What Is a Volumetric Production Payment?
A volumetric production payment (VPP) is a financial arrangement typically found in the oil and gas industry. The property owner sells a portion of the future commodity production for an advance cash payment. A buyer receives a fixed percentage of actual commodity production, a specified monthly quantity or the equivalent monetary value. The volumetric production payment agreement may expire after a set length of time or when an agreed upon commodity amount or its value has been delivered to the buyer. Such an arrangement allows production companies to raise capital while retaining ownership interest in the property.
The VPP is assembled from working interests in one or more properties. A working interest is the right to exploit a property and receive all proceeds of production after the payment of royalties. In most cases, the working interest owner leases the mineral rights from another party with a promise to pay royalties, and assumes the full cost of development and operation. A non-operating interest can be conveyed in turn by the working interest owner to investors in a volumetric production payment arrangement.
As in other financing structures, the seller must deliver a specified amount of the commodity or its equivalent value within a set time frame. Property transfer restrictions may apply to the seller, as well as requirements for increased capital expenditure for the properties servicing the debt. Typically, the seller is not only responsible for operating costs but also for all legal risks and potential environmental liabilities pertaining to the properties.
Common investors in a VPP include investment banks, energy companies or hedge funds. The investors receive an overriding royalty interest in the specified properties that may include sites that are currently producing or under development. A royalty interest grants the investor a percentage of the commodities produced or revenues derived from their production, free of the cost of production, paid by the working interest owner. Buyers remain subject to risk from fluctuations in price, but the majority of investors in a volumetric production payment cover the risk involved by entering commodity price hedges with other parties.
Investors in a VPP may enter a commodity swap as a hedge against price fluctuations. This is often used in oil production, where payment can be based on the average price of the commodity over specified period rather than the market price. Other energy derivatives such as options and futures contracts offer similar protections. The primary risk in a volumetric production payment arrangement, however, is that the investment is being based on the accuracy of a third party production forecast.
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