Item 2. Properties
ITEM 2.
PROPERTIES
The Royalty conveyed to the Trust was carved out of Southlands (now Hilcorps) working interests and royalty interests in certain
properties situated in the San Juan Basin. See Item 1. Business for information on the conveyance of the Royalty to the Trust. References below to gross wells and acres are to the interests of all persons owning interests
therein, while references to net are to the interests of Hilcorp (from which the Royalty was carved) in such wells and acres.
Unless otherwise indicated, the following information in this Item 2 is based upon data and information furnished to the Trustee by Hilcorp.
The Subject Interests
The Subject
Interests consist of working interests, royalty interests, overriding royalty interests and other contractual rights in 151,900 gross (119,000 net) producing acres in San Juan, Rio Arriba and Sandoval Counties of northwestern New Mexico. According
to the information provided by Hilcorp, there were, as of December 31, 2022, 4,401 gross (825.6 net) wells on the properties underlying the Subject Interests, calculated on a well bore basis and not including multiple completions as separate
wells, of which approximately 982 gross (281.6 net) wells were Multiple Completion Wells, resulting in a total of 5,456 gross (1,139.1 net) completions.
Hilcorp has informed the Trust that all of the subject acreage is held by production, and even though it has not been fully developed in every
formation, Hilcorp has classified all of such acreage as developed. Production from conventional natural gas wells is primarily from the Pictured Cliffs, Mesaverde and Dakota formations, ranging in depth from 1,500 to 8,000 feet. Additional
production is attributable to coal seam reserves in the Fruitland Coal formation.
Coal seam natural gas constituted approximately 23.1%
of our proved natural gas reserves as of December 31, 2022. The process of removing coal seam natural gas is often referred to as degasification or desorption. Millions of years ago, natural gas was generated in the process of coal formation
and absorbed into the coal. Water later filled the natural fracture system. When the water is removed from the natural fracture system, reservoir pressure is lowered, and the natural gas desorbs from the coal. The desorbed natural gas then flows
through the fracture system and is produced at the well bore. The volume of formation water production typically declines with time and the natural gas production may increase for a period of time before starting to decline. Typically, the volumes
of natural gas produced from a Coal Seam Well decline more rapidly than those of Conventional Wells. In order to dispose of the formation water, surface facilities including pumping units are required. The price of coal seam natural gas is typically
lower than the price of conventional natural gas. This is because the heating value of coal seam natural gas is much lower than that of conventional natural gas due to (i) ever increasing percentages of carbon dioxide in coal seam natural gas
(carbon dioxide has no heating value), and (ii) the absence of heavier hydrocarbons such as ethanes, propanes, and butanes, which are present in conventional natural gas. Furthermore, the production costs and processing fees for coal seam
natural gas are typically higher than the processing fees for conventional natural gas due to the cost of extracting the carbon dioxide.
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The Royalty conveyed to the Trust is limited to the base of the Dakota formation, which is
currently the deepest significant producing formation under acreage affected by the Royalty. Rights to production, if any, from deeper formations are retained by Hilcorp.
2023 Capital Expenditure Budget
On February 17, 2023, the Trust announced that Hilcorp had provided the Trust with its 2023 capital project plan for the Subject Interests
(the 2023 Plan), and Hilcorp has estimated its 2023 capital expenditures for the Subject Interests to be $4.4 million.
Hilcorp informed the Trust that its 2023 Plan will allocate approximately $3.7 million of the 2023 Plans budget toward 25 well
recompletions and workovers scheduled to be completed in the Mesaverde, Pictured Cliffs and Fruitland Coal formations. Approximately $0.5 million of the 2023 Plans budget will be allocated to facilities projects related to natural gas
compression, and approximately $0.2 million will be spent for permitting costs for potential future new drill projects. Hilcorp further informed the Trust that its planned project status for 2023 is subject to revision if Hilcorp revises its
assumptions underlying the 2023 Plan, and that actual capital costs may vary from these estimates.
Oil and Natural Gas Production
The natural gas volumes reported to the Trust by Hilcorp are based on plant residue gas volumes plus equivalent volumes for natural gas
liquids. Hilcorp converts one barrel of natural gas liquids to six Mcf of natural gas using industry standards. Production of oil and natural gas and related average sales prices attributable to each of the Subject Interests and the Royalty for each
of the two years ended December 31, 2022, were as follows:
For the year ended December 31,
2022
2021
Natural Gas
(Mcf)
Oil and
Condensate
(Bbls)
Natural Gas
(Mcf)
Oil and
Condensate
(Bbls)
Production
Subject Interests
24,483,167
35,386
24,209,889
47,058
Royalty
13,971,762
23,637
11,029,493
31,323
Average Price (per Mcf/Bbl)
$
5.54
$
86.73
$
3.20
$
54.72
Production costs for natural gas and oil attributable to the Subject Interests for the two years ended
December 31, 2022, were as follows:
2022
2021
Total Production Costs (including capital expenses)
$
44,279,207
$
31,964,198
Average Production Costs per unit of Production
$
1.8086
$
1.3051
Lease Operating Expenses
$
26,229,213
$
22,298,269
Average Lifting Cost per unit of Production
$
1.0713
$
0.9104
Based on Hilcorps reporting methodology, the Trust recognizes production during the month in which the
related Royalty Income is paid to the Trust. Royalty Income for a calendar year is based on the actual natural gas and oil production during the period beginning with November of the preceding calendar year through October of the current calendar
year. Sales volumes attributable to the Royalty are determined by dividing the net profits by the Trust from the sale of oil and natural gas, respectively, by the prices received for sales of such volumes from the Subject Interests, taking into
consideration production taxes attributable to the Subject Interests. Because the oil and natural gas sales attributable to the Royalty are based upon an allocation formula dependent on such factors as price and cost, including capital expenditures,
the aggregate sales amounts from the Subject Interests may not provide a meaningful comparison to sales attributable to the Royalty.
Production from the Subject Interests is influenced by the line pressure of the natural gas gathering systems in the San Juan Basin. As noted
above, oil and natural gas sales attributable to the Royalty are based on an allocation formula dependent on many factors, including oil and natural gas prices and capital expenditures.
Marketing
Natural gas produced in the
San Juan Basin is sold in both interstate and intrastate commerce. Please refer to the discussion contained herein under Regulation for information as to federal regulation of prices of oil and natural gas. As part of the transition from
Burlington to Hilcorp, Hilcorp has assumed, or been assigned, all the natural gas purchase, gathering and processing contracts affecting the Subject Interests. Natural gas produced from the Subject Interests is processed at the following sites:
Chaco, Val Verde, Milagro, Ignacio or Kutz plants, all located in the San Juan Basin. Hilcorp sells natural gas produced from the Subject Interests under various contracts.
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Hilcorps sales contracts with Chevron Natural Gas (Chevron) and EDF
Trading North America LLC (EDF) automatically renewed for an additional one-year term and now expire on March 31, 2024. Each of Hilcorps sales contracts with EDF and Chevron provides for
(i) the delivery of such natural gas at various delivery points through their respective termination dates and (ii) the sale of such natural gas at prices that fluctuate in accordance with published indices for natural gas sold in the San
Juan Basin. Hilcorps natural gas sales contract with New Mexico Gas Company, Inc. automatically renewed for an additional one-year term and now expires on March 31, 2024. The contract provides for
the sale of certain winter-only natural gas supplies processed at the Kutz plant at prices that fluctuate in accordance with published indices for natural gas sold in the San Juan Basin.
Hilcorp contracts with Enterprise Field Services, LLC (EFS) for the gathering and processing of certain natural gas produced from
the Subject Interests. Hilcorps predecessor signed an agreement with EFS which was effective November 1, 2011, for a term of 15 years. Hilcorps predecessor has disclosed to the Trust a summary of that agreement which the Trust has
reviewed with its consultants, subject to conditions of confidentiality.
Hilcorps predecessor entered into four contracts with
Williams Four Corners, LLC (WFC), each of which is effective for a term of 15 years commencing April 1, 2010. The EFS and WFC contracts covered the gathering and processing of virtually all of the natural gas produced from the
Subject Interests. On October 1, 2018, Harvest Midstream I, L.P., an affiliated midstream company of Hilcorp, completed the acquisition of WFCs gas pipeline and processing facilities in the San Juan Basin. The Conveyance sets forth the
processing costs that Hilcorp can charge for both non-affiliates and affiliates.
The Trust is not
a party to any of the purchase, gathering or processing contracts, and thus the Trust has limited ability to know or affect all of the terms of such contracts. As part of the 1996 settlement of litigation filed by the Trustee in 1992 against
Burlington and Southland, the Trustee and Burlington established a formal protocol pursuant to which compliance auditors retained by the Trustee have access to Burlington and its successors books and records, which protocol has been adopted by
Hilcorp.
Oil and Natural Gas Reserves
Proved Reserves
All of the Trusts reserves are located in the San Juan Basin. Total proved Developed and Undeveloped Oil and Natural Gas Reserves
attributable to the Royalty as of December 31, 2022, were as follows:
Proved Reserves (1)(2)
Reserves Category
Natural Gas
(MMcf)
Crude Oil and
Condensate
(MBbls)
Developed
146,641
353
Undeveloped
Total Proved
146,641
353
(1)
Proved reserves were calculated using prices equal to the 12-month
unweighted arithmetic average of the first-day-of-the-month commodity prices for each of
the preceding 12 months, which were $6.36 per MMBtu (Henry Hub) of natural gas and $93.67 per Bbl (West Texas Intermediate) of oil. The adjusted volume-weighted average prices over the life of the properties were $6.09 per Mcf of gas and $83.28 per
Bbl of oil.
(2)
The Trust does not own a specific percentage of the oil and gas reserves because the Conveyance has defined the
Trusts interest as a net overriding royalty interest. Because the Trusts reserve quantities are determined using an allocation formula, any fluctuations in actual or assumed prices or costs will result in revisions to the estimated
reserve quantities allocated to the net overriding royalty interest.
Estimated quantities of proved Developed Oil and
Natural Gas Reserves attributable to the Royalty as of December 31, 2022 and 2021 were as follows:
2022
2021
Natural Gas (MMcf)
146,641
84,142
Crude Oil and Condensate (MBbls)
353
234
Proved Undeveloped Reserves
Based on information provided by Hilcorp and analysis by our independent reserve engineer, there were no proved undeveloped reserves identified
as of December 31, 2022 or 2021.
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Internal Controls over Reserves Estimates
The process of estimating oil and natural gas reserves is complex and requires significant judgment. The Trust, however, does not have the same
level of information that generally would be available to a company with oil and natural gas operations because detailed information generally is not available to owners of royalty interests. Thus, the Trustee relies upon accumulated information and
data solely provided by Hilcorp regarding the Royalty derived from the Subject Interests and provides such information for the Trusts auditing purposes to Cawley, Gillespie & Associates, Inc. (CG&A). CG&A
extrapolates from such Hilcorp-provided information estimates of the reserves attributable to the Subject Interests based on its expertise in the oil and natural gas fields where the Subject Interests are situated, as well as other publicly
available information, and provides the results to the Trust.
The Trust maintains internal controls and procedures applicable to reserve
estimation, which are reviewed annually and updated as required, and the Trust reviews the reserve reports prepared by CG&A for reasonableness. The Trusts internal controls and procedures regarding reserve estimates require proved reserves
to be determined and disclosed in compliance with SEC definitions and guidance.
Third-Party Reserves
The Trust does not maintain an internal petroleum engineering department and instead relies upon CG&A for a qualified, independent report
of estimated reserves. The Trust has verified the qualifications and credentials of CG&A to prepare reserve estimates on behalf of the Trust. The independent petroleum engineers reports as to the proved oil and natural gas reserves as of
December 31, 2021 and 2022 were prepared by CG&A. CG&A, whose firm registration number is F-693, was founded in 1961 and is nationally recognized in the evaluation of oil and natural gas
properties. The technical person at CG&A primarily responsible for overseeing the reserve estimate with respect to the Trust is Zane Meekins. Mr. Meekins has been a practicing petroleum engineering consultant since 1989, with over 34 years
of practice experience in petroleum engineering and is a registered professional engineer in the State of Texas (License No. 71055). Mr. Meekins graduated from Texas A&M University in 1987, summa cum laude , with a B.S. in
Petroleum Engineering. Both CG&A and Mr. Meekins have indicated that they meet or exceed all requirements set forth in Standards Pertaining to the Estimating and Auditing of Oil and Gas Reserves Information promulgated by the Society of
Petroleum Engineers.
Regulation
General
Exploration for and production and sale of oil and natural gas are extensively regulated at the national, state, and local levels. These laws
may govern a wide variety of matters, including allowable rates of production, transportation, marketing, pricing, well construction, water use, prevention of waste, waste disposal, pollution, and protection of the environment. These laws,
regulations and orders have in the past, and may again, restrict the rate of oil and natural gas production below the rate that would otherwise exist in the absence of such laws, regulations and orders.
Laws affecting the oil and natural gas industry and the distribution of its products are under constant review for amendment or expansion,
frequently increasing the regulatory burden on operations. Numerous governmental departments and agencies are authorized by statute to issue, and have issued, rules and regulations binding on the oil and natural gas industry. Compliance with
applicable laws is often difficult and costly, while non-compliance may result in substantial penalties. Such costs and penalties may affect the amount of Net Proceeds attributable to the Royalty that are paid
to the Trust by Hilcorp or by subsequent operators of the Subject Interests.
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Natural Gas
The transportation and resale of natural gas in interstate commerce, historically, have been regulated pursuant to several laws enacted by
Congress and the regulations promulgated under these laws by the Federal Energy Regulatory Commission (FERC) and its predecessor. In the past, the federal government has regulated the prices at which natural gas could be sold in
interstate commerce. Congress removed all price and non-price controls affecting wellhead sales of natural gas under the Natural Gas Wellhead Decontrol Act effective January 1, 1993. Congress
could, however, reenact controls in the future.
Sales of natural gas are affected by the availability, terms, and cost of transportation.
The price and terms for pipeline transportation remain subject to extensive federal and state regulation. Several major regulatory changes have been implemented by Congress and FERC from 1985 to the present that affect the economics of natural gas
production, transportation, and sales. In addition, FERC continues to promulgate revisions to various aspects of the rules and regulations affecting those segments of the natural gas industry, most notably interstate natural gas transmission
companies, that remain subject to FERCs jurisdiction. These initiatives may also affect the intrastate transportation of gas under certain circumstances. The stated purpose of many of these regulatory changes is to promote competition among
the various sectors of the natural gas industry.
Additional proposals and proceedings that might affect the natural gas industry are
considered from time to time by Congress, FERC, state regulatory bodies and the courts. The Trust cannot predict when or if any such proposals might become effective, or their effect, if any, on the Trust. The natural gas industry historically has
been very heavily regulated; therefore, there is no assurance that the less stringent regulatory approach to natural gas sales pursued since 1993 by FERC and Congress will continue.
Sales of crude oil, condensate and gas liquids are not currently regulated and are made at market prices. The ability to transport and
sell petroleum products depends on pipelines that transport such products in interstate commerce and FERC regulates the rates, terms, and conditions of service by such pipelines under the Interstate Commerce Act.
Any such price or non-price control regulations may affect the amount of Royalty and Royalty Income
that is paid to the Trust by Hilcorp or subsequent operators of the Subject Interests.
Cyber Security
The Trust falls under PNC Banks Operational Risk Management Framework and cyber security program. The cyber security program is designed
to identify risks to sensitive information, protect that information, detect threats and events, and maintain an appropriate response and recovery capability to help ensure resilience against information security incidents. The program includes,
among other things, annual security and privacy training for all PNC Bank employees (including those assigned to the Trust) and quarterly phishing exercises to raise employee awareness. PNC Banks cyber security program is also regularly
examined by federal regulators for compliance with financial regulations and standards. The program also establishes expectations for information asset management, system development security, identity and access management, incident management,
threat and vulnerability management, security operations management and third- and fourth-party security.
Environmental Regulation
General. Activities on the Subject Interests are subject to existing stringent and complex federal, state and local
laws (including case law) and regulations governing health, safety, environmental quality and pollution control. Those requirements have frequently changed, and new programs may be even more stringent. Failure to comply with applicable health,
safety and environmental laws, rules and regulations may result in the assessment of administrative, civil or criminal penalties; the imposition of investigatory or remedial obligations; and the issuance of injunctions limiting or preventing some or
all of the operations on the Subject Interests.
Cleanup. Under certain environmental laws and regulations, the operators of
the Subject Interests could be subject to strict, joint and several liability for the removal or remediation of property contamination, whether at a drill site or a waste disposal facility, even when the operators did not cause the contamination, or
their activities were in compliance with all applicable laws at the time the actions were taken. The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), also known as the superfund law, for example,
imposes liability, regardless of fault or the legality of the original conduct, on certain classes of persons for releases into the environment of a hazardous substance. Liable persons may include the current or previous owner and
operator of a site where a hazardous substance has been disposed and persons who arranged for the disposal of a hazardous substance at a site. Under CERCLA and similar statutes, government authorities or private parties may take actions in response
to threats to the public health or the environment and sue responsible persons for the associated costs; government authorities also may direct responsible persons to implement cleanup measures. In the course of operations, the working interest
owner and/or the operator of Subject Interests may have generated and may generate materials that could trigger cleanup liabilities. In addition, the Subject Interests have produced oil and/or natural gas for many years, and previous operators may
have disposed or released hydrocarbons, wastes or hazardous substances at the Subject Interests. The operator of the Subject Interests or the working interest owners may be responsible for all or part of the costs to clean up any such contamination.
Although the Trust is not the operator of any Subject Interests, or the owner of any working interest, its ownership of the Royalty could cause it to be responsible for all or part of such costs to the extent CERCLA, or any similar statute, imposes
responsibility on such parties as owners.
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Climate Change . Mitigating climate change has become the subject of an important
public policy debate and the basis for new legislation proposed by the United States Congress and certain states. Some states have adopted climate change statutes and regulations, and in one of the first acts of his administration, President Biden
signed an executive order to rejoin the Paris Climate Agreement, which sets out an international framework to limit the increase in global average temperature to well below two degrees Celsius (or less). Participating countries prepare,
maintain and publish national greenhouse gas (GHG) reduction targets. Accordingly, the Biden administration has set ambitious domestic targets for curbing climate change, such as making the U.S. power sector climate neutral by 2035 and
achieving a net-zero emissions economy by 2050.
The Inflation Reduction Act (IRA) was
signed into law in August 2022 and contains many provisions that address climate change by creating incentives to use alternative fuels and sources of energy. The Biden administration expects the IRA to reduce U.S. GHG emissions by approximately 40%
by 2030 compared with 2005 levels and put the United States on course for a net-zero economy by 2050. The Methane Emissions Reduction Program in the IRA (Sec. 60113) gives the Environmental Protection Agency
(EPA) the ability to impose charges on methane emitted by certain oil and gas companies. The charges will start in 2024 and apply to facilities that emit over 25,000 metric tons of carbon dioxide equivalent unless exemptions are
available. The impact such regulation may have on the amount of Royalty and Royalty Income paid to the Trust by Hilcorp or subsequent operators of the Subject Interests is difficult to predict.
In addition, federal agencies are building upon their existing programs to impose new climate controls. In 2009, EPA issued an
Endangerment Finding under Section 202(a) of the Clean Air Act, concluding GHG pollution threatens the public health and welfare of future generations. And EPA has required annual reporting of greenhouse gases for persons operating
certain types of industrial facilities, including oil and natural gas production, transmission and storage operations that emit 25,000 metric tons or more of carbon dioxide equivalent per year. The data collected through the reporting rules has
helped to provide a basis for promulgating greenhouse gas emission limits.
A number of those rules have addressed emissions from the oil
and gas industry. On August 16, 2012, for example, EPA issued a final rule that established new source performance standards for volatile organic compounds (VOCs) and sulfur dioxide, an air toxics standard for sources of oil and
natural gas production, and an air toxics standard for sources of natural gas transmission and storage. That rule generally required all hydraulically fractured or refractured natural gas wells to be completed using
so-called green completion technology, which significantly reduces VOC emissions. Limiting those emissions of VOCs has the co-benefit of also limiting
methane, a greenhouse gas. These regulations, referred to as New Source Performance Standards (NSPS) Subpart OOOO, also apply to storage tanks and other equipment in the affected oil and natural gas industry segments. In May 2016, EPA
issued a suite of new final regulations, referred to as NSPS Subpart OOOOa, designed to limit methane, VOCs and other emissions from new and existing sources in the oil and natural gas sector. Among other things, these rules applied green completion
requirements to newly fractured and re-fractured oil wells. Rulemaking concerning regulation of greenhouse gas and other emissions from the oil and natural gas industry continues. In 2022, EPA proposed new
rules for oil and gas sources that would (i) ensure all wells are routinely monitored for leaks, (ii) encourage use of innovative and advanced monitoring, (iii) impose strengthened emission standards for certain equipment, and
(iv) require states to reduce methane emissions from existing sources. The ultimate scope of these regulations remains uncertain; however, any resulting increase in production costs may affect the amount of Royalty and Royalty Income that is
paid to the Trust by Hilcorp or subsequent operators of the Subject Interests.
The oil and gas industry also is likely to be indirectly
affected by EPA rulemakings covering other industry sectors. For example, in 2015 EPA promulgated its Clean Power Plan, which imposed greenhouse gas emissions limits on U.S. power plants. In the Trump Administration, EPA replaced the Clean Power
Plan with the Affordable Clean Energy rule, which interpreted the Clean Air Act as limiting the scope of the federal governments authority to establishing only source-specific (or inside the fence line) emissions reduction
requirements for coal-fired power plants. The D.C. Circuit vacated the Affordable Clean Energy rule, but the Supreme Court reversed the vacatur and ruled the Clean Power Plan was invalid. EPA has indicated that it has started work to replace the
Affordable Clean Energy rule with new standards governing emissions from fossil-fuel-fired power plants. EPA under President Bidens administration therefore will have a further opportunity to adopt more stringent limits on GHG emissions and
incentivize alternative energy sources. Adoption of any such requirements could reduce demand for oil and gas generally, including oil and natural gas produced from the Subject Interests, and could increase the cost of operations of the Subject
Interests, which could result in a loss of reserves or revenues to the Trust. The impact such regulation may have on the amount of Royalty and Royalty Income paid to the Trust by Hilcorp or subsequent operators of the Subject Interests is difficult
to predict.
The cumulative effect of the various climate change measures is likewise uncertain. Due to factors such as environmental concerns and
increased competition from renewables, the International Energy Agency (IEA) estimates that natural gas demand in established markets such as the U.S. and the European Union will begin to deteriorate by the
mid-2020s, and oil demand will plateau after 2030. Notwithstanding potential risks related to climate change, the IEA estimates that global energy demand will continue to rise and will not peak until after
2040 and that oil and natural gas will continue to represent a substantial percentage of global energy use over that time.
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Certain Tax Considerations
The classification of the Trusts income for purposes of the passive loss rules may be important to a Unit Holder. As a result of the Tax
Reform Act of 1986, royalty income such as that derived through the Trust will generally be treated as portfolio income that may not be offset or reduced by passive losses.
The Trustee has been informed that the New Mexico Oil and Gas Proceeds and Pass-Through Entity Withholding Tax Act (the Withholding Tax
Act) requires remitters who pay certain oil and natural gas proceeds from production on New Mexico wells to withhold income taxes from such proceeds in the case of certain nonresident recipients. The Trustee, on advice of New Mexico counsel,
has observed that net profits interests (such as the Royalty) and other types of interests (the extent of which cannot be determined with respect to a specific share of the oil and natural gas production), as well as amounts deducted
from payments that are for expenses related to oil and natural gas production, are excluded from the withholding requirements of the Withholding Tax Act. Unit Holders should consult with their individual tax advisors regarding the applicability of
the Withholding Tax Act and other tax matters to distributions received from the Trust by a Unit Holder.
ITEM 3.
LEGAL PROCEEDINGS
None.
ITEM 4.
MINE SAFETY DISCLOSURES
Not applicable.
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PART II
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.