CHAPTER 1 WHAT'S BEHIND THE VALUATION CONTROVERSY ANYWAY?
| Jurisdiction | United States |
(2000)
WHAT'S BEHIND THE VALUATION CONTROVERSY ANYWAY?
Washburn University School of Law
Topeka, Kansas
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I. WHY WE ARE HERE: THE ROYALTY VALUE THEOREM.
II. THE OIL INDUSTRY-JUST ANOTHER TOBACCO COMPANY?
III. TAKE THIS OIL "IN-KIND" (AND SHOVE-IT).
IV. THE ISSUES COURTS NEED TO ADDRESS.
A. The Foundational Issue: When Does the Lessor/Lessee Relationship End?
1. Upstream/Downstream: Linear Royalty Analysis.
a. The Government's "Possessory" Approach.
b. The Industry's "Functional" Approach.
c. Analytical Difficulties with Each Approach.
(1) The Possessory Approach.
(2) The Functional Approach.
2. The Scope of the Relationship Under the Mineral Leasing Act.
a. The Lessee's Burden; The Government's Advantage.
b. What Does "Removed or Sold from the Lease" Mean?
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B. How Should Production be Valued?
C. What Sort of "Production" Must the Lessee Make Available to be "Removed or Sold from the Lease"?
1. The MMS Approach.
2. The Industry Approach.
D. The "Prudent Operator" Under Federal Oil and Gas Leases.
E. Does the Mineral Leasing Act Negate Basic Principles of Corporate Law?
1. MMS Concerns Regarding Affiliate Transactions.
2. Corporate Separateness and the Supreme Court.
3. Do the Federal Leasing Laws "Speak Directly" to the "Liability Implications of Corporate Ownership"?
V. CONCLUSION
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I. WHY WE ARE HERE: THE ROYALTY VALUE THEOREM.
The question posed by my topic, "What's Behind the Valuation Controversy," is answered with what I will call the "royalty value theorem."
When compensation under a contract is based upon a set percentage of the value of something, there will be a tendency by each party to either minimize or maximize the value.
The oil and gas lease is a classic example. From the lessor's perspective, anytime they can obtain 1/8th of X+ instead of 1/8th of X, they will seek a share of X+. However, the lessee will resist because any amount in excess of X will reduce the lessee's net revenue interest under the lease. Basic contract law prohibits the lessor from demanding a 1/4th royalty when their lease provides for a 1/8th royalty. The specified fraction of royalty offers very little language that can be "interpreted" and therefore manipulated by parties to the agreement. However, the value component of the royalty equation has proven most susceptible to interpretation, and manipulation. When dealing with private lessors, the opportunity for interpretation/manipulation is generally confined to the language of the oil and gas lease and any documents that modify the lease, such as pooling agreements and division orders. However, when dealing with the federal government as lessor, the interpretation/manipulation opportunity is tripled with the prospect for interpretation of: (1) statutory language; (2) contract language; and (3) regulatory language.
II. THE OIL INDUSTRY-JUST ANOTHER TOBACCO COMPANY?
I make the observations contained in this section of my paper to confirm what the industry and government attendees at this conference deep down already know-but know better than to admit: compromise on the basic issues that impact the royalty value theorem is impossible. The
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industry's approach will be to make the best of a "bad" situation and then determine whether to challenge the Mineral Management Service's (MMS) final regulations.1 The MMS's approach will be to prospectively maximize their position under the royalty value theorem while ensuring they do nothing that could weaken application of their valuation theories to past royalty obligations.2 Disputes concerning underpayment of past royalty obligations will not be a simple issue of statutory, contractual, and regulatory interpretation. Instead, the industry will be professionally demonized while the issues are presented in the context of fraud, conspiracy, and criminal conduct. For example, consider how some of our nation's highest-ranking politicians have characterized the issues we are discussing here today:
Under the current regulations governing crude oil royalty valuation for federal leases, a mountain of evidence has emerged demonstrating that federal oil and gas lessees, primarily the large, integrated corporations, have been cheating the American people out of hundreds of millions, if not billions, of dollars in royalties on federal oil and gas production. 3
The basic premise on which Senator Boxer operates is: if there is any theory under which the government could get more money for its royalty oil and gas, and the industry is not paying in accordance with that theory, they are guilty of criminal conduct. The validity of the government's theory doesn't matter-at least not at the demonization stage of the political process. At the demonization stage all you need is a willing accomplice in the media.
In his October 5, 1999 "Fleecing Of America" broadcast, Tom Brokaw revisits one of his earlier reports on the royalty valuation issue asking reporter Chip Reid "to bring us up to date on some of the most outrageous examples" of the "Fleecing Of America."4 Mr. Reid observes: "Critics
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have long complained the oil companies don't pay enough in royalties because they are allowed to set the price for the oil they take. And those critics say they set the price too low."5 Reid states: "Bottom line, taxpayers lose up to sixty-six million dollars a year, according to the government." This is followed by an observation by Danielle Brian, the Executive Director for the "Project On Government Oversight," that: "The government is being cheated. But what that really means is that the taxpayer is getting cheated."6 Reporter Reid updates the continued "Fleecing Of America" stating:
Last year, the Interior Department tried to fix that [industry cheating]. It forced the oil companies to pay fair market value, but last week, the Senate, led by Kay Bailey Hutchison of oil-rich Texas, said no. The oil companies can keep their prices.... The 'Fleecing of America' will continue. 7
NBC's Tom Brokaw would never waste his time reporting on the intricacies of upstream royalty valuation versus downstream valuation, the deduction of costs incurred to enhance a marketable product, or the law of corporate separateness. These subjects are the "truths" involved in the valuation debate; commentators like myself, other professors, and representatives on both sides of the issue, have been engaged in legitimate discourse on these issues for years.8 But the truth on this subject does not play as well on national television as do lies of fraud, criminal conspiracy, and theft. This governmental/political propensity to cast legitimate contractual disputes as criminal corruption, when combined with a willing, superficial national media, creates enormous risk for any industry that comes within their sights. In such an environment the only real recourse is the courts.9
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The balance of this paper defines the precise disputes that exist between industry lessees and government lessors; issues that remain ripe for judicial action eighty years after enactment of the Mineral Leasing Act.10 But before we turn to the substantive issues, lets consider the take-in-kind solution that has been offered by many to address the valuation problem.
III. TAKE THIS OIL "IN-KIND" (AND SHOVE-IT).
One way to avoid problems associated with the royalty value theorem is to adopt a royalty compensation mechanism that is not dependent on value. If royalty is paid by delivering a stated fraction of production to the lessor, the "value" of the production should not matter. If the lessor believes wellhead or field values are being artificially depressed, let the lessor take their production and see if they can do any better.11 However, under the MMS's current approach to royalty valuation, taking in-kind will not survive where the lessor can share risk-free in the lessee's downstream business ventures. To the extent taking in-kind yields the government less value than the lessee obtains for its production at some downstream point, the Senator Boxers would conclude the MMS employees responsible for the in-kind program were either incompetent, duped, or bribed.12 Senator Boxer has referred to these royalty-in-kind programs as "bogus" and just another
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attempt to "obscure the fact that the new [royalty valuation] rule is necessary because the industry has cheated the American people out of billions of dollars."13 The simple fact is taking-in-kind will never be accepted by industry critics until the valuation issues noted below are fully resolved. So long as MMS methodology for valuing royalty includes downstream values, any take-in-kind program that nets less than downstream values will be deemed unacceptable.14
IV. THE ISSUES COURTS NEED TO ADDRESS.
A. The Foundational Issue: When Does the Lessor/Lessee Relationship End?
1. Upstream/Downstream: Linear Royalty Analysis.
The production, movement, treatment, and marketing of oil and gas are linear. Typically at each point along the line investment is made by someone, and risks taken, in hopes of enhancing the value of the oil and gas as it moves "down-the-line" in its downstream journey to ultimate consumption. Therefore, the value-added component of oil and gas is also linear, with an increase in value typically corresponding with an increase in investment, as the oil and gas move downstream from the wellhead. Before it can be determined whether, and to what extent, a lessor is entitled to participate in downstream oil and gas values, the scope of the oil and gas lease relationship must be
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defined. At what point does the extracted oil and gas leave the sphere of influence of the oil and gas lease and enter into an arena in which the lessor and lessee no longer have any...
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