CHAPTER 6 AN INTRODUCTION TO THE NEW FEDERAL ROYALTY VALUATION REGULATIONS: GAS PROCESSING ALLOWANCES

• Jurisdiction: United States

Royalty Valuation and Management
(Mar 1988)
CHAPTER 6
AN INTRODUCTION TO THE NEW FEDERAL ROYALTY VALUATION REGULATIONS: GAS PROCESSING ALLOWANCES
Marla J. Williams
Holme Roberts & Owen
Denver, Colorado

I. INTRODUCTION

After two years of drafts, proposals, extensive comments and heated debate, the Minerals Management Service (MMS) has finally promulgated its long-awaited gas valuation regulations, to be effective March 1, 1988.¹ The purpose of this paper is to examine these new regulations as they relate to what is commonly called the "gas processing allowance."

Because this paper is being presented in consort with others, ably written, on the topic of federal royalty valuation, familiarity with the matters covered by those other papers will be assumed.² This paper begins with a review of the new gas processing regulations to determine when and how a gas processing allowance is to be computed. The second part of the paper discusses several issues of major economic impact relating to "gas processing allowances" that are likely to be litigated in the federal courts notwithstanding the new regulations.

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II. SUMMARY OF NEW GAS PROCESSING REGULATIONS

A. Definitions

The term "processing allowance" is defined in § 206.151³ as "an allowance for the reasonable, actual costs incurred by the lessee for processing gas, or an approved or MMS-initially accepted deduction for costs of such processing determined pursuant to [the new regulations]." The term "processing" is in turn defined as "any process designed to remove elements or compounds (hydrocarbon and nonhydrocarbon) from gas, including absorption, adsorption or refrigeration", but excluding field processes normally taking place on or near the lease "such as natural pressure reduction, mechanical separation, heating, cooling, dehydration and compression." According to the MMS comments accompanying the final rulemaking, "processing" also includes fractionation.⁴

It would be error to conclude from these definitions that the allowance for the lessee's "reasonable and actual" processing costs as determined under the regulations will always be equal to the lessee's "reasonable and actual" processing costs. Although the allowance will never be greater than the lessee's (or the processing party's) costs, there are many situations in which the regulations may yield an allowance that is less than actual costs, or yield no allowance at all, regardless of the reasonableness of those costs.

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B. When is Computation of a Processing Allowance Needed?

Subject to certain exceptions, if gas produced from a federal (or Indian) lease is processed by the lessee or any other party, the value of that gas will be determined under § 206.153(a) using a "net-back" formula⁵ that employs processing allowances:

tailgate value of residue gas
+	tailgate value of gas plant products6
+	value of condensate recovered without processing
-	applicable processing and transportation allowances

The exceptions to this general rule are as follows:

1. Processed gas that is sold or otherwise disposed of by the lessee pursuant to an arm's-length contract prior to processing will be valued under § 206.152 (in the same manner as unprocessed gas) unless:

— the arm's-length contract includes a reservation of the right to process the gas, which right is being exercised by the lessee; or

— the arm's-length contract is a "percentage of proceeds" contract providing for a price based upon a percentage of the purchaser's proceeds after processing.

2. If the lessee (or the person to whom the lessee has transferred gas under a non-arm's-length contract or without a contract) processes gas and then disposes of the residue gas by some means other than sale under an arm's-length

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contract, § 206.155(a) provides that the value of the gas for royalty purpose will be the greater of:

— the combined value of the residue gas, the gas plant products and the condensate; or

— the value of the gas prior to processing.

Thus, the lessee is required to perform "dual accounting" and make two separate calculations—one based on wellhead value and one based on combined tailgate values. Read literally, § 206.155(a) does not provide for the deduction of processing allowances from the tailgate values. It appears, however, from the MMS comments that accompanied publication of the final rulemaking that § 206.155(a) should be read to provide for deduction of processing allowances to the same extent permitted under § 206.153(a)(2).⁷

3. Notwithstanding any other provision of the regulations, if the specific provisions of any statute, treaty, settlement agreement (between the lessee and the United States or Indian lessor resulting from administrative or judicial litigation) or the lease itself are inconsistent with the general rule, those specific terms will control.⁸ For example, an Indian lease may contain express provisions requiring "dual accounting". If such is the case, computation of a processing allowance will be necessary even if the lessee sells the gas prior to processing under an arm's length contract.⁹

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C. Step One: Valuation of Condensate, Residue Gas and Gas Plant Products

Unless processed gas is sold by the lessee under an arm's-length contract prior to processing (or some other exception applies), the valuation of that gas will begin with valuation of (i) the condensate, if any, recovered prior to processing and (ii) the residue gas and gas plant products that result from the processing.

1. Value of Condensate. § 206.153(a)(2) requires that any condensate recovered prior to processing be valued pursuant to § 206.102 (valuation standards for crude oil).¹⁰

2. Value of Residue and Plant Products. Residue gas and each gas plant product must be valued separately, but all natural gas liquids (NGL's) that result from the processing may be treated as a single product.¹¹ For ease of reference, the term "Product" will be used in this paper to mean either residue gas or any gas plant product. The standards used to determine the tailgate value of a Product are essentially identical to the standards used to value unprocessed gas.¹²

Arm's-length Contract. If the Product is sold at the tailgate of the plant¹³ under an arm's-length contract, the gross proceeds accruing to the lessee¹⁴ will be the value of that Product.¹⁵ If the Product is sold or transferred by the lessee to a marketing affiliate¹⁶ and then sold by the affiliate under an arm's-length contract, the gross proceeds accruing to the affiliate will be the value.¹⁷

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If the arm's-length contract does not reflect the total consideration, the MMS may require that the Product be valued as though sold under a non-arm's-length contract or no contract.¹⁸ Similarly, if the MMS determines that in entering into the arm's-length contract, the lessee did not market the Product for the mutual benefit of the lessor and if, as a result, the price received under the arm's-length contract is unreasonable, then the Product sold under that contract will be valued as though sold under a non-arm's-length contract or no contract.¹⁹ If an arm's-length contract for residue gas is a "warranty contract" as defined in § 206.151²⁰ , then the lessee must request a value determination by MMS.²¹ As always, lease terms requiring value based on some other method would control. § 206.153(a)(3)(i) also requires that "dual accounting" be performed for Indian leases if the lease provides that the Secretary may consider the highest price paid or offered for a major portion of production. Royalty would then be based on the highest of the contract price and the "major portion" price.²² Guidance for determining the "major portion" price is found at § 206.153(a)(3)(ii).

Non-Arm's Length Contract or No Contract. If the Product is not sold under an arm's-length contract, then valuation will proceed in accordance with the same "benchmark" standards that are applied under § 206.152 to unprocessed gas.

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As set forth in § 206.153(c), the tailgate value of the Product will be determined in accordance with the first applicable of three methods:

(i) the gross proceeds accruing to the lessee under the non-arm's-length contract (or other disposition), if the gross proceeds are equivalent to gross proceeds paid under comparable arm's-length contracts for like-quality Product;

(ii) the value determined by consideration of other information, including other sales from the same plant, posted prices and spot market prices; or

(iii) a net-back method or any other reasonable method.

Again, lease terms in conflict with the benchmark system would control and dual accounting would be required for Indian leases that permit the Secretary to consider the "major portion" price.

3. Computation of Volumes. Pursuant to § 206.154(b), the quantity of the Product to be valued for royalty purposes is that portion of the plant's monthly net output of such Product that is attributable to the lease. If a plant serves more than one lease, § 206.154(c) requires the net output of each Product to be allocated among the leases in proportion to the volumes of unprocessed gas delivered to the plant from each lease. If the plant serves multiple leases and the gas produced from the leases is not of uniform composition, the composition of the gas stream from each lease

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must be determined. The plant's monthly net output of each Product will be allocated separately among the leases in proportion to the volumes of unprocessed gas delivered by each lease, adjusted to account for the Product content of the unprocessed gas.

Example. Assume a plant processes gas from three leases (L₁, L₂, L₃) and that the composition of the gas stream delivered from each lease is as follows:

L₁=50% methane, 50% carbon dioxide

L₂=60% methane, 40% carbon dioxide

L₃=30% methane, 70% carbon dioxide

Assume further that the monthly volume of gas...