Item 1. Business.
General
VOC Energy Trust, which we refer to as the "trust," was formed in November 2010 by VOC Brazos Energy Partners, L.P., which we refer to as "VOC Brazos." Much of the information disclosed herein has been provided to the trust by VOC Brazos, including information associated with the underlying properties such as production and well counts, major producing areas, customer relationships, competition, marketing and post-production services, and certain information on which reserve data is based.
The trust is a statutory trust created under the Delaware Statutory Trust Act. The business and affairs of the trust are managed by The Bank of New York Mellon Trust Company, N.A., as trustee. The trust maintains its offices at the office of the trustee, at 601 Travis Street, Floor 16, Houston, Texas 77002. The telephone number of the trustee is 1-855-802-1094. In addition, Wilmington Trust Company acts as the Delaware trustee of the trust. The Delaware trustee has only minimal rights and duties as are necessary to satisfy the requirements of the Delaware Statutory Trust Act. The trust does not have any employees, and the business and affairs of the trust are managed by the trustee.
The trustee does not maintain a website for filings by the trust with the Securities and Exchange Commission, which we refer to as the "SEC." Electronic filings by the trust with the SEC are available free of charge through the SEC's website at www.sec.gov and at http://voc.investorhq.businesswire.com.
On May 10, 2011, VOC Brazos and the trust completed an initial public offering of units of beneficial interest in the trust, which are referred to herein as the "trust units." In connection with the closing of the initial public offering, on May 10, 2011, VOC Brazos conveyed a net profits interest to the trust, which entitles the trust to receive 80% of the net proceeds (calculated as described below) from the sale and production of substantially all of the interests in oil and natural gas properties in the states of Kansas and Texas held by VOC Brazos as of May 10, 2011, which is referred herein as the "net profits interest." VOC Brazos' net interests in such properties, after deduction of all royalties and other burdens on production thereon as of May 10, 2011, is referred to herein as the "underlying properties." As of December 31, 2019, the underlying properties included interests in 776 gross (475.9 net) producing wells and included 84,812 gross (52,233.0 net) acres. The net profits interest will terminate on the later to occur of (1) December 31, 2030, or (2) the time from and after January 1, 2011 when 10.6 MMBoe have been produced from the underlying properties and sold (which amount is the equivalent of 8.5 MMBoe in respect of the trust's right to receive 80% of the net proceeds from the underlying properties pursuant to the net profits interest), and the trust will soon thereafter wind up its affairs and terminate. As of December 31, 2019, cumulatively, since inception, the trust has received payment for approximately 5.1 MMBoe of the trust's 8.5 MMBoe interest.
The trust will make quarterly cash distributions of substantially all of its quarterly cash receipts, after deducting the trust's administrative expenses, on or about 45 days following the completion of each quarter through (and including) the quarter ending December 31, 2030. Because payments to the trust will be generated by depleting assets and the trust has a finite life with the production from the underlying properties diminishing over time, a portion of each distribution will represent a return of the original investment in the trust units.
The amount of trust revenues and cash distributions to trust unitholders will depend on, among other things:
• oil sales prices and, to a lesser extent, natural gas sales prices;
• volumes of oil and natural gas produced and sold attributable to the underlying properties;
• property and production taxes;
• development expenses;
• lease operating expenses; and
• administrative expenses of the trust.
The trust was created to acquire and hold the net profits interest for the benefit of the trust unitholders. The net profits interest is passive in nature and neither the trust nor the trustee has any control over or responsibility for costs relating to the operation of the underlying properties. The business and affairs of the trust are managed by the trustee, and neither VOC Brazos nor any of its affiliates has the ability to manage or influence the operations of the trust. Vess Oil Corporation, which we refer to as "Vess Oil," L.D. Drilling, Inc. and Davis Petroleum, Inc., which are collectively referred to herein as the "VOC Operators," are currently the operator or contract operator of substantially all of the underlying properties. VOC Brazos does not, as a matter of course, make public projections as to future sales, earnings or other results relating to the underlying properties.
Description of the Trust Units
Each trust unit is a unit of beneficial interest in the trust and is entitled to receive cash distributions from the trust on a pro rata basis. Each trust unitholder has the same rights regarding each of his trust units as every other trust unitholder has regarding his units. The trust units are in book-entry form only and are not represented by certificates. The trust had 17,000,000 trust units outstanding as of March 13, 2020.
Distributions and Income Computations
Each quarter, the trustee determines the amount of funds available for distribution to the trust unitholders. Available funds are the excess cash, if any, received by the trust from the net profits interest and other sources (such as interest earned on any amounts reserved by the trustee) in that quarter, over the trust's expenses for that quarter. Available funds are reduced by any cash the trustee decides to hold as a reserve against future expenses. Quarterly cash distributions during the term of the trust are made by the trustee on or before the 45th day following the end of each quarter to the trust unitholders of record on the 30th day following the end of each quarter (or the next succeeding business day).
Unless otherwise advised by counsel or the Internal Revenue Service, which we refer to herein as the "IRS," the trustee will treat the income and expenses of the trust for each quarter as belonging to the trust unitholders of record on the quarterly record date. For federal income tax purposes, trust unitholders must take into account items of income, gain, loss, deduction and credit consistent with their methods of accounting and without regard to the taxable year or accounting method employed by the trust and without regard to the quarter in which the trust makes distributions related to those items to the trust unitholders. Variances between taxable income and cash distributions may occur. For example, the trustee could establish a reserve in one quarter using funds that would be included in income in the quarter in which the reserve is created but may not result in a tax deduction or a distribution until a later quarter or possibly in a later taxable year. Similarly, the trustee could also make a payment in one quarter that would be amortized for income tax purposes over several quarters. See "-Federal Income Tax Matters."
Periodic Reports
The trustee files all required trust federal and state income tax and information returns. The trustee prepares and provides the tax information that trust unitholders need to correctly report their share of the income and deductions of the trust. The trustee also causes to be prepared and filed
reports required to be filed under the Exchange Act and by the rules of any securities exchange or quotation system on which the trust units are listed or admitted to trading, and also causes the trust to comply with the provisions of the Sarbanes-Oxley Act of 2002, including but not limited to, by establishing, evaluating and maintaining a system of internal control over financial reporting in compliance with the requirements of Section 404 thereof.
Each trust unitholder and his or her representatives may examine, for any proper purpose, during reasonable business hours, the records of the trust and the trustee.
Liability of Trust Unitholders
Under the Delaware Statutory Trust Act, trust unitholders are entitled to the same limitation of personal liability extended to stockholders of private corporations for profit under the General Corporation Law of the State of Delaware. Courts in jurisdictions outside of Delaware, however, may not give effect to such limitation.
Voting Rights of Trust Unitholders
The trustee or trust unitholders owning at least 10% of the outstanding trust units may call meetings of trust unitholders. The trust is responsible for all costs associated with calling a meeting of trust unitholders unless such meeting is called by the trust unitholders, in which case the trust unitholders are responsible for all costs associated with calling such meeting of trust unitholders. Meetings must be held in such location as is designated by the trustee in the notice of such meeting. The trustee must send written notice of the time and place of the meeting and the matters to be acted upon to all of the trust unitholders at least 20 days and not more than 60 days before the meeting. Trust unitholders representing a majority of trust units outstanding must be present or represented by proxy to have a quorum. Each trust unitholder is entitled to one vote for each trust unit owned.
Unless otherwise required by the trust agreement, a matter may be approved or disapproved by the vote of a majority of the trust units held by the trust unitholders at a meeting where there is a quorum. This is true even if a majority of the total trust units did not approve it. The affirmative vote of the holders of a majority of the outstanding trust units is required to:
• dissolve the trust;
• remove the trustee or the Delaware trustee;
• amend the trust agreement (except with respect to certain matters that do not adversely affect the rights of trust unitholders in any material respect);
• merge or consolidate the trust with or into another entity; or
• approve the sale of all or any material part of the assets of the trust.
In addition, certain amendments to the trust agreement may be made by the trustee without approval of the trust unitholders. The trustee must consent before all or any part of the trust assets can be sold except in connection with the dissolution of the trust or limited sales directed by VOC Brazos in conjunction with its sale of underlying properties.
Duration of the Trust; Sale of the Net Profits Interest
The trust will remain in existence until the later to occur of (1) December 31, 2030 or (2) the time when 10.6 MMBoe (which is the equivalent of 8.5 MMBoe in respect of the trust's right to receive 80% of the net proceeds from the underlying properties pursuant to the net profits interest) have been produced and sold. The trust will dissolve prior to its termination if:
• the trust sells the net profits interest;
• annual cash proceeds attributable to the net profits interest are less than $1 million for each of two consecutive years;
• the holders of a majority of the outstanding trust units vote in favor of dissolution; or
• there is a judicial dissolution of the trust.
Upon dissolution, the trustee would sell all of the trust's assets, either by private sale or public auction, and distribute the net proceeds of the sale to the trust unitholders.
Computation of Net Proceeds
The provisions of the conveyance governing the computation of the net proceeds are detailed and extensive. The following information summarizes the material information contained in the conveyance related to the computation of the net proceeds. For more detailed provisions concerning the net profits interest, please see the conveyance, which is referenced as an exhibit to this Form 10-K.
Net Profits Interest
The net profits interest was conveyed to the trust by VOC Brazos on May 10, 2011 by means of a conveyance instrument that has been recorded in the appropriate real property records in each county in Kansas and Texas where the oil and natural gas properties to which the underlying properties relate are located. The net profits interest burdens the net interest owned by VOC Brazos in the underlying properties in existence as of May 10, 2011.
The amounts paid to the trust for the net profits interest are based on the definitions of "gross proceeds" and "net proceeds" contained in the conveyance and described below. Under the conveyance, net proceeds are computed quarterly, and 80% of the aggregate net proceeds attributable to a computation period will be paid to the trust on or before the 30th day of the month following the computation period. VOC Brazos will not pay to the trust any interest on the net proceeds held by VOC Brazos prior to payment to the trust. The trustee will make distributions to trust unitholders quarterly, if sufficient funds are available. See "-Description of the Trust Units-Distributions and Income Computations."
"Gross proceeds" means the aggregate amount received by VOC Brazos from sales of oil and natural gas produced from the underlying properties (other than amounts received for certain future non-consent operations). However, gross proceeds does not include consideration for the transfer or sale of any underlying property by VOC Brazos or any subsequent owner to any new owner. Gross proceeds also does not include any amount for oil or natural gas lost in production or marketing or used by the owner of the underlying properties in drilling, production and plant operations. Gross proceeds includes payments for future production if they are not subject to repayment in the event of insufficient subsequent production.
"Net proceeds" means gross proceeds less the following:
• all payments to mineral owners or landowners, such as royalties, overriding royalties or other burdens against production, delay rentals, shut-in oil and natural gas payments, minimum royalty or other payments for drilling or deferring drilling;
• any taxes paid by the owner of an underlying property to the extent not deducted in calculating gross proceeds, including estimated and accrued general property (ad valorem), production, severance, sales, gathering, excise and other taxes;
• any extraordinary taxes or windfall profits taxes that may be assessed in the future that are based on profits realized or prices received for production from the underlying properties;
• costs paid by an owner of a property comprising the underlying properties under any joint operating agreement pursuant to the terms of the conveyance;
• all other costs and expenses, development costs and liabilities of drilling, recompleting, workovers, operating and producing oil and natural gas, including allocated expenses such as labor, vehicle and travel costs and materials and any plugging and abandonment liabilities (net of any capital costs for which a reserve had already been made to the extent such development costs are incurred during the computation period) other than costs and expenses for certain future non-consent operations;
• costs or charges associated with gathering, treating and processing oil and natural gas (provided, however, that any proceeds attributable to treatment or processing will offset such costs or changes, if any);
• any overhead charge incurred pursuant to any operating agreement relating to an underlying property;
• costs for recording the conveyance and costs estimated to record the termination and for the release of the conveyance;
• amounts previously included in gross proceeds but subsequently paid as a refund, interest or penalty;
• costs and expenses for renewals or extensions of leases; and
• at the option of VOC Brazos (or any subsequent owner of the underlying properties), amounts reserved for approved development, maintenance or operating expenditures, including well drilling, recompletion and workover costs, which amounts will at no time exceed $1.0 million in the aggregate, and will be subject to the limitations described below (provided that such costs shall not be debited from gross proceeds when actually incurred).
Certain non-production revenues, including salvage value for equipment related to plugged and abandoned wells, as detailed in the conveyance, offset the costs outlined above in calculating the net proceeds. If any excess amounts have not been used to offset costs at the time when the later to occur of (1) December 31, 2030 or (2) the time when 10.6 MMBoe (which is the equivalent of 8.5 MMBoe in respect of the net profits interest) have been produced from the underlying properties and sold, then trust unitholders will not be entitled to receive the benefit of such excess amounts.
During each twelve-month period beginning on the later to occur of (1) December 31, 2027 and (2) the time when 9.8 MMBoe have been produced from the underlying properties and sold (which is the equivalent of 7.8 MMBoe in respect of the net profits interest), which we refer to, in either case, as the "Capital Expenditure Limitation Date," the sum of the development expenditures and amounts reserved for approved development expenditure projects for such twelve-month period may not exceed the Average Annual Capital Expenditure Amount. The "Average Annual Capital Expenditure Amount" means the quotient of (x) the sum of the development expenditures and amounts reserved for approved development expenditure projects with respect to the three twelve- month periods ending on the Capital Expenditure Limitation Date, divided by (y) three. Commencing on the Capital Expenditure Limitation Date, and each anniversary of the Capital Expenditure Limitation Date thereafter, the Average Annual Capital Expenditure Amount will be increased by 2.5% to account for expected increased costs due to inflation.
As is customary in the oil and natural gas industry, VOC Brazos pays an overhead fee to the VOC Operators to operate the underlying properties on behalf of VOC Brazos. The operating activities include various engineering, accounting and administrative functions. The fee is based on a monthly charge per active operated well, which totaled $1.7 million paid to the VOC Operators in each of 2017 and 2018 and $1.8 million paid in 2019 for all of the underlying properties for which VOC Brazos was
designated as the operator. The fee is adjusted annually and will increase or decrease each year based on changes in the Overhead Adjustment Index ("OAI") published by the Council of Petroleum Accountants Society ("COPAS") for that year.
In the event that the net proceeds for any computation period is a negative amount, the trust will receive no payment for that period, and any such negative amount plus accrued interest at the prime rate will be deducted from gross proceeds in the following computation period for purposes of determining the net proceeds for that following computation period.
Gross proceeds and net proceeds are calculated on a cash receipts and cash disbursements basis except that certain costs, primarily ad valorem taxes and expenditures of a material amount, may be determined on an accrual basis.
Additional Provisions
If a controversy arises as to the sales price of any production, then for purposes of determining gross proceeds:
• amounts withheld or placed in escrow by a purchaser are not considered to be received by the owner of the underlying property until actually collected;
• amounts received by the owner of the underlying property and promptly deposited with a nonaffiliated escrow agent will not be considered to have been received until disbursed to it by the escrow agent; and
• amounts received by the owner of the underlying property and not deposited with an escrow agent will be considered to have been received.
The trustee is not obligated to return any cash received from the net profits interest. Any overpayments that VOC Brazos makes to the trust due to adjustments to prior calculations of net proceeds or otherwise will reduce future amounts payable to the trust until VOC Brazos recovers the overpayments plus interest at the prime rate.
The conveyance generally permits VOC Brazos to transfer without the consent or approval of the trust unitholders all or any part of its interest in the underlying properties, subject to the net profits interest. The trust unitholders are not entitled to any proceeds of a sale or transfer of VOC Brazos' interest unless certain conditions set forth in the following paragraph are satisfied. Except in certain cases where the net profits interest is released, following a sale or transfer, the underlying properties will continue to be subject to the net profits interest, and the net proceeds attributable to the transferred property will be calculated as part of the computation of net proceeds described in this Form 10-K.
In addition, VOC Brazos may, without the consent of the trust unitholders, require the trust to release the net profits interest associated with any lease that accounts for less than or equal to 0.25% of the total production from the underlying properties in the prior 12 months and provided that the net profits interest covered by such releases cannot exceed, during any 12-month period, an aggregate fair market value to the trust of $500,000. These releases will be made only in connection with a sale by VOC Brazos to a non-affiliate of the relevant underlying properties and are conditioned upon the trust receiving an amount equal to the fair value to the trust of such net profits interest. Any net sales proceeds paid to the trust are distributable to trust unitholders for the quarter in which they are received.
As the designated operator of a property comprising the underlying properties, VOC Brazos may enter into farm-out, operating, participation and other similar agreements to develop the property. VOC Brazos may enter into any of these agreements without the consent or approval of the trustee or any trust unitholder.
VOC Brazos and any transferee of an underlying property will have the right to abandon its interest in any well or property if it reasonably believes the well or property ceases to produce or is not capable of producing in commercially paying quantities. In making such decisions, VOC Brazos or any transferee of an underlying property is required under the applicable conveyance to operate, or to use commercially reasonable efforts to cause the operators of the underlying properties to operate these properties as would a reasonably prudent operator in the State of Kansas or Texas under the same or similar circumstances would act if it were acting with respect to its own properties, disregarding the existence of the net profits interest as a burden on such property. Upon termination of the lease, the portion of the net profits interest relating to the abandoned property will be extinguished.
VOC Brazos must maintain books and records sufficient to determine the amounts payable for the net profits interest to the trust. Quarterly and annually, VOC Brazos must deliver to the trustee a statement of the computation of the net proceeds for each computation period. The trustee has the right to inspect and copy the books and records maintained by VOC Brazos during normal business hours and upon reasonable notice.
Federal Income Tax Matters
The following is a summary of certain U.S. federal income tax matters that may be relevant to trust unitholders. This summary is based upon current provisions of the Internal Revenue Code of 1986, as amended, which we refer to as the "Code," existing and proposed Treasury regulations thereunder and current administrative rulings and court decisions, all of which are subject to changes that may or may not be retroactively applied. No attempt has been made in the following summary to comment on all U.S. federal income tax matters affecting the trust or the trust unitholders.
The summary is limited to trust unitholders who are individual citizens or residents of the United States. Accordingly, the following summary has limited application to domestic corporations and persons subject to specialized federal income tax treatment. Each trust unitholder should consult his or her own tax advisor with respect to his or her particular circumstances.
Classification and Taxation of the Trust
Tax counsel to the trust advised the trust at the time of formation that, for federal income tax purposes, in its opinion the trust will be treated as a grantor trust and not as an unincorporated business entity. No ruling has been or will be requested from the IRS with respect to the federal income tax treatment of the trust, including as to the status of the trust as a grantor trust for such purposes. Thus, no assurance can be provided that the tax treatment of the trust would be sustained by a court if contested by the IRS or another taxing authority. The remainder of the discussion below is based on tax counsel's opinion, at the time of formation, that the trust will be classified as a grantor trust for federal income tax purposes. As a grantor trust, the trust will not be subject to federal income tax at the trust level. Rather, each trust unitholder will be considered for federal income tax purposes to own its proportionate share of the trust's assets directly as though no trust were in existence. The income of the trust is deemed to be received or accrued by the trust unitholder at the time such income is received or accrued by the trust, rather than when distributed by the trust. Each trust unitholder will be subject to tax on its proportionate share of the income and gain attributable to the assets of the trust and will be entitled to claim its proportionate share of the deductions and expenses attributable to the assets of the trust, subject to applicable limitations, in accordance with the trust unitholder's tax method of accounting and without regard to the taxable year or accounting method employed by the trust.
The trust will allocate items of income, gain, loss, deductions and credits to trust unitholders based on record ownership at each quarterly record date. It is possible that the IRS or another taxing authority could disagree with this allocation method and could assert that income and deductions of the
trust should be determined and allocated on a daily, prorated or other basis, which could require adjustments to the tax returns of the trust unitholders affected by this issue and result in an increase in the administrative expense of the trust in subsequent periods.
Classification of the Net Profits Interest
Tax counsel to the trust also advised the trust at the time of formation that, for federal income tax purposes, based upon representations made by VOC Brazos regarding the expected economic life of the underlying properties and the expected duration of the net profits interest, in its opinion the net profits interest should be treated as a "production payment" under Section 636 of the Code or otherwise as a debt instrument. On the basis of that advice, the trust will treat the net profits interest as indebtedness subject to Treasury regulations applicable to contingent payment debt instruments, and by purchasing trust units, a trust unitholder will agree to be bound by the trust's application of those regulations, including the trust's determination of the rate at which interest will be deemed to accrue on the net profits interest. No assurance can be given that the IRS or another taxing authority will not assert that the net profits interest should be treated differently. Any such different treatment could affect the amount, timing and character of income, gain or loss in respect of an investment in trust units and could require a trust unitholder to accrue income at a rate different than that determined by the trust.
Widely Held Fixed Investment Trust Reporting Information
The trustee assumes that some trust units are held by middlemen, as such term is broadly defined in Treasury regulations (and includes custodians, nominees, certain joint owners, and brokers holding an interest for a custodian in street name). Therefore, the trustee considers the trust to be a non-mortgage widely held fixed investment trust ("WHFIT") for U.S. federal income tax purposes. The Bank of New York Mellon Trust Company, N.A., 601 Travis Street, Floor 16, Houston, Texas 77002, telephone number 1-855-802-1094, is the representative of the trust that will provide tax information in accordance with applicable Treasury regulations governing the information reporting requirements of the trust as a WHFIT. Notwithstanding the foregoing, the middlemen holding trust units on behalf of trust unitholders, and not the trustee of the trust, are solely responsible for complying with the information reporting requirements under the Treasury regulations with respect to such trust units, including the issuance of IRS Forms 1099 and certain written tax statements. Trust unitholders whose trust units are held by middlemen should consult with such middlemen regarding the information that will be reported to them by the middlemen with respect to the trust units. Any generic tax information provided by the trustee of the trust is intended to be used only to assist trust unitholders in the preparation of their federal and state income tax returns.
Available Trust Tax Information
In compliance with the reporting requirements for WHFITs and the dissemination of trust tax reporting information, the trustee provides a generic tax information reporting booklet that is intended to be used only to assist unitholders in the preparation of their 2018 federal and state income tax returns. The projected payment schedule for the net profits interest is included with the tax information booklet. This tax information booklet can be obtained at http://voc.investorhq.businesswire.com.
Description of the Underlying Properties
The underlying properties consist of VOC Brazos' net interests in substantially all of its oil and natural gas properties after deduction of all royalties and other burdens on production thereon as of May 10, 2011, which properties are located in the states of Kansas and Texas. The VOC Operators are currently the operators or contract operators of substantially all of the underlying properties.
VOC Brazos' interests in the properties comprising the underlying properties require VOC Brazos to bear its proportionate share along with the other working interest owners of the costs of development and operation of such properties. The underlying properties are burdened by non-working interests owned by third parties consisting primarily of overriding royalty and royalty interests retained by the owners of the land subject to the working interests. These landowners' royalty interests typically entitle the landowner to receive 12.5% of the revenue derived from oil and natural gas production resulting from wells drilled on the landowner's land, without any deduction for drilling costs or other costs related to production of oil and natural gas. A working interest percentage represents a working interest owner's proportionate ownership interest in a property in relation to all other working interest owners in that property, whereas a net revenue interest percentage is a working interest owner's percentage of production after reducing such percentage by the percentage of burdens on such production such as royalties and overriding royalties.
Based on the reserve report, the net profits interest would entitle the trust to receive net proceeds from the sale of production of not less than 10.6 MMBoe of proved reserves attributable to the underlying properties expected to be produced over the term of the trust. The trust is entitled to receive 80% of the net proceeds from the sale of production of oil and natural gas attributable to the underlying properties that are produced during the term of the trust, whereas total reserves as reflected on the summary reserve reports and attributable to the underlying properties include all reserves expected to be economically produced during the economic life of the properties.
In general, the producing wells included in the underlying properties have stable production profiles and their production is long-lived. Based on the reserve report, annual production from the underlying properties is expected to decline at an average annual rate of 8.4% over the next 20 years assuming no additional development drilling or other development expenditures are made on the underlying properties after 2022. VOC Brazos expects total development expenditures for the underlying properties through December 31, 2022 will be approximately $32.7 million, which it expects will partially offset the natural decline in production otherwise expected to occur with respect to the underlying properties as described in more detail below.
Reserves
The engineering department of Vess Oil Corporation, who serves as contract operator for VOC Brazos, maintains oversight and compliance responsibility for the internal reserve estimate process and, in accordance with internal policies and procedures, provides appropriate data to independent third party engineers for the annual estimation of year-end reserves. This engineering department accumulates historical production data for the underlying properties, calculates historical lease operating expenses and differentials, updates working interests and net revenue interests, and obtains logs, 3-D seismic and other geological and geophysical information. This data is forwarded to Cawley, Gillespie & Associates, Inc., which we refer to as "CG&A," thereby allowing CG&A to prepare estimated proved reserves in their entirety based on such data.
Estimates of the proved oil and gas reserves attributable to the trust as of December 31, 2017, 2018 and 2019 are based on reports prepared by CG&A. CG&A has been in business since 1961 and serves many organizations and individuals in the petroleum industry, including owners and operators of oil and gas properties, exploration groups, planners, and professionals in investment and finance. One of the principal businesses of CG&A is providing detailed assessment of producing reservoirs. CG&A is an independent firm of petroleum engineers, geologists, geophysicists and petrophysicists and does not own an interest in the underlying properties and is not employed on a contingent basis. Mr. W. Todd Brooker, Senior Vice President, is the technical person at CG&A who is primarily responsible for overseeing CG&A's preparation of the reserve estimates. Mr. Brooker is a graduate of the University of Texas at Austin with a Bachelor of Science degree in Petroleum Engineering and has 28 years of
experience in petroleum engineering. He is a licensed professional engineer in the State of Texas (License #83462).
Oil and gas proved reserves are disclosed by significant geographic area, using the 12-month average beginning-of-month price for the year, based on the use of reliable technologies to estimate proved oil and gas reserves, if those technologies have been demonstrated to result in reliable conclusions about reserves volumes. Reserve and related information for 2017, 2018 and 2019 is presented consistent with these requirements.
Proved Reserves of VOC Energy Trust. The following table sets forth, as of December 31, 2019, estimated proved reserves attributable to the trust derived from the reserve report. A summary of the reserve report is included below.
Information concerning historical changes in net proved reserves attributable to the trust, and the calculation of the standardized measure of discounted future net revenues related thereto, is contained in Note J to the financial statements of the trust included in this Form 10-K. VOC Brazos has not filed reserve estimates covering the underlying properties with any other federal authority or agency.
The following table summarizes the changes in estimated proved reserves of the trust for the periods indicated.
(1)Reflects sales volumes produced during the noted year regardless whether royalty payments thereon have been remitted to the Trust by VOC Brazos.
None of the proved undeveloped reserves have remained undeveloped for five years or more after they were initially disclosed as proved undeveloped reserves.
The reserves above represent the trust's 80% net profits interest in the underlying properties for the remainder of the term of the trust.
The following table sets forth the estimates of total proved reserves and forecasts of economics attributable to the underlying properties as of December 31, 2019 for the remainder of the term of the trust, as presented in the summary prepared by CG&A of its reserve report as of December 31, 2019 for the trust. The estimates of proved reserves have not been filed with or included in reports to any federal authority or agency. The discounted cash flow value shown in the table is not intended to represent the current market value of the trust's estimated oil and natural gas reserves.
(1)Before interest and taxes.
(2)Discounted at 10%.
The net profits interest entitles the trust to receive 80% of the net proceeds attributable to the underlying properties. The net profits interest will terminate on the later to occur of (1) December 31, 2030, or (2) the time when 10.6 MMBoe have been produced from the underlying properties and sold, and the trust will soon thereafter wind up its affairs and terminate. Based on the reserve report for the year ended December 31, 2019, CG&A estimated that the trust would terminate December 31, 2030 based on the calculation that 10.6 MMBoe would have been produced from the underlying properties and sold (which amount is the equivalent of 8.5 MMBoe in respect of the trust's right to receive 80% of the net proceeds from the underlying properties pursuant to the net profits interest) prior to this date.
Oil and gas prices were adjusted to a WTI Cushing oil price of $55.69 per Bbl and a Henry Hub natural gas price of $2.578 per MMBtu. As specified by the SEC, these prices are 12-month averages based upon the price on the first day of each month during 2019. The price adjustments were based on oil price differentials forecast at -$4.75 per Bbl for the Kansas underlying properties, -$1.00 per Bbl for the Kurten (Woodbine) Field wells in Texas, -$2.65 per Bbl for the Sand Flat Unit and Hitts Lake North Field wells in Texas and -$1.00 per Bbl for all other Texas underlying properties. Oil price differentials were not escalated. Gas price differentials varied by property as provided by VOC Brazos and were also not escalated. NGL price differentials were applied at 27% of the WTI oil price and not escalated. The base price differentials may include local basis differentials, transportation, gas
shrinkage, gas heating value (BTU content) and/or crude quality and gravity corrections. Operating expenses, workover expenses, COPAS overhead charges and investments were forecast on a per property basis as furnished by VOC Brazos. Expenses and investments were held constant in accordance with SEC rules and guidelines. For Kansas properties, severance taxes were applied at 4.33 percent of revenue until exemption levels were forecasted to be reached. The severance tax rate was dropped to zero when a rate of 6 Bbl/day per well was reached or when gross gas production value reached $87/day per gas well. Severance taxes were forecasted at 4.6 percent of oil revenue and 7.5 percent of gas revenue for properties in Texas. Ad valorem taxes for Kansas properties were applied at 6.0 percent of revenue but dropped to 2.0 percent as properties qualified for the tax exemption. Kansas oil and gas conservation taxes were included within the severance tax estimates. Ad valorem taxes were applied at 3.29 percent of revenue (after severance taxes) for the Texas properties.
The estimates of proved oil and natural gas reserves attributable to the underlying properties are based on estimates prepared by CG&A. Rules and guidelines established by the SEC regarding the present value of future net revenues were used to prepare these reserve estimates. Oil and natural gas reserve engineering is a subjective process of estimating underground accumulations of oil and natural gas that cannot be measured in an exact manner, and estimates of other engineers might differ materially from those included in the report. The accuracy of any reserve estimate is a function of the quality of available data and engineering, and estimates may justify revisions based on the results of drilling, testing, and production activities. Accordingly, reserve estimates are inherently imprecise and should not be construed as representing the actual quantities of future production or cash flows to be realized from oil and natural gas properties or the fair market value of such properties.
Producing Acreage and Well Counts
For the following data, "gross" refers to the total wells or acres in which VOC Brazos owns a working interest and "net" refers to gross wells or acres multiplied by the percentage working interest owned by VOC Brazos. Although many of VOC Brazos' wells produce both oil and natural gas, a well is categorized as an oil well or a natural gas well based upon the ratio of oil to natural gas production.
The underlying properties are interests in developed properties located in oil and natural gas producing regions of Kansas and Texas. The following is a summary of the approximate acreage of the underlying properties at December 31, 2019.
The following is a summary of the producing wells on the underlying properties as of December 31, 2019:
The following is a summary of the number of developmental wells drilled by VOC Brazos on the underlying properties during the last three years. VOC Brazos did not drill any exploratory wells during the periods presented.
In 2018, two Hawkwood Earning Wells (as defined below) were drilled and completed at no cost to VOC Brazos, one MD Earning Well (as defined below) was drilled and is waiting on completion at no cost to VOC Brazos, and one well was drilled with capital expenditures of $201,253 and is waiting on completion.
In 2019, the remaining two Hawkwood Earning Wells were drilled and completed at no cost to VOC Brazos. An additional four Hawkwood Development Wells were drilled and completed under the joint venture agreement. The one MD Earning Well is still waiting on completion. In addition, two non-joint venture agreement wells were drilled and completed and the well awaiting completion at December 31, 2018 was completed. Total capital expenditures for 2019 for these wells was $6,429,767. VOC Brazos continues to develop further proved undeveloped reserves pursuant to its planned development and workover program. See "Item 7. Trustee's Discussion and Analysis of Financial Condition and Results of Operations-Planned Development and Workover Program" for more information regarding VOC Brazos' joint venture agreements with Hawkwood Energy East Texas, LLC and MD America Energy, LLC and the Hawkwood Earning Wells, Hawkwood Development Wells and MD Earning Wells (each as defined therein).
The following table shows the average sales prices per Bbl of oil and Mcf of natural gas produced and the production costs and production and property taxes per Boe received by the trust from the underlying properties.
Major Producing Areas
The following table summarizes the estimated proved reserves by operating area attributable to the underlying properties according to the reserve report and the corresponding pre-tax PV-10 value as of December 31, 2019.
(1)In accordance with the rules and regulations promulgated by the SEC, the proved reserves presented above were determined using the twelve-month unweighted arithmetic average of the first-day-of-the-month price for the period from January 1, 2019 through December 1, 2019 and were held constant for the life of the properties. This yielded a price for oil of $55.69 per barrel and a price for natural gas of $2.578 per MMBtu.
(2)Because the trust bears no federal tax expense and taxable income is passed through to the unitholders of the trust, no provision for federal or state income taxes is included in the summary reserve reports and therefore the standardized measure of discounted future net cash flows attributable to the underlying properties is equal to the pre-tax PV-10 value. PV-10 may not be considered a GAAP financial measure as defined by the SEC and is derived from the standardized measure of discounted future net cash flows, which is the most directly comparable GAAP financial measure. The pre-tax PV-10 value and the standardized measure of discounted future net cash flows do not purport to present the fair value of the oil and natural gas reserves attributable to underlying properties.
Kansas. As of December 31, 2019, proved reserves attributable to the portion of the Kansas underlying properties were approximately 3.2 MMBoe and were located in three primary areas: Central Kansas Uplift, Western Kansas and South Central Kansas. As of December 31, 2019, the VOC Operators operated 96.4% of the total proved reserves attributable to the Kansas underlying properties based on PV-10 value.
The major fields in the Central Kansas Uplift include Fairport Field, Marcotte Field and Chase-Silica Field, all of which are producing primarily from the Arbuckle and Lansing Kansas City zones. The major fields in Western Kansas include the Bindley, Griston SW and Rosa Northwest fields, which are producing primarily from the Mississippian, Morrow, Lansing Kansas City and Cherokee zones. The major fields in South Central Kansas include the Gerberding, Spivey Grabs and Alford fields, which are producing primarily from the Mississippian, Simpson and Lansing Kansas City zones.
Texas. As of December 31, 2019, proved reserves attributable to the Texas underlying properties were approximately 5.7 MMBoe and are located in two areas: Central Texas and East Texas. As of December 31, 2019, the VOC Operators operated approximately 99.4% of the total proved reserves attributable to the Texas underlying properties based on PV-10 value.
Central Texas production is attributable to the Kurten Woodbine Unit, which is producing primarily from the EagleBine Interval, Buda and Georgetown zones. East Texas properties include the Sand Flat field and Hitts Lake North field, each of which is producing primarily from the Paluxy and Chisum zones.
The following table summarizes the production by product for the years indicated for the only field, Kurten, that contains 15% or more of total proved reserves attributable to the underlying properties from the above table:
Marketing and Post-Production Services
Pursuant to the terms of the conveyance that created the net profits interest, VOC Brazos has the responsibility to market, or cause to be marketed, the oil and natural gas production attributable to the underlying properties. The terms of the conveyance that created the net profits interest do not permit VOC Brazos to charge any marketing fee when determining the net proceeds upon which the net profits interest is calculated. As a result, the net proceeds to the trust from the sales of oil and natural gas production from the underlying properties are determined based on the same price that VOC Brazos receives for oil and natural gas production attributable to VOC Brazos' remaining interest in the underlying properties.
Texas is a mature oil producing state with a well-developed crude oil refining, transportation and marketing infrastructure. According to the Texas Railroad Commission, more than 5,000 operators reported aggregate oil production of approximately 1.520 billion barrels for the State of Texas during 2019. There were 30 operating oil refineries located in Texas in 2019 with combined capacity to refine over 5.79 million barrels of oil per day. With oil production in the state of Texas averaging approximately 4.55 million barrels of oil per day, Texas refineries are net importers of crude oil. As a result, oil producers in Texas benefit from competitive marketing conditions for their oil production as a result of the high demand from the crude oil marketing companies and refineries located in Texas.
Kansas is a mature oil producing state with a well-developed transportation infrastructure for crude oil transportation and marketing. According to the Kansas Geological Society, more than 1,900 operators reported aggregate oil production of approximately 33.0 million barrels for the state of Kansas in 2019. Kansas is home to three oil refineries located in McPherson, El Dorado and Coffeyville, Kansas. These refineries have combined capacity to refine approximately 390,000 barrels of oil per day. With oil production in the state of Kansas averaging approximately 91,000 barrels of oil per day, Kansas is a net importer of crude oil. As a result, Kansas operators benefit from the competitive marketing conditions for their oil production as a result of the high demand from the refineries located in Kansas.
Vess Oil Corporation generally sells production from the underlying properties to several purchasers, including MV Purchasing, LLC, an affiliate of VOC Brazos, which we refer to as "MV Purchasing," under short-term arrangements using market sensitive pricing. These sales to purchasers are under terms ranging from one month to six months, using market sensitive pricing. Five purchasers, including MV Purchasing, have been purchasing substantially all of the crude oil production, and a substantial portion of the crude oil production may continue be acquired by one or more single purchasers. For the years ended December 31, 2017, 2018 and 2019, MV Purchasing purchased 38%, 38% and 32%, respectively, of the production sold from the underlying properties. VOC Brazos does not believe that loss of any of these parties as a purchaser would have a material adverse impact on the business of VOC Brazos, as substitute purchasers are generally available; however, a purchaser's failure to pay for purchased crude oil could have a significant adverse impact on VOC Brazos' business.
Oil production is typically transported by truck from the field to the closest gathering facility or refinery. VOC Brazos sells the majority of the oil production from the underlying properties under short-term arrangements using market sensitive pricing. The price received by VOC Brazos for the oil production from the underlying properties is usually based on the NYMEX price applied to equal daily quantities on the month of delivery, which price is then reduced for differentials based upon delivery location and oil quality. The average differential for oil production during the years ended December 31, 2017, 2018 and 2019 received by the trust from the underlying properties was $3.78, $3.05 and $2.48 per barrel, respectively.
All natural gas produced by VOC Brazos is marketed and sold to third-party purchasers. The natural gas is sold on a contract basis and, in all but two cases, the contracts are in their secondary terms and are on a month-to-month basis. In all cases, the contract price is based on a percentage of a published regional index price, after adjustments for Btu content, transportation and related charges.
Vess Oil Corporation has committed to sell all of its natural gas production attributable to the Kurten Woodbine Unit in Texas to ETC Texas Pipeline, Ltd., on a year-to-year basis effective October 1, 2014. Vess Oil Corporation has also committed to sell to ONEOK Field Services Company, L.L.C. all of its natural gas production attributable to three wells in Kingman and Barber Counties, Kansas on a month-to-month basis effective as of August 31, 2015.
VOC Brazos does not have any volume commitments or take or pay arrangements.
Sale and Abandonment of Underlying Properties
VOC Brazos and any transferee of any of an underlying property will have the right to abandon its interest in any well or property if it reasonably believes a well or property ceases to produce or is not capable of producing in commercially paying quantities. To reduce the potential conflict of interest between VOC Brazos and the trust in determining whether a well is capable of producing in commercially paying quantities, VOC Brazos is required under the applicable conveyance to use commercially reasonable efforts to cause the operators of the underlying properties to operate these properties as would a reasonably prudent operator acting with respect to its own properties, disregarding the existence of the net profits interest as a burden on such property. Upon termination of
the lease, the portion of the net profits interest relating to the abandoned property will be extinguished. For the years ended December 31, 2017, 2018 and 2019, VOC Brazos plugged and abandoned 11, 17 and 13 wells, respectively, located on leases within the underlying properties based on its determination that such wells could no longer produce oil or natural gas in commercially economic quantities.
VOC Brazos generally may sell all or a portion of its interests in the underlying properties, subject to and burdened by the net profits interest, without the consent of the trust unitholders. In addition, VOC Brazos may, without the consent of the trust unitholders, require the trust to release the net profits interest associated with any lease that accounts for less than or equal to 0.25% of the total production from the underlying properties in the prior 12 months and provided that the net profits interest covered by such releases cannot exceed, during any 12-month period, an aggregate fair market value to the trust of $500,000. These releases will be made only in connection with a sale by VOC Brazos to a non-affiliate of the relevant underlying properties and are conditioned upon the trust receiving an amount equal to the fair value to the trust of such net profits interest. Any net sales proceeds paid to the trust are distributable to trust unitholders for the quarter in which they are received. No underlying properties were sold, and therefore no net sales proceeds were paid to the trust for its share of interest in any such underlying properties, during 2018 or 2019. VOC Brazos has not identified any of the underlying properties for sale as of December 31, 2019.
Title to Properties
The underlying properties are subject to certain burdens that are described in more detail below. To the extent that these burdens and obligations affect VOC Brazos' rights to production and the value of production from the underlying properties, they have been taken into account in calculating the trust's interests and in estimating the size and the value of the reserves attributable to the underlying properties.
VOC Brazos' interests in the underlying properties are typically subject, in one degree or another, to one or more of the following:
• royalties, overriding royalties and other burdens, express and implied, under oil and natural gas leases;
• overriding royalties, production payments and similar interests and other burdens created by VOC Brazos or its predecessors in title;
• a variety of contractual obligations arising under operating agreements, farm-out agreements, production sales contracts and other agreements that may affect the underlying properties or their title;
• liens that arise in the normal course of operations, such as those for unpaid taxes, statutory liens securing unpaid suppliers and contractors and contractual liens under operating agreements that are not yet delinquent or, if delinquent, are being contested in good faith by appropriate proceedings;
• pooling, unitization and communitization agreements, declarations and orders;
• easements, restrictions, rights-of-way and other matters that commonly affect property;
• conventional rights of reassignment that obligate VOC Brazos to reassign all or part of a property to a third party if VOC Brazos intends to release or abandon such property; and
• rights reserved to or vested in the appropriate governmental agency or authority to control or regulate the underlying properties and the net profits interest therein.
VOC Brazos has informed the trustee that VOC Brazos believes that the burdens and obligations affecting the underlying properties are conventional in the industry for similar properties. VOC Brazos
also has informed the trustee that VOC Brazos believes that the existing burdens and obligations do not, in the aggregate, materially interfere with the use of the underlying properties and do not materially adversely affect the value of the net profits interest.
VOC Brazos recorded the conveyance of the net profits interest in Kansas and Texas in the real property records in each Kansas or Texas county in which the underlying properties are located. Although under Texas law it is well-established that the recording in the appropriate real property records of an interest such as the net profits interest constitutes the conveyance of a fully vested real property interest to the trust, the law in Kansas is less certain. VOC Brazos and the trust believe that the recording in the appropriate real property records in Kansas of the net profits interest should constitute the conveyance of a fully vested real property interest, interests in hydrocarbons in place or to be produced or a production payment as such is defined under the United States Bankruptcy Code. In a bankruptcy of VOC Brazos, creditors of VOC Brazos would be able to claim the net profits interest as an asset of the bankruptcy estate to satisfy obligations to them if the conveyance of the net profits interest did not constitute the conveyance of a real property interest or interests in hydrocarbons in place or to be produced under applicable state law or a production payment, in which case the trust would be an unsecured creditor of VOC Brazos at risk of losing the entire value of the net profits interest to senior creditors.
VOC Brazos believes that its title to the underlying properties is, and the trust's title to the net profits interest is, good and defensible in accordance with standards generally accepted in the oil and gas industry, subject to such exceptions as are not so material to detract substantially from the use or value of such properties or royalty interests. Please see "Item 1A.
Item 1A. Risk Factors.
Prices of oil and natural gas fluctuate, and lower prices could reduce proceeds to the trust and cash distributions to unitholders.
The reserves attributable to the underlying properties and quarterly cash distributions of the trust are highly dependent upon the prices realized from the sale of oil and natural gas. Prices of oil and natural gas can fluctuate widely on a quarter-to-quarter basis in response to a variety of factors that are beyond the control of the trust and VOC Brazos. These factors include, among others:
• regional, domestic and foreign supply and perceptions of supply of oil and natural gas;
• the level of demand and perceptions of demand for oil and natural gas;
• political conditions or hostilities in oil and natural gas producing regions, including the Middle East, North Africa and South America;
• the occurrence or threat of epidemic or pandemic diseases, such as the recent outbreak of coronavirus, or any government response to such occurrence or threat;
• anticipated future prices of oil and natural gas and other commodities;
• weather conditions and seasonal trends;
• technological advances affecting energy consumption and energy supply;
• U.S. and worldwide economic conditions;
• the price and availability of alternative fuels;
• the proximity, capacity, cost and availability of gathering and transportation facilities;
• the volatility and uncertainty of regional pricing differentials;
• governmental regulations and taxation;
• energy conservation and environmental measures; and
• acts of force majeure.
Crude oil prices have been volatile over the last several years, and in 2019 ranged from a high of $66.30 to a low of $46.54. The NYMEX crude oil spot prices per Bbl were $60.42, $45.41 and $61.06 as of December 31, 2017, 2018 and 2019, respectively. Meanwhile, crude oil spot prices per Bbl have dropped sharply in the first quarter of 2020, from $61.17 on January 2, 2020 to $30.24 on March 9, 2020. Neither VOC Brazos nor the trust can predict the timing or the duration of any economic cycle and, depending on the prices realized, the operating results of VOC Brazos and the financial condition of the trust could be materially and adversely affected.
Continued low prices of oil and natural gas will reduce the amount of the net proceeds to which the trust is entitled and may ultimately reduce the amount of oil and natural gas that is economic to produce from the underlying properties. As a result, the operator of any of the underlying properties could determine during periods of low commodity prices to shut in or curtail production from wells on the underlying properties. In addition, the operator of the underlying properties could determine during periods of low commodity prices to plug and abandon marginal wells that otherwise may have been allowed to continue to produce for a longer period under conditions of higher prices. Specifically, VOC Brazos may abandon any well or property if it reasonably believes that the well or property can no longer produce oil or natural gas in commercially paying quantities. This could result in termination of the net profits interest relating to the abandoned well or property. In making such decisions, VOC Brazos and any transferee will be required under the applicable conveyance to operate, or to use commercially reasonable efforts to cause the operators of the underlying properties to operate, these properties as would a reasonably prudent operator, acting with respect to its own properties (without regard to the existence of the net profits interest). Because substantially all the underlying properties are located in mature fields, decreases in commodity prices could have a more significant effect on the economic viability of these properties compared to more recently discovered properties. The commodity price sensitivity of these mature wells is due to a variety of factors that vary from well-to-well, including the additional costs associated with water handling and disposal, chemicals, surface equipment maintenance, downhole casing repairs and reservoir pressure maintenance activities that are necessary to maintain production. As a result, the volatility of commodity prices may cause the amount of future cash distributions to trust unitholders to fluctuate, and a substantial decline in the price of oil or natural gas will reduce the amount of cash available for distribution to the trust unitholders. The volatility of commodity prices also reduces the accuracy of estimates of future cash distributions to trust unitholders.
Actual reserves and future production may be less than current estimates of proved reserves, which could reduce cash distributions by the trust and the value of the trust units.
The value of the trust units and the amount of future cash distributions to the trust unitholders will depend upon, among other things, the accuracy of the reserves and future production estimated to be attributable to the underlying properties and the net profits interest. It is not possible to measure underground accumulations of oil and natural gas in an exact manner, and estimating reserves is inherently uncertain. Ultimately, actual production and revenues for the underlying properties could vary negatively and in material amounts from estimates. Furthermore, development expenditures and production costs relating to the underlying properties could be higher than current estimates.
Petroleum engineers are required to make subjective estimates of underground accumulations of oil and natural gas based on factors and assumptions that include:
• historical production from the area compared with production rates from other producing areas;
• oil and natural gas prices, production levels, Btu content, production expenses, transportation costs, severance and excise taxes and development expenditures; and
• the effect of expected governmental regulation.
Changes in these assumptions and amounts of actual production and development costs could materially decrease reserve estimates.
The estimated reserves attributable to the net profits interest and the estimated future net revenues attributable to the net profits interest are based on estimates of reserve quantities and revenues for the underlying properties. See "Item 1. Business-Description of the Underlying Properties-Reserves" for a discussion of the method of allocating proved reserves to the underlying properties and the net profits interest. The quantities of reserves attributable to the underlying properties and the net profits interest may decrease in the future as a result of future decreases in the price of oil, natural gas or natural gas liquids.
The processes of drilling and completing wells are high risk activities.
The processes of drilling and completing wells are subject to numerous risks beyond the trust's and VOC Brazos' control, including risks that could delay VOC Brazos' current drilling schedule and the risk that drilling will not result in commercially viable oil production. VOC Brazos is not obligated to undertake any development activities, so any drilling and completion activities will be subject to the reasonable discretion of VOC Brazos. Furthermore, VOC Brazos' future business, financial condition, results of operations, liquidity or ability to finance its share of planned development expenditures could be materially and adversely affected by any factor that may curtail, delay or cancel drilling, including the following:
• delays imposed by or resulting from compliance with regulatory requirements, including permitting;
• unusual or unexpected geological formations;
• shortages of or delays in obtaining equipment and qualified personnel;
• equipment malfunctions, failures or accidents;
• unexpected operational events and drilling conditions;
• reductions in oil or natural gas prices;
• market limitations for oil or natural gas;
• pipe or cement failures;
• casing collapses;
• lost or damaged drilling and service tools;
• loss of drilling fluid circulation;
• uncontrollable flows of oil and natural gas;
• fires and natural disasters;
• environmental hazards, such as oil and natural gas leaks, pipeline ruptures and discharges of toxic gases;
• adverse weather conditions; and
• oil or natural gas property title problems.
In the event that drilling of development wells is delayed or cancelled, or development wells have lower than anticipated production, due to one or more of the factors above or for any other reason, estimated future distributions to trust unitholders may be reduced.
Risks associated with the production, gathering, transportation and sale of oil and natural gas could adversely affect cash distributions by the trust.
The amount of cash to be received by the trust from VOC Brazos with respect to the net profits interest, the value of the trust units and the amount of cash distributions to the trust unitholders will depend upon, among other things, oil and natural gas production and prices and the costs incurred by VOC Brazos to develop and produce oil and natural gas reserves attributable to the underlying properties. Drilling, production or transportation accidents as well as adverse weather conditions that temporarily or permanently halt the production and sale of oil or natural gas at any of the underlying properties will reduce trust distributions by reducing the amount of net proceeds received by the trust and available for distribution. For example, accidents may occur that result in personal injuries, property damage, damage to productive formations or equipment and environmental damages. To the extent VOC Brazos is not able to recover from insurance any costs incurred by VOC Brazos in connection with any such accidents, the net proceeds available for distribution to the trust may be reduced or delayed. In addition, curtailments or damage to pipelines used by VOC Brazos to transport oil and natural gas production to markets for sale could reduce the amount of net proceeds received by the trust and available for distribution. Any such curtailment or damage to the gathering systems used by VOC Brazos could also require VOC Brazos to find alternative means to transport the oil and natural gas production from the underlying properties, which could require VOC Brazos to incur additional costs that will have the effect of reducing net proceeds received by the trust and available for distribution. The trust does not maintain any type of insurance against any of the risks of conducting oil and gas exploration and production or related activities.
Production of oil and natural gas on the underlying properties could be materially and adversely affected by severe or unseasonable weather.
Production of oil and natural gas on the underlying properties could be materially and adversely affected by severe weather. Repercussions of severe weather conditions may include:
• evacuation of personnel and curtailment of operations;
• weather-related damage to drilling rigs or other facilities, resulting in suspension of operations;
• inability to deliver materials to worksites; and
• weather-related damage to pipelines and other transportation facilities.
Interruptions in production could have a material adverse effect on the trust's financial condition, results of operations and cash flows, and could reduce the amount of cash distributions to unitholders.
VOC Brazos does not have any long-term contracts related to the sale of production of oil and natural gas from the underlying properties and may be unable to find purchasers.
VOC Brazos does not have any firm commitment contracts for the sale of any production nor has it received security or other guaranty of payment for the production it sells. Therefore, there can be no assurance that VOC Brazos will be able to find buyers for its production, that buyers will pay the purchase price therefor or that the price at which the production is sold will be the current market price for such hydrocarbons at the time of delivery. During the year ended December 31, 2019, VOC
Brazos sold approximately 32% of the oil produced from the underlying properties to MV Purchasing, an affiliate of VOC Brazos. Any nonpayment by a purchaser of production, including MV Purchasing, or inability by VOC Brazos to sell any production, could reduce cash available for distribution to trust unitholders.
Neither the trust nor the trust's unitholders have the ability to influence VOC Brazos or control the operations or development of the underlying properties.
The trust and the trust's unitholders have no voting rights with respect to VOC Brazos and therefore have no managerial, contractual or other ability to influence VOC Brazos' activities or the operations of the underlying properties. Oil and natural gas properties are typically managed pursuant to an operating agreement among the working interest owners of oil and natural gas properties. Vess Oil Corporation operates, or operates on a contract basis, substantially all of the underlying properties. The typical operating agreement contains procedures whereby the owners of the working interests in the property designate one of the interest owners to be the operator of the property. Under these arrangements, the operator is typically responsible for making all decisions relating to drilling activities, sale of production, compliance with regulatory requirements and other matters that affect the property.
Shortages or increases in costs of equipment, services and qualified personnel could result in a reduction in the amount of cash available for distribution to the trust unitholders.
The demand for qualified and experienced personnel to conduct field operations, geologists, geophysicists, engineers and other professionals in the oil and natural gas industry can fluctuate significantly, often in correlation with oil and natural gas prices, causing periodic shortages. Historically, there have been shortages of drilling rigs and other equipment as demand for rigs and equipment has increased along with the number of wells being drilled. These factors also cause significant increases in costs for equipment, services and personnel. Higher oil and natural gas prices generally stimulate demand and result in increased prices for drilling rigs, crews and associated supplies, equipment and services. Shortages of field personnel and equipment or price increases could significantly decrease the amount of cash received by the trust and available for distribution to the trust unitholders or restrict the ability of VOC Brazos to drill the development wells and conduct the operations which it currently has planned for the underlying properties.
The trust units may lose value as a result of title deficiencies with respect to the underlying properties.
VOC Brazos acquired the underlying properties over approximately the past 30 years. The existence of a material title deficiency with respect to the underlying properties could reduce the value of a property or render it worthless, thus adversely affecting the net profits interest and distributions to trust unitholders. VOC Brazos does not obtain title insurance covering mineral leaseholds, and VOC Brazos' failure to cure any title defects may cause VOC Brazos to lose its rights to production from the underlying properties. In the event of any such material title problem, proceeds available for distribution to trust unitholders and the value of the trust units may be reduced.
VOC Brazos may transfer all or a portion of the underlying properties at any time without trust unitholder consent, subject to specified limitations.
VOC Brazos may at any time transfer all or part of the underlying properties, subject to and burdened by the net profits interest, and may abandon individual wells or properties that it reasonably believes would no longer produce oil or natural gas in commercially paying quantities. For the years ended December 31, 2017, 2018 and 2019, VOC Brazos plugged and abandoned 11, 17 and 13 wells, respectively, located on leases on the underlying properties. Trust unitholders will not be entitled to vote on any transfer of the underlying properties, and the trust will not receive any proceeds from any such transfer, except in certain limited circumstances when the net profits interest is released in
connection with such transfer, in which case the trust will receive an amount equal to the fair market value (net of sales costs) of the net profits interest released. Following any sale or transfer of any of the underlying properties, if the net profits interest is not released in connection with such sale or transfer, the net profits interest will continue to burden the transferred property and net proceeds attributable to such property will be calculated as part of the computation of net proceeds described in this Form 10-K. VOC Brazos may delegate to the transferee responsibility for all of VOC Brazos' obligations relating to the net profits interest on the portion of the underlying properties transferred.
In addition, VOC Brazos may, without the consent of the trust unitholders, require the trust to release the net profits interest associated with any lease that accounts for less than or equal to 0.25% of the total production from the underlying properties in the prior 12 months and provided that the net profits interest covered by such releases cannot exceed, during any 12-month period, an aggregate fair market value to the trust of $500,000. These releases will be made only in connection with a sale by VOC Brazos of the relevant underlying properties and are conditioned upon the trust's receiving an amount equal to the fair market value to the trust of such net profits interest. Any net sales proceeds paid to the trust will be distributable to trust unitholders for the quarter in which they are received. No underlying properties were sold, and therefore no net sales proceeds were paid to the trust for its share of interest in any such underlying properties, during 2018 or 2019. VOC Brazos has not identified any of the underlying properties for sale as of December 31, 2019.
The reserves attributable to the underlying properties are depleting assets and production from those properties will diminish over time. Furthermore, the trust is precluded from acquiring other oil and natural gas properties or net profits interests to replace the depleting assets and production.
The net proceeds payable to the trust attributable to the net profits interest are derived from the sale of production of oil and natural gas from the underlying properties. The reserves attributable to the underlying properties are depleting assets, which means that the reserves and the quantity of oil and natural gas produced from the underlying properties will decline over time. Furthermore, over approximately 87% of the estimated oil recovery attributable to the underlying properties has already been extracted from the producing wells located on the underlying properties. Based on the estimated production volumes in the reserve report as of December 31, 2019, the oil and natural gas production from proved reserves attributable to the underlying properties is projected to decline at an average rate of approximately 8.4% per year over the next 20 years, assuming the level of development drilling and development expenditures on the underlying properties disclosed elsewhere in this Form 10-K through 2021 and none thereafter. Actual decline rates may vary from this projected decline rate. In the event expected future development is delayed, reduced or cancelled, the average rate of decline will likely exceed 8.4% per year.
The trust agreement provides that the trust's activities are limited to owning the net profits interest and any activity reasonably related to such ownership, including activities required or permitted by the terms of the conveyance. As a result, the trust is not permitted to acquire other oil and natural gas properties or net profits interests to replace the depleting assets and production attributable to the net profits interest.
Because the net proceeds payable to the trust are derived from the sale of depleting assets, the portion of the distributions to unitholders attributable to depletion may be considered to have the effect of a return of capital as opposed to a return on investment. Eventually, the underlying properties burdened by the net profits interest may cease to produce in commercially paying quantities and the trust may, therefore, cease to receive any distributions of net proceeds therefrom.
The amount of cash available for distribution by the trust will be reduced by the amount of any costs and expenses related to the underlying properties and other costs and expenses incurred by the trust.
The net profits interest will bear its share of all costs and expenses related to the underlying properties, such as lease operating expenses, production and property taxes and development expenses, which will reduce the amount of cash received by the trust and thereafter distributable to trust unitholders. Accordingly, higher costs and expenses related to the underlying properties will directly decrease the amount of cash received by the trust in respect of its net profits interest, including those costs and expenses related to development pursuant to the joint venture arrangements described in "Item 7. Trustee's Discussion and Analysis of Financial Condition and Results of Operations-Planned Development and Workover Program." If the activities pursuant to such arrangements are pursued, other than with respect to certain excepted wells, such activities would result in increased development costs burdening the net profits interest of the trust relative to historical development costs. As a result of such increased development costs, cash available for distribution by the Trust would be temporarily reduced, and in some periods there may be no distributions to unitholders, until anticipated production for the various development efforts in the Kurten Woodbine Unit can be brought on line. In addition, cash available for distribution by the trust will be further reduced by the trust's general and administrative expenses.
If production and development costs on the underlying properties together with the other costs exceed gross proceeds of production from the underlying properties, the trust will not receive net proceeds from those properties until future gross proceeds from production exceed the total of the excess costs, plus accrued interest. If the trust does not receive net proceeds pursuant to the net profits interest, or if such net proceeds are reduced, the trust will not be able to distribute cash to the trust unitholders, or such cash distributions will be reduced, respectively. Development activities may not generate sufficient additional revenue to repay the costs. If annual cash proceeds attributable to the net profits interest are less than $1 million for each of two consecutive years, then under the terms of the trust agreement, the trust would be required to dissolve.
A purchaser's failure to pay VOC Brazos for purchased production could have a significant adverse impact on VOC Brazos, which in turn could result in VOC Brazos not having sufficient net proceeds attributable to the net profits interest for VOC Brazos to distribute cash to the trust.
A purchaser's failure to pay for purchased production could have a significant adverse impact on VOC Brazos' business, which in turn could adversely affect the trust. The recent tightening of credit in the financial markets may make it more difficult for purchasers to obtain financing and depending on the degree to which this occurs, there may be a material increase in the nonpayment and nonperformance by such purchasers.
The trustee may, under certain circumstances, sell the net profits interest and dissolve the trust prior to the expected termination of the trust. As a result, trust unitholders may not recover their investment.
The trustee must sell the net profits interest if the holders of a majority of the trust units approve the sale or vote to dissolve the trust. The trustee must also sell the net profits interest if the annual cash proceeds from the underlying properties attributable to the net profits interest are less than $1.0 million for each of any two consecutive years. The sale of the net profits interest will result in the dissolution of the trust. The net proceeds of any such sale will be distributed to the trust unitholders.
The disposal by an affiliate of VOC Brazos of its remaining trust units may reduce the market price of the trust units.
As of the date of this Form 10-K, an affiliate of VOC Brazos, VOC Partners, LLC, owned 25% of the outstanding trust units. VOC Partners, LLC may use some or all of the remaining trust units it owns for a number of business purposes, including:
• selling them for cash; and
• exchanging them for interests in oil and natural gas properties or securities of oil and natural gas companies.
If it sells additional trust units or exchanges trust units in connection with acquisitions, then additional trust units will be available for sale in the market. The sale of additional trust units may reduce the market price of the trust units. The trust has entered into a registration rights agreement with VOC Partners, LLC pursuant to which the trust has agreed to file a registration statement or a shelf registration statement to register the resale of the remaining trust units held by VOC Partners, LLC and any transferee of the trust units upon request by such holders. See "Item 13. Certain Relationships and Related Transactions, and Director Independence-Registration Rights."
The market price for the trust units may not reflect the value of the net profits interest held by the trust.
The trading price for publicly traded securities similar to the trust units tends to be tied to recent and expected levels of cash distributions. The amounts available for distribution by the trust will vary in response to numerous factors outside the control of the trust, including prevailing prices for sales of oil and natural gas production from the underlying properties and the timing and amount of production and development costs. Consequently, the trading price for the trust units may not necessarily be indicative of the value that the trust would realize if it sold the net profits interest to a third-party buyer. In addition, such market price may not necessarily reflect the fact that since the assets of the trust are depleting assets, a portion of each cash distribution paid on the trust units should be considered by investors as a return of capital, with the remainder being considered as a return on investment. As a result, distributions made to a trust unitholder over the life of these depleting assets may not equal or exceed the purchase price paid by the trust unitholder.
Conflicts of interest could arise between VOC Brazos and its affiliates, on the one hand, and the trust and the trust unitholders, on the other hand.
As working interest owners in, and operators of substantially all the wells on, the underlying properties, VOC Brazos and its affiliates could have interests that conflict with the interests of the trust and the trust unitholders. For example:
• VOC Brazos' interests may conflict with those of the trust and the trust unitholders in situations involving the development, maintenance, operation or abandonment of the underlying properties. VOC Brazos may also make decisions with respect to development expenditures that adversely affect the underlying properties. These decisions include reducing development expenditures on these properties, which could cause oil and natural gas production to decline at a faster rate and thereby result in lower cash distributions by the trust in the future.
• VOC Brazos may sell some or all of the underlying properties without taking into consideration the interests of the trust unitholders. Such sales may not be in the best interests of the trust unitholders. These purchasers may lack VOC Brazos' experience or its creditworthiness. VOC Brazos also has the right, under certain limited circumstances, to cause the trust to release all or a portion of the net profits interest in connection with a sale of a portion of the underlying properties to which such net profits interest relates.
• MV Purchasing, an affiliate of VOC Brazos, is expected to market and/or purchase a substantial portion of the oil produced from the underlying properties, and it is expected to profit from this arrangement. Provisions in the net profits interest conveyance, however, require that charges and other terms under contracts with affiliates of VOC Brazos be comparable to prices and other terms prevailing in the area for similar services or sales. During the year ended December 31, 2019, VOC Brazos sold approximately 32% of the oil produced from the underlying properties to MV Purchasing.
• VOC Partners, LLC has registration rights and can sell its trust units without considering the effects such sale may have on trust unit prices or on the trust itself. In addition, VOC Partners, LLC can vote its trust units in its sole discretion without considering the interests of the other trust unitholders.
The trust is managed by a trustee who cannot be replaced except by a majority vote of the trust unitholders at a special meeting, which may make it difficult for trust unitholders to remove or replace the trustee.
The business and affairs of the trust are managed by the trustee. The voting rights of a trust unitholder are more limited than those of stockholders of most public corporations. For example, there is no requirement for annual meetings of trust unitholders or for an annual or other periodic re-election of the trustee. The trust agreement provides that the trustee may only be removed and replaced by the holders of a majority of the outstanding trust units, including trust units held by VOC Partners, LLC, at a special meeting of trust unitholders called by either the trustee or the holders of not less than 10% of the outstanding trust units. As a result, it will be difficult for public unitholders to remove or replace the trustee without the cooperation of VOC Partners, LLC as long as it holds a significant percentage of total trust units.
Trust unitholders have limited ability to enforce provisions of the net profits interest, and VOC Brazos' liability to the trust is limited.
The trust agreement permits the trustee to sue VOC Brazos or any other future owner of the underlying properties to enforce the terms of the conveyance creating the net profits interest. If the trustee does not take appropriate action to enforce provisions of the conveyance, trust unitholders' recourse would be limited to bringing a lawsuit against the trustee to compel the trustee to take specified actions. The trust agreement expressly limits a trust unitholder's ability to directly sue VOC Brazos or any other third party other than the trustee. As a result, trust unitholders will not be able to sue VOC Brazos or any future owner of the underlying properties to enforce these rights. Furthermore, the net profits interest conveyance provides that, except as set forth in the conveyance, VOC Brazos will not be liable to the trust for the manner in which it performs its duties in operating the underlying properties as long as it acts without gross negligence or willful misconduct.
Courts outside of Delaware may not recognize the limited liability of the trust unitholders provided under Delaware law.
Under the Delaware Statutory Trust Act, trust unitholders are entitled to the same limitation of personal liability extended to stockholders of corporations under the General Corporation Law of the State of Delaware. Courts in jurisdictions outside of Delaware, however, may not give effect to such limitation.
The operations of the underlying properties are subject to environmental laws and regulations that may result in significant costs and liabilities, which could reduce the amount of cash available for distribution to trust unitholders.
The oil and natural gas exploration and production operations of VOC Brazos are subject to stringent and comprehensive federal, state and local laws and regulations governing the discharge of materials into the environment or otherwise relating to environmental protection. These laws and regulations may impose numerous obligations that apply to VOC Brazos' operations, including the requirement to obtain a permit before conducting drilling, waste disposal or other regulated activities; the restriction of types, quantities and concentrations of materials that can be released into the environment; the incurrence of significant development expenditures to install pollution or safety-related controls at the operated facilities; the limitation or prohibition of drilling activities on certain lands lying within wilderness, wetlands and other protected areas; and the imposition of substantial liabilities for pollution resulting from operations. Numerous governmental authorities, such as the EPA and analogous state environmental and oil and gas agencies, have the power to enforce compliance with these laws and regulations and the permits issued under them, oftentimes requiring difficult and costly actions. Failure to comply with these laws 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 VOC Brazos' operations. Furthermore, the inability to comply with environmental laws and regulations in a cost effective manner, such as removal and disposal of produced water and other generated oil and gas wastes, could impair VOC Brazos' ability to produce oil and natural gas commercially from the underlying properties, which would reduce proceeds attributable to the net profits interest.
There is inherent risk of incurring significant environmental costs and liabilities in the performance of VOC Brazos' operations as a result of its handling of petroleum hydrocarbons and wastes, air emissions and wastewater discharges related to its operations, and historical industry operations and waste disposal practices. Under certain environmental laws and regulations, VOC Brazos could be subject to joint and several strict liability for the removal or remediation of previously released materials or property contamination regardless of whether VOC Brazos was responsible for the release or contamination or whether the operations were in compliance with all applicable laws at the time those actions were taken. Private parties, including the owners of properties upon which VOC Brazos' wells are drilled and facilities where VOC Brazos' petroleum hydrocarbons or wastes are taken for reclamation or disposal, may also have the right to pursue legal actions to enforce compliance as well as to seek damages for non-compliance with environmental laws and regulations or for personal injury or property damage. In addition, the risk of accidental spills or releases could expose VOC Brazos to significant liabilities that could have a material adverse effect on its financial condition or results of operations. Changes in environmental laws and regulations occur frequently, and any changes that result in more stringent or costly operational control requirements or waste handling, storage, transport, disposal or cleanup requirements could require VOC Brazos to make significant expenditures to attain and maintain compliance and may otherwise have a material adverse effect on its results of operations, competitive position or financial condition. VOC Brazos may be unable to recover some or any of these costs from insurance, in which case the amount of cash received by the trust may be decreased. The net profits interest held by the trust will bear 80% of all costs and expenses incurred by VOC Brazos in regard to environmental costs and liabilities associated with the underlying properties, including costs and liabilities resulting from conditions that existed prior to VOC Brazos' acquisition of the underlying properties unless such costs and expenses result from VOC Brazos' gross negligence or willful misconduct. In addition, as a result of the increased cost of compliance, VOC Brazos may decide to discontinue drilling.
The operations of the underlying properties are subject to complex federal, state, local and other laws and regulations that could adversely affect the cost, manner or feasibility of conducting its operations or expose VOC Brazos to significant liabilities, which could reduce the amount of cash available for distribution to trust unitholders.
The production and development operations on the underlying properties are subject to complex and stringent laws and regulations. In order to conduct its operations in compliance with these laws and regulations, VOC Brazos must obtain and maintain numerous permits, drilling bonds, approvals and certificates from various federal, state and local governmental authorities and engage in extensive reporting. VOC Brazos may incur substantial costs in order to maintain compliance with these existing laws and regulations, and the net profits interest will bear its share of these costs. In addition, VOC Brazos' costs of compliance may increase if existing laws and regulations are revised or reinterpreted, or if new laws and regulations become applicable to VOC Brazos' operations. Such costs could have a material adverse effect on VOC Brazos' business, financial condition and results of operations and reduce the amount of cash received by the trust in respect of the net profits interest, VOC Brazos must also comply with laws and regulations prohibiting fraud and market manipulations in energy markets. To the extent VOC Brazos is a shipper on interstate pipelines, it must comply with the tariffs of such pipelines and with federal policies related to the use of interstate capacity, and such compliance costs will be borne indirectly in part by the trust.
Laws and regulations governing exploration and production may also affect production levels. VOC Brazos is required to comply with federal and state laws and regulations governing conservation matters, including: provisions related to the unitization or pooling of oil and natural gas properties; the establishment of maximum rates of production from wells; the spacing of wells; the plugging and abandonment of wells; and the removal of related production equipment. These and other laws and regulations can limit the amount of oil and natural gas VOC Brazos can produce from its wells, limit the number of wells it can drill, or limit the locations at which it can conduct drilling operations, which in turn could negatively impact trust distributions, estimated and actual future net revenues to the trust and estimates of reserves attributable to the trust's interests.
New laws or regulations, or changes to existing laws or regulations, may unfavorably impact VOC Brazos, could result in increased operating costs or have a material adverse effect on VOC Brazos' financial condition and results of operations and reduce the amount of cash received by the trust. These and other potential regulations could increase the operating costs of the underlying properties, reduce VOC Brazos' liquidity, delay VOC Brazos' operations or otherwise alter the way VOC Brazos conducts its business, any of which could have a material adverse effect on the net profits interest and the trust's cash flows.
Climate change laws and regulations restricting emissions of "greenhouse gases" could result in increased operating costs and reduced demand for the oil and natural gas that VOC Brazos produces while the physical effects of climate change could disrupt VOC Brazos' production and cause VOC Brazos to incur significant costs in preparing for or responding to those effects.
The oil and gas industry is a direct source of certain greenhouse gases, or "GHG," emissions, namely carbon dioxide and methane, and future restrictions on such emissions could impact VOC Brazos' future operations. In 2009, the EPA published its findings that emissions of carbon dioxide, methane and other GHGs present an endangerment to public health and the environment because emissions of such gases are, according to the EPA, contributing to the warming of the earth's atmosphere and other climate changes. The EPA has taken a number of steps aimed at gathering information about, and reducing the emissions of, GHGs from industrial sources, including oil and natural gas sources. The EPA has adopted rules requiring the reporting of GHG emissions from oil, natural gas and NGL production and processing facilities on an annual basis, as well as reporting GHG emissions from gathering and boosting systems, oil well completions and workovers using hydraulic
fracturing. The EPA has also adopted and implemented regulations under existing provisions of the CAA that, among other things, establish Prevention of Significant Deterioration, or "PSD," construction and Title V operating permit reviews for GHG emissions from certain large stationary sources that already are potential major sources of certain principal, or criteria, pollutant emissions. Facilities required to obtain PSD permits for their GHG emissions also will be required to meet "best available control technology" standards that typically are established by the states. This rule could adversely affect Avalon's operations upon the Underlying Properties and restrict or delay its ability to obtain air permits for new or modified facilities that exceed GHG emission thresholds. In June 2016, the EPA published a final rule adopting New Source Performance Standards for new, modified, or reconstructed oil and gas facilities that require control of the GHG methane from affected facilities, including requirements to find and repair fugitive leaks of methane emissions at well sites, or the "Methane Rule." However, following the November 2016 presidential election and change in administrations, the EPA convened a reconsideration proceeding that culminated in a 2019 rule proposal that would eliminate the obligation to control methane emissions under the NSPS, while maintaining the rule's substantive emissions control requirements because they serve to control emissions of other, non-methane pollutants. While the ultimate fate of the Methane Rule is unclear, it may require VOC Brazos to incur development expenses to install and utilize specific equipment, technologies, or work practices to control methane emissions from its operations.
In addition, in November 2016, the U.S. Department of the Interior Bureau of Land Management, or "BLM," issued final rules to reduce methane emissions from venting, flaring, and leaks during oil and gas operations on federal and tribal lands (the "BLM Methane and Waste Prevention Rule") that are substantially similar to the EPA's Methane Rule. However, in December 2017, the BLM published a final rule to temporarily suspend or delay certain requirements contained in the BLM Methane and Waste Prevention Rule until January 17, 2019, including those requirements relating to venting, flaring and leakage from oil and gas production activities. Further, in September 2018, the BLM published a final rule to revise or rescind certain provisions of the BLM Methane and Waste Prevention Rule. While the future implementation of the EPA and BLM rules aimed at controlling GHG emissions from oil and natural gas sources remains uncertain, future federal GHG regulations for the oil and gas industry remain a possibility given the long-term trend towards increasing regulation. Moreover, several states have already adopted rules requiring operators of both new and existing sources to develop and implement a LDAR program and to install devices on certain equipment to capture 95 percent of methane emissions. Compliance with these rules could require VOC Brazos to purchase pollution control equipment and optical gas imaging equipment for LDAR inspections, and to hire additional personnel to assist with inspection and reporting requirements.
In addition, almost half of the states have already taken legal measures to reduce emissions of GHGs, primarily through the planned development of GHG emission inventories and/or regional GHG cap and trade programs. Most of these cap and trade programs work by requiring either major sources of emissions or major producers of fuels to acquire and surrender emission allowances, with the number of allowances available for purchase reduced each year until the overall GHG emission reduction goal is achieved. These reductions would be expected to cause the cost of allowances to escalate significantly over time. The adoption of any legislation or regulations that requires reporting of GHGs or otherwise limits emissions of GHGs from VOC Brazos' equipment and operations could require VOC Brazos to incur costs to monitor and report on GHG emissions or reduce emissions of GHGs associated with its operations, and such requirements also could adversely affect demand for the oil and natural gas produced, all of which could reduce proceeds attributable to the net profits interest and, as a result, the trust's cash available for distribution.
Finally, it should be noted that some scientists have concluded that increasing concentrations of GHGs in the Earth's atmosphere may produce climate changes that have significant physical effects, such as increased frequency and severity of storms, droughts, and floods and other climatic events. If
any such effects were to occur, they could have an adverse effect on VOC Brazos' assets and operations and, consequently, may reduce the proceeds attributable to the net profits interest and, as a result, the trust's cash available for distribution.
Federal and state legislative and regulatory initiatives relating to hydraulic fracturing could result in increased costs and additional operating restrictions or delays as well as adversely affect VOC Brazos' services.
Hydraulic fracturing is an important and common practice that is used to stimulate production of hydrocarbons, particularly natural gas, from tight formations. The process involves the injection of water, sand and chemicals under pressure into formations to fracture the surrounding rock and stimulate production. The process is typically regulated by state oil and gas commissions. The EPA finalized a study of the potential environmental impacts of hydraulic fracturing activities in December 2016, finding that under certain circumstances the "water cycle" activities associated with hydraulic fracturing could impact drinking water resources. Some states have adopted, and other states are considering adopting, regulations that could restrict or impose additional requirements relating to hydraulic fracturing in certain circumstances. If hydraulic fracturing is regulated at the federal level, VOC Brazos' fracturing activities could become subject to additional permit requirements or operational restrictions and also to associated permitting delays and potential increases in costs. If new laws or regulations that significantly restrict or otherwise impact hydraulic fracturing are passed by Congress or adopted in Texas or Kansas such legal requirements could make it more difficult or costly for VOC Brazos to perform hydraulic fracturing activities and thereby affect the determination of whether a well is commercially viable. More recently, the injection of water produced as a result of hydraulic fracturing has been associated with seismic activity leading to restrictions on injection in some areas. Restrictions on hydraulic fracturing and disposal of water from such production could reduce the amount of oil and natural gas that VOC Brazos is ultimately able to produce in commercially paying quantities from the underlying properties.
The bankruptcy of VOC Brazos or any operator of the underlying properties could impede the operation of the wells and the development of the proved undeveloped reserves.
VOC Brazos is a privately-held limited partnership engaged in the production and development of oil and natural gas from properties located in Kansas and Texas. VOC Brazos intends to implement a development and workover program, including the expenditure through 2023 of approximately $32.7 million to drill additional wells and recomplete and workover other wells. Without this development and workover program, the average decline rate over the life of the trust of the oil and natural gas production from the proved reserves attributable to the underlying properties will likely exceed the 8.4% per year projected in the reserve report. The operator of substantially all of the underlying properties is a privately-held corporation engaged in the operation of oil and natural gas wells in Kansas and Texas. Therefore, the value of the net profits interest and the trust's ultimate cash available for distribution will be highly dependent on the financial condition of VOC Brazos and the operator. Neither VOC Brazos nor the operator is a reporting company or files periodic reports with the SEC. Therefore, trust unitholders do not have access to financial information about VOC Brazos or the operator. Furthermore, neither VOC Brazos nor the operator has agreed with the trust to maintain a certain net worth or to be restricted by other similar covenants.
The ability of VOC Brazos to develop the underlying properties and the ability of the operator to operate the wells on the underlying properties depends on the future financial condition and economic performance and access to capital of VOC Brazos and the operator, which in turn will depend upon the supply and demand for oil and natural gas, prevailing economic conditions and financial, business and other factors, many of which are beyond the control of VOC Brazos and the operator.
In the event of the bankruptcy of VOC Brazos or the operator, the trust would have to seek a new party to perform the development and workover program or the operations of the wells operated by
such operator. The trust may not be able to find a replacement driller or operator, and it may not be able to enter into a new agreement with such replacement party on favorable terms within a reasonable period of time. As a result, such a bankruptcy may result in reduced production from the reserves and decreased distributions to trust unitholders.
The trust may be treated as an unsecured creditor with respect to the net profits interest attributable to properties in Kansas in the event of the bankruptcy of VOC Brazos if a court were to hold that the conveyance and recording of the net profits interest was not a conveyance of a fully vested real property interest or an interest in hydrocarbons in place or to be produced.
VOC Brazos and the trust believe that the recording in the appropriate real property records in Kansas of the net profits interest should constitute the conveyance of a fully vested real property interest, interests in hydrocarbons in place or to be produced or a production payment as such is defined under the United States Bankruptcy Code. In a bankruptcy of VOC Brazos, creditors of VOC Brazos would be able to claim the net profits interest as an asset of the bankruptcy estate to satisfy obligations to them if the conveyance of the net profits interest did not constitute the conveyance of a real property interest or interests in hydrocarbons in place or to be produced under applicable state law or a production payment, in which case the trust would be an unsecured creditor of VOC Brazos at risk of losing the entire value of the net profits interest to senior creditors.
Due to lack of geographic diversification of the underlying properties, adverse developments in Kansas or Texas could adversely impact the results of operations and cash flows of the underlying properties and reduce the amount of cash available for distributions to trust unitholders.
The operations of the underlying properties are focused on the production and development of oil and natural gas within the states of Kansas and Texas. As a result, the results of operations and cash flows of the underlying properties depend upon continuing operations in these areas. Due to the lack of diversification in geographic location, adverse developments in exploration and production of oil and natural gas in either of these areas of operation could have a significantly greater impact on the results of operations and cash flows of the underlying properties than if the operations were more diversified.
The trust has not requested a ruling from the IRS regarding the tax treatment of ownership of the trust units. If the IRS were to determine (and be sustained in that determination) that the trust is not a "grantor trust" for federal income tax purposes, or that the net profits interest is not properly treated as a production payment (and thus would fail to qualify as a debt instrument) for federal income tax purposes, the trust unitholders may receive different and potentially less advantageous tax treatment than expected.
If the trust were not treated as a grantor trust for federal income tax purposes, the trust should be treated as a partnership for such purposes. Although the trust would not become subject to federal income taxation at the entity level as a result of treatment as a partnership, and items of income, gain, loss and deduction would flow through to the trust unitholders, the trust's tax reporting requirements would be more complex and costly to implement and maintain, and its distributions to trust unitholders could be reduced as a result.
If the net profits interest were not treated as a production payment (and thus would fail to qualify as a debt instrument for federal income tax purposes) the amount, timing and character of income, gain, or loss in respect of an investment in the trust could be affected.
Neither VOC Brazos nor the trustee has requested a ruling from the IRS regarding these tax questions, and neither VOC Brazos nor the trust can provide assurance that such a ruling would be granted if requested or that the IRS will not challenge these positions on audit.
Cyber-attacks or other failures in telecommunications or information technology systems could result in information theft, data corruption and significant disruption of the business operations of VOC Brazos and its VOC Operators.
VOC Brazos and its VOC Operators rely on information technology ("IT") systems and networks in connection with various business activities, including exploration, development and production activities. VOC Brazos and its VOC Operators rely on digital technology, including information systems and related infrastructure, as well as cloud applications and services, to, among other things, estimate quantities of oil and natural gas reserves, analyze seismic and drilling information, process and record financial and operating data and communicate with employees and third parties. As dependence on digital technologies has increased, cyber incidents, including deliberate attacks and attempts to gain unauthorized access to computer systems and networks, have increased in frequency and sophistication. These threats pose a risk to the security of the systems and networks of VOC Brazos and its VOC Operators, the confidentiality, availability and integrity of their data and the physical security of employees and assets. VOC Brazos and its VOC Operators have experienced, and expect to continue to experience, attempts from hackers and other third parties to gain unauthorized access to IT systems and networks. Although prior cyber-attacks have not had a material adverse effect on the operations or financial performance of VOC Brazos or of its VOC Operators, VOC Brazos and its VOC Operators may not be successful in preventing cyber-attacks or mitigating their effect. Any cyber-attack could have a material adverse effect on the reputation, competitive position, business, financial condition and results of operations of VOC Brazos and its VOC Operators, and could have a material adverse effect on the trust. Cyber-attacks or security breaches also could result in litigation or regulatory action, as well as significant additional expense to VOC Brazos and its VOC Operators to implement further data protection measures.
In addition to the risks presented to the systems and networks of VOC Brazos and its VOC Operators, cyber-attacks affecting oil and natural gas distribution systems maintained by third parties, or the networks and infrastructure on which they rely, could delay or prevent delivery to markets. A cyber-attack of this nature would be outside the ability of VOC Brazos and its VOC Operators to control, but could have a material adverse effect on the business, financial condition and results of operations of VOC Brazos and its VOC Operators, and could have a material adverse effect on the trust.
Cyber-attacks or other failures in telecommunications or IT systems could result in information theft, data corruption and significant disruption of the Trustee's operations.
The trustee depends heavily upon IT systems and networks in connection with its business activities. Despite a variety of security measures implemented by the trustee, events such as the loss or theft of back-up tapes or other data storage media could occur, and the trustee's computer systems could be subject to physical and electronic break-ins, cyber-attacks and similar disruptions from unauthorized tampering, including threats that may come from external factors, such as governments, organized crime, hackers and third parties to whom certain functions are outsourced, or may originate internally from within the respective companies.
If a cyber-attack were to occur, it could potentially jeopardize the confidential, proprietary and other information processed and stored in, and transmitted through, the trustee's computer systems and networks, or otherwise cause interruptions or malfunctions in the operations of the trust, which could result in litigation, increased costs and regulatory penalties. Although steps are taken to prevent and detect such attacks, it is possible that a cyber incident will not be discovered for some time after it occurs, which could increase exposure to these consequences.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
Reference is made to "Item 1 - Business" and "Item 7 - Trustee's Discussion and Analysis of Financial Condition and Results of Operations-Planned Development and Workover Program," which are incorporated herein by reference.
Item 3.
Item 3. Legal Proceedings.
Currently, there are no legal proceedings pending to which the trust is a party or of which any of its property is the subject.
Item 4.
Item 4. Mine Safety Disclosures.
None.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Unitholder Matters and Issuer Purchases of Equity Securities.
The trust units commenced trading on the New York Stock Exchange on May 10, 2011 under the symbol "VOC." As of March 13, 2020, the 17,000,000 units outstanding were held by 11 unitholders of record.
Each quarter, the trustee determines the amount of funds available for distribution to the trust unitholders. Available funds are the excess cash, if any, received by the trust from the net profits interest and other sources (such as interest earned on any amounts reserved by the trustee) that quarter, over the trust's expenses for that quarter. Available funds are reduced by any cash that the trustee decides to hold as a reserve against future expenses. Quarterly cash distributions during the term of the trust are made by the trustee on or before the 45th day following the end of each quarter to the trust unitholders of record on the 30th day following the end of each quarter (or the next succeeding business day).
Equity Compensation Plans
The trust does not have any employees and, therefore, does not maintain any equity compensation plans.
Recent Sales of Unregistered Securities
There were no equity securities sold by the trust during the year ended December 31, 2019 that were not registered under the Securities Act of 1933, as amended, which we refer to as the "Securities Act."
Purchases of Equity Securities
There were no purchases of trust units by the trust or any affiliated purchaser during the fourth quarter of the year ended December 31, 2019.
Item 6.
Item 6. Selected Financial Data.
The following table sets forth selected data for the trust as of December 31, 2015, 2016, 2017, 2018 and 2019, and for the years ended December 31, 2015, 2016, 2017, 2018 and 2019, based on the audited statements of assets and trust corpus as of December 31, 2015, 2016, 2017, 2018 and 2019 and the audited statements of distributable income for the years ended December 31, 2015, 2016, 2017, 2018 and 2019.
Item 7.
Item 7. Trustee's Discussion and Analysis of Financial Condition and Results of Operations.
The following review of the trust's financial condition and results of operations should be read in conjunction with the financial statements and notes thereto. The trust's purpose is, in general, to hold the net profits interest, to distribute to the trust unitholders cash that the trust receives in respect of the net profits interest, and to perform certain administrative functions in respect of the net profits
interest and the trust units. The trust derives substantially all of its income and cash flows from the net profits interest.
Critical Accounting Policies
The trust uses the modified cash basis of accounting to report receipts by the trust of the net profits interest and payments of expenses incurred. The net profits interest represents the right to receive revenues (oil and natural gas sales), less direct operating expenses (lease operating expenses and production and property taxes) and development expenses (which are capitalized in financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP")) of the underlying properties, times 80%. Cash distributions of the trust will be made based on the amount of cash received by the trust pursuant to terms of the conveyance creating the net profits interest.
The financial statements of the trust, as prepared on a modified cash basis, reflect the trust's assets, trust corpus, earnings and distributions as follows:
(a)Income from the net profits interest is recorded when distributions are received by the trust;
(b)Distributions to trust unitholders are recorded when paid by the trust;
(c)Trust general and administrative expenses (which include the trustee's fees as well as accounting, engineering, legal and other professional fees) are recorded when paid;
(d)Cash reserves for trust expenses may be established by the trustee for certain expenditures that would not be recorded as contingent liabilities under U.S. GAAP;
(e)Amortization of the investment in net profits interest, calculated using the units-of-production method based upon total estimated proved reserves, is charged directly to trust corpus and does not affect distributable income; and
(f)The trust evaluates its investment in the net profits interest periodically to determine whether its aggregate value has been impaired below its total capitalized cost based on the underlying properties. The trust will provide a write-down to its investment in the net profits interest if and when total capitalized costs, less accumulated amortization, exceed undiscounted future net cash flows attributable to the trust's interests in the proved oil and gas reserves of the underlying properties.
While these statements differ from financial statements prepared in accordance with U.S. GAAP, the modified cash basis of reporting revenues and distributions is considered most meaningful because quarterly distributions to the trust unitholders are based on net cash receipts received from VOC Brazos.
This comprehensive basis of accounting other than U.S. GAAP corresponds to the accounting permitted for royalty trusts by the SEC as specified by Staff Accounting Bulletin Topic 12:E, Financial Statements of Royalty Trusts.
The following is a summary of income from net profits interest received by the trust for the years ended December 31, 2017, 2018 and 2019, consisting of the February, May, August and November distributions for each respective year.
(1)Oil and gas sales volumes and related revenues for the year ended December 31, 2017 (consisting of VOC Brazos' February, May, August and November 2017 net profits interest distributions to the trust) generally represent the production by VOC Brazos from September 2016 through August 2017.
(2)Oil and gas sales volumes and related revenues for the year ended December 31, 2018 (consisting of VOC Brazos' February, May, August and November 2018 net profits interest distributions to the trust) generally represent the production by VOC Brazos from September 2017 through August 2018.
(3)Oil and gas sales volumes and related revenues for the year ended December 31, 2019 (consisting of VOC Brazos' February, May, August and November 2019 net profits interest distributions to the trust) generally represent the production by VOC Brazos from September 2018 through August 2019.
Included in the results of operations for the year ended December 31, 2017 is the following information representing a one-time event associated with the collection of proceeds of $1,209,412,
which VOC Brazos received in connection with the settlement of a lawsuit arising from an unaffiliated operator having drilled and completed a well across land partly owned by VOC Brazos without observing VOC Brazos' legal ownership in such well. In connection with the settlement, VOC Brazos received a working interest in the well and the settlement proceeds. The following table includes the well's volumes, average sales prices and net profits for the period from January 2015 through the quarter ended March 31, 2017. The extended period of time reflected in the table below is due to the time it took for the settlement to be finally approved by the court and the parties to the lawsuit. As a result, VOC Brazos was not able to distribute the settlement proceeds and net proceeds received from its net profits interest in such well until the quarter ended March 31, 2017.
Comparison of Results of the Trust for the Years Ended December 31, 2019 and 2018
Income from Net Profits Interest. Income from net profits interest is recorded on a modified cash basis when the trust receives net profits interest proceeds from VOC Brazos. Net profits interest proceeds that VOC Brazos remits to the trust are based on the oil and gas production VOC Brazos has received payment for within one month following the end of the most recent fiscal quarter. VOC Brazos receives payment for its crude oil sales generally within 30 days following the month in which it is produced. Income from net profits interest is generally a function of oil and gas gross proceeds, lease operating expenses, production and property taxes and development expenses as follows:
Total oil and natural gas sales. Oil and natural gas sales were $32,951,145 for the year ended December 31, 2019, an increase of $623,229 or 1.9% from $32,327,916 for the year ended December 31, 2018. Revenues are a function of oil and natural gas sales prices and volumes sold. The increase in gross proceeds was due to an increase in oil sales volumes partially offset by a small decrease in gas sales volumes during 2019 compared to 2018. This increase was also partially offset by a decrease in market prices for oil and natural gas sales during 2019 compared to 2018. Oil sales volumes were 570,216 Bbls for the year ended December 31, 2019, an increase of 42,167 Bbls or 8.0% from 528,049 Bbls for the year ended December 31, 2018, while natural gas sales volumes were 330,906 Mcf, a decrease of 76 Mcf from 330,982 Mcf for the year ended December 31, 2018. During the year ended
December 31, 2019, the average price for oil decreased 5.2% to $56.11 per Bbl and the average price for natural gas decreased 11.0% to $2.90 per Mcf.
Costs. Lease operating expenses were $12,688,464 for the year ended December 31, 2019, an increase of $206,750 or 1.7% from $12,481,714 for the year ended December 31, 2018. The increase was primarily due to increases in the costs of oilfield goods and services. Production and property taxes were $1,755,076 for the year ended December 31, 2019, a decrease of $318,877 or 15.4% from $2,073,953 for the year ended December 31, 2018. The decrease is primarily due to a $380,540 or 30.6% decrease in property taxes partially offset by an increase of $61,663 or 7.4% in production taxes as a result of higher oil sales volumes. Development expenses were $2,680,356 for the year ended December 31, 2019, an increase of $1,081,486 or 67.6% from $1,598,870 for 2018. The increase was primarily due to an increase in the limited drilling activity and corresponding limited development expenses during the year ended December 31, 2019 compared to the year ended December 31, 2018.
Excess of revenues over direct operating expenses and lease equipment and development costs. The excess of revenues over direct operating expenses and lease equipment and development costs from the underlying properties was $15,827,249 for the year ended December 31, 2019, a decrease of $346,130 or 2.1% from $16,173,379 for the year ended December 31, 2018. The trust's 80% net profits interest of these totals were $12,661,799 and $12,938,703, respectively. During the years ended December 31, 2019 and 2018, VOC Brazos did not withhold or release any dollar amounts due to the Trust from previously established cash reserve for future development, maintenance or operating expenditures, which resulted in income from the net profits interest of $12,661,799 and $12,938,703 for such years, respectively. These amounts were further reduced by a trust holdback for future expenses of $846,799 and $868,703 for the years ended December 31, 2019 and 2018, respectively. The trustee paid general and administrative expenses of $880,832 for the year ended December 31, 2019, an increase of $55,774 from $825,058 for the year ended December 31, 2018. These factors resulted in distributable income for the year ended December 31, 2019 of $11,815,000, a decrease of $255,000 from $12,070,000 for the year ended December 31, 2018.
Comparison of Results of the Trust for the Years Ended December 31, 2018 and 2017
Income from Net Profits Interest. Income from net profits interest is recorded on a modified cash basis when the trust receives net profits interest proceeds from VOC Brazos. Net profits interest proceeds that VOC Brazos remits to the trust are based on the oil and gas production VOC Brazos has received payment for within one month following the end of the most recent fiscal quarter. VOC Brazos receives payment for its crude oil sales generally within 30 days following the month in which it is produced. Income from net profits interest is generally a function of oil and gas gross proceeds, lease operating expenses, production and property taxes and development expenses as follows:
Total oil and natural gas sales. Oil and natural gas sales were $32,327,916 for the year ended December 31, 2018, an increase of $6,769,407 or 26.5% from $25,558,509 (including $265,723 as noted above for a one-time event) for the year ended December 31, 2017. Revenues are a function of oil and natural gas sales prices and volumes sold. The increase in gross proceeds was due to higher market prices for oil and natural gas during 2018 compared to 2017. These increases were partially offset by a decrease in oil sales volumes and gas sales volumes during 2018 compared to 2017. During the year ended December 31, 2018, the average price for oil increased 30.8% to $59.18 per Bbl and the average price for natural gas increased 17.3% to $3.26 per Mcf. Oil sales volumes were 528,049 Bbls for the year ended December 31, 2018, a decrease of 15,805 Bbls or 2.9% from 543,854 Bbls (including 5,864 Bbls as noted above for a one-time event) for the year ended December 31, 2017, while natural gas sales volumes were 330,982 Mcf a decrease of 7,948 Mcf or 2.3% from 338,930 Mcf (including 6,420 Mcf as noted above for a one-time event).
Costs. Lease operating expenses were $12,481,714 for the year ended December 31, 2018, an increase of $831,049 or 7.1% from $11,650,665 (including $43,369 as noted above for a one-time event) for the year ended December 31, 2017. The increase was primarily due to increases in the costs of oilfield goods and services. Production and property taxes were $2,073,953 for the year ended December 31, 2018, an increase of $516,985 or 33.2% from $1,556,968 (including $16,984 as noted above for a one-time event) for the year ended December 31, 2017. The increase is primarily due to a 36.7% increase in property taxes and an increase of 28.2% in production taxes as a result of higher prices for oil and natural gas. Development expenses were $1,598,870 for the year ended December 31, 2018, a decrease of $450,141 or 22.0% from $2,049,011 for 2017. The decrease was primarily due to limited drilling activity and corresponding limited development expenses during the year ended December 31, 2018 compared to the year ended December 31, 2017.
Excess of revenues over direct operating expenses and lease equipment and development costs. The excess of revenues over direct operating expenses and lease equipment and development costs from the underlying properties was $16,173,379 for the year ended December 31, 2018, an increase of $4,662,102 or 40.5% from $11,511,277 (including $205,370 and $1,209,412 as noted above for a one-time event and lawsuit settlement, respectively) for the year ended December 31, 2017. The trust's 80% net profits interest of these totals were $12,938,703 and $9,209,023, respectively. During the years ended December 31, 2018 and 2017, VOC Brazos did not withhold or release any dollar amounts due to the Trust from previously established cash reserve for future development, maintenance or operating expenditures, which resulted in income from the net profits interest of $12,938,703 and $9,209,023 for such years, respectively. These amounts were further reduced by a trust holdback for future expenses of $868,703 and $794,023 for the years ended December 31, 2018 and 2017, respectively. The trustee paid general and administrative expenses of $825,058 for the year ended December 31, 2018, an increase of $108,915 from $716,143 for the year ended December 31, 2017. These factors resulted in distributable income for the year ended December 31, 2018 of $12,070,000, an increase of $3,655,000 from $8,415,000 for the year ended December 31, 2017.
Liquidity and Capital Resources
Other than trust administrative expenses, including any reserves established by the trustee for future liabilities, the trust's only use of cash is for distributions to trust unitholders. Available funds are the excess cash, if any, received by the trust from the net profits interest and payments from other sources (such as interest earned on any amounts reserved by the trustee) in that quarter, over the trust's expenses paid for that quarter. Available funds are reduced by any cash the trustee decides to hold as a reserve against future expenses. As of December 31, 2019, the trustee held $326,132 as such a reserve. The trust paid, out of the first cash payment received by the trust, the trustee's and Delaware trustee's legal expenses incurred in forming the trust, in connection with the initial public offering (that were not otherwise paid by VOC Brazos) and related matters, as well as the Delaware trustee's acceptance fee in the amount of $5,000.
The trustee can authorize the trust to borrow money to pay trust administrative or incidental expenses that exceed cash held by the trust. The trustee may authorize the trust to borrow from the trustee as lender provided the terms of the loan are fair to the trust unitholders. The trustee may also deposit funds awaiting distribution in an account with itself, if the interest paid to the trust at least equals amounts paid by the trustee on similar deposits, and make no other short-term investments with the funds distributed to the trust. The trustee has no current plans to authorize the trust to borrow money. If the trust borrows funds, the trust unitholders will not receive distributions until the borrowed funds are repaid. During the year ended December 31, 2019, the trust made no borrowings.
As substantially all of the underlying properties are located in mature fields, VOC Brazos does not expect future costs for the underlying properties to change significantly as compared to recent historical costs other than changes due to fluctuations in the cost of oilfield services generally. However, see
"Item 7. Trustee's Discussion and Analysis of Financial Condition and Results of Operations-Planned Development and Workover Program" below. VOC Brazos has agreed to post a letter of credit in the amount of $1.7 million in favor of the trustee to protect the trustee against the risk that the trust does not have sufficient cash to pay its expenses.
The trust pays the trustee an administrative fee of $150,000 per year. The trust pays the Delaware trustee a fee of $2,500 per year. The trust also incurs, either directly or as a reimbursement to the trustee, legal, accounting, tax and engineering fees, printing costs and other expenses that are deducted by the trust before distributions are made to trust unitholders, including the $18,750 administrative services fee payable quarterly to VOC Brazos pursuant to an administrative services agreement. The trust is also responsible for paying other expenses incurred as a result of being a publicly traded entity, including costs associated with annual and quarterly reports to trust unitholders, tax return and Form 1099 preparation and distribution, NYSE listing fees, independent auditor fees and registrar and transfer agent fees.
The trust does not have any transactions, arrangements or other relationships with unconsolidated entities or persons that could materially affect the trust's liquidity or the availability of capital resources.
Planned Development and Workover Program
The primary goals of VOC Brazos' development and workover program have been to develop proved undeveloped reserves, manage workovers and minimize the natural decline in production in areas in which it operates. However, VOC Brazos is not obligated to undertake any development activities, so any drilling and completing activities will be subject to the reasonable discretion of VOC Brazos. No assurance can be given, however, that any development well will produce in commercially paying quantities or that the characteristics of any development well will match the characteristics of VOC Brazos' existing wells or VOC Brazos' historical drilling success rate. With respect to the underlying properties, VOC Brazos expects, but is not obligated, to implement the following development strategies specific to each of its primary operating areas:
• Kansas. VOC Brazos' historical development and workover program for the Kansas Underlying Properties has included recompleting certain existing wells, drilling infill development wells, conducting 3-D seismic surveys, completing workovers and applying new production technologies. VOC Brazos expects to incur future development expenditures for these properties through December 31, 2023 of approximately $1.9 million, of which VOC Brazos contemplates spending approximately $1.6 million to drill and complete seven vertical wells. The remaining approximately $0.3 million is expected to be used for recompletions and workovers of nine wells.
• Texas. VOC Brazos' historical development and workover program for the Texas underlying properties has included recompleting certain existing wells, drilling infill development wells, completing workovers and applying new production technologies. In particular, since 2003, through its ownership in the Kurten Woodbine Unit, VOC Brazos has pursued operational, strategic and technological initiatives to economically produce and sell hydrocarbons from the Woodbine Interval, also commonly referred to as the Eaglebine formation, which is the correlative interval defined as encompassing all depths from the base of the Austin Chalk to the top of the Buda formation. VOC Brazos has: (a) operated approximately 100 primary and secondary recovery vertical wells in various Woodbine sands, (b) drilled, completed and operated 13 horizontal wells primarily from, but not limited to, the Woodbine C sand, (c) conducted geologic evaluations, including 3-D seismic data acquisition and analysis, of the source shale present throughout the Woodbine Interval, and (d) most recently, pursued development of the lower depths of the source shale present throughout the Woodbine Interval, defined as the Lower Woodbine Organic Shale ("LWOS").
In 2018, VOC Brazos entered into a new joint venture agreement with Hawkwood Energy East Texas, LLC ("Hawkwood"). Under the terms of the new joint venture agreement, Hawkwood carried VOC Brazos for its share of drilling and completion costs for four LWOS wells (the "Hawkwood Earning Wells"). In exchange, Hawkwood earned a working interest representing 50% of VOC Brazos' interest in each Hawkwood Earning Well and up to a 50% interest in VOC Brazos' acreage in the south half of the Kurten Woodbine Unit. Hawkwood now has the right to propose and drill up to twelve LWOS wells in 2020, with no contractual limitation of the number of wells per year to propose and drill after 2020 (collectively, the "Hawkwood Development Wells"). To date, Hawkwood has drilled and completed the four Hawkwood Earning Wells and four Hawkwood Development Wells. VOC Brazos is paying Vess Oil, as the operator, for its share of costs and related interest in the Hawkwood Development wells, as net revenue from each of the wells is received, thereby having no current effect to Trust distributions. The balance of the unpaid costs that would have had an effect on the distributions to trust unitholders through the November 14, 2019 distribution was $2,220,352. The unpaid balance thru December 31, 2019 was $5,354,517; as of March 13, 2020, the current unpaid balance is $4,219,530.
In 2018, VOC Brazos also entered into a joint venture agreement with MD America Energy, LLC ("MD America") to develop the LWOS, within the north half of the Kurten Woodbine Unit (the "North Contract Area"). Under the terms of the joint venture agreement, MD America may carry VOC Brazos for its share of drilling and completion costs for up to four LWOS wells (the "MD Earning Wells"), with the first MD Earning Well to be spud by December 31, 2018 and the fourth MD Earning Well to be spud by November 20, 2020. In exchange, MD America has the opportunity to earn a working interest representing 50% of VOC Brazos' interest in each MD Earning Well and up to a 50% interest in VOC Brazos' acreage in the North Contract Area. After the MD Earning Wells are completed, MD America also has the right to propose and drill up to three LWOS wells per year. MD America spudded the first MD Earning Well on November 20, 2018 and has since drilled and set production casing for the well, with completion expected to occur later in 2020.
VOC Brazos is evaluating the potential economic benefits associated with development of the LWOS. If these activities are pursued, with the exception of the MD Earning Wells in which MD America would carry VOC Brazos for its share of drilling and completion costs, such activities would result in increased development costs burdening the net profits interest of the trust relative to historical development costs. As a result of such increased development costs, cash available for distribution by the trust would be temporarily reduced, and in certain periods there may be no distributions to unitholders, until anticipated production from the various development efforts in the Kurten Woodbine Unit can be brought on-line. To address these emerging opportunities, VOC Brazos will continue to evaluate the appropriate strategy and capital plan to fund development for the trust.
VOC Brazos expects to incur future development expenditures for the Texas underlying properties through December 31, 2022 of approximately $12.2 million to drill and complete three horizontal wells in the Woodbine C formation and approximately $12.6 million to drill and complete four Hawkwood Development Wells, all within the Woodbine Interval of the Kurten Woodbine Unit. Additionally, VOC Brazos expects to incur approximately $5.4 million to pay the operator for the costs of two previously drilled Hawkwood Development Wells incurred on behalf of VOC Brazos, and approximately $0.6 million to convert 14 horizontal wells from gas lift to rod pump. The trust will indirectly bear an 80% share of these development expenditures as described below.
The trust is not directly obligated to pay any portion of the capital expenditures made with respect to the underlying properties; however, capital expenditures made by VOC Brazos with respect to the
underlying properties will be deducted from the gross proceeds in calculating the net proceeds from which cash will be paid to the trust. As a result, the trust will indirectly bear an 80% (subject to certain limitations during the final three years of the trust, as described above under "Item 1. Business-Computation of Net Proceeds-Net Profits Interest") share of any capital expenditures made with respect to the underlying properties. Accordingly, higher or lower capital expenditures will, in general, directly decrease or increase, respectively, the cash received by the trust in respect of its net profits interest, which will have a corresponding effect on cash available for distribution to unitholders. As the cash received by the trust in respect of the net profits interest will be reduced by the trust's pro rata share of these capital expenditures, VOC Brazos expects that it will incur capital expenditures with respect to the underlying properties throughout the term of the trust on a basis that balances the impact of the capital expenditures on current cash distributions to the trust unitholders with the longer term benefits of increased oil and natural gas production expected to result from the capital expenditures. In addition, VOC Brazos may establish a capital reserve of up to $1.0 million in the aggregate at any given time to reduce the impact on distributions of uneven capital expenditure timing. However, if annual cash proceeds attributable to the net profits interest are less than $1 million for each of two consecutive years, then under the terms of the trust agreement, the trust would be required to dissolve.
VOC Brazos, as the designated operator of the underlying properties, is entitled to make all determinations related to capital expenditures with respect to the underlying properties, and there are no limitations on the amount of capital expenditures that VOC Brazos may incur with respect to the underlying properties. VOC Brazos is required under the conveyance to use commercially reasonable efforts to cause the operators of the underlying properties to operate these properties as would a reasonably prudent operator acting with respect to its own properties (without regard to the existence of the net profits interest). As the trust unitholders would not be expected to fully realize the benefits of capital expenditures made with respect to the underlying properties towards the end of the term of the trust, during each twelve-month period beginning on the later to occur of (1) December 31, 2027 and (2) the time when 9.8 MMBoe have been produced from the underlying properties and sold (which is the equivalent of 7.8 MMBoe in respect of the net profits interest), capital expenditures that may be taken into account in calculating net proceeds attributable to the net profits interest will be limited to the average annual capital expenditures during the preceding three years, as increased by 2.5% to account for expected increased costs due to inflation.
Off-Balance Sheet Arrangements
The trust has no off-balance sheet arrangements. The trust has not guaranteed the debt of any other party, nor does the trust have any other arrangements or relationships with other entities that could potentially result in unconsolidated debt, losses or contingent obligations.
Contractual Obligations
As of December 31, 2019, the trust had no obligations or commitments to make future contractual payments other than the administrative services fee and trustee fee payable to VOC Brazos and the trustee, respectively. See "Item 8. Financial Statements and Supplementary Data-Notes to Financial Statements-Note G-Related Party Transactions."
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
The trust is a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and is not required to provide the information under this item.
Item 8.
Item 8. Financial Statements and Supplementary Data.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Trustee and Unitholders
VOC Energy Trust
Opinion on the financial statements
We have audited the accompanying statements of assets and trust corpus of VOC Energy Trust (the "Trust") as of December 31, 2018 and 2019, the related statements of distributable income and changes in trust corpus for each of the three years in the period ended December 31, 2019, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the assets and trust corpus of the Trust as of December 31, 2018 and 2019, and its distributable income and its changes in trust corpus for each of the three years in the period ended December 31, 2019, in conformity with the modified cash basis of accounting described in Note B to the financial statements.
Basis of accounting
As described in Note B to the financial statements, these financial statements have been prepared on a modified cash basis of accounting, which is a comprehensive basis of accounting other than accounting principles generally accepted in the United States of America.
Basis for opinion
These financial statements are the responsibility of the Trustee. Our responsibility is to express an opinion on the Trust's financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Trust in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Trust is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Trust's internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by the Trustee, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ Grant Thornton LLP
We have served as the Trust's auditor since 2010.
Oklahoma City, Oklahoma
March 13, 2020
VOC ENERGY TRUST
STATEMENTS OF ASSETS AND TRUST CORPUS
STATEMENTS OF DISTRIBUTABLE INCOME
(1)Includes $70,260, $121,475 and $75,995 paid to VOC Brazos and $150,000, $150,000 and $150,000 paid to The Bank of New York Mellon Trust Company, N.A. for the years ended December 31, 2017, 2018 and 2019, respectively.
STATEMENTS OF CHANGES IN TRUST CORPUS
The accompanying notes are an integral part of these financial statements.
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS
NOTE A-ORGANIZATION OF THE TRUST
VOC Energy Trust (the "Trust") is a statutory trust formed on November 3, 2010 (capitalized on December 17, 2010) under the Delaware Statutory Trust Act pursuant to a trust agreement dated November 3, 2010 (as amended and restated on May 10, 2011, the "Trust Agreement") among VOC Brazos Energy Partners, L.P., a Texas limited partnership ("VOC Brazos"), as trustor, The Bank of New York Mellon Trust Company, N.A., as Trustee (the "Trustee"), and Wilmington Trust Company, as Delaware Trustee (the "Delaware Trustee"). The Trust was created to acquire and hold a term net profits interest for the benefit of the Trust unitholders.
VOC Brazos is a privately-held limited partnership engaged in the production and development of oil and natural gas from properties located in Texas. VOC Kansas Energy Partners, L.L.C., a Kansas limited liability company ("VOC Kansas"), is a privately-held limited liability company engaged in the production and development of oil and natural gas from properties primarily located in Kansas along with a limited number of Texas properties. In connection with the closing of the initial public offering of units of beneficial interest in the Trust ("Trust Units") in May 2011, VOC Brazos acquired all of the membership interests in VOC Kansas in exchange for newly issued limited partner interests in VOC Brazos pursuant to a Contribution and Exchange Agreement, dated August 30, 2010, as amended, by and between VOC Brazos and VOC Kansas. This resulted in VOC Kansas becoming a wholly-owned subsidiary of VOC Brazos.
The Trust was created to acquire and hold a term net profits interest representing the right to receive 80% of the net proceeds (calculated as described below in Note C) from production from the Underlying Properties (as defined below). The net profits interest consists of working interests in substantially all of the oil and natural gas properties held by VOC Brazos and VOC Kansas in the States of Kansas and Texas as of the date of the conveyance of the net profits interest to the Trust. We refer to the properties in which the Trust holds the net profits interest as the "Underlying Properties."
The net profits interest is passive in nature, and the Trustee has no management control over and no responsibility relating to the operation of the Underlying Properties. The net profits interest entitles the Trust to receive 80% of the net proceeds attributable to VOC Brazos' interest from the sale of production from the underlying properties during the term of the Trust. The net profits interest will terminate on the later to occur of (1) December 31, 2030 or (2) the time when 10.6 million barrels of oil equivalent ("MMBoe") (which is the equivalent of 8.5 MMBoe in respect of the net profits interest) have been produced from the Underlying Properties and sold, and the Trust will soon thereafter wind up its affairs and terminate.
As of December 31, 2019, cumulatively, since inception, the Trust has received payment for approximately 5.1 MMBoe (unaudited).
The trust will dissolve prior to its termination if:
• the trust sells the net profits interest;
• annual cash proceeds attributable to the net profits interest are less than $1 million for each of two consecutive years;
• the holders of a majority of the outstanding trust units vote in favor of dissolution; or
• there is a judicial dissolution of the trust.
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE A-ORGANIZATION OF THE TRUST (Continued)
Upon dissolution, the trustee would sell all of the trust's assets, either by private sale or public auction, and distribute the net proceeds of the sale to the trust unitholders.
The Trustee can authorize the Trust to borrow money to pay administrative or incidental expenses of the Trust that exceed cash held by the Trust. The Trustee may authorize the Trust to borrow from the Trustee or the Delaware Trustee as a lender provided the terms of the loan are similar to the terms it would grant to a similarly situated commercial customer with whom it did not have a fiduciary relationship. The Trustee may also deposit funds awaiting distribution in an account with itself and make other short-term investments with the funds distributed to the Trust.
NOTE B-TRUST ACCOUNTING POLICIES
A summary of the significant accounting policies of the Trust follows.
1.Basis of accounting The Trust uses the modified cash basis of accounting to report receipts by the Trust of the net profits interest and payments of expenses incurred. The net profits interest represents the right to receive revenues (oil and natural gas sales), less direct operating expenses (lease operating expenses and production and property taxes) and development expenses (which are capitalized in financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP")) of the Underlying Properties times 80%. Cash distributions of the Trust will be made based on the amount of cash received by the Trust pursuant to terms of the conveyance creating the net profits interest.
The financial statements of the Trust, as prepared on a modified cash basis, reflect the Trust's assets, Trust corpus, and distributable income as follows:
(a)Income from net profits interest is recorded when distributions are received by the Trust;
(b)Distributions to Trust unitholders are recorded when paid by the Trust;
(c)Trust general and administrative expenses (which includes the Trustee's fees as well as accounting, engineering, legal and other professional fees) are recorded when paid;
(d)Cash reserves for Trust expenses may be established by the Trustee for certain expenditures that would not be recorded as contingent liabilities under U.S. GAAP;
(e)Amortization of the investment in net profits interest, calculated using the units-of-production method based upon total estimated proved reserves, is charged directly to Trust corpus and does not affect distributable income; and
(f)The Trust evaluates its investment in the net profits interest periodically to determine whether its aggregate value has been impaired below its total capitalized cost based on the Underlying Properties. The Trust will provide a write-down to its investment in the net profits interest if and when total capitalized costs, less accumulated amortization, exceed undiscounted future net cash flows attributable to the Trust's interests in the proved oil and gas reserves of the Underlying Properties.
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE B-TRUST ACCOUNTING POLICIES (Continued)
While these statements differ from financial statements prepared in accordance with U.S. GAAP, the modified cash basis of reporting revenues and distributions is considered most meaningful because quarterly distributions to the Trust unitholders are based on net cash receipts.
This comprehensive basis of accounting other than U.S. GAAP corresponds to the accounting permitted for royalty trusts by the U.S. Securities and Exchange Commission (the "SEC") as specified by Staff Accounting Bulletin Topic 12:E, Financial Statements of Royalty Trusts.
No new accounting pronouncements have been adopted or issued during the year ended December 31, 2018 that would impact the financial statements of the Trust.
2.Cash equivalents For purposes of these statements, the Trust considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.
3.Use of estimates The preparation of financial statements requires estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates.
Significant estimates affecting these financial statements include estimates of proved oil and gas reserves, which are used to compute the Trust's amortization of net profits interest.
NOTE C-NET PROFITS INTEREST
Under the conveyance, 80% of the aggregate net proceeds attributable to the sale of oil and natural gas production from the Underlying Properties for each calendar quarter will be paid to the Trust on or before the 30th day of the month following the end of each quarter. VOC Brazos will not pay to the Trust any interest on the net proceeds held by VOC Brazos prior to payment to the Trust. The Trustee will make distributions to Trust unitholders quarterly.
"Gross proceeds" means the aggregate amount received by VOC Brazos from sales of oil and natural gas produced from the Underlying Properties (other than amounts received for certain future non-consent operations). However, gross proceeds does not include consideration for the transfer or sale of any underlying property by VOC Brazos or any subsequent owner to any new owner. Gross proceeds also does not include any amount for oil or natural gas lost in production or marketing or used by the owner of the Underlying Properties in drilling, production and plant operations. Gross proceeds includes payments for future production if they are not subject to repayment in the event of insufficient subsequent production.
"Net proceeds" means gross proceeds less the following costs:
• all payments to mineral or landowners, such as royalties, overriding royalties or other burdens against production, delay rentals, shut-in oil and natural gas payments, minimum royalty or other payments for drilling or deferring drilling;
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE C-NET PROFITS INTEREST (Continued)
• any taxes paid by the owner of an Underlying Property to the extent not deducted in calculating gross proceeds, including estimated and accrued general property (ad valorem), production, severance, sales, gathering, excise and other taxes;
• any extraordinary taxes or windfall profits taxes that may be assessed in the future that are based on profits realized or prices received for production from the Underlying Properties;
• costs paid by an owner of a property comprising the Underlying Properties under any joint operating agreement pursuant to the terms of the conveyance;
• all other costs and expenses, development costs and liabilities of drilling, recompleting, workovers, operating and producing oil and natural gas, including allocated expenses such as labor, vehicle and travel costs and materials and any plugging and abandonment liabilities (net of any development costs for which a reserve had already been made to the extent such development costs are incurred during the computation period) other than costs and expenses for certain future non-consent operations;
• costs or charges associated with gathering, treating and processing oil and natural gas (provided, however, that any proceeds attributable to treatment or processing will offset such costs or changes, if any);
• any overhead charge incurred pursuant to any operating agreement or other arrangement relating to an Underlying Property as permitted under the applicable conveyance, including the overhead fees payable by VOC Brazos to its affiliates Vess Oil Corporation ("Vess Oil"), L.D. Drilling Inc. and Davis Petroleum (Vess Oil, L.D. Drilling Inc. and Davis Petroleum are referred to collectively as the "VOC Operators");
• costs for recording the conveyance and costs estimated to record the termination and for release of the conveyance;
• amounts previously included in gross proceeds but subsequently paid as a refund, interest or penalty;
• costs and expenses for renewals or extensions of leases; and
• at the option of VOC Brazos (or any subsequent owner of the Underlying Properties), amounts reserved for approved development, maintenance or operating expenditures, including well drilling, recompletion and workover costs, which amounts will at no time exceed $1.0 million in the aggregate, and will be subject to the limitations described below (provided that such costs shall not be debited from gross proceeds when actually incurred).
Certain other non-production revenues, including salvage value for equipment related to plugged and abandoned wells, as detailed in the conveyance, offset the costs outlined above in calculating the net proceeds. If any excess amounts have not been used to offset costs at the time when the later to occur of (1) December 31, 2030, or (2) the time when 10.6 MMBoe (which is the equivalent of 8.5 MMBoe in respect of the net profits interest) have been produced from the Underlying Properties and sold, then Trust unitholders will not be entitled to receive the benefit of such excess amounts.
During each twelve-month period beginning on the later to occur of (1) December 31, 2027 and (2) the time when 9.8 MMBoe have been produced from the Underlying Properties and sold (which is the equivalent of 7.8 MMBoe in respect of the net profits interest) (in either case, the "Capital
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE C-NET PROFITS INTEREST (Continued)
Expenditure Limitation Date"), the sum of the development expenditures and amounts reserved for approved development expenditure projects for such twelve-month period may not exceed the Average Annual Capital Expenditure Amount. The "Average Annual Capital Expenditure Amount" means the quotient of (x) the sum of the development expenditures and amounts reserved for approved development expenditure projects with respect to the three twelve-month periods ending on the Capital Expenditure Limitation Date, divided by (y) three. Commencing on the Capital Expenditure Limitation Date, and each anniversary of the Capital Expenditure Limitation Date thereafter, the Average Annual Capital Expenditure Amount will be increased by 2.5% to account for expected increased costs due to inflation.
In the event that the net proceeds for any computation period is a negative amount, the Trust will receive no payment for that period, and any such negative amount plus accrued interest will be deducted from gross proceeds in the following computation period for purposes of determining the net proceeds for that following computation period.
Gross proceeds and net proceeds are calculated on a cash basis, except that certain costs, primarily ad valorem taxes and expenditures of a material amount, may be determined on an accrual basis.
The net profits interest was recorded at the historical cost of VOC Brazos on May 10, 2011, the date of the conveyance, and was calculated as follows:
NOTE D-INCOME FROM NET PROFITS INTEREST
(1)Pursuant to the terms of the conveyance of the net profits interest, lease equipment and development costs are to be deducted when calculating the distributable income to the Trust.
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE D-INCOME FROM NET PROFITS INTEREST (Continued)
(2)Pursuant to the terms of the conveyance of the net profits interest, VOC Brazos can reserve up to $1.0 million for future development, maintenance or operating expenditures at any time. The reserve balance was $1,000,000 at December 31, 2017, 2018 and 2019, respectively
(3)The income from the net profits interest for the year ended December 31, 2017 (consisting of VOC Brazos' February, May, August and November 2017 net profits interest distributions to the Trust) generally represents the production by VOC Brazos from September 2016 through August 2017.
(4)The income from the net profits interest for the year ended December 31, 2018 (consisting of VOC Brazos' February, May, August and November 2018 net profits interest distributions to the Trust) generally represents the production by VOC Brazos from September 2017 through August 2018.
(5)The income from the net profits interest for the year ended December 31, 2019 (consisting of VOC Brazos' February, May, August and November 2019 net profits interest distributions to the Trust) generally represents the production by VOC Brazos from September 2018 through August 2019.
NOTE E-INCOME TAXES
Tax counsel to the Trust advised the Trust at the time of formation that, under then current tax laws, in its opinion the net profits interest should be treated as a debt instrument for federal income tax purposes, and the Trust should be required to treat a portion of each payment it receives with respect to the net profits interest as interest income in accordance with the "noncontingent bond method" under the original issue discount rules contained in the Internal Revenue Code of 1986, as amended, and the corresponding regulations. Tax counsel to the Trust also advised the Trust at the time of formation that in its opinion the Trust will be treated as a grantor trust for federal income tax purposes. On the basis of this advice, Trust unitholders will be considered to own and receive the Trust's assets and income and will be directly taxable thereon as if no trust were in existence. No provision for federal or state income taxes has been made in the accompanying statements.
NOTE F-DISTRIBUTIONS TO UNITHOLDERS
The Trustee determines for each quarter the amount available for distribution to the Trust unitholders. This distribution is expected to be made on or before the 45th day following the end of each quarter to the Trust unitholders of record on the 30th day of the month following the end of each quarter (or the next succeeding business day). Such amounts will be equal to the excess, if any, of the cash received by the Trust relating to the preceding quarter, over the expenses of the Trust paid for
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE F-DISTRIBUTIONS TO UNITHOLDERS (Continued)
such quarter, subject to adjustments for changes made by the Trustee during such quarter in any cash reserves established for future expenses of the Trust.
(1)Pursuant to the terms of the conveyance of the net profits interest, VOC Brazos can reserve up to $1.0 million for future development, maintenance or operating expenditures at any time.
NOTE G-RELATED PARTY TRANSACTIONS
Trustee Administrative Fee. Under the terms of the Trust Agreement, the Trust pays an annual administrative fee of $150,000 to the Trustee and $2,500 to the Delaware Trustee.
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE G-RELATED PARTY TRANSACTIONS (Continued)
Agreement with VOC Brazos. In May 2011, the Trustee, not in its individual capacity but solely as Trustee of the Trust, entered into an administrative services agreement with VOC Brazos whereby, in connection with the conveyance of the net profits interest to the Trust, VOC Brazos agreed to provide the Trust with accounting, bookkeeping and informational services relating to the net profits interest in exchange for an administrative services fee of $18,750 that will be paid to VOC Brazos on a quarterly basis, The administrative services agreement will terminate on the earliest to occur of: (i) the date the Trust shall have dissolved and commenced winding up in accordance with the Trust Agreement, (ii) the date that all of the net profits interest has been terminated or is no longer held by the Trust and (iii) a date mutually agreed to by VOC Brazos and the Trustee. The quarterly fee increases by 4% each year. For 2017, 2018 and 2019, $70,260 (representing three quarters), $121,475 (representing five quarters) and $75,995 (representing three quarters) respectively, was paid to VOC Brazos as administrative fees.
Sales to MV Purchasing, LLC. For the year ended December 31, 2017, 2018 and 2019, MV Purchasing, LLC, an affiliate of VOC Brazos and referred to as MV Purchasing, purchased 38%, 38% and 32%, respectively, of the production sold from the Underlying Properties. Sales to MV Purchasing are under short-term arrangements, ranging from one to six months, using market sensitive pricing.
Joint Venture Agreement. In 2018, VOC Brazos entered into a joint venture agreement with Hawkwood Energy East Texas, LLC ("Hawkwood"). Under the terms of the joint venture agreement, Hawkwood carried VOC Brazos for its share of drilling and completion costs for four wells in the Lower Woodbine Organic Shale (the "Hawkwood Earning Wells"). In exchange, Hawkwood earned a working interest representing 50% of VOC Brazos' interest in each Hawkwood Earning Well and up to a 50% interest in VOC Brazos' acreage in the south half of the Kurten Woodbine Unit. After the Hawkwood Earning Wells were completed, Hawkwood had the right to propose and drill up to eight wells in the Lower Woodbine Organic Shale ("LWOS") in 2019 and twelve LWOS wells in 2020, with no contractual limitation of the number of wells per year to propose and drill after 2020 (collectively, the "Hawkwood Development Wells").
In 2019, Hawkwood drilled and completed four Hawkwood Development Wells. VOC Brazos is paying Vess Oil, as the operator, for its share of costs and related interest in the Hawkwood Development Wells, as net revenue from each of the wells is received, thereby having no current effect on Trust distributions. The balance of the unpaid drilling and completion costs that would have had an effect on the distributions to Trust unitholders through the November 14, 2019 distribution was $2,220,352. The unpaid balance thru December 31, 2019 was $5,354,517.
VOC Brazos is evaluating the potential economic benefits associated with development of the LWOS. If these activities are pursued, such activities would result in increased development costs burdening the net profits interest of the trust relative to historical development costs. As a result of such increased development costs, cash available for distribution by the Trust would be temporarily reduced, and in certain periods there may be no distributions to unitholders, until anticipated production from the various development efforts in the Kurten Woodbine Unit can be brought on-line. If annual cash proceeds attributable to the net profits interest are less than $1 million for each of two consecutive years, then under the terms of the Trust Agreement, the Trust would be required to dissolve. To address these emerging opportunities, VOC Brazos will continue to evaluate the appropriate strategy and capital plan to fund development for the Trust.
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE H-ADVANCE FOR TRUST EXPENSES
Under the terms of the Trust Agreement, the Trustee is allowed to borrow money to pay Trust expenses. During 2017, 2018 and 2019, the Trust did not borrow any money. Any advances will be shown as additions to Trust Corpus when the borrowing is made, and any repayments will be shown as reductions to Trust Corpus when the borrowing is repaid. Under the terms of the Trust Agreement, VOC Brazos has provided a letter of credit in the amount of $1.7 million to the Trustee to protect the Trust against the risk that it does not have sufficient cash to pay future expenses.
NOTE I-OTHER EVENTS
Subsequent event
On January 16, 2020, the Trust announced a Trust distribution to unitholders of record on January 30, 2020 of $1,870,000, or $0.11 per unit, which was paid on February 14, 2020. Such distribution consisted of the net proceeds of production collected by VOC Brazos from October 1, 2019 through December 31, 2019.
NOTE J-DISCLOSURES ABOUT OIL AND GAS ACTIVITIES (UNAUDITED)
The Trust is required to disclose proved reserves in accordance with the SEC's reporting rules, which require that the average, first-day-of-the-month price during the 12-month period before the end of the year be used when estimating whether reserve quantities are economical to produce. This same 12-month average price is also used in calculating the aggregate amount of (and changes in) future cash inflows related to the standardized measure of discounted future net cash flows. The rules also allow for the use of reliable technology to estimate proved oil and gas reserves if those technologies have been demonstrated to result in reliable conclusions about reserve volumes. The unaudited supplemental information on oil and gas exploration and production activities for 2017, 2018 and 2019 has been presented in accordance with these rules.
Estimates of the proved oil and gas reserves attributable to the Trust as of December 31, 2017, 2018 and 2019 are based on reports of Cawley, Gillespie & Associates, Inc., independent petroleum and geological engineers, and the contract property management engineering staff of the manager of VOC Brazos who operates the Underlying Properties, in accordance with the SEC's rules and definitions. Users of this information should be aware that the process of estimating quantities of "proved" and "proved developed" and "proved undeveloped" crude oil and natural gas reserves is very complex, requiring significant subjective decisions in the evaluation of all available geological, engineering and economic data for each reservoir. The data for a given reservoir may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and continual reassessment of the viability of production under varying economic conditions. Consequently, material revisions to existing reserve estimates occur from time to time.
The reserve data below represent estimates only and should not be construed as being exact. Moreover, the discounted values should not be construed as representative of the current market value of the net profits interest. A market value determination would include many additional factors including: (i) anticipated future oil and gas prices; (ii) the effect of federal income taxes, if any, on the Trust; (iii) an allowance for return on investment; (iv) the effect of governmental legislation; (v) the value of additional potential reserves, not considered proved at present, which may be recovered as a result of further exploration and development activities; and (vi) other business risks.
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE J-DISCLOSURES ABOUT OIL AND GAS ACTIVITIES (UNAUDITED) (Continued)
The following tables set forth (i) the estimated net quantities of proved, proved developed and proved undeveloped oil and natural gas reserves attributable to the Trust, and (ii) the standardized measure of the discounted future net profits interest income attributable to the Trust and the nature of changes in such standardized measure between years. These tables are prepared on the accrual basis, which is the basis on which VOC Brazos maintains its production records and is different from the basis on which the Trust is reporting.
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE J-DISCLOSURES ABOUT OIL AND GAS ACTIVITIES (UNAUDITED) (Continued)
ESTIMATED QUANTITIES OF OIL AND GAS RESERVES
The Trust recognized net decreases in reserves for its share of VOC Brazos' total during 2017 associated with the production of properties of 475,578 Boe. This decrease was compounded by a
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE J-DISCLOSURES ABOUT OIL AND GAS ACTIVITIES (UNAUDITED) (Continued)
decrease in reserves of 958,682 Boe as a result of the removal of proved undeveloped locations due to changes in a previously adopted development plan. This decrease was partially offset by a net positive revision due to increases in realized prices during 2017.
The Trust recognized net increases in reserves for its share of VOC Brazos' total during 2018. This increase was primarily the result of net positive revisions due to increases in realized prices during 2018, including additional proved undeveloped reserve locations of 321,318 Boe due to changes in a previously adopted development plan, offset by production of properties of 462,021 Boe.
The Trust recognized net decreases in reserves for its share of VOC Brazos' total during 2019 associated with the production of properties of 537,319 Boe. This decrease was partially offset by additional undeveloped reserve locations of 400,768 Boe and decreased by reserves of 142,351 Boe due to the removal of proved undeveloped locations in a previously adopted development plan. This decrease was also compounded by a net negative revision due to decreases in realized prices during 2019.
STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS
FROM PROVED OIL AND GAS RESERVES
Estimates of future net cash flows from proved reserves of crude oil and natural gas are computed using the average, first-day-of-the-month price during the 12-month period for 2017, 2018 and 2019.
VOC Energy Trust
NOTES TO FINANCIAL STATEMENTS (Continued)
NOTE J-DISCLOSURES ABOUT OIL AND GAS ACTIVITIES (UNAUDITED) (Continued)
CHANGES IN STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH
FLOWS FROM PROVED OIL AND GAS RESERVES
The average, first-day-of-the-month price during the 12-month period for 2017, 2018 and 2019 used in determining future net revenues related to the standardized measure calculation are as follows:
NOTE K-SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
Evaluation of disclosure controls and procedures. The trustee maintains disclosure controls and procedures designed to ensure that information to be disclosed by the trust in the reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the rules and regulations promulgated by the SEC. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by the trust is accumulated and communicated by VOC Brazos to The Bank of New York Mellon Trust Company, N.A., as trustee of the trust, and its employees who participate in the preparation of the trust's periodic reports as appropriate to allow timely decisions regarding required disclosure.
As of the end of the period covered by this report, the trustee carried out an evaluation of the trust's disclosure controls and procedures. Mike Ulrich, as Trust Officer of the trustee, has concluded that the disclosure controls and procedures of the trust are effective.
Due to the contractual arrangements of (i) the trust agreement and (ii) the conveyance of the net profits interest, the trustee relies on (A) information provided by VOC Brazos, including historical operating data, plans for future operating and capital expenditures, reserve information and information relating to projected production, and (B) conclusions and reports regarding reserves by the trust's independent reserve engineers. See "Item 1A. Risk Factors-Neither the trust nor the trust's unitholders have the ability to influence VOC Brazos or control the operations or development of the underlying properties" in this Form 10-K, and "Item 7. Trustee's Discussion and Analysis of Financial Condition and Results of Operations" for a description of certain risks relating to these arrangements and reliance on information when reported by VOC Brazos to the trustee and recorded in the trust's results of operations.
Changes in Internal Control Over Financial Reporting. During the fourth quarter ended December 31, 2019, there has been no change in the trustee's internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the trustee's internal control over financial reporting. The trustee notes for purposes of clarification that it has no authority over, and makes no statement concerning, the internal control over financial reporting of VOC Brazos.
Trustee's Report on Internal Control Over Financial Reporting. The trustee is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f), by the trust. The trust's internal control over financial reporting is a process designed under the supervision of the trustee to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the trust's financial statements for external purposes in accordance with the accounting permitted for royalty trusts by the SEC as specified by Staff Accounting Bulletin Topic 12:E, Financial Statements of Royalty Trusts, which is a comprehensive basis of accounting other than generally accepted accounting principles.
As of December 31, 2019, the trustee assessed the effectiveness of the trust's internal control over financial reporting based on the criteria for effective internal control over financial reporting established in "Internal Control-Integrated Framework," issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that assessment, the trustee determined that the trust maintained effective internal control over financial reporting as of December 31, 2019, based on those criteria.
Item 9B.
Item 9B. Other Information.
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
The trust has no directors or executive officers. The trustee is a corporate trustee that may be removed by the affirmative vote of the holders of not less than a majority of the outstanding trust units at a meeting at which a quorum is present.
Audit Committee and Nominating Committee
Because the trust does not have a board of directors, it does not have an audit committee, an audit committee financial expert or a nominating committee.
Code of Ethics
The trust does not have a principal executive officer, principal financial officer, principal accounting officer or controller and, therefore, has not adopted a code of ethics applicable to such persons. However, employees of the trustee must comply with the bank's code of ethics.
Item 11.
Item 11. Executive Compensation.
During the years ended December 31, 2017, 2018 and 2019, the trustee received compensation from the trust in the amount of $150,000 for each year. The trust does not have any executive officers. Because the trust does not have a board of directors, it does not have a compensation committee.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Unitholder Matters.
(a) Security Ownership of Certain Beneficial Owners.
The following table sets forth certain information regarding the beneficial ownership of our trust units as of March 13, 2020 by each person who, to our knowledge, beneficially owns more than 5% of the outstanding trust units.
(1)Based on 17,000,000 trust units outstanding as of March 13, 2020.
(2)The information is based on a Schedule 13D filing with the SEC on August 18, 2011. The address of the beneficial owner is 1700 Waterfront Parkway, Building 500, Wichita, KS 67206.
(3)The information is based on a Schedule 13G dated February 8, 2019 filed jointly by Robert J. Raymond ("Raymond"), RR Advisors, LLC ("Advisors"), RCH Black Fund GP, L.P. ("RCH GP"), and RCH Black Fund, L.P. ("RCH LP" and, together with Raymond, Advisors and RCH GP, the "Reporting Persons"). The principal business address of the Reporting Persons is 3953 Maple Avenue, Suite 180, Dallas, Texas 75219. According to the filing, Raymond has sole voting power and dispositive power with respect to 202,056 trust units; Raymond and Advisors each have shared voting and dispositive power with respect to 1,654,906 trust units; and RCH GP and RCH LP each have shared voting and dispositive power with respect to 1,619,837 trust units. According to the filing, each Reporting Person expressly disclaims (a) the existence of any group and (b) beneficial ownership with respect to any trust units other than the trust units owned of record by such Reporting Person.
(b) Security Ownership of Management.
Not applicable.
(c) Changes in Control.
The registrant knows of no arrangement, including any pledge by any person of securities of the registrant or any of its parents, the operation of which may at a subsequent date result in a change of control of the registrant.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Under the terms of the conveyance governing the net profits interest, VOC Brazos is obligated to make certain payments to the trust on a quarterly basis. Please see "Item 1. Business-Computation of Net Proceeds" for more information about these agreements.
Administrative Services Agreement
The trust has entered into an administrative services agreement with VOC Brazos that obligates the trust, throughout the term of the trust, to pay to VOC Brazos each quarter an administrative services fee for accounting, bookkeeping and informational services performed by VOC Brazos on behalf of the trust relating to the net profits interest. The annual fee of $75,000 is payable in equal quarterly installments and increases by 4% each year. For 2017, 2018 and 2019, $70,260 (representing three quarters), $121,475 (representing five quarters) and $75,995 (representing three quarters), respectively, was paid to VOC Brazos as administrative fees. The administrative services agreement will terminate upon the termination of the net profits interest unless earlier terminated by mutual agreement of the trustee and VOC Brazos.
Registration Rights
The trust entered into a registration rights agreement with VOC Brazos in connection with VOC Brazos' conveyance to the trust of the net profits interest. In the registration rights agreement, the trust agreed, for the benefit of VOC Brazos and any transferee of its trust units (each, a "holder"), to register the trust units it holds. Specifically, the trust agreed:
• subject to certain restrictions, to use its reasonable best efforts to file a registration statement, including, if so requested, a shelf registration statement, with the SEC as promptly as practicable following receipt of a notice requesting the filing of a registration statement from holders representing a majority of the then outstanding registrable trust units;
• to use its reasonable best efforts to cause the registration statement or shelf registration statement to be declared effective under the Securities Act as promptly as practicable after the filing thereof; and
• to continuously maintain the effectiveness of the registration statement under the Securities Act for 90 days (or for three years if a shelf registration statement is requested) after the effectiveness thereof or until the trust units covered by the registration statement have been sold pursuant to such registration statement or until all registrable trust units:
• have been sold pursuant to Rule 144 under the Securities Act if the transferee thereof does not receive "restricted securities;"
• have been sold in a private transaction in which the transferor's rights under the registration rights agreement are not assigned to the transferee of the trust units; or
• become eligible for resale pursuant to Rule 144(k) (or any similar rule then in effect under the Securities Act).
The holders will have the right to require the trust to file up to three registration statements and will have piggyback registration rights in certain circumstances.
In connection with the preparation and filing of any registration statement, VOC Brazos will bear all costs and expenses incidental to any registration statement, excluding certain internal expenses of the trust, which will be borne by the trustee, and any underwriting discounts and commissions, which will be borne by the seller of the trust units.
Item 14.
Item 14. Principal Accounting Fees and Services.
The trust does not have an audit committee. Any pre-approval and approval of all services performed by the principal auditor or any other professional service firms and related fees are granted by the trustee.
The following table presents fees for professional audit services rendered by Grant Thornton LLP for the audit of the trust's financial statements for 2018 and 2019 and fees billed for other services rendered by Grant Thornton LLP.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a)(1) Financial Statements
The following financial statements are set forth under Part II, Item 8 of this Form 10-K on the pages indicated:
(a)(2) Schedules
Schedules have been omitted because they are not required, not applicable or the information required has been included elsewhere herein.
(a)(3) Exhibits
Exhibit
Number
Description
3.1
-
Certificate of Trust of VOC Energy Trust. (Incorporated herein by reference to Exhibit 3.4 to the Registration Statement on Form S-1, filed on December 30, 2010 (Registration No. 333-171474))
3.2
-
Amended and Restated Trust Agreement of VOC Energy Trust, dated May 10, 2011, among VOC Brazos Energy Partners, L.P., The Bank of New York Mellon Trust Company, N.A., as Trustee of VOC Energy Trust, and Wilmington Trust Company, as Delaware Trustee of VOC Energy Trust. (Incorporated herein by reference to Exhibit 3.1 to our Current Report on Form 8-K filed on May 10, 2011 (File No. 001-35160))
4.1
-
Registration Rights Agreement, dated as of May 10, 2011, by and between VOC Partners, LLC and VOC Energy Trust. (Incorporated herein by reference to Exhibit 4.1 to our Current Report on Form 8-K filed on May 10, 2011 (File No. 0001-35160))
4.2 * -
Description of Securities Registered Pursuant to Section 12 of the Securities Exchange Act of 1934
10.1
-
Conveyance of Term Net Profits Interest and Assignment of Pre-Effective Time Payment, dated May 10, 2011, from VOC Brazos Energy Partners, L.P. and VOC Kansas Energy Partners, LLC, to The Bank of New York Mellon Trust Company, N.A. in its capacity as Trustee of VOC Energy Trust. (Incorporated herein by reference to Exhibit 10.1 to our Current Report on Form 8-K filed on May 10, 2011 (File No. 001-35160))
10.2
-
Administrative Services Agreement, dated May 10, 2011, by and between VOC Brazos Energy Partners, L.P. and The Bank of New York Mellon Trust Company, N.A., in its capacity as Trustee of VOC Energy Trust. (Incorporated herein by reference to Exhibit 10.2 to our Current Report on Form 8-K filed on May 10, 2011 (File No. 001-35160))
31.1 * -
Certification filed pursuant to Section 302 of the Sarbanes Oxley Act of 2002
Exhibit
Number
Description
32.1 * -
Certification furnished pursuant to Section 906 of the Sarbanes Oxley Act of 2002
99.1 * -
Report of Cawley, Gillespie & Associates, Inc., Petroleum Consultants
*Filed or furnished herewith.
Item 16. Form 10-K Summary
None.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
March 13,
The Registrant, VOC Energy Trust, has no principal executive officer, principal financial officer, board of directors or persons performing similar functions. Accordingly, no additional signatures are available and none have been provided. In signing the report above, the trustee does not imply that it has performed any such function or that such function exists pursuant to the terms of the trust agreement under which it serves.