CHAPTER 16 CURRENT ROYALTY VALUATION ISSUES ON STATE LANDS
| Jurisdiction | United States |
(Mar 1988)
CURRENT ROYALTY VALUATION ISSUES ON STATE LANDS
Holland & Hart
Cheyenne, Wyoming
Stephen York
Exxon Company, U.S.A.
Midland, Texas
PREFACE
This paper discusses current royalty valuation issues on state lands. In surveying the energy-producing states, the principal issues of concern relate to oil and gas production and, accordingly, this paper will focus on oil and gas royalty issues. The apparent cessation of hostilities over coal leasing on state lands reflects the relative lack of mining activity on state lands. In Wyoming, for example, there is but one section of school land being mined, and the state has no litigation or ongoing audits relating to its coal leasing program.
To the extent that questions of coal valuation and deductions are encountered by the practitioner, the general discussion of the various state positions regarding the trust doctrine, the requirement for and definition of market value at the point of production (be it at the well or mine), and the limitations on deductions should prove instructive with respect to coal royalties. In addition, the discussion of audit practices, enforcement and administrative appeals will apply equally to coal royalties as to oil and gas royalty matters.
Because of the practical problems inherent in attempting to survey issues in all states within areas served by the Rocky Mountain Mineral Law Foundation, the discussion will focus on two states, New Mexico and Wyoming, whose leases represent the "proceeds" and "market value" types discussed, and the positions the states have taken on royalty issues. Coincidentally, these states have taken the lead in the preparation of written materials elaborating upon their interpretation of royalty valuation concepts. Mention will be made of other states in passing. However, it can be assumed that the position taken by Wyoming and New Mexico may be representative of states with similar lease provisions. As principles for oil and gas are the same, the following discussion applies to both, unless noted.
The authors would like to thank Patricia A. Rooney, Holland & Hart, for her assistance on this paper.
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TABLE OF CONTENTS
Page No.
I. INTRODUCTION
II. THE TRUST DOCTRINE ON STATE LANDS
III. AN OVERVIEW OF FUNDAMENTAL PRIVATE ROYALTY VALUATION CONCEPTS
A. Proceeds v. Market Value Provisions
B. Determination of Market Value Where Long-Term Contract Exists
C. Royalties on Processed Gas and Gas Products
IV. STATE ROYALTY VALUATION PROVISIONS
A. Application of Proceeds Royalty Provision—The New Mexico Example
B. Wyoming—The Market Value Standard
C. Royalty on Take-or-Pay Payments
D. Other Consideration Upon Which Royalties Are Due
E. Non-Sales Volumes
1. Unavoidably Lost Volumes
2. Operational Uses
F. In-Kind Royalties
G. Oil Royalties
V. DEDUCTIONS APPROPRIATE FOR PRODUCTION FROM STATE LANDS
A. Introduction
B. Relevant Case Law Under Private Leases
1. Early Royalty Provisions
2. Market Value at the Well Royalty Provisions
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3. Proceeds, Net Proceeds and Gross Proceeds Royalty Provisions
C. Categories of Deductible Costs
1. Deductions for Costs or Value of "Marketing": Gathering, Compression, Dehydration, Sweetening, Storage
a. Market Value at the Well Royalty Provisions
1) Wyoming Lease Form
b. Proceeds Type Royalty Provisions
1) New Mexico Leases
2. Processing Costs
a. Wyoming
b. New Mexico
3. Transportation Costs
a. Wyoming
b. New Mexico
4. Return on Investment/Cost of Capital
a. General Discussion
b. New Mexico
c. Wyoming
VI. THE AUDIT PROCESS—PROCEDURES, PRACTICES AND STANDARDS
———————
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I. INTRODUCTION
Determining the value of production and the propriety of deductions from the selling price under state leases will be an uncertain endeavor for some time to come. Armed with arguments of trust obligation and inspired by the discretion enjoyed by the Minerals Management Service in valuing federal royalties, western mineral-producing states appear increasingly willing to adopt and litigate aggressive, even unprecedented, interpretations of state lease royalty provisions. In the wake of the federal royalty rulemaking, New Mexico has already issued comprehensive draft proposed regulations for production from state lands, and Wyoming is expected to commence a rulemaking later in 1988. If current and past proposed state royalty regulations are any indication, state proposals can be expected to be influenced by federal valuation concepts and methods; to resolve questions of interpretation in favor of increasing royalty values; to pick and choose among favorable court precedent of private royalty; and finally, to propose rules that are intended to be applied uniformly to existing leases even if varying lease royalty provisions exist.
Questions regarding royalty valuation under state leases must be resolved by reference to state statutes, the lease provisions, regulations (if any),1 judicial opinions construing the lease terms (or similar lease terms), and any agency guidelines.2 At this time, few specifically applicable authorities exist; valuation regulations are frequently cursory if they exist at all,3 published judicial opinions construing state lease royalty provisions are limited to less than a handful of reported cases,4 useful legislative history is generally not available, and agency guidelines may be scarce or out of date.5
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Accordingly, unless the lease terms are specific6 state royalty valuation issues must be resolved against the backdrop of the specific lease language, interpreted in light of existing case law on private leases, at least until state lease provisions are tested by litigation or comprehensive regulations are promulgated and, if challenged, upheld.
II. THE TRUST DOCTRINE ON STATE LANDS
During the expansionist era of this country, when the United States was pushing its borders westward, the Rocky Mountain states of Colorado, New Mexico, Montana, Utah, and Wyoming were admitted into the Union. As part of admission to statehood, each of these states was granted enormous tracts of land for the benefit of public schools, state colleges, charitable and other public institutions, collectively referred to as "state lands."7 The acts of admission and state constitutions imposed a trust obligation upon the Rocky Mountain states which became part of the organic laws of each state and which govern the use of and disposition of these lands. This trust obligation generally requires: that the lands be granted for the support of common schools; that all the lands granted be disposed of only at public sale; that the proceeds be dedicated to the creation of a permanent school fund with the interest to be expended in the support of said schools; and that the lands granted by the acts of admission be held, appropriated, and disposed of exclusively for the specified public purposes.8
A Board of Land Commissioners was generally given the direction and control of leasing and disposal of these public lands. The responsibility of the Board of Land Commissioners with respect to the leasing of state lands is further defined by state
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statute in each of the Rocky Mountain states.9
When leasing state mineral lands, we are therefore concerned with a special character of property, different from either federal or private lands, at least with respect to the legal and historical origins which gave rise to these state owned mineral interests in the first instance.10 The courts have recognized and developed a body of law acknowledging the unique nature of these lands and the responsibilities and obligations of the states attendant thereto.
Acknowledging that the public lands held by the states constitute trust lands, the United States Supreme Court in Lassen v. Arizona,11 , examined the Arizona Enabling Act, and described the scope of this public trust:
"The Enabling Act unequivocally demands both that the trust receive the full value of any lands transferred from it and that any funds received be employed only for the purpose for which the land was given....All of these restrictions in combination indicate Congress' concern both that the grants provide the most substantial support possible to the beneficiaries and that only those beneficiaries profit from the trust."
The question remains whether this trust character of state public lands justifies the applicability of different principles of law to the interpretation of mineral leases and the valuation of royalties due and owing under state mineral leases.
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The states conclude that the trust doctrine dictates how the states compute their royalties from minerals produced from state lands. Thus, as a general rule, the states believe it is their duty to obtain the highest price possible from school lands. Royalty based on anything less than the highest possible price is viewed as a contravention of the language in the Enabling Acts and a breach of their trust obligation.12
Interestingly, when one analyzes the recent state decisions which consider school land trusts, the cases do not necessarily support this view of the trust obligation. Among the cases most often cited in support of the states' view of their trust responsibilities are Lassen v. Arizona Highway Department,13 ; State v. University of Alaska,14 , County of Skamania v. State,15 , and Gladden Farms, Inc. v. State,16 each involving the sale or other disposition of school lands. Though each of these cases certainly involves state lands, none involve leasing of state lands for mineral development.17
One of the few oil and gas leasing cases to acknowledge the trust argument in the royalty context is the recent Wyoming case of State v. Moncrief et al.18 . There, the Wyoming Supreme Court found no need to look to analyze the effect of the...
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