CHAPTER 12 LITIGATION UPDATE: RECENT CASELAW ON FEDERAL AND INDIAN LEASE ROYALTY ISSUES

• Jurisdiction: United States

Federal & Indian Oil & Gas Royalty Valuation and Management III
(2000)
CHAPTER 12
LITIGATION UPDATE: RECENT CASELAW ON FEDERAL AND INDIAN LEASE ROYALTY ISSUES
Mary V. Laitos, Esq.
Welborn Sullivan Meck & Tooley, P.C. ¹
Denver, Colorado

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I. Duty to Market and the Marketable Condition Rule.

Independent Petroleum Ass'n of Am. v. Armstrong, No. 98-00531, D.D.C. consolidated with American Petroleum Institute v. Babbitt No. 98-00631 Order and Final Judgment (D.D.C., March 28, 2000).

In these cases the District Court enjoins the Minerals Management Service ("MMS"), from implementing or enforcing its revised transportation allowance regulations, which became effective February 1, 1998. 62 Fed. Reg. 65753 (December 16, 1997). These regulations were promulgated after FERC Order 636, which unbundled pipelines' sales services from their transportation services. In essence, the new regulations separate previously bundled (and deductible) costs and identify those costs which are now non-deductible from royalty calculations as marketing costs. In overturning the regulations, the Court rejected MMS' claimed authority for the rules, based upon an implied duty on the lessee to market gas downstream of the well.

In its analysis, the Court confirms that the duty to place production in marketable condition is legally distinct from a duty to market production at no cost to the lessor. The Court first reviewed the provisions of the applicable statutes such as the Mineral Leasing Act, Indian leasing statutes and Outer Continental Shelf Lands Act, all of which limit the collection of royalties to "the value of production saved, removed or sold from the lease."

The Court then reviewed the express terms of various federal and Indian leases and MMS processed gas regulations, (which it offered in support of the new rules), and found that a broad duty to market could not be reasonably implied from those provisions. This was particularly so, where the new rules admittedly contradicted MMS' prior practice:

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To the contrary, the lease forms enumerate the various production and royalty related duties and rights without any mention of marketing or sale of gas beyond the lease or wellhead. Had the parties contemplated such an expanded duty when the contract was formed, it is likely that they would have expressly addressed it in the leases. Slip. Op. at 31.

The Court's final judgment ruled the following regulations are unlawful and of no force or effect: 30 C.F.R. §§ 206.152(i) ; 206.153(i) ; 206.157(f)(i) ; 206.157(g)(2) ; 206.157(g)(4) ; 206.157(g)(5) ; 206.172(i) ; 206.173(i) ; 206.177(f)(1) ; 206.177(g)(2) ; 206.177(g)(4) ; and 206.177(g)(5) .

Seagull Energy Corp., 148 IBLA 300 (1999)

Texaco Exploration and Production Inc.,___I.D.___(May 18, 1999)

Fina Oil and Chemical Co., 149 IBLA 168 (1999)

The first of these cases, Seagull, concerns Seagull's OCS gas sales to an affiliate who also purchased gas from other lessees on an arm's-length basis. There was no evidence that MMS required the arm's-length lessees to recalculate royalties, or that the gas was not marketable at the wellhead. Nevertheless, MMS contended that the Seagull affiliates' price was proper because the differences constituted non-deductible marketing, fuel costs and transportation costs, it incurred. The Interior Board of Land Appeals ("IBLA"), refused to adopt a per se rule that under the duties to market lease production or to place leasehold products in marketable condition, the affiliates' price must always be utilized. Such a rule contravenes the provisions of 30 C.F.R. § 206.152(c)(1) requiring use of comparable arm's-length sales as the first applicable benchmark.

The Board also concluded that the affiliation relationship was only the first part of the analysis. If the facts demonstrated that the gas was not in marketable condition and the producer was merely transferring costs to place the gas in marketable condition to its affiliate, then MMS properly looked to the affiliate's sale under the marketable condition rule. If in fact the affiliate also bought gas arm's-length at the wellhead, then the gas was in marketable condition at the wellhead, and the first benchmark, using comparable arm's-length sales, would apply. The IBLA concluded that for royalty purposes, Seagull should not "bear the costs of downstream marketing where the gas sold at the wellhead was in marketable condition and where a market existed there."

The Acting Assistant Secretary for Land and Minerals of the Department of Interior, immediately rejected the IBLA's holding in Seagull, and limited its precedential value to the facts of that case in the Texaco decision, which she signed as a final agency action, thereby bypassing IBLA. The Assistant Secretary's focus in Texaco, was the relationship between Texaco Exploration and Production, Inc. and its marketing affiliate, Texaco Refining and Marketing, Inc. To the Assistant Secretary, since each affiliate was owned by Texaco Inc.,

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in essence "Texaco" received total gross proceeds of its affiliate under application of the gross proceeds rule. However, the gross proceeds rule expressly applies to the proceeds of the "lessee", not the "lessee and any affiliates". Despite this language, the Department's expanded interpretation of the term lessee is justified in the decision as the "plain intent" of the gross proceeds rule that "common sense supports." The Assistant Secretary asserts further that a per se rule using affiliates' proceeds applies because even production in marketable condition does not mean that the lessee's duty to market has been satisfied. In essence, where a producer and its affiliate choose to capture downstream enhanced revenues. the federal lessor must share in the ultimate proceeds without deduction for any additional costs, despite the existence of a wellhead market.

In the third case, Fina, the IBLA affirmed the MMS decision in accordance with the holding set down in Texaco, without further analysis.

Anson Co. 145 IBLA 221, GFS (O&G) 29 (1998).

Yates Petroleum Corp. 148 IBLA 33, GFS (O&G) 12 (1999).

In these two administrative appeals, a two percent (2%) reduction in price to the lessee from the purchaser, constituted a marketing fee that had to be added back to royalty computation under the gross proceeds rule. It is...