CHAPTER 15 WHAT? IT'S STILL BROKE? ROYALTY VALUATION AND REPORTING ISSUES ARISING FROM FEDERAL UNITIZATION AND COMMUNITIZATION AGREEMENTS (TAKES VERSUS ENTITLEMENTS)
| Jurisdiction | United States |
(Feb 2004)
WHAT? IT'S STILL BROKE? ROYALTY VALUATION AND REPORTING ISSUES ARISING FROM FEDERAL UNITIZATION AND COMMUNITIZATION AGREEMENTS (TAKES VERSUS ENTITLEMENTS)
Manager
Team 3
Offshore Compliance Asset Management
Minerals Management Service
Denver, Colorado
Judith M. Matlock, Esq.
Davis Graham & Stubbs LLP
Denver, Colorado
I. INTRODUCTION
II. GENERAL BACKGROUND
Types of Jointly Developed Properties
Entitlements Share of Production
Causes of Producer Imbalances
Problems Caused By Producer Imbalances
Payment of Royalties
Approaches to Royalty Payment Issues (takes versus entitlements)
The Weighted Average Rule
The Tract Allocation Rule in General
The Tract Allocation Rule/Takes or Sales Basis
The Tract Allocation Rule/Entitlements Basis
III. THE FEDERAL RULE
Royalties are Due When Production is Removed
Problems Caused by Imbalances
Royalties on Imbalanced Takes Before 1988
Federal 1988 Valuation Regulations
The Federal Tracing Rule for Producer Imbalances
Summary of the Tracing Rule
MMS Perspective on Problems with the Tracing Rule
Industry's Perspective on Problems with the Tracing Rule
Problems with the Tracing Rule - Advance Notice of Proposed Rulemaking
1993 Payor Handbook
Federal Oil and Gas Royalty Simplification and Fairness Act
Summary of RSFA
What is not addressed by RSFA
Workshops
Dear Reporter Letter
Rulemaking
Current Regulatory and Statutory Requirements
Current Payor Handbook
IV. IS IT STILL BROKE?
MMS Perspective
Industry Perspective
Royalty In-Kind
Attachments
1 - Section 1.2, 1986 Payor Handbook
2 - Excerpts from Hardwick, Bragg & Price 1992 Paper
3 - Advance Notice of proposed rulemaking, June 1, 1992
4 - Section 2.6, 1993 Payor Handbook
5 - Dear Reporter Letter, January 30, 1997
6 - Section 2.6, Release 2.0, 08/01/00, Payor Handbook
7 - Payor Handbook Figure 2-7 restated per RSFA entitlements
8 - Figures 4-48 and 4-49, Payor Handbook
Power Point Slides
I. INTRODUCTION
This paper concerns Federal royalty valuation and reporting issues which arise when the volume of natural gas taken in kind and disposed of by each owner of a single Federal lease or each owner in leases subject to Federal unitization or communitization agreements differs from the volume of gas which each owner is entitled to take and dispose of. This difference is known as an imbalance and, in this paper, is referred to as a "producer imbalance" to distinguish it from the imbalances which may occur between shippers and their transporting pipelines. The owners in this situation are said to have made "disproportionate sales" meaning sales of production not in proportion to their "entitlements share" of production or, as the MMS refers to it, their share of "agreement production."
On August 13, 1996, the President signed into law the Federal Oil and Gas Royalty Simplification and Fairness Act (RSFA) which amended the Federal Oil and Gas Royalty Management Act of 1982 (FOGRMA). RSFA addressed some, but not all, of the royalty valuation and reporting issues involving disproportionate sales of production from Federal leases. This paper will discuss imbalances in general, the law prior to enactment of RSFA, MMS and industry concerns prior to RSFA, and MMS and industry concerns since enactment of RSFA.
II. GENERAL BACKGROUND
Types of Jointly Developed Properties
A single lease owned by two or more working interest owners may be jointly developed pursuant to an operating agreement. The AAPL Model Form Joint Operating Agreement is the most common type of operating agreement. It includes a 1956 form, a 1977 form, a 1982 form and a 1989 form, all of which are still in use today.
Joint development of mineral property can also occur due to pooling, unitization or communitization. Pooling has been defined as "the voluntary or compulsory joining of leases for common development within a state-established drilling unit. It contemplates the invocation of pooling provisions in private land leases or forced pooling by the state oil and gas commission." 1 Communitization is "the pooling of Federal or Indian leases with one another or with fee leases within a state-established drilling (spacing) unit. Communitization can be voluntary as with the Bureau of Land Management and/or Bureau of Indian Affairs approving the pooling arrangement, or, it can be compulsory as when a lessee refuses to pool and the Bureau of Land Management forces the issue." 2
Unitization encompasses more than the joint development of a single lease or of leases within a drilling and spacing unit. "ÝT¨he terms "unitization" or "unit operations" refer to the consolidation of mineral, leasehold or royalty interests covering all or a portion of a common source of supply." 3 Unitization is "the joining for common development and unified operation of leases covering all or part of the reservoir or structure as a geologic unit." 4
Entitlements Share of Production
When there is joint development of a lease or leases, production must be allocated. In the single lease situation, production is generally allocated in proportion to each owner's working interest. The allocation of production under a unit agreement or communitization agreement can be more complicated. First, production must be allocated to each tract in the unit or communitized area and then it must be further allocated to each owner in the tract. Each owner's allocated share of production is known as that owner's "entitlements share" of production. The MMS refers to the quantity of production allocated to each lease in a unit or CA as the "agreement production." 5
Section 2.6 of Volume III of the Payor Handbook contains the following general description of the allocation process:
Unitization agreements, also known as units, are established to provide for the unified development and operation of an entire geologic structure or area so that drilling and production can proceed in the most efficient and economical manner.
Production from a unit is normally allocated to each tract of unitized land within the controlling participating area(s) (PA) on a surface-area basis, a volumetric basis, or a combination of these and/or other factors. For royalty purposes, all oil and gas produced from a Federally approved unit must be allocated to the participating Federal or Indian leases under the allocation requirements contained in the unit agreement. Lessees are responsible for paying royalties on the volume of production established in the agreement allocation schedule. Value of the allocated volumes is determined by lease terms and regulations.
Communitization agreements (CAs) are agreements established to allow the development of separate tracts that could not be fully and independently developed and operated because of limitations imposed by established well spacing programs. Communitization is required in order to conform to nonoptional spacing patterns established by State order.
Production under a CA is normally allocated to a Federal or Indian tract(s) within the CA based on the ratio of the surface acreage of the tract(s) to the total surface acreage within the CA. For royalty purposes, all oil and gas produced from a Federally approved CA must be allocated to the communitized Federal or Indian tract(s) under the allocation requirements contained in the CA. Lessees are responsible for paying royalties on the volume of production established in the agreement allocation schedule. Value of the allocated volumes is determined by lease terms and regulations. 6
Causes of Producer Imbalances
As mentioned in the introduction, a producer imbalance occurs whenever the working interest owners in a jointly developed property do not market their full entitlements share of production. This can occur for a number of reasons including (i) delays in the construction of facilities for one of more of the working interest owners, (ii) failure of a purchaser to take production, (iii) the decision of one or more of the working interest owners not to sell due to unfavorable market conditions, and (iv) since the restructuring of the gas industry culminating in FERC Order 636, the impossibility of matching nominations for transportation and sales at the beginning of a month and during the month with the actual production which occurs during the month.
Because oil can be stored in tanks on the lease or transported by pipeline, rail or truck to market, it is an easier commodity to market than natural gas which must always be in a pipeline under pressure. As a result, it has always been more common for the working interest owners in a jointly developed property and, in many cases, the royalty owners as well, to take their share of oil production in kind and market it.
In contrast, most natural gas wells are connected to only one pipeline and, historically, that pipeline was often the sole purchaser of all of the production from the well. In that era, imbalances were rare. Occasionally, a particular working interest owner would not have a contract with the pipeline connected to the well and the operator would not elect to exercise its rights under standard form joint operating agreements to market that nonoperator's share of the gas. In those situations, producer imbalances would occur. 7
Where a gas stream was split between two wellhead pipeline connections, balancing problems were more common. Although both pipeline connections may have been contracted for, the connections would not always be completed at the same time. 8
Split stream connections could lead to production imbalances for other reasons as well. For example, if the line pressure in one of the lines was too high, then the proper volume of gas would not flow into that line. 9 Even if all of the lines were in place and operating at acceptable pressures, it was impossible for...
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