CHAPTER 2 ACCOUNTING CONCEPTS APPLICABLE TO FEDERAL ROYALTIES

• Jurisdiction: United States

Royalty Valuation and Management
(Mar 1988)
CHAPTER 2
ACCOUNTING CONCEPTS APPLICABLE TO FEDERAL ROYALTIES
Howard A. Roach
ARCO Oil and Gas Company
Dallas, Texas
Patricia A. Patten
Cities Service Oil and Gas Corporation
Tulsa, Oklahoma

As many of you are aware, MMS issued new final regulations on January 15, 1988 concerning valuation of oil and gas for royalty purposes. This brings to closure a process that has gone on for more than four years, and has been the subject of intense debate and review. The new regulations became effective March 1, and apply prospectively only. This afternoon in the Oil and Gas Section, Bonnie Mandell-Rice, Marla Williams, and Chip Rothschild will cover in detail the principal valuation issues and legal implications of the changes wrought by the new regulations. The focus of my presentation will be a little different. Our paper will address several issues that will likely have significant impact on the accounting and administrative process your firms or clients use to calculate and pay Federal and Indian Royalties.

First, you should be aware that existing Notices to Lessees which relate to valuation issues were terminated March 1. Specifically cancelled were NTL-1 which applied to onshore federal production, NTL 1-A which applied to Indian production, NTL-5 which applied to onshore federal and Indian gas, and those OCS NTL's

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which concerned royalty payments on oil and gas lost or used on leases or units. These Notices should no longer be relied upon for guidance in valuing production for royalty purposes.

The new regulations rely primarily on actual transactions occurring in the marketplace to establish value for royalty purposes. Proceeds accruing to the lessee under the terms of arm's-length sales contracts are the first and primary indicator of value. Not all contracts you might regard as arm's-length will qualify, however, so it is necessary that accountants and royalty administrators know and understand the distinctions. Under the regulations, no contract between inter-company affiliates or relatives is considered to be arm's-length. Further, firms and corporations are considered to be affiliated if one controls, is controlled by, or is under common control with another. A presumption of control exists if one firm owns more than 10% of another, with the burden falling on the lessee to rebut that presumption. Cross-ownership of 50% or more is not rebuttable, and precludes arm's-length treatment for transactions between those so linked. Involvement in a separately established joint venture creates affiliation between the participants as to that venture. To be considered arm's-length, the contract must meet the above tests both at the time of execution and during the month of production for which royalty value is being calculated. MMS is empowered by these regulations to require lessees to certify

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ownership status, and may require that you furnish copies of filings made with the Securities and Exchange Commission which concern significant changes in ownership.

The new regulations contain what I refer to as an "all consideration" test with respect to the proceeds accruing to the lessee under an arm's-length contract. When considering this test is coupled with a highly expansive definition of gross proceeds, it represents an area in which accountants and royalty administrators must be exceptionally vigilant, and must closely collaborate with their legal advisors. Gross proceeds in these regulations is defined as the total monies or other consideration accruing to the lessee for the disposition of lease production. Gross proceeds includes more than the value of production sold; it also includes the value of services provided by others such as compression, dehydration, measurement, and field gathering if the lessee is obligated to provide such services. The value of assets such as compressors, gathering lines, etc., received as consideration for settlement of disputes between lessees and purchasers could be considered to be part of the gross proceeds. Moreover, it should be noted that royalty is indicated to be due on proceeds accruing to the lessee, and not just those paid to the lessee. On audit, MMS will examine whether the contract reflects the total consideration actually transferred directly or indirectly from the buyer to the seller. Further, MMS

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may require that a lessee certify that its arm's-length contract provisions include all of the consideration paid by the buyer, directly or indirectly.

If you do not have an arm's-length sale of crude oil but instead transfer the product internally, you may not be able to use your posting as the basis for valuing the crude or condensate for royalty purposes...