ACCOUNTING CONCEPTS APPLICABLE TO FEDERAL ROYALTY ANALYSIS OF THE PROCESSING ALLOWANCE FORMULA
| Jurisdiction | United States |
(Mar 1988)
ACCOUNTING CONCEPTS APPLICABLE TO FEDERAL ROYALTY ANALYSIS OF THE PROCESSING ALLOWANCE FORMULA
Cities Service Oil and Gas Corporation
Tulsa, Oklahoma
Howard A. Roach
ARCO Oil and Gas Company
Dallas, Texas
I. INTRODUCTION
Although the MMS has finally codified the costs which will be included in the calculation of the processing allowance,1 a significant portion of the formula is not included within the regulations and must be extrapolated from the guidelines which the MMS has issued and which will be incorporated into the MMS payor handbook.2
The manner in which the MMS intends to implement the new processing formula will significantly impact a lessee with an ownership in a plant which processes nonowner production and a lessee with an ownership in an extraction plant which does not contain the fractionation facility therein.
Although there are other possible results, there are two key areas in which the allocation by the MMS of expenses and other data furnished by the lessee significantly impacts the resulting formula:
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1. Whether expenses are allocated to income attributable to the plant owners in calculating the processing allowance or whether expenses are allocated to production on a per unit basis.
2. Whether the fractionation allowance attributable to a plant geographically distinct from the extraction facility is proportionately reduced by the manufacturing allowance attributable to the extraction plant.
II. THE PROCESSING ALLOWANCE — EXTRACTION AND FRACTIONATION.
The processing allowance is recognized by the MMS as "quite frequently the sum of two distinct allowances — an extraction allowance for extracting liquids from a wet gas stream and a fractionation allowance for fractionating the liquid stream into constituent products."3 Thus, the processing allowance would be the sum of the following: (1) the extraction allowance plus (2) the fractionation allowance for fractionation of the liquid stream into constituent products. The MMS proportionately reduces the fractionation allowance by the percentage of the extraction allowance. Thus, the MMS formula has been calculated as follows:
Value–[Extraction+(Extraction×Fractionation)]=Net Value×Royalty Rate
Applying simple figures the formula would be implemented as follows:
100–[30+(70%×10)]=100– (30+7)=100–37=63
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Extraction Allowance is 30%×100
Fractionation Allowance is 10%×100
As can be seen from the above formula, the MMS is recognizing a deduction of 100% of the extraction cost, but is recognizing only 70% of the fractionation cost. This will result in significant reduction in any royalty which may be due as a result of a disallowance of any portion of its fractionation allowance.4
The regulations in place prior to the promulgation of the new regulations imposed a dual system for determination of the processing allowance, and did not patently distinguish extraction from fractionation. The regulations determined the value basis for computing royalties on gas produced onshore on the basis of "...the value of 1/3 (or the lessee's portion if greater than 1/3) of all casing-head or natural gasoline, butane, propane, or other liquid hydrocarbon substances extracted from the gas produced from the leasehold. The value of the remainder is an allowance for the cost of manufacture and no royalty thereon is required."5
The value basis for gas produced offshore which was processed was the value of the residue gas and "...all natural gasoline, butane, propane or other substances extracted from the gas. A reasonable allowance, determined by the director and based upon
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regional plant practices and actual plant costs and other pertinent factors, may be made for the cost of processing and may be deducted from the royalty payment due on said constituent substances."6
These regulations provided little guidance to the lessee as to the proper manner of calculating the processing allowance and it was left to the MMS to develop policies, procedures and internal guidelines to develop formulas to implement the processing allowance. An examination of the history of this process will enable the lessee to more fully appreciate the formulation of the current allowance.
III. DEVELOPMENT OF FORMULAS FOR CALCULATING A PROCESSING ALLOWANCE — BEFORE §30 C.F.R. 206.159 .
A. CONSERVATION DIVISION MANUAL §647.7.3
The Conservation Division Manual7 (CDM) dated May 10, 1974, set forth guidelines for determining manufacturing allowances on a "net realization"8 basis for residue gas and associated liquids produced from onshore and Indian oil and gas leases under the jurisdiction of the Conservation Division.
Although the CDM applied exclusively to onshore production, it is helpful to analyze the calculation of the allowance to gain insight into the MMS' policies and procedures. The pertinent section, CDM §647.7.3 described certain gas processing situations
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involving non-arm's length transactions and required that a manufacturing allowance be computed on a net realization basis. This method was applied when more than 50 percent of the total gas processed through a plant was from leases owned by the plant owner. If the owner of the plant owns less than 50 percent of the total gas processed through the plant, the CDM recognized contract terms as the basis for the manufacturing allowance.9
In order to calculate a processing allowance based on net realization the CDM required an evaluation of plant investment costs and annual operating expenditures. The plant operator was to "initially submit a breakdown of plant investment costs and subsequent annual breakdowns of 100 percent plant income and 100 percent operating costs."10
Plant investment costs were described as "generally those expenditures for fixed assets (including delivery and installation costs) that are directly dissociated with the recovery of natural gas liquids."11 Most investment items were generally located within the confines of the plant.
Operation and maintenance expenditures included the following:12
1. Salaries and wages.
2. Electrical or other energy expenditures.
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3. Depreciation.
4. Imputed interest on undepreciated investment.
5. Chemicals and lubricants.
6. Repairs, contract labor, material and supplies.
7. Insurance and taxes (personal property and payroll income taxes were not an allowable...
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