CHAPTER 5 FEDERAL GAS AND GAS PRODUCTS VALUATION REGULATIONS
| Jurisdiction | United States |
(Mar 1988)
FEDERAL GAS AND GAS PRODUCTS VALUATION REGULATIONS
Parcel, Mauro, Hultin & Spaanstra
Denver, Colorado
I. INTRODUCTION
II. HISTORICAL PERSPECTIVE
A. Statutory Enactments
B. Onshore Lease Regulations
C. Offshore Lease Regulations
D. Indian Lease Regulations
E. Notices to Lessees -1 and -1A
F. Notice to Lessees — 5
G. Payor Handbook and Other Instructions
H. Effect of Various Regulations and Instructions
III. THE NEW REGULATIONS
A. General
B. Gas Subject to Royalty
C. Royalty Free Gas
D. Valuation Standards
1. General
2. Key Definitions and Related Issues
(a) Gross Proceeds
(i) Take or Pay Payments
(ii) Reimbursements for Production-Related Costs and Services
(iii) Other Reimbursements
(iv) Receivables
(v) Exclusions from Gross Proceeds
(vi) Other Issues
(b) Arm's Length Contracts
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3. Valuation Standards
(a) Acceptance of Gross Proceeds Under Arm's Length Contracts
(i) The Revolution
(ii) Limitations and Exclusions
(b) Non-Arm's Length Contract And No Contract Situations
(c) Effect of Pricing Regulations
(d) Unitized And Communitized Leases
(e) Accounting for Comparison
E. Procedures
IV. OUTLOOK FOR THE FUTURE
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I. Introduction
On January 15, 1988, the Minerals Management Service ("MMS") of the Department of the Interior finally published its long awaited and much debated "new" regulations for the valuation of gas and gas products. In the rule-making process, these regulations were hailed or denounced, depending upon one's perspective, as "revolutionary."1 The regulations, as finally promulgated, are revolutionary in some respects, but they more accurately may be characterized as the culmination of policies and practices that the Department of the Interior has been developing over the past decade or more. This paper will attempt to explore these aspects of the regulations, as well as to familiarize the reader with the new gas and gas products valuation regulations generally.
II. Historical Perspective
In order to understand how the new regulations developed and what their impact is, it is useful to consider how the valuation of gas and gas products has been treated historically. By viewing the valuation issues from an historical perspective, one also may gain insights into some of the grounds upon which the new regulations already are being challenged and upon which they are likely to be challenged in the future.
A. Statutory Enactments
The various acts for the leasing of Federal onshore2 and offshore3 and Indian oil and gas4 and the lease forms issued pursuant to those acts5 require the lessee to pay royalty based generally upon the "value of production." The Secretary of the Interior is granted discretion in carrying out the purposes of those enactments and in establishing the value of production under those enactments and the lease forms.6 The Secretary's discretion and authority have been construed broadly.7
B. Onshore Lease Regulations
Pursuant to the authority granted to the Secretary, the Secretary has promulgated a series of regulations and instructions dealing with the valuation of production. The earliest of these were the "Operating Regulations to Govern the Production of Oil and Gas — Act of February 25, 1920,"8 which
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were promulgated by the Secretary on June 4, 1920. Those regulations specified that casinghead gas would be valued at the greater of the price received by the lessee or one-third of the value of the marketable casinghead gasoline extracted from the casinghead gas.9 In contrast to the new regulations, the 1920 regulations did not attempt to define what constitutes the "price received by the lessee." Due to the lack of a market for dry gas,10 the 1920 regulations also were silent as to how gas produced from gas wells was to be valued.
The 1920 regulations were superseded on July 1, 1926, by the "Operating Regulations to Govern the Production of Oil and Gas — Acts of February 25, 1920, June 4, 1920, and March 4, 1923."11 The 1926 regulations recognized that gas well gas and residue gas produced after processing of casinghead gas may be sold, but did not specify how the value of such dry gas would be determined.12 The 1926 regulations did specify that when gas was processed and sold, royalties would be payable on the greater of (i) the price received by lessee for such gas as a single commodity or (ii) the combined value of the "two commodities, the natural gas gasoline and the dry residual gas."13 Thus, the dual accounting concept was born, although, in practice, it was applied over the years for onshore lands only in certain circumstances.14
Under the 1926 regulations, the value of the raw gasoline in the natural gas was assumed to be one-third the value of the marketable gasoline extracted; the remaining two-thirds were allowed to the lessee as a cost of manufacture.15 In providing that allowance, the government stated that "it does not wish to collect royalty on that part of the value which is derived from the cost of manufacturing,"16 because, as it acknowledged, its "equity is confined to the value of the raw material involved."17 As will be seen infra, the government has deviated substantially, if not reversed, the policy expressed in that statement in the years since it was made and in the new regulations.18
Subsequently, the government determined that the cost of extracting the marketable gasoline from the raw natural gasoline was not always as great as two-thirds of the value of the marketable gasoline. The Secretary of the Interior thus issued the Net Realization Order of June 7, 1937,19 which provided that royalty is payable on the greater of the combined value of natural gas and its derivative products, "as measured by the lessee's gross field realizations less his actual extraction costs (net field realization value)," or on the combined value of the dry residual gas plus one-third the value of the natural gas gasoline, as provided in the 1926 regulations.20
The onshore regulations were revised in 1942.21 The 1942 regulations relating to valuation of gas and gas products, as codified, have remained virtually unchanged.
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Pursuant to those regulations, the value of production, for the purpose of computing royalty, was to be "the estimated reasonable value of the product as determined by the Supervisor [Associate Director]."22 (Emphasis supplied.) In determining value, the Supervisor was to consider "the highest price paid for a part or for a majority of production of like quality in the same field, the price received by the lessee, posted prices and other relevant matters."23 The regulations specified, however, that the value determined by the Supervisor might not be "less than the gross proceeds accruing to the lessee from the sale [of produced substances] or less than the value computed on such reasonable unit value as shall have been determined by the Secretary."24 They also specified that, "[i]n the absence of good reason to the contrary, value computed on the basis of the highest price per barrel, thousand cubic feet, or gallon paid or offered at the time of production in a fair and open market for the major portion of like-quality oil, gas, or other products produced and sold from the field or area when the leased lands are situated will be considered to be a reasonable value."25
Consistent with the 1926 regulations, the 1942 regulations provided that wet gas would be valued at the higher of the gross proceeds accruing to the lessee from the sale of the wet gas or the aggregate value, determined by the Secretary, of all commodities, including residue gas, obtained from the wet gas.26 Also consistent with the 1926 regulations, the 1942 regulations provided that royalty would be paid only on the value of one-third (or the lessee's portion if greater than one-third) of all casinghead gasoline and other liquids derived from the wet gas; the remaining two-thirds being an allowance for the cost of manufacture.27 No consideration was given at that time or any subsequent time to changes in the relative market values of residue gas and natural gas liquids, nor to changes in the cost of manufacture.
C. Offshore Lease Regulations
Consistent with the onshore lease regulations, the offshore lease regulations provided for the establishment of value by the Director, after consideration of market value indicators such as the highest price paid for a part or for a majority of like quality products produced from the field or area, the price received by the lessee, and posted prices. The offshore lease regulations also provided for consideration of regulated prices and "other relevant matters."28 They established that value of offshore production would never be less than the fair market value, the gross proceeds accruing to the lessee from the disposition of produced substances, or the value computed on the reasonable unit value established by the Secretary.29 As to processed gas, the offshore regulations provided that royalty would accrue on the value of the residue gas and liquids, with a "reasonable" allowance, not to exceed two-thirds the value of the substances extracted from the gas,
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for processing.30 They also specified that if gas was sold without processing for the recovery of constituent products, royalty nevertheless would be payable on the value of the gas and constituent products.31
D. Indian Lease Regulations
The regulations promulgated by the Bureau of Indian Affairs for tribal (other than Osage Indian) and allotted Indian land leases provided that, in the discretion of the Secretary, the value of production under an Indian lease could be calculated on the basis of the highest price paid or offered at the time of production for the major portion of the oil, gas or other hydrocarbon substances produced and sold...
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