VOC Energy Trust: Form 10-Q for the period ended Sep 30, 2021

The following discussion of the Trust’s financial condition and results of operations should be read in conjunction with the financial statements and notes thereto. The Trust’s purpose is, in general, to hold the net profits interest, to distribute to the Trust unitholders cash that the Trust receives in respect of the net profits interest and to perform certain administrative functions in respect of the net profits interest and the Trust Units. The Trust derives substantially all of its income and cash flows from the net profits interest. All information regarding operations has been provided to the Trustee by VOC Brazos.

Overview

Impact of COVID-19. The 2020 outbreak of the novel form of coronavirus known as COVID-19 and its development into a global pandemic negatively impacted worldwide economic and commercial activity and financial markets, as well as global demand for crude oil and natural gas. The West Texas Intermediate (“WTI”) spot price of crude oil dropped sharply in the beginning of 2020, from $61.18 per barrel on January 2, 2020 to $12.34 per barrel on April 28, 2020, primarily attributable to the economic effects of the COVID-19 pandemic and the dispute over production levels between Russia and the members of the Organization of Petroleum Exporting Countries (“OPEC”) which resulted in an oversupply of crude oil and exacerbated the decline in crude oil prices. The responses by federal, state and local governmental authorities to the pandemic have also resulted in significant business and operational disruptions, including business closures, supply chain disruptions, travel restrictions, stay-at-home orders and limitations on the availability of workforces. After April 28, 2020, the WTI price started increasing and has returned to pre-COVID levels. Nevertheless, prices could decline again, and the Trust’s quarterly cash distributions could similarly decline, depending on future actions by OPEC or the future course of the ongoing COVID-19 pandemic.

Impairment of Net Profits Interest. Based on the substantial decline of the oil future markets at March 31, 2020, the Trust determined that its aggregate value of the underlying properties was impaired, which has resulted in an impairment expense of $41,261,354 during the quarter ended March 31, 2020. The impairment was charged directly to Trust corpus and did not affect distributable income.

Results of Operations

Results of Operations for the Quarters Ended September 30, 2021 and 2020

The following is a summary of income (loss) from net profits interest received by the Trust for the three months ended September 30, 2021 and 2020 consisting of the July distribution for each respective year:

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The cash received by the Trust from VOC Brazos during the quarter ended September 30, 2021 substantially represents the production by VOC Brazos from March 2021 through May 2021. The cash received by the Trust from VOC Brazos during the quarter ended September 30, 2020 substantially represents the production by VOC Brazos from March 2020 through May 2020. The revenues from oil production are typically received by VOC Brazos one month after production.

Gross proceeds. Oil and natural gas sales were $7,938,356 for the three months ended September 30, 2021, an increase of $5,048,764 or 174.7% from $2,889,592 for the three months ended September 30, 2020. Revenues are a function of oil and natural gas sales volumes and prices received. The increase in gross proceeds was due to an increase in oil sales volumes and increases in market prices for oil and natural gas sales, partially offset by a decrease in natural gas sales volumes during the third quarter of 2021. During the three months ended September 30, 2021, the average price for oil increased 164.6% to $59.62 per Bbl and the average price for natural gas increased 165.3% to $3.29 per Mcf. Oil sales volumes were 128,814 Bbls for the three months ended September 30, 2021, an increase of 6,142 Bbls or 5.0% from 122,672 Bbls for the three months ended September 30, 2020, while natural gas sales volumes were 78,734 Mcf, a decrease of 22,070 Mcf or 21.9% from 100,804 Mcf for the same period in 2020.

Costs. Lease operating expenses were $3,069,270 for the three months ended September 30, 2021, an increase of $818,062 or 36.3% from $2,251,208 for the three months ended September 30, 2020. Production and property taxes were $608,076 for the three months ended September 30, 2021, an increase of $345,301 or 131.4% from $262,775 for the same period in 2020. Such increase is the result of an increase of $239,526 or 136.6% in property taxes resulting primarily from a timing difference as to when payments are normally made and an increase of $105,775 or 121.1% in production taxes due primarily to higher sales volumes for oil and higher sales prices for oil and natural gas. Development expenses were $706,669 for the three months ended September 30, 2021, an increase of $322,254 or 83.8% from $384,415 for the same period in 2020. Such increase was primarily due to an increase in drilling activity and development expenses. Included in the $384,415 is $290,204 in payments made to the operator from net revenue received from the Hawkwood Development wells during the three months ended September 30, 2020. See “Liquidity and Capital Resources” below for further discussion.

Excess of revenues over direct operating expenses and lease equipment and development costs. The excess of revenues over direct operating expenses and lease equipment and development costs from the underlying properties was $3,554,341 for the three months ended September 30, 2021, an increase of $3,563,147 from the deficit of revenues over direct operating expenses and lease equipment and development costs from the underlying properties of $(8,806) for the three months ended September 30, 2020. The Trust’s 80% net profits interest of these totals was $2,843,473 and $(7,045), respectively. During the three months ended September 30, 2021, VOC Brazos did not withhold or release any dollar amounts due to the Trust from the reserve; however, during the three months ended September 30, 2020, VOC Brazos released $7,045 previously held for future development, maintenance, or operating expenditures to cover the Trust deficit for the three months ended September 30, 2020. This resulted in income from the net profits interest of $2,843,473 and $0 for such periods, respectively. These amounts were reduced by a Trust holdback for future expenses of $123,473 and $0 for the three months ended September 30, 2021 and 2020, respectively. The Trustee paid general and administrative expenses of $174,503 for the three months ended September 30, 2021, an increase of $35,273 from $139,230 for the three months ended September 30, 2020. This increase was primarily due to the differences in timing of receipt and payment of recurring general and administrative expenses. These factors resulted in distributable income for the three months ended September 30, 2021 of $2,720,000 as compared to $0 for the three months ended September 30, 2020.

Results of Operations for the Nine Months Ended September 30, 2021 and 2020

The following is a summary of income from net profits interest received by the Trust for the nine months ended September 30, 2021 and 2020 consisting of the January, April and July distributions for each respective year:

The cash received by the Trust from VOC Brazos during the nine months ended September 30, 2021 substantially represents the production by VOC Brazos from September 2020 through May 2021. The cash received by the Trust from VOC Brazos during the nine months ended September 30, 2021 substantially represents the production by VOC Brazos from September 2019 through May 2020. The revenues from oil production are typically received by VOC Brazos one month after production.

Gross proceeds. Oil and natural gas sales were $19,213,184 for the nine months ended September 30, 2021, a decrease of $1,521,501 or 7.3% from $20,734,685 for the nine months ended September 30, 2020. Revenues are a function of oil and natural gas sales prices and volumes sold. The decrease in gross proceeds was due to increases in market prices for oil and natural gas during the first nine months of 2021 that were offset by decreases in oil and natural gas sales volumes. During the nine months ended September 30, 2021, the average price for oil increased 6.2% to $47.89 per Bbl and the average price for natural gas increased 41.8% to $2.68 per Mcf. Oil sales volumes were 386,416 Bbls for the nine months ended September 30, 2021, a decrease of 61,219 Bbls or 13.7% from 447,635 Bbls for the nine months ended September 30, 2020, while natural gas sales volumes were 263,871 Mcf, a decrease of 29,721 Mcf or 10.1% from 293,592 Mcf for the same period in 2020.

Costs. Lease operating expenses were $8,563,799 for the nine months ended September 30, 2021, a decrease of $214,627 or 2.4% from $8,778,426 for the nine months ended September 30, 2020. Production and property taxes were $1,479,730 for the nine months ended September 30, 2021, a decrease of $159,374 or 9.7% from $1,639,104 for the nine months ended September 30, 2020. Such decrease is primarily due to a decrease of $151,402 or 25.0% in production taxes due to lower production volumes for oil and natural gas along with a decrease of $7,972 or 0.8% in property taxes. Development expenses were $2,004,473 for the nine months ended September 30, 2021, a decrease of $3,932,869 or 66.2% from $5,937,342 for the same period in 2020. Such decrease was primarily the result of the inclusion in 2020 of payments totaling $4,940,967 made to the operator from net revenue received from the Hawkwood Development wells during the nine months ended September 30, 2020, partially offset by an increase in drilling activity and development expenses in 2021. See “Liquidity and Capital Resources” below for further discussion.

Excess of revenues over direct operating expenses and lease equipment and development costs. The excess of revenues over direct operating expenses and lease equipment and development costs from the underlying properties was $7,165,182 for the nine months ended September 30, 2021, an increase of $2,785,369 or 63.6% from $4,379,813 for the nine months ended September 30, 2020. The Trust’s 80% net profits interest of these totals were $5,732,146 and $3,503,850, respectively. During the nine months ended September 30, 2021, VOC Brazos did not withhold or release any dollar amounts due to the Trust from the previously established cash reserve for future development, maintenance or operating expenditures, but did release $7,045 from the previously established cash reserve for future development, maintenance or operating expenditures to cover the deficit for the three months ended September 30, 2020 which resulted in income from the net profits interest of $5,732,146 and $3,510,895 for such periods, respectively. These amounts were further reduced by a Trust holdback for future expenses of $462,146 and $1,130,895 for the nine months ended September 30, 2021 and 2020, respectively. This decrease of $668,749 is primarily the result of the inclusion in 2020 of an amount estimated to be sufficient to pay estimated Trust expenses through approximately April 2021. The Trustee paid general and administrative expenses of $736,348 for the nine months ended September 30, 2021, an increase of $74,769 from $661,579 for the nine months ended September 30, 2020. This increase was primarily due to the differences in timing of receipt and payment of recurring general and administrative expenses. These factors resulted in distributable income of $5,270,000 for the nine months ended September 30, 2021 and $2,380,000 for the nine months ended September 30, 2020.

Liquidity and Capital Resources

Other than Trust administrative expenses, including any reserves established by the Trustee for future liabilities, the Trust’s only use of cash is for distributions to Trust unitholders. Administrative expenses include payments to the Trustee as well as a quarterly administrative fee to VOC Brazos pursuant to an administrative services agreement. Each quarter, the Trustee determines the amount of funds available for distribution. Available funds are the excess cash, if any, received by the Trust from the net profits interest and other sources (such as interest earned on any amounts reserved by the Trustee) in that quarter, over the Trust’s expenses paid for that quarter. Available funds are reduced by any cash that the Trustee decides to reserve for future development, maintenance or operating expenses. As of September 30, 2021, $328,802 was held by the Trustee as such a reserve.

In November 2021, the Trustee notified VOC Brazos that the Trustee intends to build a reserve for the payment of future known, anticipated or contingent expenses or liabilities, commencing with the distribution payable in the first quarter of 2022. The Trustee may increase or decrease the targeted amount at any time, and may increase or decrease the rate at which it is withholding funds to build the cash reserve at any time, without advance notice to the unitholders. Cash held in reserve will be invested as required by the Trust Agreement. Any cash reserved in excess of the amount necessary to pay or provide for the payment of future known, anticipated or contingent expenses or liabilities eventually will be distributed to unitholders, together with interest earned on the funds.

The Trustee may cause the Trust to borrow funds required to pay expenses if the Trustee determines that the cash on hand and the cash to be received are insufficient to cover the Trust’s expenses. If the Trust borrows funds, the Trust unitholders will not receive distributions until the borrowed funds are repaid. During the three and nine months ended September 30, 2021 and 2020, there were no such borrowings. VOC Brazos has provided a letter of credit in the amount of $1,700,000 to the Trustee to protect the Trust against the risk that it does not have sufficient cash to pay future expenses.

Income to the Trust from the net profits interest is based on the calculation and definitions of “gross proceeds” and “net proceeds” contained in the conveyance.

As substantially all of the underlying properties are located in mature fields, VOC Brazos does not expect future costs for the underlying properties to change significantly compared to recent historical costs other than changes due to fluctuations in the general cost of oilfield services. VOC Brazos may establish a cash reserve of up to $1.0 million in the aggregate at any given time from the dollar amount otherwise distributable to the Trust to reduce the impact on distributions of uneven capital expenditure timing. The cash reserve balance was $1,000,000 and $992,955 at September 30, 2021 and 2020, respectively.

In 2018, VOC Brazos entered into a joint venture agreement with Hawkwood Energy East Texas, LLC (“Hawkwood”). Under the terms of the joint venture agreement, Hawkwood carried VOC Brazos for its share of drilling and completion costs for four wells in the Lower Woodbine Organic Shale (the “Hawkwood Earning Wells”). In exchange, Hawkwood earned a working interest representing 50% of VOC Brazos’ interest in each Hawkwood Earning Well and up to a 50% interest in VOC Brazos’ acreage in the south half of the Kurten Woodbine Unit. After the Hawkwood Earning Wells were completed, Hawkwood had the right to propose and drill up to eight wells in the Lower Woodbine Organic Shale (“LWOS”) in 2019 and twelve LWOS wells in 2020, with no contractual limitation of the number of wells per year to propose and drill after 2020 (collectively, the “Hawkwood Development Wells”). In 2019, Hawkwood drilled and completed four Hawkwood Development Wells. VOC Brazos was paying Vess Oil, as the operator, for its share of costs and related interest in the Hawkwood Development Wells, as net revenue from each of the wells was received, thereby having no current effect on Trust distributions. The balance owed to Vess Oil was paid in full on December 31, 2020. No new Hawkwood Development Wells were drilled in 2020, or through the date of this Form 10-Q.

Note Regarding Forward-Looking Statements

This Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements other than statements of historical fact included in this Form 10-Q, including without limitation the statements under “Trustee’s Discussion and Analysis of Financial Condition and Results of Operations”, are forward-looking statements. Although VOC Brazos advised the Trust that it believes that the expectations reflected in the forward-looking statements contained herein are reasonable, no assurance can be given that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from expectations (“Cautionary Statements”) are disclosed in this Form 10-Q and in the Trust’s Annual Report on Form 10-K for the year ended December 31, 2020 (the “Form 10-K”), including under the section “Item 1A. Risk Factors”. All subsequent written and oral forward-looking statements attributable to the Trust or persons acting on its behalf are expressly qualified in their entirety by the Cautionary Statements.

The Trust is a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and is not required to provide the information under this Item.

Evaluation of Disclosure Controls and Procedures. The Trustee maintains disclosure controls and procedures designed to ensure that information required to be disclosed by the Trust in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and regulations promulgated by the SEC. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by the Trust is accumulated and communicated by VOC Brazos to the Trustee, as trustee of the Trust, and its employees who participate in the preparation of the Trust’s periodic reports as appropriate to allow timely decisions regarding required disclosure.

As of the end of the period covered by this report, the Trustee carried out an evaluation of the Trust’s disclosure controls and procedures. A Trust Officer of the Trustee has concluded that the disclosure controls and procedures of the Trust are effective.

Due to the contractual arrangements of (i) the Trust Agreement and (ii) the conveyance of the net profits interest, the Trustee relies on (A) information provided by VOC Brazos, including historical operating data, plans for future operating and capital expenditures, reserve information and information relating to projected production and (B) conclusions and reports regarding reserves by the Trust’s independent reserve engineers. See “Risk Factors—Neither the Trust nor the Trust’s unitholders have the ability to influence VOC Brazos or control the operations or development of the underlying properties” in the Form 10-K.

Changes in Internal Control over Financial Reporting. During the quarter ended September 30, 2021, there was no change in the Trust’s internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Trust’s internal control over financial reporting. The Trustee notes for purposes of clarification that it has no authority over, and makes no statement concerning, the internal control over financial reporting of VOC Brazos.

There have not been any material changes from the risk factors previously disclosed in the Trust’s response to Item 1A to Part I of the Form 10-K.