CHAPTER 13 FEDERAL AND INDIAN ROYALTY LITIGATION REPORT

• Jurisdiction: United States

Federal and Indian Oil & Gas Royalty Valuation and Management
(Oct 2018)
CHAPTER 13
FEDERAL AND INDIAN ROYALTY LITIGATION REPORT
L. Poe Leggette ¹
Partner
BakerHostetler
Denver, CO

[Page 13 - 1]

POE LEGGETTE recently received special recognition from the Board of Directors of the Independent Petroleum Association of America. Poe has represented IPAA for over 25 years and, according to the Association's citation, has saved the oil and gas industry over $25 billion dollars in needless regulatory costs and in unlawful royalty demands. Poe is stepping down as the Managing Partner of the Denver, Colorado office of Baker & Hostetler LLP to head its national energy practice, based in its Houston office. That practice was named a 2015 Practice Group of the Year by Law360. Poe was also named a 2015 "Colorado Lawyer of the Year" by Law Week Colorado. Poe's practice focuses on litigation and transactional work in the energy industry. Before entering private practice, Poe served as assistant solicitor for the U.S. Department of the Interior, advising the Bureau of Land Management (BLM) and the Minerals Management Service (MMS), including MMS's Royalty Management Program. Poe has practiced federal royalty law since 1980. So pay attention.

ABSTRACT

This paper and accompanying presentation review significant administrative and judicial decisions within the last decade. In the paper, those cases that could be addressed before the Foundation's deadline are summarized simply, with analysis reserved for the presentation. For the paper only, closer attention will be given to the issue of the duty to place production in marketable condition without cost to the lessor. This written report, therefore, is not a real "paper," and in all events not an "article." This written submission is really more like the "album notes" one would read when albums were played at 33 rpm and records were packaged in cardboard. Of course, much longer than album notes, and intrinsically less interesting.

SECTION ONE: INTRODUCTION

The presentation will divide litigation thematically. To catch everyone's attention early, it will first discuss civil penalties cases and cases brought under the False Claims Act. It will turn to several of the more bread-and-butter issues in federal royalty law. To what extent is production not subject to the royalty obligation? How does one distinguish an arm's-length sale of production from one that is not? How does one distinguish the non-deductible costs of gathering from the deductible costs of transportation?

The presentation will also cover the nettlesome topic of those circumstances under which an administrative entity or court lacks jurisdiction to hear a royalty dispute. It will consider two recent decisions challenging ONRR regulations. It will, as time allows, cover other topics that Mr. Marchetti deems noteworthy. Finally, it will address the issue of marketable condition.

A. Civil Penalties under 30 U.S.C. § 1719

Two decisions of the Interior Board of Land Appeals ("IBLA") illustrate the scope of ONRR's authority to impose a penalty and the factors it is to consider in setting a penalty amount.

Statoil USA E&P, Inc. v. ONRR, 185 IBLA 302 (2015). By order issued in August 2010, ONRR directed the company to correct reporting of gas volumes, giving the company until January 10, 2011, to do so. Id. at 307. Statoil did not correct the reports and did not appeal the order. The record suggests multiple communications between ONRR and Statoil staff, id. n. 9, without results to ONRR's satisfaction. In February 2012, ONRR issued a notice of civil penalty.

The chief issue was whether ONRR could penalize Statoil simply for failing to correct after notice of a violation or for knowingly maintaining incorrect reports. IBLA assumed the evidence

[Page 13 - 2]

supported a finding of Statoil's knowledge and focused on whether the company's failure to correct reports meant it "maintained" inaccurate information in ONRR's database within the meaning of 30 U.S.C. § 1719(d). IBLA held Statoil "maintained" inaccurate records by failure to correct them. Id. at 317-19.

Quinex Energy Corp., 192 IBLA 88 (2017). This case concerns the criteria ONRR is to consider in assessing penalties. Here ONRR ordered Quinex to correct reports for royalties. Quinex corrected them eventually, taking eight to twenty-two months to complete the corrections. An administrative law judge found that "'Quinex was knowingly gaming the electronic filing system and clearly had knowledge of the falsity and inaccuracy of its data.'" Id at 91. Quinex's underpayments totaled only $120,242, but ONRR imposed a penalty of $3,217,250. Affirming the penalty, IBLA ruled that ONRR could only consider those factors identified in the regulation in 30 C.F.R. § 1241.70. ONRR therefore could not consider the violator's ability to pay or the fact that the penalty amount was 26 times the amount of the underpayment. Id. 99-100.

B. Jurisdictional Matters

Jicarilla Apache Nation v. Dep't of the Interior, 892 F.Supp.2d 285 (D.D.C 2012). Although this case also raises an interesting issue about the Department's trust responsibility when interpreting its regulations, the main issue is whether a recipient of a civil penalty notice, who had not appealed an earlier order to pay, may challenge both the proposed penalty and the underlying order. IBLA held that, as long as the lessee requested a nearing on the notice of civil penalty, it could also challenge the order it had not previously appealed. The court upheld that interpretation as reasonable. In the course of so doing, it observed "the royalties program for federal and Indian oil and gas royalties is a complex and highly technical regulatory program which requires significant expertise and the exercise of judgment grounded in policy concerns[.]" Id. at 292. It does seem implausible that whether a lessee has waived the right to challenge an order is matter that a court would find complex or highly technical.

Statoil USA E&P, Inc., 183 IBLA 61 (2012), concerns the power of ONRR to issue a subpoena in a matter relevant to a case already on appeal to IBLA. Although there are significant limitations on what an agency may do with a decision once it is on appeal, subpoenas by regulation are not appealable. Id. at 68.,

XTO Energy, Inc., 193 IBLA 101 (2018), raises a recurring problem in the administration of the federal royalties program. A lessee appeals an order to pay. The Director adopts a rule of decision (referred to the "legal standard" in the decision) that may be incorrect, but remands the matter to the auditors to apply that legal standard. From the lessee's perspective, the remand is wasteful, focusing on facts to be applied to the wrong legal standard. IBLA held, however, that the lessee cannot appeal the decision as to the legal standard until the Director issues another decision after the remand. Id. at 108. Until then, the IBLA lacks jurisdiction.

Continental Resources, Inc. v. Jewell, 846 F.3d 1232 (D.C. Cir. 2017), addressed an issue of court jurisdiction over appeals of royalty decisions. [complete]

SECTION TWO: MARKETABLE CONDITION

[Page 13 - 3]

In 2018, the most visible issue is one that has been raised by the Department of the Interior's (the "Department's") prolonged efforts to develop a reasonable interpretation of its marketable condition rule. The issue is called "unbundling." Unbundling refers to the task of taking a unified (or "bundled") fee--charged by a third party to gather, treat, and process natural gas--and splitting into those parts that are deductible as transportation or processing from those that are not.. The Department is now in its fourth decade of trying to unbundle third-party charges, issuing subpoenas to midstream companies with whom it has no privity of contract to extract sensitive internal cost information.

Although the marketable condition rule is stated identically for both oil and natural gas valuation, its application has been different. There has been no publicized effort (if any effort at all) to unbundle charges in connection with royalties on crude oil.

So, what makes federal royalty litigation high-stakes? A paraphrase of Paul's letter to the Corinthians sums it up: Risk, cost, and uncertainty, but the greatest of these is uncertainty. This section of the paper will begin with a description of the federal marketable condition rule. It will summarize some of the key turning points in the evolution of the Department's interpretation. It will also analyze in detail the Department's current project to compel lessees to unbundle those third-party charges. Finally, it will conclude with a few observations on the government's enforcement mechanisms that allow treble damages and penalties.

I. THE TEXT OF THE FEDERAL MARKETABLE CONDITION RULE

Under federal regulation, the marketable condition rule is in two parts. One part states the general obligation, the other defines the term. The basic idea is that although there are some costs a lessee can deduct from its gross proceeds from sale, costs to make the production "marketable" are not among them. But even at this most basic level, uncertainty emerges instantly from the terms used in the obligation.

First, for oil:

You must place oil in marketable condition and market the oil for the mutual benefit of the lessee and the lessor at no cost to the federal government. If you use gross proceeds under an arm's-length contract in determining value, you must increase those gross proceeds to the extent that the purchaser, or any other person, provides certain services that the seller normally would be responsible to perform to place the oil in marketable condition or to market the oil. ²

Next, for natural gas:³

The lessee must place gas in marketable condition and market the gas for the mutual

[Page 13 - 4]

benefit of the lessee and the lessor at no cost to the Federal Government. Where the value

...