CHAPTER 12 DESIGN AND RATIONALE OF THE FINAL RULE ON ROYALTY RELIEF FOR DEEP GAS PRODUCTION FROM SHALLOW-WATER LEASES IN THE GULF OF MEXICO
| Jurisdiction | United States |
(Feb 2004)
DESIGN AND RATIONALE OF THE FINAL RULE ON ROYALTY RELIEF FOR DEEP GAS PRODUCTION FROM SHALLOW-WATER LEASES IN THE GULF OF MEXICO
Alvin G. Durr, Jr.
Minerals Management Service
New Orleans, Louisiana
This paper was prepared for presentation at the Institute on Federal and Indian Oil and Gas Royalty Valuation and Management held in Houston, Texas, February 11-13, 2004. The Institute was sponsored by the Rocky Mountain Mineral Law Foundation and the Minerals Management Service, U.S. Department of the Interior.
Introduction
Natural gas production over the last 20 years from offshore Federal lands has been fairly constant at about 5 TCF per year, which supplies approximately 25 percent of domestic demand. Forecasts, however, indicate that demand for natural gas will increase significantly. For example, the Energy Information Administration projects that demand for natural gas in the United States could increase more than 50 percent in the next 20 years, rising from 22 TCF in 2003 to 35 TCF in 2025. Without new sources of domestic natural gas, there will be a growing imbalance between supply and demand, resulting in continued gas price volatility and an increased reliance on imports, such as liquefied natural gas (LNG) from overseas.
Production from deep wells in the shallow waters (less than 200 meters) of the Gulf of Mexico is one of the most attractive sources of additional natural gas supplies needed to alleviate predicted shortages and help moderate price increases over the next decade. Abundant infrastructure needed to produce the gas and transport it to onshore processing plants is already in place. Further, according to "Gulf of Mexico OCS Deep Shelf Gas Update: 2001-2002" published by the Minerals Management Service (MMS) in April 2003, completions in new deep gas reservoirs on the OCS are showing signs of providing the best opportunity for quickly increasing natural gas production. Well test information from recent deep gas completions suggests that production rates tend to increase with depth.
Deep gas exploration, however, requires large capital outlays and leading edge technology involving upgraded drilling rigs and advanced well design. Wells targeting deep-shelf reservoirs face a high risk of failure because of high pressure and temperature conditions, poor quality 3D seismic data, and an overall lack of experience by industry in drilling at very deep depths. Improved drilling and seismic exploration technologies are still needed to overcome many of the challenges associated with deep drilling.
To encourage and accelerate discovery and production of deep gas reserves, the MMS began offering a royalty relief incentive for shallow-water leases in the Gulf of Mexico starting with lease sales held in 2001. In accordance with the royalty relief provisions in the lease instrument, a royalty suspension volume of 20 BCF of deep gas production is earned when a well is drilled and completed in a new deep gas reservoir and commences production within the first five years of the life of the lease. Deep gas production is defined as any gas production from a completion with the top of the perforated interval 15,000 feet or deeper subsea (true vertical depth below the datum at mean sea level). Royalties would be due, however, during a calendar year when the average gas price exceeds the threshold price of $5.00 per MMBTU ($3.50 per MMBTU for leases in Sale 178), which is adjusted annually for inflation from the year 2000. Currently, three leases issued since 2001 are producing under this deep gas royalty relief program.
The above incentive applies to 1,240 shallow-water leases issued since the beginning of 2001, but most of deep gas potential on the Gulf of Mexico Shelf, which the MMS believes could be as much as 55 TCF, underlies many of the 2,400 shallow-water leases in existence before 2001. On March 26, 2003, MMS published a proposed rule that would provide a deep gas royalty relief incentive for these leases. So lessees would not delay drilling new deep wells, MMS made the relief applicable to deep wells that commenced drilling on or after March 26, 2003, but the relief would only apply to production occurring on and after the effective date of the final rule.
The final rule was published on January 26, 2004, and will become effective on March 1, 2004. Since the date of the proposed rule, nine lessees have notified the MMS of their intent to drill a total of 28 deep wells on leases that were in effect before 2001.
Summary of Final Rule on Deep Gas Royalty Relief
A lease is eligible for deep gas royalty relief under the final rule if it (1) is located in the Gulf of Mexico wholly west of 87 degrees, 30 minutes West longitude, and in water depth less than 200 meters, (2) was in existence on January 1, 2001, or elected a one-time option to replace the deep gas royalty relief terms in the lease instrument with the terms in the final rule, and (3) has not produced from a well with a perforated interval, the top of which is 18,000 feet TVD SS or deeper, which commenced drilling before the date of the proposed rule (March 26, 2003).
A qualified well can earn a royalty suspension volume up to 25 BCF for deep gas production, which is the maximum suspension volume allowed per lease. A qualified well is an original (new) well or sidetrack with a perforated interval, the top of which is at least 15,000 TVD SS, that begins drilling on or after March 26, 2003, commences production within five years following the effective date of the final rule, and meets the regulatory reporting requirements. Deep sidetracks earn a royalty suspension volume based on the actual length of the sidetrack. Subsequent qualified wells may share in the lease's royalty suspension volume.
A lease may also earn a royalty suspension supplement up to 5 BCFE by drilling an unsuccessful well or sidetrack to a target depth of 18,000 feet TVD SS or deeper. A lease is allowed two royalty suspension supplements or a maximum of 10 BCFE. A royalty suspension supplement can only be earned if no qualified well has produced on the lease at or below 18,000 feet TVD SS. Future oil and gas production from the lease, regardless of depth, can be applied toward a royalty suspension supplement.
On the basis of the above incentives, a lease can earn the right to produce as much as 35 BCFE of royalty-free hydrocarbon, that is 10 BCFE for two unsuccessful wells and then 25 BCF for a subsequent qualified well drilled to at least 18,000 feet TVD SS. Further details on specific royalty suspension volumes and supplements that can be earned by an eligible lease are found later in this paper under Main Components of the Final Rule.
In the proposed rule, if the average gas price for a calendar year exceeds the threshold price established at $5.00 per MMBTU, adjusted annually for inflation from the year 2000, then the lessees must pay royalties on deep gas production for that calendar year. The MMS has decided to revise the gas price threshold in the final rule. The revised threshold is $9.34 per MMBTU, adjusted annually for inflation from the year 2004. A discussion of the price threshold can be found in this paper under Major Issues.
Major Issues
Following publication of the Proposed Rule for Deep Gas Royalty Relief on March 26, 2003, the MMS addressed five major issues based on comments received from industry at an MMS sponsored workshop held in Houston on April 30, 2003, and written comments submitted by 14 respondents.
1. Lease/Well Eligibility
The MMS received comments requesting that we either drop the stipulation that leases with previous deep gas production are not eligible for relief or that we consider deep wells drilled on leases with previous deep production be eligible for relief if drilled to a substantially deeper depth.
It was the MMS' position in the proposed rule that a lease already producing from a deep depth did not need royalty relief as an incentive to conduct additional deep drilling operations. While we still believe deep drilling and production prior to March 26, 2003, reduces the economic risks associated with further deep drilling, it is less likely to reduce the risks associated with drilling to a deeper depth interval.
Therefore, the MMS has reconsidered its position in the proposed rule on this issue. The final rule provides a royalty suspension volume for a qualified well drilled to 18,000 feet TVD SS or deeper even if there was production on the lease from 15,000 to less than 18,000 feet TVD SS, regardless if the production was prior to or after March 26, 2003. Since the successful drilling of a well in the 15,000 to less than 18,000 feet category may provide some encouragement to drill to a deeper target, the MMS has established under this scenario a lower royalty suspension volume for the deeper depth interval. For example, if a lease has production from 15,000 to less than 18,000 feet TVD SS, and subsequent production from a qualified original well at 18,000 feet TVD SS or deeper, then the lease earns a royalty suspension volume of 10 BCF, the difference in the royalty suspension volumes for the two depth intervals.
Further, in the proposed rule the first qualified well establishes the royalty suspension volume for the lease. For example, if the first qualified original well produces from 15,000 to less than 18,000 feet TVD SS, the royalty suspension volume for the lease under the proposed rule would be limited to 15 BCF, which is the suspension volume applicable to that depth interval. The MMS has structured the final rule so that the total magnitude of the royalty suspension volume that can be earned on the lease is independent of the order in which wells are drilled to different depth categories. If a qualified original well produces from 15,000 to less than 18,000 feet TVD SS and...
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