CHAPTER 5 CRUDE OIL VALUATION FOR FEDERAL ONSHORE LEASES

• Jurisdiction: United States

Federal and Indian Oil & Gas Royalty Valuation and Management
(Oct 2018)
CHAPTER 5
CRUDE OIL VALUATION FOR FEDERAL ONSHORE LEASES
Rosario Doriott Domínguez
Associate
BakerHostetler
Denver, CO

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ROSARIO C. DORIOTT DOMÍNGUEZ is an Energy & Regulatory Attorney at the Denver Office of BakerHostetler. She focuses her practice on natural resources and energy litigation and has extensive experience in governmental investigations as well as other disputes affecting federal, Indian, State, and private royalty payments. Her most recent experience includes:

• Defense of U.S. multinational energy corporation in investigation by the Office of Inspector General (OIG) regarding sale and transportation of oil condensate;

• Defense of independent natural gas and oil producer in civil investigation by the Department of Justice (DOJ) under the False Claims Act regarding the "marketable condition rule" and federal royalties paid on natural gas production;

• Defense of various oil and gas producers in appeals of Demands for Payment, Orders to Pay, Orders to Report, and Orders for Restructured Accounting issued by the Office of Natural Resources Revenue (ONRR) or its various delegated States, including the State of Wyoming, Department of Audit, and the State of New Mexico, Taxation and Revenue Department, regarding claimed royalty underpayment, underreporting, and/or misreporting;

• Appeals of adverse Decisions issued by the ONRR Director regarding claimed royalty underpayment, underreporting, and/or misreporting, including appeals to the Interior Board of Land Appeals (IBLA) and federal court;

• Assistance to various oil and gas producers performing internal self-audits of private, federal, Indian, and State royalty payments and deductions; and

• Assistance to various national oil and gas trade associations in reviewing and preparing comments to proposed amendments to regulations affecting federal and Indian oil and gas leases and royalty payments.

Rosario received her J.D. from the University of Southern California, Gould School of Law, and her B.A. from Yale University. She is licensed to practice in Colorado, California, and Montana. In her spare time, she (still) skateboards around town.

The steady increase in crude oil production in the U.S., including the vast increase of crude oil production anticipated from the Permian Basin, has a variety of implications for reporting and paying royalties under federal leases. This paper will provide a history of the federal statutes governing crude oil valuation as well as a discussion of current oil valuation rulemaking. This paper will then address practical issues and challenges likely to arise with the current rulemaking, such as the consequences of producing higher gravity crude oil from federal lands within the Permian Basin and a likelihood that such production may be exported to overseas markets.

I. Legislation and History Affecting Royalty Valuation

An understanding of federal royalty valuation for onshore¹ crude oil begins with the language of the Mineral Leasing Act (30 U.S.C. §§ 181, et seq., the "MLA"), which governs the terms of federal oil (and gas) leases.² Enacted in 1920, the MLA was intended by Congress "to promote wise development of natural resources and to obtain for the public reasonable financial returns on assets belong to the public."³ By its text, the MLA requires that royalty for federal onshore production be paid "in amount or value of the production removed or sold from the lease."⁴

Unfortunately, this language leaves us to ask ourselves: What really is the value of "production"⁵ "removed" or "sold" from a lease? Is it a wellhead value? An actual sales value or theoretical sales value? Is value to be determined while production is on the lease, or as soon as it leaves the

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lease? As soon as it is sold for the first time? Is an arm's-length sale⁶ required? Does the "or" permit producers to elect when their production is to be valued, or does the federal government get to decide? How far downstream can the government go to determine value? Must value be determined while production is still within the United States? Must value be determined while the lessee still has interest and title to the production? Should it be?

Unfortunately, the MLA does not answer these questions, and despite occasional efforts by Congress over the years to revise and improve the statute, which we will now discuss in turn, the MLA's royalty valuation language has remained unchanged.

A. 1976 - 1982: Perceived Deficiency in Federal Oil and Gas Royalty Collection

Since 1879, the United States Geological Survey (the "Geological Survey" or "USGS") was responsible inter alia for managing receipts and disbursements of royalties received from all energy projects (onshore, offshore, and on Indian lands) regulated by the United States Department of the Interior (the "Department").⁷

Between 1976 and 1981, the United States Government Accountability Office (an agency that works for Congress and investigates how the federal government spends taxpayer dollars, as the "GAO")⁸ audited the USGS's practices and operations. The GAO issued several reports documenting its perceived problems in the agency's collection and management of royalties due on federal oil (and gas) production.⁹ The GAO's 1981 report summarily stated:

Historically, the Geological Survey has not placed a high priority on collecting oil and gas royalties. Because sufficient management attention has not been focused on correcting deficiencies previously reported, financial management problems existing 20 years ago persist today. As a result, the Geological Survey is not collecting all oil and gas royalties; hundreds of millions of dollars owed the Government may be going uncollected each year. Moreover, millions of dollars in royalty income are not collected when due, thus increasing the Government's

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interest costs.¹⁰

Also in 1981, the Secretary of the Department (the "Secretary") established a Commission on Fiscal Accountability of the Nation's Energy Resources (known as the Linowes Commission (the "Commission")) to investigate the same issues. By January of 1982, the Commission issued its own report on the royalty management and collection system, providing numerous recommendations for improvement.¹¹ Like the GAO, the Commission also believed the royalty management system was not being managed properly and a major overhaul was needed:

Management of royalties for the Nation's energy resources has been a failure for more than 20 years. Because the Federal government has not adequately managed this multibillion dollar enterprise, the oil and gas industry is not paying all the royalties it rightly owes. The government's royalty recordkeeping for Federal and Indian oil and gas leases is in disarray. For this reason, the exact amount of underpayment is unknown. The results of individual audits, which have often uncovered large underpayments, suggest that hundreds of millions of dollars due the U.S. Treasury, the States, and Indian tribes are going uncollected every year. . . . The Nation can no longer afford mismanagement of royalties for its energy resources. The stakes are too high. With the rapid escalation of energy prices, oil and gas royalties have risen from less than $500 million in 1971 to more than $4 billion in 1981. The government's royalty management system needs a thorough overhaul. ¹²

B. 1982: The Federal Oil and Gas Royalty Management Act

Both the Secretary and Congress responded in turn. The Secretary reorganized the royalty management and collection functions of the Department under a newly created agency - the Minerals Management Service (the "MMS").¹³ And Congress enacted the Federal Oil and Gas Royalty Management Act (30 U.S.C. §§ 1701, et seq., "FOGRMA") in December 1982.

Congress found that:

(1) the Secretary of the Interior should enforce effectively and uniformly existing regulations under the mineral leasing laws providing for the inspection of

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production activities on lease sites on Federal and Indian lands;

(2) the system of accounting with respect to royalties and other payments due and owing on oil and gas produced from such lease sites is archaic and inadequate;

(3) it is essential that the Secretary initiate procedures to improve methods of accounting for such royalties and payments and to provide for routine inspection of activities related to the production of oil and gas on such lease sites; and

(4) the Secretary should aggressively carry out his trust responsibility in the administration of Indian oil and gas. ¹⁴

As a result, the expressly stated purposes of FOGRMA were inter alia:

(1) to clarify, reaffirm, expand, and define the responsibilities and obligations of lessees, operators, and other persons involved in transportation or sale of oil and gas from the Federal and Indian lands and the Outer Continental Shelf;

(2) to clarify, reaffirm, expand, and define the authorities and responsibilities of the Secretary of the Interior to implement and maintain a royalty management system for oil and gas leases on Federal lands, Indian lands, and the Outer Continental Shelf; [and]

(3) to require the development of enforcement practices that ensure the prompt and proper collection and disbursement of oil and gas revenues owed to the United States and Indian lessors and those inuring to the benefit of States[.] ¹⁵

Congress mandated that the Secretary audit oil and gas lease accounts and make additional collections as warranted.¹⁶ Toward that effort, Congress also commanded, "The Secretary shall give priority to auditing those lease accounts identified by a State or Indian tribe as having significant potential for underpayment."¹⁷

However, FOGRMA did not change (or address what was missing from) the royalty valuation language of the MLA. But what it did do was direct the Secretary to establish a...