What is Volumetric Production Payment (VPP)?
A volumetric production payment (VPP) is a means of financing used predominantly in the oil and gas industry in which the owner of an oil or gas property sells a percentage of the total production of hydrocarbons for an upfront cash payment. The VPP deal includes an overriding royalty interest, i.e., a predetermined fraction of total production (or proceeds from the sale of the produced commodity) over the stated term paid by the owner of the gas field to the VPP purchaser.
VPP’s been employed by exploration and production (E&P) companies for several decades to monetize a portion of their oil and gas properties. Such deals enable the companies to raise operating capital without incurring debt or diluting their control on the enterprise by issuing stock. They can fund their growth while retaining full ownership of their property.
- A volumetric production payment (VPP) is a means of financing used predominantly in the oil and gas industry wherein the owner of an oil or gas property sells a percentage of the total production for an upfront cash payment.
- It allows the issuer to monetize his/her assets without diluting his control on them.
- Despite the interest risk, commodity price risk, and operational risk associated with VPP, the model’s been successful in both the oil & gas and mining industries.
How Does Volumetric Production Payment Work?
The terms of a volumetric production payment deal are governed by purchase & sale and production & marketing agreements. The conveyance of overriding royalty interest is also governed by the terms of the deal.
The VPP purchaser makes an upfront cash payment to the issuer in return for a certain fraction of the total production to be delivered at the end of the term. The delivery may be in cash or kind, with any shortfall to be covered in the next term of the contract along with the accumulated interest.
Example of a VPP Deal
For example, consider the owner of an oil field X who sells a volumetric production payment to Y on April 1 that entitles Y to 20% of the total production of oil in the next six months. By October 1, 2018, X’s property produces 10,000 barrels of oil with a market value of $20 million. As decided, 2,000 barrels of oil worth $4 million are delivered to Y.
For the given period, X includes the proceeds from production of $20 million in his/her taxable income and claims relevant deductions from it. X’s payment of $20 million to Y includes both principal repayment and interest expense, and X is eligible for a deduction on the interest amount.
In the first decade of the 21st century, the mining sector began employing the VPP model to finance its operational costs, following in the footsteps of Silver Wheaton, a mining company. It involved the exchange of a percentage of metal production in return for an upfront payment. The business model soon gained popularity after Silver Wheaton’s astounding success and is today known as “metal streaming.”
Advantages of VPP
To the Seller:
- Allows the seller to monetize assets while still retaining operational control on them
- The VPP is treated as a loan, which makes the interest paid tax-deductible
- An effective hedger, as the buyer bears commodity price and interest rate risk
To the Buyer:
- Exercises no liability for operating costs
- Can easily hedge the price risk through derivatives such as commodity swaps
- Gives the investor access to oil or gas in kind
Risks Associated with VPP
1. Reserve Risk
The VPP deal entitles the VPP holder to a fraction of production on specific leases. An unanticipated fall in production from the associated reserves may lead to the holder’s return also taking a hit.
The holder can reduce such a risk by surveying the reserves prior to the deal. An ideal scenario is when 50%-60% of the scheduled production can cover the return to the holder. Entering VPP deals on diversified leases as opposed to just one area can also help to mitigate the reserve risk.
2. Commodity Price Risk
The VPP holder assumes the risk of price fluctuations in the oil and gas market. However, the risk can be hedged through derivatives, such as commodity swaps, or by entering a contract to sell the products at a predetermined price.
3. Interest Rate Risk
The holder assumes the risk of a rise in interest rates over the term of the VPP contract while the return on the VPP will be constant. The holder can hedge his position in the market to reduce the interest rate risk.
4. Operational Risk
Inefficient production processes employed by the VPP issuer may pose a risk to the volume of production over the term of the contract.
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