CHAPTER 7 FEDERAL OIL ROYALTY VALUATION AND OIL AND GAS TRANSPORTATION ALLOWANCE REGULATIONS

• Jurisdiction: United States

Royalty Valuation and Management
(Mar 1988)
CHAPTER 7
FEDERAL OIL ROYALTY VALUATION AND OIL AND GAS TRANSPORTATION ALLOWANCE REGULATIONS
George H. Rothschild, Jr.
Marathon Oil Company
Houston, Texas

I. INTRODUCTION¹

Practically at its creation in 1982, the Minerals Management Service (MMS) began working on new royalty valuation and allowance regulations. At the beginning of this effort, MMS contemplated the issuance of "guidelines" respecting the determination of royalty values and deductions. Subsequently, MMS was persuaded to embark on a rulemaking proceeding leading to the issuance of regulations that could be included in the Code of Federal Regulations to replace the existing regulations.

In 1986, MMS launched its rulemaking efforts in earnest by making available advance notices of proposed rulemaking governing coal, oil and gas.² MMS held public hearings and received written comments on the advance notices. In addition, the Secretary of the Interior's Royalty Management Advisory Committee (RMAC), which had been created for the purpose of advising the Secretary on royalty management matters in general, requested and was given permission to review the advance notices of proposed rulemaking and to comment on them. RMAC created separate work panels to consider oil, gas and coal valuation regulations, but the full RMAC was unable to adopt officially any of its panels' comprehensive valuation reports because of substantive disagreements among the RMAC membership, which was composed almost exclusively of representatives of industry, states, and Indians. These disagreements were largely the result of the economic fears of many non-industry RMAC members that the proposed regulations would result in dramatic decreases in royalty collections by MMS.

In early 1987, MMS published formal notices of proposed rulemaking (NOPR's) for new coal, oil and gas royalty valuation and allowance regulations.³ Following issuance of the NOPR's, MMS held public hearings and received written comments. Then, however, Congress became deeply involved as a result of its concerns with procedural and substantive aspects of the rulemaking proceedings. To afford itself time to review the process and the substance of the rulemakings, Congress enacted, as part of the supplemental appropriations bill for 1987, a provision prohibiting MMS from amending its product valuation regulations until November 1, 1987.⁴ As part of that review process, Congressional hearings were held to scrutinize the proposed regulations.

During the summer of 1987, meetings were held among representatives of various interested parties (Indians, states, lessees, DOI and Congressional staff) in an attempt to resolve substantive

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disagreements. Largely as a result of these informal discussions, MMS issued further notices of proposed rulemaking for oil and gas on August 17, 1987.⁵ Following the receipt of comments on the August 17 proposals, further informal discussions were held, and those discussions led to publication of the second further notices of proposed rulemaking on October 23, 1987.⁶ Finally, on January 15, 1988, MMS published final valuation and allowance rules for oil and gas.⁷

II. OIL VALUATION REGULATIONS

A. Purposes and Scope of the Oil Valuation Regulations

According to the preamble to the new oil rule, MMS had five objectives in promulgating new regulations:

(1) Clarification and reorganization of the existing regulations...

(2) Creation of regulations consistent with the present organizational structure of the Department of the Interior (DOI).

(3) Placement of the oil royalty valuation regulations in a format compatible with the valuation regulations for all leasable minerals.

(4) Clarification that royalty is to be paid on all consideration received by lessees, less applicable allowances, for lease production.

(5) Creation of regulations to guide the lessee in the determination of allowable transportation costs for oil to aid in the calculation of proper royalty due the lessor.⁸

The overriding objective of the rule, however, is to provide clear, consistent guidance to lessees and auditors by codifying certain past decisions and creating new generic regulations to address virtually all common valuation issues. In keeping with their purpose of ushering in a new regime of detailed generic regulations, the new rule specifically supersedes "all existing oil royalty valuation directives contained in numerous Secretarial, Minerals Management Service, and U. S. Geological Survey Conservation Division (now Bureau of Land Management, Onshore Operations), orders, directives, regulations and Notice to Lessees (NTL's) issued

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over past years."⁹ (Note, however, that MMS expects to use its Payor Handbook to supplement the regulations.¹⁰

The regulations apply to all oil¹¹ from federal, OCS, and Indian leases (except leases on the Osage Indian Reservation, Osage County, Oklahoma) produced on and after March 1, 1988,¹² unless the specific provisions of a statute, treaty, settlement agreement, or lease are to the contrary, in which case the statute, treaty, settlement agreement, or lease provision will govern to the extent of the inconsistency.¹³ The regulations also apply regardless of whether the royalties are actually paid by the lessee or by some third party (e. g., a purchaser), though the rule does not purport to address the issue of who must actually report and pay royalties.¹⁴ In addition, the oil royalty valuation regulations apply to condensate recovered from natural gas prior to processing as well as to crude oil.¹⁵

B. Key Concepts in the New Valuation Rule

In crafting the new rule, MMS relied on three key concepts, each of which is defined in §206.101 but each of which can only be fully comprehended by reviewing the rule in its entirety. Those three concepts are discussed below.

(1) "Arm's-Length Contract."

An understanding of what constitutes an "arm's-length contract" is essential because the determination of whether or not one's oil sales contract is at arm's-length will be determinative of the methodology used to value the oil for royalty purposes. If the oil is sold under an arm's-length contract, the value of the oil will be the gross proceeds accruing to the lessee under that contract.¹⁶ If the disposition is not at arm's-length, then the lessee must use the first applicable of several benchmarks to value the oil.¹⁷ Moreover, with respect to the determination of a transportation allowance, if the transportation contract is arm's-length, then the transportation costs will be determined under one methodology; if transportation is not being provided pursuant to an arm's-length contract, then the lessee may have to resort to detailed costs accounting procedures to determine the proper transportation allowance.¹⁸ Thus, for royalty valuation and allowance purposes, it is always preferable to have a contract that is arm's-length rather than one that is not.

The elements of an "arm's-length contract" are set out in the definition,¹⁹ and all of those elements must

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be met in order for a contract to be accepted as arm's-length:

(a) Contracting parties must be of "opposing economic interests" with respect to the particular contract at issue. Thus, parties may have the same economic interests in other relationships, but so long as the parties have opposing interests for purposes of that particular contract, the arm's-length contract definition is met. For example, two totally unaffiliated companies may be involved in a joint venture to develop production from a lease and, therefore, have similar interests in maximizing production revenues from the lease and minimizing their costs of production. However, if one lessee sells his share of production to the other lessee, then they have opposing economic interests for the purpose of that sales contract.

(b) The parties to the contract must be independent and unaffiliated, which means that neither must control the other, nor may the two be under the common control of a third person. Control is to be determined on the basis of the instruments of ownership of the voting securities of an entity, and a lessee may be required by MMS to certify ownership control of its voting securities. Ownership of more than 50% constitutes control, while ownership of 10% through 50% creates a presumption of control, and ownership of less than 10% creates a presumption of non-control (i.e., non-affiliation) which MMS may rebut "if it can demonstrate some actual or legal control, including the existence of interlocking directorates." ("Interlocking directorates" is nowhere defined in the rule.) The preamble to the rule suggests that ownership of 5% of a corporation by another could give the other sufficient control to direct the activities of that corporation, with the result that a contract between the two would not be at arm's-length.²⁰

In addition, the definition also provides that contracts between relatives, either by blood or by marriage, will not be considered under any circumstances to be arm's-length contracts. MMS has left for another day, however, an explanation of the meaning of "relatives".²¹

(c) Finally, for a contract to be considered arm's-length, it must meet the definitional criteria both in the month of production and in the month of exe- cution of the contract. Thus, for example, if

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a contract between non-affiliated parties is executed on January 1, 1985, and one of the parties acquires the other on January 1, 1988, then the sale of oil on or after January 1, 1988, under the contract is deemed to be a non-arm's-length sale. Conversely, if two affiliated parties entered into a contract on February 1, 1985, and one of the affiliates is sold to a third party on February 1, 1988, then even though future sales would be between non-affiliated parties, the rule would still consider future sales to be non-arm's-length, seemingly on...