federal income tax at regular graduated rates. The tax on a foreign holder’s disposition of a US real property interests does not apply if the VPP is held to maturity.

Tax-exempt investors such as pension funds, universities and charitable organisations generally are not subject to federal income tax on investment income, including interest. The Treasury Regulations specifically include interest from VPPs as not taxable to tax-exempt entities. Accordingly, VPPs are attractive investments for tax-exempt organisations.

Advantages of VPPs for producers and investors

As a result of the bankruptcy protection provided to the holder of a VPP, producers with relatively high credit risk may be able to grant a VPP even if they have a limited ability to otherwise obtain financing at an acceptable rate. Often, VPP arrangers are willing to provide a greater advance rate on VPPs than for a borrowing base loan on the same assets.

In addition, as a VPP includes an implicit commodity and interest rate hedge, the grantor is able to obtain hedging without margin or other collateral. The VPP obligation is limited recourse to the producer and the producer may not be limited by financial covenants found in standard loan agreements. Finally, VPPs allow the producer to retain operational control of the assets.

Investors also benefit from the bankruptcy protection afforded to VPPs through lower exposure to the issuer’s credit.

VPPs compared to RBLs

A significant advantage of a VPP, compared to a reserves-based loan (RBL) or forward contract, is the holder’s right to receive production payments is not stayed in the event of the issuer’s bankruptcy. In the event of bankruptcy, an RBL holder’s right to payment is stayed and the holder of a forward contract generally only has the right to close out the contract.

Upon an event of default by the issuer, however, a holder of a VPP is not entitled to accelerate payment, but the holder of an RBL may accelerate payment and a holder of a forward contract typically can terminate and close out the forward contract upon an event of default. If the value of the grantor’s reserves decline, the holder of a VPP is not entitled to any repayment, but the holder of a RBL can force the grantor to repay the RBL.

However, the holder of a VPP may be entitled to increased scheduled quantities if the anticipated tail reserves at the end of the term decline.

A variable VPP alternative

Because VPPs typically are priced on the forward price of the underlying commodity, they can be less attractive to issuers when the price of that commodity is depressed. To increase the attractiveness of VPPs in such circumstances, the returns can be based on volumes to be delivered that decrease as the commodity price rises over a certain level. Accordingly, the issuer retains a greater portion of the production if the commodity price sufficiently rises over the term of the VPP. In addition, the VPP can be sold to the investor together with a fixed for floating hedge entitling the holder to payment if the commodity price drops below a specified level. The combination of these features effectively create a band on the benefit of, and exposure to, commodity price volatility for the investor.

Economic considerations in negotiating VPPs

Because a holder of a VPP only is entitled to repayment from the minerals or hydrocarbons when, and if, produced, the holder of a VPP should ensure that the issuer is properly incentivised to continue producing over the term of the VPP. Generally, this is achieved by determining that the producer will receive sufficient economic benefit each period from the production in excess of the potion dedicated to the VPP. In addition, the holder should secure indemnification in the event of an issuer breaching its obligation to continue to produce, secured by the production anticipated to remain at the end of the term of the VPP, the tail reserve. If the value of the tail reserve is sufficiently large, the issuer will be incentivised to produce and abide by its commitments under the VPP agreements to retain this value.

VPPs covering minerals

Volumetric production payments can be granted on coal and other mineral properties. Although the Internal Revenue Code provisions applicable to VPPs covering oil and gas properties apply equally to other mineral properties, the Bankruptcy Code provisions only apply to oil and gas production. However, bankruptcy and state law typically afford substantially similar protection for holders of VPPs on mineral properties as are afforded by the specific provisions for VPPs on oil and gas properties.

Conclusion

Volumetric production payments can be a highly effective way of raising financing for producers that seek to obtain higher advance rates and cost-effective hedging than otherwise available to them in the RBL market. They convey bankruptcy, tax and other advantages to the holder of the VPP, and can be adapted to operate effectively in different price environments.