For operators and mineral rights owners, oil and gas leases are complicated at best. Adding to the Gordian knot of contractual obligations and regulations is a document called a division order. If not handled correctly, a division order could spell trouble in the form of double liability.
As with many other issues surrounding oil and gas exploration and production, division orders may be handled differently from state to state. Texas, for example, regulates division orders under the terms of the Texas Natural Resources Code.
The laws and statutes are informed by a variety of legal hassles over the years, prompting a state with a significant resource in hydrocarbons to try to reign in abusive uses of the division order. The move protected both operators and mineral rights owners.
So, what is a division order, what is double liability, and how are the two related?
Division Orders Come After Production Begins
A division order protects the payor of the proceeds of production from double liability. It acts as verification of the royalty amounts listed in the lease. It is not sent until a well becomes productive.
Once a well becomes productive, the operator has a limited amount of time to begin paying royalties. However, to ensure each royalty recipient receives the correct percentage of royalties from production, a division order is created that must be signed by each royalty owner.
- A division order spells out exactly how royalties are paid to each recipient.
- The order is a binding and executable document.
- There can be multiple landowners and investors who are named in the lease and receive a share of royalties.
- An owner may be entitled to only a fraction of the royalties depending on the share of mineral ownership.
- The oil and gas lease lays out who is paid royalties, and, in Texas, at least, a division order cannot modify that lease.
Division orders may be the most common legal agreement owners receive for signature. Before signing, however, the mineral rights owner should understand what the order says and ensure the percentage of royalties to be paid match the lease agreement.
Essentially, the division order requires royalty owners to do two things: verify that what is called the decimal interest is correct and agree that the oil or gas company can make payments based on the percentages called out in the division order.
There is another part to that second item. The royalty owner must notify the company if ownership has changed.
This Is Where Double Liability Protection Comes In
Texas Natural Resources Code Section 91.402(c)(1) says that oil and gas operators may withhold payment on a specific lease until the landowner (royalty recipient) returns a signed division order. Why would an operator need or want to do this?
Let’s look at an example:
Landowner Mason and Landowner Dixon own equal claims to the surface rights of a given parcel that is part of the lease for Stackhouse Well #1.
Until recently, Landowner Mason owned 75% of the parcel's mineral rights, and Landowner Dixon owned 25%. However, Landowner Mason recently sold 25% of his mineral rights to Landowner Dixon in a transaction that has not yet been recorded with the county. Remember that will be 25% of Mason's 75%, meaning Dixon purchased an additional 18.75% to add to his original share.
Before the transaction transferring that 18.75% to Dixon is recorded, both owners sign a division order verifying the original 75%-25% ownership split. Dixon expects to receive 43.75% of the decimal interest but only receives 25%, because as far as the operator is concerned, that is what he agreed to.
Now Dixon is pretty mad. Even though he signed the division order, Landowner Dixon can still have it thrown out on the grounds that it fails to value his mineral interest properly. At that point, he will have to negotiate a new order with the operator.
The nice thing (for the operator anyway) is that the company is not required to repay the royalties that it "technically" owed Landowner Dixon. Instead, Landowner Dixon will need to recover it from Landowner Mason. The operator can stay out of the dispute. The division order has done its job.
What if Mason and Dixon had not signed and executed the division order? The operator would have been liable for Landowner Dixon’s 25% plus the additional 18.75%. Since it would also have been liable for Landowner Mason’s full 75% share, the company would have effectively paid more than 100% in royalties. And that is double liability.
When Division Orders Are Weaponized
Each state regulates division orders differently. What happens in Texas may not be the same as what happens in Ohio or Oklahoma.
Oil and gas companies are high-risk, high-reward ventures. While most of these operators tend to be honest in their dealings, the temptation of the returns a productive well brings was too much for some of them. It was one thing to agree to a decimal interest when the lease was signed. Nobody knew if the well would spew oil or gas.
However, once the well is productive, it’s another story. Some operators decided to try to grab a bit more of the spoils than in the original lease. So they would send the required division orders to the mineral rights owners with lower percentages named. Great for the operator. Not so good for the mineral rights owners.
After numerous legal battles, the Texas legislature spoke. “A division order cannot modify a lease.” The same may or may not be true in other oil and gas producing states.
The company negotiates a lease with (potentially) multiple mineral rights owners to explore for oil or gas. When a well begins to produce, the company must verify royalty percentages with mineral owners. The mineral owners verify the percentages by signing a division order sent by the company.
If the company did not verify the royalty payment percentages, it could be liable for the percentages in the original lease as well as additional royalties created due to ownership changes in the mineral rights. In other words, the company is hit with double liability.
To avoid double liability, companies may withhold decimal interest or royalty payments until a mineral rights owner has signed a division order verifying the decimal interest and agreeing to notify the company of ownership changes. Then, any disputes are between mineral owners. The operator is protected from paying more than 100% and losing money.
For any questions about division orders or leases in general, it’s best to consult with a knowledgeable oil and gas attorney, whether you are a mineral rights owner or an operator.
When it comes time to perform a title search before negotiating a lease agreement, contact CourthouseDirect.com.