Diversified Oil and Gas Holdings (DVFI)

[Imperial Whazoo]

A good hard question, but I'll try to answer it.

If I have a piece of property and an oil company comes to me and wants to punch a well on my land, there is a standard interest scheme that has been developed over time in the industry.

Generally, the interest is broken into two pieces: Working interest (WI) and Royalty Interest (RI). Override (ORI) is interest cut out of the WI that is paid on as though it were RI. I'll explain below.

The common expression in the industry is "Seven Eighths, One Eighth", which in practice is:

The WI is .875 (or, stated another way, 87.5%)

The RI is the remaining .125 (12.5%).

The operator is in the WI part. They pay all the well costs: water trucking, electrical, rework, maintainance, pipeline, all the accounting (run check expenses), miscellaneous bills. The operator files the production reports (for example, P-1's & P-2's here in Texas). They bear the legal exposure to environmental lawsuits. They post bonds with the state if necessary. And, of course, the cash coming in for the sales of product goes through their bank accounts. They cut the run checks to the RI owners, for example. Most of the business of the well is their responsibility. And, since all the operational issues are on their shoulders, they have the largest share (.875).

The royalty owners get their checks (generally monthly) according to the % they own. In practice, these folks simply get paid and bank the money. If you have ever participated in a well, in most cases, you are on the royalty side of the equation. You buy a certain percentage and the money starts flowing in if the well is a producer.

ORI is known as "Override". It is generally interest cut out of the WI side but it is treated just like it is RI. In practice, savvy land-owners can get pretty fancy when a suitor comes a calling. That’s why I keep trying to tell the board that this is probably what has been going on as part of the delays.

First off, lets look at Grimes. The Russians and Hydroslotter came into California in the summer of 2005 looking through the geological records of the state and they targeted the Grimes area because of geology that was favorable to Hydroslotting. Their idea was to rework plugged and abandoned wells. According to my conversations with the state, Skip became the operator out there. What he was faced with was he had to go out to the old land owners and persuade them to lease the old property to his little company. He had a list of properties he wanted to rework, but it was not as simple as it might seem. When a well gets plugged & abandoned (P&A), the old division order is no longer meaningful. Skip had to renegotiate every single well he wanted to rework. Given that the property owners out there are familiar with the oil business because they had been receiving royalty checks for many years back before the wells were P&A, Skip had a baseline problem of affordably renegotiating every single well he wanted to rework. To line them up one after the other, he had to successfully and in a timely fashion renegotiate far enough ahead to have a backlog of wells to rework. In all candor, this simple issue probably accounts for a great deal of the delay out there. He had to put money into the pockets of each & every landowner on whose land he intended to do the slotting. And, he had to put up a cash bond with the state for every one he intended to do. And, he had to have cash to pay the slotting crews. All of these expenses are born by the WI side, but they are simply expenses until a property begins to produce.

On the RI side, a savvy property owner will do as much nut-cutting as he can. If Skip reworked side-by-side properties, you can bet your bottom dollar that every property owner caught on and upped the price as Skip tried to move through the list of geologically favorable properties the Russians had worked up.

So, lets look at the East Texas properties that are the subject of the LOI. If these are existing producers and if they have not been formally P&A, then the deal can get done by simply transferring title to the interests involved in each division order. You simply buy the lease as is. If you then want to cut out a portion of the WI, it is not as costly because you do not have cash bonds with the state, you don't have to make a new costly lease with the royalty owner(s), and so on.

So, what I keep proposing is that the clever formula these venture cap guys from Toronto have as a business plan is to obtain existing properties and to rework them. They use as little cash as they can. What they do is they cut out a chunk of their WI side (ie... the land bank with the "land" being their interest asset and the "bank' being the portion they use as the bank, or financing, of the deal) and deed it to the people/company from whom they are buying the property. The income stream from the future rework activities will increase the cash flow from the well, because thats what happens when you successfully rework and old and almost dead property. If the interest they cut out is WI, then the people receiving this WI have to share their prorata portion of all costs (because the WI side bears the expenses... all of them). If the former owner is savvy, he could force the venture cap guys to give them an ORI that is cut out of the WI side, thereby taking them out of the direct business side, with direct sharing of all the expenses.

Anyway, that’s what I know about the subject.

Hope this helps.

Imperial Whazoo