Carried Interest

Carried Interest: A Key to Oil & Gas Exploration and Development

In the world of oil and gas, securing funding for exploration and development can be a daunting task. One way to incentivize investment and attract partners is through the use of carried interest.

Carried interest is a fractional working interest in an oil and gas lease that arises from a deal between co-owners. It's essentially a form of "carried" ownership, where one party (the "carrier") contributes capital upfront, while another party (the "carried party") provides expertise and effort.

Here's a breakdown of the mechanics:

The Carrier: The carrier provides the initial capital for exploration and development. They bear the financial risk and responsibility for the project's success.
The Carried Party: The carried party typically contributes their expertise in oil and gas exploration, development, or production. They may also provide equipment or other resources.
The Agreement: The parties agree on a specific percentage of working interest that the carried party will receive once the project starts generating revenue. This percentage can be fixed or vary depending on the project's profitability.

Why Use Carried Interest?

Attracting Expertise: Carried interest allows the carrier to access specialized skills and knowledge from the carried party, even if they lack the necessary expertise themselves.
Sharing Risk and Reward: It allows the carrier to share the financial risk of the project with the carried party, while also ensuring a potential reward for the carried party's contribution.
Reducing Upfront Capital: For the carried party, it's a way to access a valuable working interest without needing to contribute significant capital upfront.

Types of Carried Interest:

Back-in Carried Interest: The carried party earns their interest gradually, receiving a portion of the revenue as the project progresses.
Overriding Royalty Interest (ORRI): The carried party receives a royalty payment on the production, typically a percentage of the gross revenue, regardless of the project's expenses.
Back-end Carried Interest: The carried party only receives their share of the revenue after the carrier has recouped their initial investment.

Example:

Imagine Company A, a major oil and gas producer, is looking to explore a new drilling site. They lack expertise in the specific geological formation. Company B, a smaller exploration company with significant knowledge of the region, offers to partner on the project.

Company A agrees to provide the necessary capital for exploration, while Company B contributes their expertise and drilling capabilities. They agree on a back-in carried interest, where Company B will receive 20% of the working interest once the well starts producing oil.

Key Considerations:

Profit Split: The profit split between the carrier and carried party should be clearly defined and fair.
Recoupment: The carrier needs to ensure they can recoup their initial investment before the carried party starts receiving their share of the revenue.
Tax Implications: Both parties should consult with tax advisors to understand the tax implications of carried interest.

Conclusion:

Carried interest plays a vital role in the oil and gas industry, enabling companies with different resources and expertise to collaborate on exploration and development projects. By sharing risks and rewards, it creates a win-win situation for both parties, driving innovation and ensuring the continued growth of the industry.

Test Your Knowledge

Carried Interest Quiz:

Instructions: Choose the best answer for each question.

1. What is the primary purpose of carried interest in oil and gas exploration?

a) To provide tax benefits to investors b) To incentivize investment and attract partners c) To ensure a guaranteed return on investment d) To reduce regulatory compliance requirements

Answer

b) To incentivize investment and attract partners

2. Who typically provides the upfront capital for an oil and gas project with carried interest?

a) The carried party b) The government c) The carrier d) A third-party investor

Answer

c) The carrier

3. Which type of carried interest allows the carried party to earn their interest gradually as the project progresses?

a) Back-end carried interest b) Overriding royalty interest c) Back-in carried interest d) None of the above

Answer

c) Back-in carried interest

4. What is a key consideration when structuring a carried interest agreement?

a) Ensuring the carrier receives a majority share of the revenue b) Minimizing the carried party's potential profit c) Defining a clear profit split between the parties d) Eliminating all financial risk for the carried party

Answer

c) Defining a clear profit split between the parties

5. Which statement BEST describes the role of carried interest in the oil and gas industry?

a) It eliminates all financial risk for the carrier. b) It guarantees profitability for the carried party. c) It facilitates collaboration between parties with different resources. d) It replaces traditional financing methods for oil and gas projects.

Answer

c) It facilitates collaboration between parties with different resources.

Carried Interest Exercise:

Scenario:

Company A, a major energy company, is interested in exploring a new shale oil deposit. They lack expertise in shale oil extraction but have sufficient capital. Company B, a smaller company specializing in shale oil extraction, has the technical expertise but limited capital.

Task:

Design a carried interest agreement between Company A and Company B. Consider the following:

Type of carried interest: Choose between back-in, overriding royalty, or back-end carried interest, justifying your decision.
Profit split: Determine a fair percentage of working interest for Company B once the project becomes profitable.
Recoupment: How will Company A recoup its initial investment?
Additional considerations: Include any other terms or conditions relevant to the agreement.

Example Structure:

Type of carried interest: Back-in carried interest
Profit split: Company B receives 20% working interest after Company A recoups its investment
Recoupment: Company A receives 100% of the revenue until its investment is recouped.
Additional considerations: A specific timeline for Company B receiving its working interest, clauses for potential project delays or cost overruns, etc.

Exercice Correction

The specific details of the carried interest agreement will vary depending on the negotiation between Company A and Company B. Here's a possible structure:

**Type of carried interest:** Back-in carried interest is the most suitable for this scenario. This allows Company B to gradually earn their working interest as production starts, reflecting their contribution of expertise and skill.

**Profit split:** Company B receives 25% of the working interest after Company A recoups its initial investment. This represents a fair balance between the risk taken by Company A and the expertise provided by Company B.

**Recoupment:** Company A receives 100% of the revenue until its initial investment is recouped with a reasonable rate of return (e.g., 10%). This ensures Company A is adequately compensated for its financial risk.

**Additional considerations:**

Timeline for working interest: Define a clear timeline for when Company B starts receiving their share of the working interest, perhaps after a certain amount of production or a specified period.
Cost overrun clauses: Include clauses for potential project delays or cost overruns, outlining how these will be handled and shared between the companies.
Exit strategy: Define how the partnership will be dissolved in the future, whether by selling the project, sharing proceeds from production, or other methods.
Dispute resolution: Specify a process for resolving any potential disputes between the companies, like arbitration or mediation.

Remember, the specific terms of the agreement should be carefully negotiated and formalized in a legally binding contract to protect both parties' interests.

Books

Oil and Gas Law in a Nutshell by Michael J. O'Donnell and Patrick J. O'Donnell: This book provides a comprehensive overview of oil and gas law, including detailed explanations of various contractual terms, like carried interest.
Petroleum Law and Taxation in the United States by John S. Lowe: This textbook covers the legal and tax aspects of the oil and gas industry, offering insights into carried interest agreements.
The Oil and Gas Handbook by Jack W. Dempsey: This practical guide for industry professionals includes sections on oil and gas agreements, including carried interest arrangements.

Articles

"Carried Interest: A Primer" by Baker McKenzie: This article offers a concise explanation of carried interest, its various types, and key considerations.
"Understanding Carried Interest in Oil and Gas" by the American Petroleum Institute (API): This API resource provides a basic overview of carried interest, its benefits, and potential risks.
"The Evolution of Carried Interest in Oil and Gas" by the Harvard Business School: This academic paper discusses the historical evolution of carried interest and its impact on the oil and gas industry.

Online Resources

"Carried Interest" by the Energy Information Administration (EIA): This website provides a clear definition of carried interest and its application in the oil and gas industry.
"Carried Interest" by Investopedia: This website offers a basic definition of carried interest and its implications for investors.
"Oil and Gas Law" by Legal Information Institute (Cornell Law School): This website provides a comprehensive overview of oil and gas law, including relevant sections on carried interest.

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