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, 2023, 4,371 gross (827.4 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 998 gross (287.9 net) wells were Multiple Completion Wells, resulting in a total of 5,444 gross (1,148.5 net) completions.
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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 10.6% of the Trusts proved natural gas reserves as of December 31, 2023. 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.
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.
2024
Capital Expenditure Budget
On February 16, 2024, the Trust announced that Hilcorp had provided the Trust with its 2024 capital
project plan for the Subject Interests (the 2024 Plan), and Hilcorp has estimated its 2024 capital expenditures for the Subject Interests to be $36.0 million. This plan was updated on March 6, 2024, with a reduction of
approximately $2.0 million, bringing the total estimate of 2024 capital expenditures to $34.0 million.
Hilcorp informed the
Trust that its 2024 Plan will allocate approximately $25.0 million of the 2024 Plans budget toward two drilling projects in the Mancos formation. Approximately $8.0 million of the 2024 Plans budget will be allocated to 36 well
recompletions and workovers scheduled to be completed in the Mesaverde and Fruitland Coal formations. Approximately $1.0 million of the 2024 Plans budget will be allocated to facilities projects related to natural gas compression. Hilcorp
further informed the Trust that its planned project status for 2024 is subject to revision if Hilcorp revises its assumptions underlying the 2024 Plan, in which event the actual capital costs may vary from these estimates.
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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, 2023, were as follows:
For the year ended December 31,
2023
2022
Natural Gas
(Mcf)
Oil and
Condensate
(Bbls)
Natural Gas
(Mcf)
Oil and
Condensate
(Bbls)
Production
Subject Interests
23,447,077
43,959
24,483,167
35,386
Royalty
8,881,158
29,275
13,971,762
23,637
Average Price (per Mcf/Bbl)
$
4.69
$
66.34
$
5.54
$
86.73
Production costs for natural gas and oil attributable to the Subject Interests for the two years ended
December 31, 2023, were as follows:
2023
2022
Total Production Costs (including capital expenses)
$
43,492,282
$
44,279,207
Average Production Costs per unit of Production
$
1.8549
$
1.8086
Lease Operating Expenses
$
27,348,678
$
26,229,213
Average Lifting Cost per unit of Production
$
1.1664
$
1.0713
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.
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, 2025. Each of Hilcorps sales contracts with EDF and Chevron provides for (i) the delivery of such natural gas
at various
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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, 2025. 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, 2023, were as follows:
Proved Reserves (1)(2)
Reserves Category
Natural Gas
(MMcf)
Crude Oil and
Condensate
(MBbls)
Developed
57,488
186
Undeveloped
9,134
-
Total Proved
66,622
186
(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 $2.64 per MMBtu (Henry Hub) of natural gas and $78.22 per Bbl (West Texas Intermediate) of oil. The adjusted volume-weighted average prices over the life of the properties were $2.50 per Mcf of gas and $67.59 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, 2023 and 2022 were as follows:
2023
2022
Natural Gas (MMcf)
57,488
146,641
Crude Oil and Condensate (MBbls)
186
353
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Proved Undeveloped Reserves
Based on information provided by Hilcorp and analysis by the Trusts independent reserve engineer, there were 9,135 MMcf of proved
undeveloped reserves identified as of December 31, 2023. There were no proved undeveloped reserves identified in 2022. The increase in proved undeveloped reserves was due to Hilcorps plan for two drilling projects in the Mancos formation
in 2024.
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, 2022 and 2023 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
35 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
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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.
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.
Any transportation of crude oil, natural gas liquids and purity components (ethane, propane, butane,
iso-butane, and natural gasoline) by rail is also subject to regulation by the DOTs Pipeline and Hazardous Materials Safety Administration (PHMSA) and the DOTs Federal Railroad
Administration (FRA) under the Hazardous Materials Regulations at 49 CFR Parts 171-180 (HMR), including Emergency Orders by the FRA and new regulations being proposed by the PHMSA,
arising due to the consequences of train accidents and the increase in the rail transportation of flammable liquids.
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.
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. Accordingly, these regulations often require difficult and costly compliance measures.
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Waste Handling. The Resource Conservation and Recovery Act (RCRA), as
amended, and comparable state statutes and regulations promulgated thereunder, affect oil and natural gas exploration, development and production activities by imposing requirements regarding the generation, transportation, treatment, storage,
disposal and cleanup of hazardous and non-hazardous wastes. With federal approval, the individual states administer some or all of the provisions of RCRA, sometimes in conjunction with their own, more
stringent requirements. Although most wastes associated with the exploration, development and production of oil and natural gas are exempt from regulation as hazardous wastes under RCRA and its state analogs, it is possible that some wastes the
operators of the Subject Interests generate presently or in the future could be subject to regulation under RCRA and state analogs. Legislation has been proposed from time to time in Congress to
re-categorize certain oil and natural gas exploration, development and production wastes as hazardous wastes. If the EPA proposes a rulemaking for revised oil and gas waste regulations in the
future, any such changes in the laws and regulations could have a resulting increase in production costs that may affect the amount of Royalty and Royalty Income that is paid to the Trust by Hilcorp or subsequent operators of 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. Although CERCLA excludes petroleum from the definition of hazardous substance, in
the course of operations, the working interest owner and/or the operator of Subject Interests may have generated and may generate materials that fall outside of this exclusion and 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.
Water Discharges. The Federal Water Pollution Control Act of 1972, as amended, also known as the Clean Water Act
(CWA), the Safe Drinking Water Act, the Oil Pollution Act of 1990 (OPA), and analogous state laws and regulations promulgated thereunder impose restrictions and strict controls regarding the unauthorized discharge of
pollutants, including produced waters and other gas and oil wastes, into waters of the United States (WOTUS), as well as state waters for analogous state programs. The discharge of pollutants into regulated waters is prohibited, except
in accordance with the terms of a permit issued by the EPA or applicable state analog. The CWA and regulations implemented thereunder also prohibit the discharge of dredge and fill material into regulated waters, including jurisdictional wetlands,
unless authorized by an appropriately issued permit from the U.S. Army Corps of Engineers (the Corps). In May 2023, the U.S. Supreme Courts decision in Sackett v. EPA narrowed federal jurisdiction over wetlands to
traditional navigable waters and wetlands or other waters that have a continuous surface connection with or are otherwise indistinguishable from traditional navigable water. In September 2023, the EPA and the Corps published
a direct-to-final rule that conforms the regulatory definition of WOTUS to the Supreme Courts May 2023 decision in Sackett . In the wake of the
Sackett decision, several states have developed their own wetlands policies or regulatory programs to address discharges to intra-state waters that may no longer be regulated as WOTUS.
The EPA has also adopted regulations requiring certain oil and natural gas exploration and production facilities to obtain individual permits
or coverage under general permits for storm water discharges. Costs may be
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associated with the treatment of wastewater or developing and implementing storm water pollution prevention plans, as well as for monitoring and sampling the storm water runoff from certain of
our facilities. Some states also maintain groundwater protection programs that require permits for discharges or operations that may impact groundwater conditions. EPA and various states also impose permitting requirements for the disposal of
produced water by underground injection.
The OPA is the primary federal law for oil spill liability and contains numerous requirements
relating to the prevention of and response to petroleum releases into WOTUS, including the requirement that operators of offshore facilities and certain onshore facilities near or crossing waterways must develop and maintain facility response
contingency plans and maintain certain significant levels of financial assurance to cover potential environmental cleanup and restoration costs. The OPA subjects owners of facilities to strict, joint and several liability for all containment and
cleanup costs and certain other damages arising from a release, including, but not limited to, the costs of responding to a release of oil to surface waters.
These permitting requirements could create additional production costs, and any noncompliance with the CWA or the OPA may result in
substantial administrative, civil and criminal penalties, as well as injunctive obligations that the operator of the Subject Interests or the working interest owners may be responsible.
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 the Biden Administration has pursued executive actions to address climate change. At the international
level, the 21st Conference of the Parties of the United Nations Framework Convention on Climate Change (UNFCCC) resulted in nearly 200 countries, including the United States, coming together to develop the Paris Agreement, intended to
nationally determine their contributions and set greenhouse gas (GHG) emission reduction goals every five years beginning in 2020. In February 2021, as a party to the Paris Agreement, the U.S. announced a target to achieve a 50% to 52%
reduction from 2005 levels in economy-wide GHG emissions by 2030. 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. In addition, in September 2021, President Biden publicly announced the Global Methane Pledge, a pact that aims to reduce global methane emissions at least 30% below 2020 levels by
2030, including all feasible reductions in the energy sector.
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: Methane Emissions and Waste Reduction Incentive Program, which requires the EPA to impose a
waste emissions charge on certain natural gas and oil sources that are already required to report under the EPAs Greenhouse Gas Reporting Program. To implement the program, the IRA requires revisions to GHG reporting regulations
for petroleum and natural gas systems (Subpart W) by 2024. In July 2023, the EPA proposed to expand the scope of the Greenhouse Gas Reporting Program for petroleum and natural gas facilities, as required by the IRA. Among other things, the proposed
rule would expand the emissions events that are subject to reporting requirements to include other large release events and apply reporting requirements to certain new sources and sectors. The rule is expected to be finalized in the
spring of 2024 and become effective on January 1, 2025, in advance of the deadline for GHG reporting for 2024 (March 2025). The fee imposed under the Methane Emissions and Waste Reduction Incentive Program for 2024 would be $900 per ton emitted
over annual methane emissions thresholds, and would increase to $1,200 in 2025, and $1,500 in 2026. The Methane Emissions Reduction Program in the IRA (Sec. 60113) also 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. Funding under the IRA also
provides grant money for methane and greenhouse gas emission mitigation activities.
The IRA aims to reduce U.S. GHG emissions by
approximately 40% by 2030 compared with 2005 levels and put the United States on course for its commitment to attain a net-zero economy by 2050. In addition, many state and local governments have intensified
or stated their intent to intensify efforts to support international
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climate commitments and treaties, in addition to developing programs that are aimed at reducing GHG emissions by means of cap and trade programs, carbon taxes, the development of greenhouse gas
inventories or encouraging the use of renewable energy or alternative low-carbon fuels. 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, like those governed by the Clean Air Act, as amended (the CAA), to impose new climate controls. In 2009, EPA issued an Endangerment Finding under Section 202(a) of the CAA, concluding GHG pollution threatens
the public health and welfare of future generations. And EPA has required annual reporting of GHG 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 GHG emission limits.
Air Emissions. The CAA and comparable state and local laws and regulations, regulate emissions of various air pollutants
through the issuance of permits and the imposition of other requirements. The EPA has developed, and continues to develop, stringent regulations governing emissions of air pollutants at specified sources. New facilities may be required to obtain
permits before work can begin, and modified and existing facilities may be required to obtain additional permits. As a result, operators may need to incur capital costs in order to remain in compliance. Obtaining or renewing permits also has the
potential to delay the development of oil and natural gas projects. Federal and state regulatory agencies can impose administrative, civil and criminal penalties and seek injunctive relief for non-compliance
with air permits or other requirements of the CAA and associated state laws and regulations. The operators of the Subject Interests are responsible for maintaining compliance with all applicable air emissions regulations and holding all necessary
and valid construction and operating permits for operations.
A number of those rules have addressed emissions from the oil and gas
industry. On August 16, 2012, for example, the 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 December 2023,
EPA finalized 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 final rule gives states, along with federal tribes that wish to regulate existing sources, two years to develop and submit their plans for reducing
methane emissions from existing sources. The final emissions guidelines under Subpart OOOOc provide three years from the plan submission deadline for existing sources to comply. States have also begun to regulate through their New Source Performance
Standards (NSPS) and other air emissions programs the emission of VOCs and methane from oil and gas production process equipment, storage tanks and produced water impoundments and other assets. 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
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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. On May 11, 2023, the EPA issued a proposed rulemaking to replace the Affordable Clean Energy rule with new standards governing emissions from fossil-fuel-fired power plants (EPA-HQ-OAR-2023-0072) and supplemented its proposal on November 15, 2023. The EPA therefore may 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.
On January 20, 2021, President Biden signed an executive order that reversed the United
States withdrawal from the Paris Agreement, and the United States formally rejoined the Paris Agreement on February 19, 2021. At the federal regulatory level, both the EPA and the Bureau of Land Management (BLM) have adopted
regulations for the control of methane emissions, which also include leak detection and repair requirements, from the oil and gas industry. Additionally, President Biden has issued an executive order seeking to adopt new regulations and policies to
address climate change and suspend, revise or rescind prior agency actions that are identified as conflicting with the Biden Administrations climate policies. In addition, President Biden has declared that he supports federal government
efforts to limit or prohibit hydraulic fracturing and banning new leases for production of minerals on federal properties, including onshore lands. Any of these actions could require Hilcorp to increase capital expenditures for the Subject
Interests, decrease demand for natural gas and oil production, or limit the Subject Interests ability to produce natural gas or oil production. The Trust is unable to determine what, if any, the effects of such actions will have on the Subject
Interests ability to produce natural gas and oil, and Hilcorps ability to pay Royalty Income to the Trust.
Hilcorp has
informed the Trust that it does not believe that actions undertaken by President Bidens administration to curtail future leases for natural gas and oil drilling on federally owned land will impact the Subject Interests because, at the present
time, they do not impact current leases.
The Biden administration announced in September 2023 that it has moved to shut down future
development of oil, gas and mining activity on approximately 4,200 acres in Sandoval County, New Mexico for the next 50 years. Hilcorp has informed the Trust that the proposed tracts are not within the production area of the Subject Interests
or part of any future proposed development plans.
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.
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