CHAPTER 3 THE MECHANICS OF FEDERAL ROYALTY MANAGEMENT AND FUNDAMENTAL COMPUTERESE

• Jurisdiction: United States

Royalty Valuation and Management
(Mar 1988)
CHAPTER 3
THE MECHANICS OF FEDERAL ROYALTY MANAGEMENT AND FUNDAMENTAL COMPUTERESE
Jennifer A. Cates
Standard Oil Production Company
Houston, Texas

I. INTRODUCTION

Until the early 1980s, the process of compliance with Federal royalty valuation, payment and reporting requirements was fairly straightforward. Once a lessee properly established his Federal lease payment number, he remitted royalty based on his determination of "market value". The United States Geological Survey (USGS) might later audit and contest such a payment. The lessee then had an opportunity to resolve any dispute. In 1982, a special committee appointed to study the royalty collection system issued a report entitled "Fiscal Accountability of the Nation's Energy Resources," more commonly known as the Linowes Commission report. The Commission found fault with the royalty collection system and concluded that large amounts of royalty went uncollected. The Commission recommended a number of new initiatives for both the valuation of royalty and the Minerals Management Service (MMS) royalty collection and management process. The royalty management goals of the Commission were to have MMS establish new systems to value and track production in a more business-like manner, establish controls to assure that royalty was paid correctly, and enhance the audit process.

Also in 1982, at least in partial response to the Linowes Commission report, Congress passed the Federal Oil and Gas Royalty Management Act (FOGRMA), 30 U.S.C. § 1701 et. seq., which provided MMS and the Department of the Interior with new authority to collect information, audit and enforce royalty collections. Since that date, MMS has used that authority to establish new reporting requirements, demand large amounts of data from lessees and others, begin cooperative audits employing State and Indian Tribe auditors and, in general, respond to the Commission's mandate that MMS maximize Federal royalty collections.

Critics have charged that MMS moved too far and too fast, resulting in more chaos and uncertainty than before. Lessees have claimed that MMS failed to seek input which would have avoided much of the confusion. Legal critics are concerned that MMS is attempting to change substantive royalty valuation principles through the design and technical editing of its forms, manuals and computer

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systems.. Notwithstanding the criticism from practically every sector of the royalty industry, MMS has continued its efforts.

II. THE MECHANICS

One of the early decisions facing a lessee is the question of whether to pay royalty himself or contract with the operator or purchaser to make royalty remittance on his behalf. Contracts providing that someone other than the traditional lessee would remit royalty usually provide that the lessee is the responsible party and must ascertain and advise the remitting party of the proper royalty payment basis. Based upon the definition of "lessee" in FOGRMA, MMS has taken the position that the royalty payor may also be responsible for any error in royalty payment. MMS has defined "lessee" in its regulations to mean

...any person to whom the United States, an Indian Tribe, or an Indian allottee issues a lease, and any person who has been assigned an obligation to make royalty or other payments required by the lease. This includes any person who has an interest in a lease as well as an operator or payor who has no interest in the lease but who has assumed the royalty payment responsibility.

30 C.F.R. § 206.151 , 53 F.R. 1273 (January 15, 1988). Even though certain lessees continue to contest this position of the MMS, its very existence requires that operators and purchasers carefully consider the obligations they may be assuming when they agree to remit royalty on a lessee's behalf. Under MMS's determination, agreement to remit is also the agreement to reconcile accounts, receive and respond to demand letters, and to pay amounts demanded during an audit. While certain lessees are actively challenging MMS's position in a variety of appeals, the outcome is still uncertain.

A. The Reporting Requirements

1. Auditing and Financial System Reporting (AFS)

A lessee (or payor) must also comply with the MMS reporting requirements. Currently, these requirements fall under two basic information aggregation systems. The first is known as the "Auditing and Financial System" or "AFS." Regulations governing the operation of this system are found at 30 C.F.R. Part 210. Additional detail is provided in the Auditing and Financial System (AFS) Oil and

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Gas Payor Handbook (the Payor Handbook). Copies of the Payor Handbook may be obtained from MMS, Attention Lessee Contact Branch, P.O. Box 5760, TA, Denver, CO 80217.

The first volume of the Payor Handbook contains instructions on completing the Payor Information Form discussed above. The second volume contains detailed instructions on completing the MMS Report of Sales and Royalty Remittance (Form MMS-2014).

Once it is decided which party will act as remitting agent, a Payor Information Form (PIF) must be filed to advise the MMS of the identity of the lease, payor and other basic information. 30 C.F.R. § 210.51 . This form (Form MMS-4025) must be filed within 30 days of the issuance of a new lease or any modification of an existing lease which changes the paying responsibility on the lease.

Information is used to establish or update records in the AFS database so that comparable monthly reporting at that level is received and validated. PIFs must be filed before paying rent, minimum royalty or production royalties and any time:

° a payor has previously submitted incorrect PIF information;

° additional wells begin production or an existing well ceases production;

° additional product types are produced (i.e. processed gas and liquids);

° leases are pooled;

° there are changes in operators;

° there is a revision of unit allocation or communitization agreement;

° upon cessation of paying rent or minimum royalty;

° upon cessation of royalty payments;

° revision of Windfall Profit Tax Information;

° a new contract for product(s) is executed;

° royalty payments change to royalty-in-kind;

° sales change to spot market basis;

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° there is a change in sales agreement;

° a product is no longer produced;

° a lessee will no longer be paying on a given product; or

° the lessee's payment responsibilities are transferred to another.

After MMS processes the PIF, MMS issues the payor a Payor Confirmation Report (PCR) identifying the correct lease, revenue source, selling arrangement and product code combination to report on the Form MMS-2014.

The other main form in the AFS system is the MMS-2014. This may be submitted in hard copy or on magnetic tape (following approval by MMS to use tape). On this form the payor must report the monthly information on the lease, including identification of the selling arrangements, products, values, etc. Volume II of the Payor Handbook contains a number of examples of the proper way to complete this necessary form, which is due the end of the month following the production month.

Problems have been experienced with AFS. System design has changed over time, requiring numerous edits to the systems of MMS and those designed by lessees. The Payor Handbook has never been published for official notice and comment rulemaking, thus no lessee has been provided the opportunity to challenge any substantive portion. The handbook is not always clear with respect to the requirements. In some cases, the example does not conform with the textual explanation. Further, MMS's treatment of the handbook as a "living document" leaves open the possibility that MMS may change substantive royalty concepts through the guise of amending the handbook. At least one royalty payor has challenged an addendum to the handbook issued by MMS regarding the treatment of the Blanchard decision in Oklahoma. While MMS...