Item 1.
Business.
DESCRIPTION OF THE TRUST
Sabine Royalty Trust (the Trust) is an express trust formed under the laws of the State of Texas by the Sabine Corporation Royalty
Trust Agreement (the Trust Agreement) made and entered into effective as of December 31, 1982, between Sabine Corporation, as trustor, and InterFirst Bank Dallas, N.A. (InterFirst), as trustee. The current trustee of the
Trust is Southwest Bank, an independent state bank chartered under the laws of the State of Texas and headquartered in Fort Worth, Texas (Southwest Bank). In accordance with the successor trustee provisions of the Trust Agreement,
Southwest Bank, as trustee of the Trust (the Trustee) is subject to all terms and conditions of the Trust Agreement. The principal office of the trust (sometimes referred to herein as the Registrant) is located at 2911 Turtle
Creek Boulevard, Suite 850, Dallas, Texas, 75219. The telephone number of the trust is 1-855-588-7839.
On January 9, 2014, Bank of
America, N.A. (as successor to InterFirst Bank Dallas, N.A.) gave notice to Unit holders that it was resigning as the Trustee subject to certain conditions including the appointment of Southwest Bank as trustee of the Trust. At a special meeting of
Trust Unit holders the Unit holders approved the appointment of Southwest Bank as successor trustee of the Trust, once Bank of America, N.A.s resignation took effect. The effective date of Bank of America, N.A.s resignation and the
effective date of Southwest Banks appointment as successor trustee was May 30, 2014. The defined term Trustee as used herein shall refer to Bank of America, N.A. for periods prior to May 30, 2014 and shall refer to Southwest Bank
for periods on or after May 30, 2014.
The Trust maintains an Internet website, and as a result, reports such as its annual reports on
Form 10-K,
quarterly reports on
Form 10-Q,
current reports on
Form 8-K,
and amendments to such reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, will now be made available at
http://www.sbr-sabine.com
as soon as reasonably practicable after such information is electronically filed
with or furnished to the SEC.
On November 12, 1982, the shareholders of Sabine Corporation approved and authorized Sabine
Corporations transfer of royalty and mineral interests, including landowners royalties, overriding royalty interests, minerals (other than executive rights, bonuses and delay rentals), production payments and any other similar,
nonparticipatory interests, in certain producing and proved undeveloped oil and gas properties located in Florida, Louisiana, Mississippi, New Mexico, Oklahoma and Texas (the Royalty Properties) to the Trust. The conveyances of the
Royalty Properties to the Trust were effective with respect to production as of 7:00 a.m. (local time) on January 1, 1983.
In
order to avoid uncertainty under Louisiana law as to the legality of the Trustees holding record title to the Royalty Properties located in that state, title to such properties has historically been held by a separate trust formed under the
laws of Louisiana, the sole beneficiary of which was the Trust. Sabine Louisiana Royalty Trust was a passive entity, with the trustee thereof, Hibernia National Bank in New Orleans, having only such powers as were necessary for the collection
of and distribution of revenues from and the protection of the Royalty Properties located in Louisiana and the payment of liabilities of Sabine Louisiana Royalty Trust. Southwest Bank now serves as Trustee of the Sabine Louisiana Royalty Trust,
since Louisiana law now permits an
out-of-state
bank to act in this capacity. A separate trust also was established to hold record title to the Royalty Properties
located in Florida. Legislation was adopted in Florida in 1992 that eliminated the provision of Florida law that prohibited the Trustee from holding record title to the Royalty Properties located in that state. In November 1993, record title to
the Royalty Properties held by the trustee of Sabine Florida Land Trust was transferred to the Trustee. As used herein, the term Royalty Properties includes the Royalty Properties held directly by the Trust and the Royalty Properties
located in Louisiana and Florida that were held indirectly through the Trusts ownership of 100 percent beneficial interest of Sabine Louisiana Royalty Trust and Sabine Florida Land Trust. In discussing the Trust, this report disregards
the technical ownership formalities described in this paragraph, which have no effect on the tax or accounting treatment of the Royalty Properties, since the observance thereof would significantly complicate the information presented herein without
any corresponding benefit to Unit holders.
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Certificates evidencing units of beneficial interest (the Units) in the Trust were
mailed on December 31, 1982 to the shareholders of Sabine Corporation of record on December 23, 1982, on the basis of one Unit for each outstanding share of common stock of Sabine Corporation. The Units are listed and traded on the
New York Stock Exchange under the symbol SBR.
In May 1988, Sabine Corporation was acquired by Pacific Enterprises, a
California corporation. Through a series of mergers, Sabine Corporation was merged into Pacific Enterprises Oil Company (USA) (Pacific (USA)), a California corporation and a wholly owned subsidiary of Pacific Enterprises, effective
January 1, 1990. This acquisition and the subsequent mergers had no effect on the Units. Pacific (USA), as successor to Sabine Corporation, assumed by operation of law all of Sabine Corporations rights and obligations with respect to the
Trust. References herein to Pacific (USA) shall be deemed to include Sabine Corporation where appropriate.
In connection with the
transfer of the Royalty Properties to the Trust upon its formation, Sabine Corporation had reserved to itself all executive rights, including rights to execute leases and to receive bonuses and delay rentals. In January 1993, Pacific
(USA) completed the sale of substantially all of Pacific (USA)s producing oil and gas assets to Hunt Oil Company. The sale did not include the executive rights relating to the Royalty Properties, and Pacific (USA)s ownership of such
rights was not affected by the sale.
The following summaries of certain provisions of the Trust Agreement are qualified in their entirety
by reference to the Trust Agreement itself, which is an exhibit to the
Form 10-K
and available upon request from the Trustee. The definitions, formulas, accounting procedures and other terms governing the
Trust are complex and extensive and no attempt has been made below to describe all such provisions. Capitalized terms not otherwise defined herein are used with the meanings ascribed to them in the Trust Agreement.
Assets of the Trust
The Royalty Properties are the only assets of the Trust, other than cash being held for the payment of expenses and liabilities and for
distribution to the Unit holders. Pending such payment of expenses and distribution to Unit holders, cash may be invested by the Trustee only in certificates of deposit, United States government securities, repurchase agreements secured by United
States government securities or other interest bearing accounts in FDIC-insured state or national banks (including the Trustee) so long as the entire amount in such accounts is at all times fully insured by the FDIC. See Duties and Limited
Powers of Trustee below.
Liabilities of the Trust
Because of the passive nature of the Trusts assets and the restrictions on the power of the Trustee to incur obligations, it is
anticipated that the only liabilities the Trust will incur are those for routine administrative expenses, such as insurance and trustees fees, accounting, engineering, legal and other professional fees. The total general and administrative
expenses for the trust for 2016 were $2,554,716 of which, pursuant to the terms of the Trust Agreement, $383,681 was paid to Southwest Bank as Trustee, and $1,151,046 was paid to Southwest Bank as escrow agent.
Duties and Limited Powers of Trustee
The duties of the Trustee are specified in the Trust Agreement and by the laws of the State of Texas. The basic function of the Trustee is to
collect income from the Trust properties, to pay out of the Trusts income and assets all expenses, charges and obligations, and to pay available income to Unit holders. Since Pacific (USA) has retained the executive rights with respect to the
minerals included in the Royalty Properties and the right to receive any future bonus payments or delay rentals resulting from leases with respect to such minerals, the Trustee is not required to make any investment or operating decision with
respect to the Royalty Properties.
The Trust has no employees. Administrative functions of the Trust are performed by the Trustee.
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The Trustee has the discretion to establish a cash reserve for the payment of any liability that
is contingent or uncertain in amount or that otherwise is not currently due and payable. The Trustee has the power to borrow funds required to pay liabilities of the Trust as they become due and pledge or otherwise encumber the Trusts
properties if it determines that the cash on hand is insufficient to pay such liabilities. Borrowings must be repaid in full before any further distributions are made to Unit holders. All distributable income of the Trust is distributed on a monthly
basis. The Trustee is required to invest any cash being held by it for distribution on the next Distribution Date or as a reserve for liabilities in certificates of deposit, United States government securities, repurchase agreements secured by
United States government securities or other interest bearing accounts in FDIC-insured state or national banks (including the Trustee) so long as the entire amount in such accounts is at all times fully insured by the FDIC. The Trustee furnishes
Unit holders with periodic reports. See Item 1 Description of Units Reports to Unit Holders.
The
Trust Agreement grants the Trustee only such rights and powers as are necessary to achieve the purposes of the Trust. The Trust Agreement prohibits the Trustee from engaging in any business, commercial or, with certain exceptions, investment
activity of any kind and from using any portion of the assets of the Trust to acquire any oil and gas lease, royalty or other mineral interest other than the Royalty Properties. The Trustee may sell Trust properties only as authorized by a vote of
the Unit holders, or when necessary to provide for the payment of specific liabilities of the Trust then due or upon termination of the Trust. Pledges or other encumbrances to secure borrowings are permitted without the authorization of Unit holders
if the Trustee determines such action is advisable. Any sale of Trust properties must be for cash unless otherwise authorized by the Unit holders or unless the properties are being sold to provide for the payment of specific liabilities of the Trust
then due, and the Trustee is obligated to distribute the available net proceeds of any such sale to the Unit holders.
Liabilities of Trustee
The Trustee is to be indemnified out of the assets of the Trust for any liability, expense, claim, damage or other loss incurred by it in the
performance of its duties unless such loss results from its negligence, bad faith or fraud or from its expenses in carrying out such duties exceeding the compensation and reimbursement it is entitled to under the Trust Agreement. The Trustee can be
reimbursed out of the Trust assets for any liability imposed upon the Trustee for its failure to ensure that the Trusts liabilities are satisfiable only out of Trust assets. In no event will the Trustee be deemed to have acted negligently,
fraudulently or in bad faith if it takes or suffers action in good faith in reliance upon and in accordance with the advice of parties considered to be qualified as experts on the matters submitted to them. The Trustee is not entitled to
indemnification from Unit holders except in certain limited circumstances related to the replacement of mutilated, destroyed, lost or stolen certificates. See Item 1 Description of Units Liability of Unit Holders.
Duration of Trust
The Trust is irrevocable and Pacific (USA) has no power to terminate the Trust or, except with respect to certain corrective amendments, to
alter or amend the terms of the Trust Agreement. The Trust will exist until it is terminated by (i) two successive fiscal years in which the Trusts gross revenues from the Royalty Properties are less than $2,000,000 per year,
(ii) a vote of Unit holders as described below under Voting Rights of Unit Holders or (iii) operation of provisions of the Trust Agreement intended to permit compliance by the Trust with the rule against
perpetuities.
Upon the termination of the Trust, the Trustee will continue to act in such capacity until all the assets of the
Trust are distributed. The Trustee will sell all Trust properties for cash (unless the Unit holders authorize the sale for a specified
non-cash
consideration, in which event the Trustee may, but is not
obligated to, consummate such
non-cash
sale) in one or more sales and, after satisfying all existing liabilities and establishing adequate reserves for the payment of contingent liabilities, will distribute
all available proceeds to the Unit holders.
Voting Rights of Unit Holders
Although Unit holders possess certain voting rights, their voting rights are not comparable to those of shareholders of a corporation. For
example, there is no requirement for annual meetings of Unit holders or for annual or other periodic
re-election
of the Trustee.
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The Trust Agreement may be amended by the affirmative vote of a majority of the outstanding Units
at any duly called meeting of Unit holders. However, no such amendment may alter the relative rights of Unit holders unless approved by the affirmative vote of 100 percent of the Unit holders and by the Trustee. In addition, certain special
voting requirements can be amended only if such amendment is approved by the holders of at least 80 percent of the outstanding Units and by the Trustee.
Removal of the Trustee requires the affirmative vote of the holders of a majority of the Units represented at a duly called meeting of Unit
holders. In the event of a vacancy in the position of Trustee or if the Trustee has given notice of its intention to resign, a successor trustee of the Trust may be appointed by similar voting approval of the Unit holders.
The sale of all or any part of the assets of the Trust must be authorized by the affirmative vote of the holders of a majority of the
outstanding Units. However, the Trustee may, without a vote of the Unit holders, sell all or any part of the Trust assets upon termination of the Trust or otherwise if necessary to provide for the payment of specific liabilities of the Trust then
due. The Trust can be terminated by the Unit holders only if the termination is approved by the holders of a majority of the outstanding Units.
Meetings of Unit holders may be called by the Trustee at any time at its discretion and must be called by the Trustee at the written request
of holders of not less than 10 percent of the then outstanding Units. The presence of a majority of the outstanding Units is necessary to constitute a quorum and Unit holders may vote in person or by proxy.
Notice of any meeting of Unit holders must be given not more than 60 nor less than 20 days prior to the date of such meeting. The notice
must state the purposes of the meeting and no other matter may be presented or acted upon at the meeting.
DESCRIPTION OF UNITS
Each Unit represents an equal undivided share of beneficial interest in the Trust and is evidenced by a transferable certificate issued by the
Trustee. Each Unit entitles its holder to the same rights as the holder of any other Unit, and the Trust has no other authorized or outstanding class of equity security. At March 10, 2017, there were 14,579,345 Units outstanding.
The Trust may not issue additional Units unless such issuance is approved by the holders of at least 80 percent of the outstanding Units
and by the Trustee. Under limited circumstances, Units may be redeemed by the Trust and canceled. See Possible Divestiture of Units below.
Distributions of Net Income
The identity of Unit holders entitled to receive distributions of Trust income and the amounts thereof are determined as of each Monthly Record
Date. Unit holders of record as of the Monthly Record Date (the 15th day of each calendar month except in limited circumstances) are entitled to have distributed to them the calculated Monthly Income Amount for the related Monthly Period no
later than 10 business days after the Monthly Record Date. The Monthly Income Amount is the excess of (i) revenues from the Trust properties plus any decrease in cash reserves previously established for contingent liabilities and any other cash
receipts of the Trust over (ii) the expenses and payments of liabilities of the Trust plus any increase in cash reserves for contingent liabilities.
Transfer
Units
are transferable on the records of the Trustee upon surrender of any certificate in proper form for transfer (or in compliance with the Trustees procedures for uncertificated Units) and compliance with such reasonable regulations as the
Trustee may prescribe. No service charge is made to the transferor or transferee for any transfer of a Unit, but the Trustee may require payment of a sum sufficient to cover any tax or governmental charge that may be
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imposed in relation to such transfer. Until any such transfer, the Trustee may conclusively treat the holder of a Unit shown by its records as the owner of that Unit for all purposes. Any such
transfer of a Unit will, as to the Trustee, vest in the transferee all rights of the transferor at the date of transfer, except that the transfer of a Unit after the Monthly Record Date for a distribution will not transfer the right of the
transferor to such distribution.
The transfer of Units by gift and the transfer of Units held by a decedents estate, and
distributions from the Trust in respect thereof, may be restricted under applicable state law.
American Stock Transfer and Trust Company
serves as the transfer agent and registrar for the Units.
Reports to Unit Holders
As promptly as practicable following the end of each fiscal year, the Trustee mails to each person who was a Unit holder on any Monthly Record
Date during such fiscal year, a report showing in reasonable detail on a cash basis the receipts and disbursements and income and expenses of the Trust for federal and state tax purposes for each Monthly Period during such fiscal year and containing
sufficient information to enable Unit holders to make all calculations necessary for federal and state tax purposes. As promptly as practicable following the end of each of the first three fiscal quarters of each year, the Trustee mails a report for
such fiscal quarter showing in reasonable detail on a cash basis the assets and liabilities, receipts and disbursements, and income and expenses of the Trust for such fiscal quarter to Unit holders of record on the last Monthly Record Date
immediately preceding the mailing thereof. Within 120 days following the end of each fiscal year, or such shorter period as may be required by the New York Stock Exchange, the Trustee mails to Unit holders of record on the last Monthly
Record Date immediately preceding the mailing thereof, an annual report containing audited financial statements of the Trust and an audited statement of fees and expenses paid by the Trust to Bank of America and Southwest Bank, as Trustee and escrow
agent. See Federal Taxation below.
Each Unit holder and his or her duly authorized agent has the right, during reasonable
business hours at his or her own expense, to examine and make audits of the Trust and the records of the Trustee, including lists of Unit holders, for any proper purpose in reference thereto.
Widely Held Fixed Investment Trust Reporting Information
Some Trust Units are held by middlemen, as such term is broadly defined in U.S. Treasury Regulations (and includes custodians,
nominees, certain joint owners, and brokers holding an interest for a customer in street name, referred to here in collectively as middlemen). Therefore, the Trustee considers the Trust to be a
non-mortgage
widely held fixed investment trust (WHFIT) for U.S. federal income tax purposes. Southwest Bank, EIN 75-1105980, Post Office Box 962020, Fort Worth, Texas, 76162-2020, telephone
number 1-855-588-7839, email address
trustee@sbr-sabine.com,
is the representative of the Trust that will provide tax information in accordance with applicable U.S. Treasury Regulations governing the
information reporting requirements of the Trust as a WHFIT. Tax information is also posted by the Trustee at
www.sbr-sabine.com
. Notwithstanding the foregoing, the middlemen holding Trust Units on behalf of Unit holders, and not the Trustee
of the Trust, are solely responsible for complying with the information reporting requirements under the U.S. Treasury Regulations with respect to such Trust Units, including the issuance of IRS Forms 1099 and certain written tax statements. Unit
holders 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.
Liability of Unit Holders
As regards the Unit holders, the Trustee, in engaging in any activity or transaction that results or could result in any kind of liability,
will be fully liable if the Trustee fails to take reasonable steps necessary to ensure that such liability is satisfiable only out of the Trust assets (even if the assets are inadequate to satisfy the liability) and in no event out of amounts
distributed to, or other assets owned by, Unit holders. However, the Trust might be held to constitute a joint stock company under Texas law, which is unsettled on this point, and therefore a Unit holder may be jointly and severally
liable for any liability of the Trust if the satisfaction of such liability was not contractually limited to the assets of the Trust and the assets of both the Trust and the Trustee are not adequate to satisfy such liability. In view of the
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substantial value and passive nature of the Trust assets, the restrictions on the power of the Trustee to incur liabilities and the required financial net worth of any trustee of the Trust, the
imposition of any liability on a Unit holder is believed to be extremely unlikely.
Possible Divestiture of Units
The Trust Agreement imposes no restrictions based on nationality or other status of the persons or entities which are eligible to hold Units.
However, the Trust Agreement provides that if at any time the Trust or the Trustee is named a party in any judicial or administrative proceeding seeking the cancellation or forfeiture of any property in which the Trust has an interest because of the
nationality, or any other status, of any one or more Unit holders, the following procedure will be applicable:
1. The
Trustee will give written notice to each holder whose nationality or other status is an issue in the proceeding of the existence of such controversy. The notice will contain a reasonable summary of such controversy and will constitute a demand to
each such holder that he or she dispose of his or her Units within 30 days to a party not of the nationality or other status at issue in the proceeding described in the notice.
2. If any holder fails to dispose of his or her Units in accordance with such notice, the Trustee shall have the
preemptive right to redeem and shall redeem, at any time during the
90-day
period following the termination of the
30-day
period specified in the notice, any Unit not so
transferred for a cash price equal to the closing price of the Units on the stock exchange on which the Units are then listed or, in the absence of any such listing, the mean between the closing bid and asked prices for the Units in the
over-the-counter
market, as of the last business day prior to the expiration of the
30-day
period stated in the notice.
3. The Trustee shall cancel any Unit acquired in accordance with the foregoing procedures.
4. The Trustee may, in its sole discretion, cause the Trust to borrow any amount required to redeem Units.
FEDERAL TAXATION
The tax consequences to a Unit holder of the ownership and sale of units will depend in part on the Unit holders tax circumstances.
Each Unit holder should therefore consult the Unit holders tax advisor about the federal, state and local tax consequences to the Unit holder of the ownership of units.
In May 1983, the Internal Revenue Service (the Service) ruled that the Trust would be classified as a grantor trust for federal
income tax purposes and not as an association taxable as a corporation. Accordingly, the income and deductions of the Trust are reportable directly by Unit holders for federal income tax purposes. The Service also ruled that Unit holders would be
entitled to deduct cost depletion with respect to their investment in the Trust and that the transfer of a Unit in the Trust would be considered to be a transfer of a proportionate part of the properties held by the Trust.
Transferees of Units transferred after October 11, 1990, may be eligible to use the percentage depletion deduction on oil and gas income
thereafter attributable to such Units, if the percentage depletion deduction would exceed cost depletion. Unlike cost depletion, percentage depletion is not limited to a Unit holders depletable tax basis in the Units. Rather, a Unit holder is
entitled to a percentage depletion deduction as long as the applicable Royalty Properties generate gross income.
If a taxpayer disposes
of any Section 1254 property (certain oil, gas, geothermal or other mineral property), and if the adjusted basis of such property includes adjustments for deductions for depletion under Section 611 of the Internal Revenue Code (the
Code), the taxpayer generally must recapture the amount deducted for depletion as ordinary income (to the extent of gain realized on the disposition of the property). This depletion recapture rule applies to any disposition of property
that was placed in service by the taxpayer after December 31, 1986. Detailed rules set forth in
Sections 1.1254-1
through 1.1254-6
of the U.S. Treasury
Regulations govern dispositions of property after March 13, 1995. The Service will likely take the position that a Unit holder who purchases a Unit subsequent to December 31, 1986, must recapture depletion upon the disposition of that
Unit.
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In order to facilitate creation of the Trust and to avoid the administrative expense and
inconvenience of daily reporting to Unit holders by the Trustee, the conveyances by Sabine Corporation of the Royalty Properties located in five of the six states (Florida, Mississippi, New Mexico, Oklahoma, and Texas) provided for the execution of
an escrow agreement by Sabine Corporation and InterFirst (the initial trustee of the Trust), in its capacities as trustee of the Trust and as escrow agent. The conveyances by Sabine Corporation of the Royalty Properties located in Louisiana provided
for the execution of a substantially identical escrow agreement by Sabine Corporation and Hibernia National Bank in New Orleans, in the capacities of escrow agent and of trustee of Sabine Louisiana Royalty Trust. The Trust now only has one escrow
agent, which is the Trustee, and a single escrow agreement.
Pursuant to the terms of the escrow agreement and the conveyances of the
Royalty Properties, the proceeds of production from the Royalty Properties for each calendar month, and interest thereon, are collected by the escrow agent and are paid to and received by the Trust only on the next Monthly Record Date. The escrow
agent has agreed to endeavor to assure that it incurs and pays expenses and fees for each calendar month only on the next Monthly Record Date. The Trust Agreement also provides that the Trustee is to endeavor to assure that income of the Trust will
be accrued and received and expenses of the Trust will be incurred and paid only on each Monthly Record Date.
Assuming that the escrow
arrangement is recognized for federal income tax purposes and that the Trustee, as escrow agent, is able to control the timing of income and expenses, as stated above, cash and accrual basis Unit holders should be treated as realizing income only on
each Monthly Record Date. The Trustee, as escrow agent, may not be able to cause third party expenses to be incurred on each Monthly Record Date in all instances. Cash basis Unit holders, however, should be treated as having paid all expenses and
fees only when such expenses and fees are actually paid. Even if the escrow arrangement is recognized for federal income tax purposes, however, accrual basis Unit holders might be considered to have accrued expenses when such expenses are incurred
rather than on each Monthly Record Date when paid.
No ruling was requested from the Service with respect to the effect of the escrow
arrangements when established. Due to the absence of direct authority and the factual nature of the characterization of the relationship among the escrow agents, Pacific (USA) and the Trust, no opinion was expressed by legal counsel with respect to
the tax consequences of the escrow arrangements. If the escrow arrangement is recognized, the income from the Royalty Properties for a calendar month and interest income thereon will be taxed to the holder of the Unit on the next Monthly Record Date
without regard to the ownership of the Unit prior to that date. The Trustee is treating the escrow arrangement as effective for tax purposes and furnishes tax information to Unit holders on that basis.
The Service might take the position that the escrow arrangement should be ignored for federal tax purposes. In such case, the Trustee could be
required to report the proceeds from production and interest income thereon to the Unit holders on a daily basis, in accordance with their method of accounting, as the proceeds from production and interest thereon were received or accrued by the
escrow agent. Such reporting could impact who is taxed on the production and interest income and result in a substantial increase in the administrative expenses of the Trust. In the event of a transfer of a Unit, the income and the depletion
deduction attributable to the Royalty Properties for the period up to the date of transfer would be allocated to the transferor, and the income and depletion deduction attributable to the Royalty Properties on and after the date of transfer would be
allocated to the transferee. Such allocation would be required even though the transferee was the holder of the Unit on the next Monthly Record Date and, therefore, would be entitled to the monthly income distribution. Thus, if the escrow
arrangement is not recognized, a mismatching of the monthly income distribution and the Unit holders taxable income and deductions could occur between a transferor and a transferee upon the transfer of a Unit.
Unit holders of record on each Monthly Record Date are entitled to receive monthly distributions. See Description of Units
Distributions of Net Income above. The terms of the escrow agreement and the Trust Agreement, as described above, seek to assure that taxable income attributable to such distributions will be reported by the Unit holder who receives such
distributions, assuming that such holder is the holder of record on the Monthly Record Date. In certain circumstances, however, a Unit holder may be required to report taxable income attributable to his or her Units but the Unit holder will not
receive the distribution attributable to such income. For example, if the Trustee establishes a
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reserve or borrows money to satisfy debts and liabilities of the Trust, income used to establish such reserve or to repay such loan will be reported by the Unit holder, even though such income is
not distributed to the Unit holder.
Interest and royalty income attributable to ownership of Units and any gain on the sale thereof are
considered portfolio income, and not income from a passive activity, to the extent a Unit holder acquires and holds Units as an investment and not in the ordinary course of a trade or business. Therefore, interest and royalty income
attributable to ownership of Units generally may not be offset by losses from any passive activities.
Individuals may incur expenses in
connection with the acquisition or maintenance of Trust Units. These expenses may be deductible as miscellaneous itemized deductions only to the extent that such expenses exceed 2 percent of the individuals adjusted gross income.
Under current law, the highest marginal U.S. federal income tax rate applicable to ordinary income of individuals is 39.6%, and the
highest marginal U.S. federal income tax rate applicable to long-term capital gains (generally, gains from the sale or exchange of certain investment assets held for more than one year) and qualified dividends of individuals is 20%. Such marginal
tax rates may be effectively increased by up to 1.2% due to the phaseout of personal exemptions and the limitations on itemized deductions. The highest marginal U.S. federal income tax rate applicable to corporations is 35%, and such rate
applies to both ordinary income and capital gains.
Section 1411 of the Code imposes a 3.8% Medicare tax on certain investment income
earned by individuals, estates, and trusts for taxable years beginning after December 31, 2012. For these purposes, investment income generally will include a Unit holders allocable share of the Trusts interest and royalty income plus
the gain recognized from a sale of Trust Units. In the case of an individual, the tax is imposed on the lesser of (i) the individuals net investment income from all investments, or (ii) the amount by which the individuals modified
adjusted gross income exceeds specified threshold levels depending on such individuals federal income tax filing status. In the case of an estate or trust, the tax is imposed on the lesser of (i) undistributed net investment income, or (ii)
the excess adjusted gross income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.
Pursuant to the Foreign Account Tax Compliance Act (commonly referred to as FATCA), distributions from the Trust to foreign
financial institutions and certain other non-financial foreign entities may be subject to U.S. withholding taxes. Specifically, certain withholdable payments (including certain royalties, interest and other gains or
income from U.S. sources) made to a foreign financial institution or non-financial foreign entity will generally be subject to the withholding tax unless the foreign financial institution or non-financial foreign entity complies with certain
information reporting, withholding, identification, certification and related requirements imposed by FATCA. Foreign financial institutions located in jurisdictions that have an intergovernmental agreement with the United States governing FATCA may
be subject to different rules.
The Treasury Department issued guidance providing that the FATCA withholding rules described above
generally will apply to qualifying payments made after June 30, 2014. Foreign Unit holders are encouraged to consult their own tax advisors regarding the possible implications of these withholding provisions on their investment in Trust Units.
The foregoing summary is not exhaustive and does not purport to be complete. Many other provisions of the federal tax laws may affect
individual Unit holders. Each Unit holder should consult his or her personal tax adviser with respect to the effects of his or her ownership of Units on his or her personal tax situation.
STATE TAX CONSIDERATIONS
The following is intended as a brief summary of certain information regarding state taxes and other state tax matters affecting the trust
and the Unit holders. Unit holders should consult the Unit holders tax advisor regarding state tax filing and compliance matters.
Texas.
Texas does not impose an income tax. Therefore, no part of the income produced by the Trust is subject to
an income tax in Texas. However, Texas imposes a franchise tax at a rate of .75% on gross revenues less certain
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deductions, as specifically set forth in the Texas franchise tax statutes. Entities subject to tax generally include trusts and most other types of entities having limited liability protection,
unless otherwise exempt. Trusts that receive at least 90% of their federal gross income from designated passive sources, including royalties from mineral properties and other
non-operated
mineral interest
income, and do not receive more than 10% of their income from operating an active trade or business, are generally exempt from the Texas franchise tax as passive entities. The Trust has been and expects to continue to be exempt from
Texas franchise tax as a passive entity. Because the Trust should be exempt from Texas franchise tax at the Trust level as a passive entity, each Unit holder that is considered a taxable entity under the Texas franchise tax would generally be
required to include its share of Trust revenues in its own Texas franchise tax computation. This revenue is sourced to Texas under provisions of the Texas Administrative Code providing that such income is sourced according to the location of
the
day-to-day
operations of the Trust, which is Texas.
Louisiana.
The Trustee is required to file with Louisiana a return reflecting the income of the Trust
attributable to mineral interests located in Louisiana. Both Louisiana resident and
non-resident
Unit holders may be subject to the Louisiana personal, corporate and/or franchise tax as certain income and
expenses from the Trust are from sources within Louisiana.
Florida, Mississippi, New Mexico and
Oklahoma.
Florida does not have a personal income tax. Florida imposes an income tax on resident and nonresident corporations (except for S corporations not subject to the
built-in
gains tax or passive investment income tax), which will be applicable to royalty income allocable to a corporate Unit holder from properties located within Florida. Mississippi, New Mexico and
Oklahoma each impose an income tax applicable to both resident and nonresident individuals and/or corporations (subject to certain exceptions for S corporations and limited liability companies, depending on their treatment for federal tax
purposes), which will be applicable to royalty income allocable to a Unit holder from properties located within these states. Although the Trust may be required to file information returns with taxing authorities in those states and provide copies
of such returns to the Unit holders, because the Trust distributes all of its net income to Unit holders, the Trust should not be taxed at the Trust level in any of these states. The Royalty Properties that are located in such states should be
considered economic interests in minerals for state income tax purposes.
Generally, the state income tax due by nonresidents in all of
the aforementioned states is computed as a percentage of taxable income attributable to the particular state. By contrast, residents are taxed on their taxable income from all sources, wherever earned. Furthermore, even though state laws vary,
taxable income for state purposes is often computed in a manner similar to the computation of taxable income for federal income tax purposes. Some of these states give credit for taxes paid to other states by their residents on income from sources
in those other states. In certain of these states, a Unit holder is required to file a state income tax return if income is attributable to the Unit holder even though no tax is owed.
Both New Mexico and Oklahoma impose a withholding tax on payments of oil and gas proceeds derived from royalty interests. To reduce the
administrative burden imposed by these rules, the Trustee has opted to allow the payors of oil and gas proceeds to withhold on royalty payments made to the Trust. The Trust files New Mexico and Oklahoma tax returns, obtains a refund, and distributes
that refund to Unit holders.
Withholding at the Trust level reduces the amount of cash available for distribution to Unit holders. Unit
holders who transfer their Units before either the New Mexico or Oklahoma tax refunds are received by the Trust or after the refunds are received but before the next Monthly Record Date will not receive any portion of the refund. As a result, such
Unit holders may incur a double tax first through the reduced distribution received from the Trust and second by the tax payment made directly to New Mexico or Oklahoma with the filing of their New Mexico or Oklahoma income tax returns.
9
REGULATION AND PRICES
Regulation
General
Exploration for and production and sale of oil and gas are extensively regulated at the national, state, and local levels. Oil and gas
development and production activities are subject to state law, regulation and orders of regulatory bodies pursuant thereto. These laws may govern a wide variety of matters, including allowable rates of production, transportation, marketing,
pricing, well construction, water use, prevention of waste, waste disposal, pollution, and protection of the environment. These laws, regulations and orders have in the past, and may again, restrict the rate of oil and gas production below the rate
that would otherwise exist in the absence of such laws, regulations and orders.
Laws affecting the oil and gas industry and the
distribution of its products are under constant review for amendment or expansion, frequently increasing the regulatory burden. Numerous governmental departments and agencies are authorized by statute to issue, and have issued, rules and regulations
binding on the oil and gas industry which are often difficult and costly to comply with and which impose substantial penalties for the failure to comply.
Natural Gas
Prices for
the sale of natural gas, like the sale of other commodities, are governed by the marketplace and the provisions of applicable gas sales contracts. The Federal Energy Regulatory Commission (FERC), which principally is responsible for
regulating interstate transportation and the sale of natural gas, has taken significant steps in the implementation of a policy to restructure the natural gas pipeline industry to promote full competition in the sales of natural gas, so that all
natural gas suppliers, including pipelines, can compete equally for sales customers. This policy has been implemented largely through restructuring proceedings and is subject to continuing refinement. The effects of this policy are now presumably
fully reflected in the natural gas markets. The current policy of FERC continues to promote increased competition among gas industry participants. Accordingly, various regulations and orders have been proposed and implemented to encourage
nondiscriminatory open-access transportation by interstate pipelines and to provide for the unbundling of pipeline services so that such services may also be furnished by non-pipeline suppliers on a competitive basis.
Many other statutes, rules, regulations and orders affect the pricing or transportation of natural gas. Some of the provisions are and will be
subject to court or administrative review. Consequently, uncertainty as to the ultimate impact of these regulatory provisions on the prices and production of natural gas from the Royalty Properties is expected to continue for the foreseeable future.
Environmental Regulation
General.
Activities on the Royalty Properties are subject to existing stringent and complex federal, state and
local laws (including case law), rules and regulations governing health, safety, environmental quality and pollution control. Absent the occurrence of an extraordinary event, the cost of compliance with existing federal, state and local laws, rules
and regulations regulating health; safety; the acquisition of a permit before conducting drilling or underground injection activities; the limitation or prohibition of drilling activities on certain lands lying within wilderness, wetlands,
endangered species habitat and other protected areas; the imposition of substantial liabilities for pollution resulting from operations including waste generation, air emissions, water discharges and current and historical waste disposal practices;
the release of materials into the environment; or otherwise relating to the protection of the environment should not have a material adverse effect upon the Trust or Unit holders. Failure, however, to comply with these laws, rules and regulations
may result in the assessment of administrative, civil or criminal penalties; the imposition of investigatory or remedial obligations; and the issuance of injunctions limiting or preventing some or all of the operations. Under certain environmental
laws and regulations, the operators of the Royalty Properties could also be subject to joint and several, strict liability for the removal or remediation of previously released materials or property contamination, in either case, whether at a drill
site or a waste disposal facility, regardless of whether the operators were responsible for the release or contamination or if the operations were in compliance with all applicable laws at the time the actions were taken.
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Superfund.
The Comprehensive Environmental Response, Compensation
and Liability Act (CERCLA), also known as the superfund law, imposes liability, regardless of fault or the legality of the original conduct, on certain classes of persons that contributed to the release of a hazardous
substance into the environment. These persons include the current or previous owner and operator of a site where a hazardous substance has been disposed and persons who disposed or arranged for the disposal of a hazardous substance at a site,
or transported a hazardous substance to a site for disposal. CERCLA also authorizes the Environmental Protection Agency and, in some cases, private parties to take actions in response to threats to the public health or the environment and to seek
recovery from such responsible classes of persons of the costs of such an action. In the course of operations, the working interest owner and/or the operator of Royalty Properties may have generated and may generate wastes that may fall within
CERCLAs definition of hazardous substances. The operator of the Royalty Properties or the working interest owners may be responsible under CERCLA for all or part of the costs to clean up sites at which such substances have been
disposed. Although the Trust is not the operator of any Royalty Properties, or the owner of any working interest, its ownership of royalty interests could cause it to be responsible for all or part of such costs to the extent CERCLA imposes
responsibility on such parties as owners.
Solid and Hazardous Waste.
The Royalty Properties
have produced oil and/or gas for many years, and, although the Trust has no knowledge of the procedures followed by the operators of the Royalty Properties in this regard, hydrocarbons or other solid or hazardous wastes may have been disposed or
released on or under the Royalty Properties by the current or previous operators. Federal, state and local laws and regulations applicable to oil and gas-related wastes and properties have become increasingly more stringent. 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/or the issuance of injunctions limiting or preventing some or all of the operations.
Under these laws, removal or remediation of previously disposed wastes or property contamination at a drill site or a waste disposal facility could be required by a governmental authority regardless of whether the operators were responsible for the
release or contamination or if the operations were in compliance with all applicable laws at the time those actions were taken could be required by a governmental authority.
Climate Change/Hydraulic Fracturing
. Climate change has become the subject of an important public policy debate
and the basis for new legislation proposed by the United States Congress and certain states. Some states have adopted climate change statutes and regulations. The United States Environmental Protection Agency (EPA) has issued greenhouse
gas monitoring and reporting regulations. Under those rules, since 2012, persons that hold state drilling permits that emit 25,000 metric tons or more of carbon dioxide equivalent per year have been required to annually report their greenhouse gas
emissions.
Beyond measuring and reporting, EPA issued an Endangerment Finding under Section 202(a) of the Clean Air Act,
concluding greenhouse gas pollution threatens the public health and welfare of future generations. EPA indicated that it will use data collected through the reporting rules to decide whether to promulgate future greenhouse gas emission limits. In
April 2012, EPA issued a final rule that established new source performance standards for volatile organic compounds (VOCs) and sulfur dioxide, an air toxics standard for major sources of oil and natural gas production, and an air toxics
standard for major sources of natural gas transmission and storage. Since January 1, 2015, all hydraulically fractured or refractured natural gas wells must have been completed using so called green completion technology, which
significantly reduces VOC emissions. Limiting emissions of VOCs will have the co-benefit of also limiting methane, a greenhouse gas. These regulations also apply to storage tanks and other equipment. In May 2016, EPA issued a suite of new final
regulations designed to limit methane and VOC emissions. Among other things, these new rules apply green completion requirements to newly fractured and re-fractured oil wells.
With respect to hydraulic fracturing, in February 2014, the EPA published a final guidance that broadly defined diesel fuel and which required
the issuance of a Class II Underground Injection control permit for hydraulic fracturing treatments using diesel fuel. Those requirements may cause additional costs and delays in hydraulic fracturing operations using diesel fuels. To the extent
diesel fuels are used in hydraulic fracturing activities on properties underlying the Royalty Properties, this guidance will apply.
11
Congress and various states, including Texas, Louisiana, New Mexico and Oklahoma, have proposed
or adopted legislation regulating or requiring disclosure of the chemicals in the hydraulic fracturing fluid that is used in the drilling operation. Texas requires oil and gas operators to disclose the chemicals on the Frac Focus website.
A number of governmental agencies have conducted studies on hydraulic fracturing. For example, in 2016 EPA published a final report of a
four-year study focused on the possible relationship between hydraulic fracturing and drinking water. These investigations and studies could, depending on their results, encourage additional efforts to regulate hydraulic fracturing.
The Trustee cannot predict the effect that noncompliance with existing environmental laws, rules and regulations; compliance with new
legislation or regulation, or enforcement policies thereunder; or claims for damages to property, employees, other persons and the environment resulting from operations on the Royalty Properties could have on the Trust or Unit holders. Even if the
Trust were not directly liable for costs or expenses related to these matters, increased costs to achieve compliance with existing or new environmental laws, rules or regulations or to respond to an enforcement action or a private party action could
result in wells being plugged and abandoned earlier in their productive lives, resulting in a loss of reserves and revenues to the Trust.
Prices
Oil
The Trust's average per barrel oil price decreased from $54.01 in 2015 to $39.58 in 2016. The Trustee believes that the oversupply of oil along
with worldwide geopolitical unrest led to the decrease in the price of oil in 2015 compared to 2014 prices. Oil prices remained volatile in 2016 and although the continued geopolitical unrest and lower demand for oil continued to put downward
pressure on prices for most of the year, the fact that OPEC had some success in agreeing on production cuts helped the price of oil to rebound slightly at the end of 2016.
Natural Gas
Natural gas
prices, which once were determined largely by governmental regulations, are now being governed by the marketplace. Substantial competition in the natural gas marketplace continues. In addition, competition with alternative fuels persists. The
average price received by the Trust in 2016 on natural gas volumes sold of $2.33 per Mcf represented a decrease from the $3.21 per Mcf received in 2015, due largely to international instability, warmer-than-average weather early in 2016 and
increased demand for cleaner-burning fuels. In 2016, the uncertainty around the election in the United States along with global geopolitical unrest as well as a continued surplus in gas inventories continued to keep gas prices low.
Item 1A.
Risk Factors
Crude oil and natural gas prices are volatile and fluctuate in response to a number of factors; Lower prices could reduce the net proceeds payable to the
Trust and Trust distributions.
The Trusts monthly distributions are highly dependent upon the prices realized from the sale of
crude oil and natural gas and a material decrease in such prices could reduce the amount of cash distributions paid to Unit holders. Crude oil and natural gas prices can fluctuate widely on a
month-to-month
basis in response to a variety of factors that are beyond the control of the Trust. Factors that contribute to price fluctuation include, among others:
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political conditions in major oil producing regions, especially in the Middle East;
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worldwide economic conditions;
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the supply and price of domestic and foreign crude oil or natural gas;
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the level of consumer demand;
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the price and availability of alternative fuels;
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the proximity to, and capacity of, transportation facilities;
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the effect of worldwide energy conservation measures; and
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the nature and extent of governmental regulation and taxation.
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When crude oil and natural gas
prices decline, the Trust is affected in two ways. First, net income from the Royalty Properties is reduced. Second, exploration and development activity by operators on the Royalty Properties may decline as some projects may become uneconomic and
are either delayed or eliminated. It is impossible to predict future crude oil and natural gas price movements, and this reduces the predictability of future cash distributions to Unit holders.
Trust reserve estimates depend on many assumptions that may prove to be inaccurate, which could cause both estimated reserves and estimated future net
revenues to be too high, leading to write-downs of estimated reserves.
The value of the Units will depend upon, among other things,
the reserves attributable to the Royalty Properties. The calculations of proved reserves and estimating reserves is inherently uncertain. In addition, the estimates of future net revenues are based upon various assumptions regarding future
production levels, prices and costs that may prove to be incorrect over time.
The accuracy of any reserve estimate is a function of the
quality of available data, engineering interpretation and judgment, and the assumptions used regarding the quantities of recoverable crude oil and natural gas and the future prices of crude oil and natural gas. Petroleum engineers consider many
factors and make many assumptions in estimating reserves. Those factors and assumptions include:
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historical production from the area compared with production rates from similar producing areas;
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the effects of governmental regulation;
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assumptions about future commodity prices, production and taxes;
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the availability of enhanced recovery techniques; and
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relationships with landowners, working interest partners, pipeline companies and others.
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Changes in any of these factors and assumptions can materially change reserve and future net revenue estimates. The Trusts estimate of
reserves and future net revenues is further complicated because the Trust holds an interest in net royalties and overriding royalties and does not own a specific percentage of the crude oil or natural gas reserves. Ultimately, actual production,
revenues and expenditures for the Royalty Properties, and therefore actual net proceeds payable to the Trust, will vary from estimates and those variations could be material. Results of drilling, testing and production after the date of those
estimates may require substantial downward revisions or write-downs of reserves.
The assets of the Trust are depleting assets and, if the operators
developing the Royalty Properties do not perform additional development projects, the assets may deplete faster than expected. Eventually, the assets of the Trust will cease to produce in commercial quantities and the Trust will cease to receive
proceeds from such assets. In addition, a reduction in depletion tax benefits may reduce the market value of the Units.
The net
proceeds payable to the Trust are derived from the sale of depleting assets. The reduction in proved reserve quantities is a common measure of depletion. Projects, which are determined solely by the operator, on the Royalty Properties will affect
the quantity of proved reserves and can offset the reduction in proved reserves. If the operators developing the Royalty Properties do not implement additional maintenance and development projects, the future rate of production decline of proved
reserves may be higher than the rate currently expected by the Trust.
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Because the net proceeds payable to the Trust are derived from the sale of depleting assets, the
portion of distributions to Unit holders attributable to depletion may be considered a return of capital as opposed to a return on investment. Distributions that are a return of capital will ultimately diminish the depletion tax benefits available
to the Unit holders, which could reduce the market value of the Units over time. Eventually, the Royalty Properties will cease to produce in commercial quantities and the Trust will, therefore, cease to receive any distributions of net proceeds
therefrom.
The market price for the Units may not reflect the value of the royalty interests held by the Trust.
The public trading price for the Units tends to be tied to the recent and expected levels of cash distribution on the Units. The amounts
available for distribution by the Trust vary in response to numerous factors outside the control of the Trust, including prevailing prices for crude oil and natural gas produced from the Royalty Properties. The market price is not necessarily
indicative of the value that the Trust would realize if it sold those Royalty Properties to a third party buyer. In addition, such market price is not necessarily reflective of the fact that since the assets of the Trust are depleting assets, a
portion of each cash distribution paid on the Units should be considered by investors as a return of capital, with the remainder being considered as a return on investment. There is no guarantee that distributions made to a Unit holder over the life
of these depleting assets will equal or exceed the purchase price paid by the Unit holder.
Terrorism and continued hostilities in the Middle East
could decrease Trust distributions or the market price of the Units.
Terrorist attacks and the threat of terrorist attacks, whether
domestic or foreign, as well as the military or other actions taken in response, cause instability in the global financial and energy markets. Terrorism, continued hostilities in the Middle East, and other sustained military campaigns could
adversely affect Trust distributions or the market price of the Units in unpredictable ways, including through the disruption of fuel supplies and markets, increased volatility in crude oil and natural gas prices, or the possibility that the
infrastructure on which the operators developing the Royalty Properties rely could be a direct target or an indirect casualty of an act of terror.
Future royalty income may be subject to risks related to the creditworthiness of third parties.
The Trusts future royalty income may be subject to risks relating to the creditworthiness of the operators of the underlying properties
and other purchasers of the crude oil and natural gas produced from the underlying properties, as well as risks associated with fluctuations in the price of crude oil and natural gas.
Unit holders and the Trustee have no influence over the operations on, or future development of, the Royalty Properties.
Neither the Trustee nor the Unit holders can influence or control the operations on, or future development of, the Royalty Properties. The
failure of an operator to conduct its operations, discharge its obligations, deal with regulatory agencies or comply with laws, rules and regulations, including environmental laws and regulations, in a proper manner could have an adverse effect on
the net proceeds payable to the Trust. The current operators developing the Royalty Properties are under no obligation to continue operations on the Royalty Properties. Neither the Trustee nor the Unit holders have the right to replace an operator.
The operator developing any Royalty Property may abandon the property, thereby terminating the royalties payable to the Trust.
The operators developing the Royalty Properties, or any transferee thereof, may abandon any well or property without the consent of the Trust
or the Unit holders if they reasonably believe that the well or property can no longer produce in commercially economic quantities. This could result in the termination of the royalties relating to the abandoned well or property.
14
The Royalty Properties can be sold and the Trust would be terminated.
The Trustee must sell the Royalty Properties if Unit holders approve the sale or vote to terminate the Trust as described under
Item 1 Description of the Trust Voting Rights of Unit Holders above. The Trustee must also sell the Royalty Properties if they fail to generate net revenue for the Trust of at least $2,000,000 per year over any
consecutive
two-year
period. Sale of all of the Royalty Properties will terminate the Trust. The net proceeds of any sale will be distributed to the Unit holders.
Unit holders have limited voting rights and have limited ability to enforce the Trusts rights against the current or future operators developing the
Royalty Properties.
The voting rights of a Unit holder are more limited than those of stockholders of most public corporations. For
example, there is no requirement for annual meetings of Unit holders or for an annual or other periodic
re-election
of the Trustee.
The Trust Agreement and related trust law permit the Trustee and the Trust to take appropriate action against the operators developing the
Royalty Properties to compel them to fulfill the terms of the conveyance of the Royalty Properties. If the Trustee does not take appropriate action to enforce provisions of the conveyance, the recourse of the Unit holders would likely be limited to
bringing a lawsuit against the Trustee to compel the Trustee to take specified actions. Unit holders probably would not be able to sue any of the operators developing the Royalty Properties.
Financial information of the Trust is not prepared in accordance with GAAP.
The financial statements of the Trust are 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, or GAAP. Although this basis of accounting is permitted for royalty trusts by the U.S. Securities and Exchange Commission, the financial statements of the Trust differ from
GAAP financial statements because revenues are not accrued in the month of production and cash reserves may be established for specified contingencies and deducted which could not be accrued in GAAP financial statements.
The limited liability of the Unit holders is uncertain.
The Unit holders are not protected from the liabilities of the Trust to the same extent that a shareholder would be protected from a
corporations liabilities. The structure of the Trust does not include the interposition of a limited liability entity such as a corporation or limited partnership which would provide further limited liability protection to Unit holders. While
the Trustee is liable for any excess liabilities incurred if the Trustee fails to insure that such liabilities are to be satisfied only out of Trust assets, under the laws of Texas, which are unsettled on this point, a holder of Units may be jointly
and severally liable for any liability of the Trust if the satisfaction of such liability was not contractually limited to the assets of the Trust and the assets of the Trust and the Trustee are not adequate to satisfy such liability. As a result,
Unit holders may be exposed to personal liability.
Item 2.
Properties.
The assets of the Registrant consist principally of the Royalty Properties, which constitute
interests in gross production of oil, gas and other minerals free of the costs of production. The Royalty Properties consist of royalty and mineral interests, including landowners royalties, overriding royalty interests, minerals
(other than executive rights,
15
bonuses and delay rentals), production payments and any other similar, nonparticipatory interest, in certain producing and proved undeveloped oil and gas properties located in Florida, Louisiana,
Mississippi, New Mexico, Oklahoma and Texas. These properties are represented by approximately 5,400 tracts of land. Approximately 2,950 of the tracts are in Oklahoma, 1,750 in Texas, 330 in Louisiana, 200 in New Mexico, 150 in Mississippi and
12 in Florida.
The following table summarizes total developed and proved undeveloped acreage represented by the Royalty Properties at
December 31, 2016.
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Mineral and Royalty
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State
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Gross Acres
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Net Acres
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Florida
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5,448
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697
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Louisiana
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244,391
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23,682
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Mississippi
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75,489
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9,713
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New Mexico
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112,294
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9,141
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Oklahoma
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381,538
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67,558
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Texas
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1,273,132
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105,760
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Total
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2,092,292
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216,551
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Detailed information concerning the number of wells on royalty properties is not generally available to the
owner of royalty interests. Consequently, the Registrant does not have information that would be disclosed by a company with oil and gas operations, such as an accurate count of the number of wells located on the Royalty Properties, the number of
exploratory or development wells drilled on the Royalty Properties during the periods presented by this report, or the number of wells in process or other present activities on the Royalty Properties, and the Registrant cannot readily obtain such
information.
Title
The conveyances of the Royalty Properties to the Trust covered the royalty and mineral properties located in the six states that were vested in
Sabine Corporation on the effective date of the conveyances and that were subject to existing oil, gas and other mineral leases other than properties specifically excluded in the conveyances. Since Sabine Corporation may not have had available to it
as a royalty owner information as to whether specific lands in which it owned a royalty interest were subject to an existing lease, minimal amounts of nonproducing royalty properties may also have been conveyed to the Trust. Sabine Corporation did
not warrant title to the Royalty Properties either expressly or by implication.
Reserves
The Registrant has obtained from DeGolyer and MacNaughton, independent petroleum engineering consultants, a study of the proved oil and gas
reserves attributable as of January 1, 2017 to the Royalty Properties. The following letter report summarizes such reserve study and sets forth information as to the assumptions, qualifications, procedures and other matters relating to such
reserve study. Because the only assets of the Trust are the Royalty Properties, the Trustee believes the reserve study provides useful information for Unit holders. There are many uncertainties inherent in estimating quantities and values of proved
reserves and in projecting future rates of production. The reserve data set forth herein, although prepared by independent petroleum engineers in a manner customary in the industry, are estimates only, and actual quantities and values of oil and gas
are likely to differ from the estimated amounts set forth herein. In addition, the reserve estimates for the Royalty Properties will be affected by future changes in sales prices for oil and gas produced. See Note 8 of the Notes to Financial
Statements in Item 8 hereof for additional information regarding the proved oil and gas reserves of the Trust. Other than those filed with the SEC, our estimated reserves have not been filed with or included in any reports to any federal
agency.
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The process of estimating oil and gas reserves is complex and requires significant judgment. As a
result, the Trustee has developed internal policies and controls for estimating reserves attributable to the Trust. As described above, the Trust does not have information that would be available to a company with oil and gas operations because
detailed information is not generally available to owners of royalty interests. The Trustee gathers production information (which information is net to the Trusts interests in the Royalty Properties) and provides such information to DeGolyer
and MacNaughton, who extrapolates from such information estimates of the reserves attributable to the Royalty Properties based on its expertise in the oil and gas fields where the Royalty Properties are situated, as well as publicly available
information. The Trusts policies regarding reserve estimates require proved reserves to be in compliance with the SEC definitions and guidance.
DeGolyer and MacNaughton, the independent petroleum engineering consultants who prepared the reserve study, have provided petroleum consulting
services for more than 70 years. Dennis W. Thompson, the Assistant Manager, North America Division with DeGolyer and MacNaughton, was the primary engineer responsible for the report. Mr. Thompsons qualifications are set forth in the
Certificate of Qualification attached to the letter report below.
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DeGolyer and MacNaughton
5001 Spring Valley Road
Suite 800 East
Dallas,
Texas 75244
February 20, 2017
Southwest
Bank
P.O. Box 962020
Fort Worth, Texas 76162-2020
Ladies and Gentlemen:
Pursuant to the request
of Sabine Royalty Trust (the Trust), we have prepared estimates of the extent and value of the net proved oil, condensate, natural gas liquids (NGL), and gas reserves, as of January 1, 2017, of certain properties that the Trust has represented that
it owns. This evaluation was prepared for the purpose of reporting estimates of the Trusts reserves and associated future net revenue. This evaluation was completed on February 20, 2017. The properties evaluated consist of royalties located in
Florida, Louisiana, Mississippi, New Mexico, Oklahoma, and Texas. Southwest Bank (Southwest Bank) acts as trustee of the Trust. Southwest Bank has represented that these properties account for 100 percent of revenues attributed to royalty
interest payments received by the Trust as of January 1, 2017. The properties evaluated account for 100 percent of the Trusts proved reserves. The net proved reserves estimates have been prepared in accordance with the reserves definitions of
Rules 410(a) (1)(32) of Regulation SX of the Securities and Exchange Commission (SEC) of the United States. This report was prepared in accordance with guidelines specified in Item 1202(a)(8) of Regulation S-K and is to be
used for inclusion in certain SEC filings by the Trust.
Reserves estimates included herein are expressed as net reserves. Gross reserves
are defined as the total estimated petroleum to be produced from these properties after December 31, 2016. Net reserves are defined as that portion of the gross reserves attributable to the interests owned by the Trust after deducting all interests
owned by others.
Gas quantities estimated herein are expressed as sales gas. Sales gas is defined as that portion of the total gas to be
delivered into a gas pipeline for sale after field separation, processing, fuel use, and flare. Gas reserves are expressed at a temperature base of 60 degrees Fahrenheit (°F) and at the pressure base of the state in which the interest is
located. Oil and condensate reserves estimated herein are those to be recovered by conventional lease separation. NGL reserves are those attributed to the leasehold interests according to processing agreements. For reporting purposes, oil,
condensate, and NGL reserves have been estimated separately and are presented herein as a summed quantity.
Values shown herein are
expressed in terms of future gross revenue, future net revenue, and present worth. Future gross revenue is that revenue which will accrue to the evaluated interests from the production and sale of the estimated net reserves. Future net revenue is
calculated by deducting estimated production taxes, ad valorem taxes, and expenses including, but not limited to, treating, compression, and marketing expenses incurred on the Trusts royalty interests from the future gross revenue. Future
income tax expenses were not taken into account in the preparation of these estimates. Present worth is defined as future net revenue discounted at a specified arbitrary discount rate compounded monthly over the expected period of realization.
Present worth should not be construed as fair market value because no consideration was given to additional factors that influence the prices at which properties are bought and sold.
Estimates of oil, condensate, and NGL, and gas reserves and future net revenue should be regarded only as estimates that may change as further
production history and additional information become available. Not only are such reserves and revenue estimates based on that information which is currently available, but such estimates are also subject to the uncertainties inherent in the
application of judgmental factors in interpreting such information.
Data used in this evaluation were obtained from reviews with
Southwest Bank personnel, from Southwest Bank files, from records on file with the appropriate regulatory agencies, and from public sources. Additionally, this information includes data supplied by IHS Global Inc.; Copyright 2017 IHS
Global Inc. In the preparation of this report we have relied, without independent verification, upon such information furnished by Southwest Bank with respect to property interests owned by the Trust, production from such properties, current
costs of operation and development,
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current prices for production, agreements relating to current and future operations and sale of production, and various other information and data that were accepted as represented. A field
examination of the properties was not considered necessary for the purposes of this report.
Methodology and Procedures
Estimates of reserves were prepared by the use of appropriate geologic, petroleum engineering, and evaluation principles and techniques that
are in accordance with practices generally recognized by the petroleum industry as presented in the publication of the Society of Petroleum Engineers entitled Standards Pertaining to the Estimating and Auditing of Oil and Gas Reserves
Information (Revision as of February 19, 2007). The method or combination of methods used in the analysis of each reservoir was tempered by experience with similar reservoirs, stage of development, quality and completeness of basic data, and
production history.
Based on the current stage of field development, production performance, the development plans provided by the Trust,
and the analyses of areas offsetting existing wells with test or production data, reserves were classified as proved.
An analysis of
reservoir performance, including production rate, reservoir pressure, and gas-oil ratio behavior, was used in the estimation of reserves. For depletion-type reservoirs or those whose performance disclosed a reliable decline in producing-rate trends
or other diagnostic characteristics, reserves were estimated by the application of appropriate decline curves or other performance relationships. In the analyses of production-decline curves, reserves were estimated only to the limits of economic
production. Because the Trust is unable to provide actual operating expenses for the properties evaluated (since the Trusts interests are only royalty interests), typical operating expenses, based on our knowledge of the area and/or field
operations, were used to determine the economic limits of production.
In certain cases, when the previously named methods could not be
used, reserves were estimated by analogy with similar wells or reservoirs for which more complete data were available.
The Trust owns
several thousand royalty interests. In view of the limited information available to a royalty owner and the small reserves volumes attributable to many of these interests, certain of the reserves representing approximately 27 percent of the total
net reserves of the properties included herein were summarized by state or field and estimated in the aggregate rather than on a property-by-property basis. Historical records of net production and revenue and experience with similar properties were
used in evaluating these properties.
Undeveloped reserves were estimated for certain properties based on industry activity on and
adjacent to these certain properties as well as other public knowledge concerning the future development of certain properties. Typical drilling capital costs, operating expenses, and abandonment costs in these areas were used to validate that the
undeveloped reserves are economic. These undeveloped reserves represent only 4 percent of the total net reserves evaluated herein.
Definition of
Reserves
Petroleum reserves included in this report are classified as proved. Only proved reserves have been evaluated for this
report. Reserves classifications used in this report are in accordance with the reserves definitions of Rules 410(a) (1)(32) of Regulation SX of the SEC. Reserves are judged to be economically producible in future years from known
reservoirs under existing economic and operating conditions and assuming continuation of current regulatory practices using conventional production methods and equipment. In the analyses of production-decline curves, reserves were estimated only to
the limit of economic rates of production under existing economic and operating conditions using prices and costs consistent with the effective date of this report, including consideration of changes in existing prices provided only by contractual
arrangements but not including escalations based upon future conditions. The petroleum reserves are classified as follows:
Proved oil
and gas reserves
Proved oil and gas reserves are those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically produciblefrom a given date
forward, from known reservoirs, and under existing economic conditions, operating methods, and
19
government regulationsprior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether
deterministic or probabilistic methods are used for the estimation. The project to extract the hydrocarbons must have commenced or the operator must be reasonably certain that it will commence the project within a reasonable time.
(i) The area of the reservoir considered as proved includes: (A) The area identified by drilling and limited by fluid contacts, if any, and (B)
Adjacent undrilled portions of the reservoir that can, with reasonable certainty, be judged to be continuous with it and to contain economically producible oil or gas on the basis of available geoscience and engineering data.
(ii) In the absence of data on fluid contacts, proved quantities in a reservoir are limited by the lowest known hydrocarbons (LKH) as seen in a
well penetration unless geoscience, engineering, or performance data and reliable technology establishes a lower contact with reasonable certainty.
(iii) Where direct observation from well penetrations has defined a highest known oil (HKO) elevation and the potential exists for an
associated gas cap, proved oil reserves may be assigned in the structurally higher portions of the reservoir only if geoscience, engineering, or performance data and reliable technology establish the higher contact with reasonable certainty.
(iv) Reserves which can be produced economically through application of improved recovery techniques (including, but not limited to, fluid
injection) are included in the proved classification when:
(A) Successful testing by a pilot project in an area of the reservoir with
properties no more favorable than in the reservoir as a whole, the operation of an installed program in the reservoir or an analogous reservoir, or other evidence using reliable technology establishes the reasonable certainty of the engineering
analysis on which the project or program was based; and (B) The project has been approved for development by all necessary parties and entities, including governmental entities.
(v) Existing economic conditions include prices and costs at which economic producibility from a reservoir is to be determined. The price shall
be the average price during the 12-month period prior to the ending date of the period covered by the report, determined as an unweighted arithmetic average of the first-day-of-the-month price for each month within such period, unless prices are
defined by contractual arrangements, excluding escalations based upon future conditions.
Developed oil and gas reserves
Developed oil and gas reserves are reserves of any category that can be expected to be recovered:
(i) Through existing wells with existing
equipment and operating methods or in which the cost of the required equipment is relatively minor compared to the cost of a new well; and
(ii) Through installed extraction equipment and infrastructure operational at the time of the reserves estimate if the extraction is by means
not involving a well.
Undeveloped oil and gas reserves
Undeveloped oil and gas reserves are reserves of any category that
are expected to be recovered from new wells on undrilled acreage, or from existing wells where a relatively major expenditure is required for recompletion.
(i) Reserves on undrilled acreage shall be limited to those directly offsetting development spacing areas that are reasonably certain of
production when drilled, unless evidence using reliable technology exists that establishes reasonable certainty of economic producibility at greater distances.
(ii) Undrilled locations can be classified as having undeveloped reserves only if a development plan has been adopted indicating that they are
scheduled to be drilled within five years, unless the specific circumstances justify a longer time.
(iii) Under no circumstances shall
estimates for undeveloped reserves be attributable to any acreage for which an application of fluid injection or other improved recovery technique is contemplated, unless such techniques have been proved effective by actual projects in the same
reservoir or an analogous reservoir, as defined in [section 210.410 (a) Definitions], or by other evidence using reliable technology establishing reasonable certainty.
20
Primary Economic Assumptions
Revenue values in this report were estimated using the initial prices and expenses provided by Southwest Bank. The following economic
assumptions were used for estimating existing and future prices and costs:
Oil, Condensate, NGL, and Gas Prices
Oil, condensate, NGL, and gas prices were based on a reference price, calculated as the unweighted arithmetic average of the
first-day-of-the-month price for each month within the 12-month period prior to the end of the reporting period. A West Texas Intermediate oil reference price of $42.60 per barrel and a Henry Hub gas reference price of $2.50 per million British
thermal units were used for this evaluation. The prices were held constant thereafter and were not escalated for inflation. The volume-weighted average prices attributable to estimated proved reserves over the lives of the properties were $39.34 per
barrel of oil and condensate, $2.422 per thousand cubic feet of gas, and $11.66 per barrel of NGL.
Based on royalty receipts received by
the Trust, as provided by Southwest Bank, various oil, condensate, NGL, and gas price differentials based on product quality and property location were determined for each property. These differentials were then applied to the above reference
prices, respectively, to reflect the net wellhead prices anticipated to be received by each property.
Operating Expenses, Capital
Costs, and Abandonment Costs
The properties evaluated are royalties. Therefore, no operating expenses, capital costs, or abandonment
costs are incurred. Because the Trust is unable to provide actual operating expenses for the properties evaluated, typical operating expenses, based on our knowledge of the area and/or field operations, were used to determine the economic limits of
production. For undeveloped reserves, typical drilling capital costs, operating expenses, and abandonment costs in these areas were used to validate that the undeveloped reserves are economic.
The expenses reported are primarily severance taxes and ad valorem taxes, which were based on historical tax rates furnished by Southwest
Bank. Several properties incur additional expenses related to transportation, marketing, and/or other expenses that were charged to the royalty interests. These expenses are reported as transportation expenses. No escalation has been applied to the
expenses.
While the oil and gas industry may be subject to regulatory changes from time to time that could affect an industry
participants ability to recover its oil and gas reserves, we are not aware of any such governmental actions which would restrict the recovery of the January 1, 2017, estimated oil and gas reserves.
Our estimates of the Trusts net proved reserves, as of January 1, 2017, attributable to the reviewed properties were based on the
definitions of proved reserves of the SEC and are summarized by geographic area as follows, expressed in thousands of barrels (Mbbl) and millions of cubic feet (MMcf):
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Estimated by DeGolyer and MacNaughton
Net Proved Reserves
as of January 1, 2017
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Proved Developed Reserves
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Proved Undeveloped Reserves
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State
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Oil, Condensate,
and NGL*
(Mbbl)
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Sales
Gas
(MMcf)
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Oil, Condensate,
and NGL*
(Mbbl)
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Sales
Gas
(MMcf)
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Florida
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51
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0
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0
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0
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Louisiana
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54
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444
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0
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0
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Mississippi
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104
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501
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16
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0
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New Mexico
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380
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1,868
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0
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0
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Oklahoma
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597
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9,421
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0
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0
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Texas
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4,813
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20,611
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5
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2,772
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Total
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5,999
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32,845
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21
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2,772
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*
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Includes total net NGL reserves of 1,702 Mbbl proved developed and 0 Mbbl proved undeveloped.
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21
A projection of the estimated future net revenue from the properties evaluated, as of January 1,
2017, based on the aforementioned assumptions concerning prices and expenses is summarized as follows, expressed in thousands of dollars (M$):
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Year Ending
December 31
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Future Net
Revenue*
(M$)
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2017
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23,222
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2018
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20,587
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2019
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18,564
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Subtotal
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62,373
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Remaining
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175,992
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Total
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238,365
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* Future income tax expenses were not taken into account in the preparation of these
estimates.
The present worth at a discount rate of 10 percent of future net revenue, as of January 1, 2017, has been estimated to be
M$121,084.
In our opinion, the information relating to estimated proved reserves, estimated future net revenue from proved reserves, and
present worth of estimated future net revenue from proved reserves of oil, condensate, natural gas liquids, and gas contained in this report has been prepared in accordance with Paragraphs 932-235-50-4, 932-235-50-6, 932-235-50-7, 932-235-50-9,
932-235-50-30, and 932-235-50-31(a), (b), and (e) of the Accounting Standards Update 932-235-50,
Extractive Industries Oil and Gas (Topic 932): Oil and Gas Reserve Estimation and Disclosures
(January 2010) of the Financial Accounting
Standards Board and Rules 410(a) (1)(32) of Regulation SX and Rules 302(b), 1201, 1202(a) (1), (2), (3), (4), (8), and 1203(a) of Regulation SK of the Securities and Exchange Commission; provided, however, that (i)
future income tax expenses have not been taken into account in estimating the future net revenue and present worth values set forth herein and (ii) estimates of the proved developed and proved undeveloped reserves are not presented at the beginning
of the year.
To the extent the above-enumerated rules, regulations, and statements require determinations of an accounting or legal
nature, we, as engineers, are necessarily unable to express an opinion as to whether the above-described information is in accordance therewith or sufficient therefor.
DeGolyer and MacNaughton is an independent petroleum engineering consulting firm that has been providing petroleum consulting services
throughout the world since 1936. DeGolyer and MacNaughton does not have any financial interest, including stock ownership, in the Trust. Our fees were not contingent on the results of our evaluation. This letter report has been prepared at the
request of Southwest Bank on behalf of the Trust. DeGolyer and MacNaughton has used all assumptions, data, procedures, and methods that it considers necessary and appropriate to prepare this report.
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Submitted,
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/s/ DeGolyer and MacNaughton
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DeGOLYER and MacNAUGHTON
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Texas Registered Engineering Firm F-716
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/s/ Dennis W. Thompson, P.E.
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Dennis W. Thompson, P.E.
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[SEAL]
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Senior Vice President
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DeGolyer and MacNaughton
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22
CERTIFICATE of QUALIFICATION
I, Dennis W. Thompson, Petroleum Engineer with DeGolyer and MacNaughton, 5001 Spring Valley Road, Suite 800 East, Dallas, Texas, 75244 U.S.A.,
hereby certify:
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1.
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That I am a Senior Vice President with DeGolyer and MacNaughton, which company did prepare the letter report addressed to Southwest Bank dated February 20, 2017, and that I, as Senior Vice President, was
responsible for the preparation of this letter report.
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2.
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That I attended Eastern New Mexico University, and that I graduated with a Bachelor of Science degree in Geology in the year 1973; that I earned a Master of Science degree in Petroleum Engineering from the University of
Texas at Austin in 1975; that I am a Registered Professional Engineer in the State of Texas; that I am a member of the Society of Petroleum Engineers and the Society of Petroleum Evaluation Engineers; and that I have in excess of 37 years of
experience in oil and gas reservoir studies and reserves evaluations.
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/s/ Dennis W. Thompson, P.E.
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Dennis W. Thompson, P.E.
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[SEAL]
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Senior Vice President
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DeGolyer and MacNaughton
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23
There are numerous uncertainties inherent in estimating quantities of proved reserves and in
projecting the future rates of production and timing of development. The preceding reserve data in the letter regarding the study represent estimates only and should not be construed to be exact. The estimated present worth of future net revenue
amounts shown by the study should not be construed as the current fair market value of the estimated oil and gas reserves since a market value determination would include many additional factors.
Reserve estimates may be adjusted from time to time as more accurate information on the volume or recoverability of existing reserves becomes
available. Actual reserve quantities do not change, however, except through production. The Trust continues to own only the Royalty Properties that were initially transferred to the Trust at the time of its creation and is prohibited by the Trust
Agreement from acquiring additional oil and gas interests.
The future net revenue shown by the study has not been reduced for
administrative costs and expenses of the Trust in future years. The costs and expenses of the Trust may increase in future years, depending on the amount of income from the Royalty Properties, increases in the Trustees fees (including escrow
agent fees) and expenses, accounting, engineering, legal and other professional fees, and other factors. It is expected that the costs and expenses of the Trust in 2016 will be approximately $2,741,500.
The present value of future net revenue of the Trust's proved developed reserves decreased from $140,342,269 at January 1, 2016 to
$121,083,826 at January 1, 2017. This decrease resulted from the oil and gas prices used in the calculation of such amount, from an average price of $46.66 per barrel of oil, $12.39 per barrel of natural gas liquids (NGL) and $2.62 per Mcf of gas at
January 1, 2016 to an average price of $39.34 per barrel of oil, $11.66 per barrel of NGL and $2.42 per Mcf of gas at January 1, 2017.
Subsequent to December 31, 2016, the price of both oil and gas continued to fluctuate, giving rise to a correlating adjustment of the
respective standardized measure of discounted future net cash flows. As of February 21, 2017, NYMEX posted oil prices were approximately $46.50 per barrel, which compared to the average posted price of $42.60 per barrel, used to calculate the worth
of future net revenue of the Trusts proved developed reserves, would result in an increase in the standardized measure of discounted future net cash flows for oil. As of February 21, 2017, NYMEX posted gas prices were
$2.56 per million British thermal units. The use of such price, as compared to the average posted price of $2.50 per million British thermal units, used to calculate the future net revenue for the Trusts proved developed
reserves would result in an increase in the standardized measure of discounted future net cash flows for gas.
The volatile nature of the
world energy markets makes it difficult to estimate future prices of oil and gas. The prices obtained for oil and gas depend upon numerous factors, none of which is within the Trustees control, including the domestic and foreign supply of oil
and gas and the price of foreign imports, market demand, the price and availability of alternative fuels, the availability of pipeline capacity, instability in
oil-producing
regions and the effect of
governmental regulations.