CHAPTER 2 LEGAL FOUNDATION FOR FEDERAL AND INDIAN OIL AND GAS ROYALTY VALUATION AND MANAGEMENT

• Jurisdiction: United States

Federal and Indian Oil & Gas Royalty Valuation and Management
(Oct 2018)
CHAPTER 2
LEGAL FOUNDATION FOR FEDERAL AND INDIAN OIL AND GAS ROYALTY VALUATION AND MANAGEMENT
Peter J. Schaumberg ¹
Principal
Beveridge & Diamond
Washington, D.C.

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PETER J. SCHAUMBERG is a principal with Beveridge & Diamond, P.C. in Washington, D.C. His practice focuses on issues related to development of energy resources on the Outer Continental Shelf and on federally managed lands onshore, including oil & gas, solar, wind, and geothermal resources, as well as development of coal and hard-rock mineral resources on public lands. He also advises clients with respect to royalty reporting and payment issues for federal mineral leases offshore and onshore, and for Indian leases. Mr. Schaumberg joined Beveridge & Diamond in 2006 after 25 years with the Office of the Solicitor, Department of the Interior. He was the Deputy Associate Solicitor for Mineral Resources, the senior career attorney responsible for providing legal advice to the energy, minerals, and royalty programs of the Minerals Management Service (now the Bureau of Ocean Energy Management, the Bureau of Safety and Environmental Enforcement, and the Office of Natural Resources Revenue), and the Bureau of Land Management. Mr. Schaumberg has written and lectured on a wide range of legal topics relating to federal mineral royalties and development of oil & gas, coal, hard-rock minerals, and alternative energy on federally-managed lands. He is a member of the American Bar Association's Section of Environment, Energy and Resources and the Rocky Mountain Mineral Law Foundation, and is the Chair of the Oceans Committee of the DC Bar's Environment, Energy & Natural Resources Section. He earned his J.D., with Honors, in 1975 from George Washington University National Law Center, and his B.A., cum laude, in 1972 from Tulane University. He is admitted to the bars of the District of Columbia and the U.S. Supreme Court.

The Office of Natural Resources Revenue ("ONRR") in the U.S. Department of the Interior ("DOI") is responsible for the collection and disbursement of royalties paid on production from leases on Federal lands onshore and on the Outer Continental Shelf ("OCS"), and on Indian lands, and for enforcement of lessees' royalty obligations. ONRR is the successor to the U.S. Geological Survey ("USGS") and the Minerals Management Service ("MMS"), and was formed in 2010 by Secretarial Order 3299. ONRR is headed by a Director who reports to the DOI Assistant Secretary for Policy, Management and Budget. The agency collected approximately $7 billion in Fiscal Year 2017, making ONRR the second largest revenue collector for the Federal Government after the Treasury Department.

Valuing oil and gas produced from Federal and Indian lands for purposes of calculating royalty obligations involves application of a complex set of regulations and principles that have developed over a period of decades. Understanding the evolution of the Federal and Indian valuation regulations and the concepts and principles they embody is very helpful in understanding the current set of regulations and how they apply. This paper tracks the development of legislative provisions, regulations, and royalty valuation concepts with that in mind. Other papers presented during the course of this Institute will address in greater depth several of the provisions and concepts mentioned briefly herein.

I. The Mineral Leasing Statutes

The Secretary of the Interior ("the Secretary") leases Federally-owned lands (not excluded from leasing either by statute or other withdrawal) for exploration for, and development and production of, oil and gas under two principal statutes, depending on whether the leased lands are part of the public domain or are acquired lands.² Public domain lands are leased under the Mineral Leasing Act ("MLA"), 30 U.S.C. §§ 181 et seq., originally enacted in 1920. Acquired lands are

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leased on the same terms as public domain lands under the Mineral Leasing Act for Acquired Lands (the "Acquired Lands Act"), 30 U.S.C. §§ 351 et seq., enacted in 1946.

The MLA, at 30 U.S.C. § 226, requires a royalty of "not less than 12 ½ per centum in amount or value of the production removed or sold from the lease." The reference to "amount" of production refers to the Secretary's authority to take royalty in kind rather than in money (see 30 U.S.C. § 192). ONRR currently takes little to none of the royalty accruing to the United States in kind (i.e., where ONRR accepts physical delivery of the royalty percentage of the oil or gas produced, which ONRR then disposes of through sale or other disposition--see 30 C.F.R. Part 1208). ONRR therefore currently receives almost all royalty in value, i.e., in cash. Most onshore federal leases have a fixed 12 ½ percent royalty rate, although there are a few exceptions including some older sliding-scale or step-scale leases.

Both public domain and acquired lands are generally referred to in this paper as "onshore" lands, to distinguish them from lands on the offshore Outer Continental Shelf ("OCS") that are leased under a different statute. There are a few additional special categories of onshore lands that are leased under statutes other than the MLA or the Acquired Lands Act. The most prominent example is certain categories of public domain lands that originally were excluded from leasing under the MLA and became available for lease under later statutes. For example, the MLA excluded lands within the National Petroleum Reserve in Alaska (the former Naval Petroleum Reserve No. 4) under 30 U.S.C. § 181 's exclusion of lands within the naval petroleum reserves. Congress made these lands available for lease in 1980 under 42 U.S.C. § 6508. The valuation regulations that apply to production from leases issued under the MLA or the Acquired Lands Act also apply to production from these specialized categories of lands.

The Secretary leases oil and gas deposits underlying the OCS under the Outer Continental Shelf Lands Act ("OCSLA"), 43 U.S.C. §§ 1331 et seq., enacted in 1953 and substantially amended in 1978. OCSLA also requires that the leases provide for a royalty of "not less than 12 ½ per centum fixed by the Secretary in amount or value of the production saved, removed, or sold." 43 U.S.C. § 1337(a). Though the statute sets a 12 ½ percent royalty rate as the minimum, many offshore leases have a 16 2/3 percent or 18 ¾ percent royalty rate.

Indian tribal lands are leased by the tribes, with the Secretary's approval, under the Indian Mineral Leasing Act ("IMLA"), 25 U.S.C. §§ 396a-396d, enacted in 1938. Unlike the MLA and the OCSLA, the IMLA does not set a floor royalty rate. Section 396d grants the Secretary the authority to establish the lease terms by rule. See 30 C.F.R. part 211.³

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Indian allotted lands are leased under 25 U.S.C. § 396, enacted in 1909. This very short statutory provision reserves to the Secretary the authority to prescribe the terms upon which leases are to be issued. Like the other mineral leasing statutes, it grants the Secretary general rulemaking authority, which is discussed further below. See 25 C.F.R. Part 212. Many Indian leases have royalty rates higher than 12 ½ percent, and the Indian tribal or allottee lessors receive 100 percent of the royalty and other revenues derived from the lease.

The question becomes what the proper value of the production is upon which the lessee must calculate the royalty owed. The royalty rate prescribed in the lease is applied to the volume and value of the oil or gas produced from the lease to determine the amount of royalty owed. In other words:

volume × royalty value × royalty rate = amount owed

Lessees generally must pay royalties monthly, with payment due by the end of the month following the production month.

II. Key Lease Terms

In addition to the royalty clause required by statute (or, in the case of Indian leases, authorized by regulation), almost all the leases contain an express term incorporating the Department's regulations, both those in force at the time the lease is issued and those promulgated thereafter. Almost all the leases also expressly reserve to the Secretary the authority and discretion to establish the reasonable value of production for royalty purposes. (These provisions are in different sections of different lease forms, and it is not necessary here to give lengthy citations to the respective sections of successive lease forms.) As a general matter, the Secretary exercises that discretion through rulemaking under the statutory grants of rulemaking authority discussed below.

The reservation of authority to the Secretary to determine the reasonable value of the production on which the lessee must pay royalty is an unusual feature of Federal and Indian leases. Most oil and gas leases entered into between lessees and private lessors do not reserve to the lessor the authority to determine the royalty value of production. The courts have uniformly upheld the Secretary's broad authority and discretion to establish the reasonable value of production for royalty purposes under the statutes, lease terms, and Departmental regulations.⁴ However, ONRR does not

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possess unlimited discretion. Final agency actions (both rulemakings and administrative adjudications) are subject to judicial review under the Administrative Procedure Act ("APA"), 5 U.S.C. §§ 701-706.

In some of the lease forms used in earlier years, the royalty clause that reserved authority to the Secretary to establish the value of production contained specific valuation language that was substantively identical to the regulations that were in force at the time the lease was issued. Beginning in 1988, the rules were substantially revised. In cases where there is a conflict between specific lease terms and regulations, the lease terms control. Nevertheless, the effect of...