CHAPTER 8 DEFERENCE? FAIR NOTICE? RULEMAKING? MATERIALITY? KEY (NON- ROYALTY) DECISIONS THAT DIRECTLY IMPACT THE FEDERAL AND INDIAN ROYALTY PROGRAM

• Jurisdiction: United States

Federal and Indian Oil & Gas Royalty Valuation and Management
(Oct 2018)
CHAPTER 8
DEFERENCE? FAIR NOTICE? RULEMAKING? MATERIALITY? KEY (NON- ROYALTY) DECISIONS THAT DIRECTLY IMPACT THE FEDERAL AND INDIAN ROYALTY PROGRAM
Jonathan A. Hunter
Jones Walker LLP
New Orleans, LA

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JONATHAN HUNTER is a partner with Jones Walker LLP, where he devotes his practice full-time to representing oil and gas companies. He advises upstream oil and gas companies on matters governed by the Outer Continental Shelf Lands Act, the Mineral Leasing Act, the False Claims Act, the Federal Oil and Gas Royalty Management Act, the Foreign Investment and National Security Act, the National Environmental Policy Act, and other statutes and related regulations. He has represented federal oil and gas lessees in dozens of administrative and judicial proceedings, including disputes involving multi-billion-dollar royalty, lease cancelation, and fraud claims. On behalf of federal oil and gas lessees, he has intervened in lawsuits challenging the United States Department of the Interior's administration of the federal oil and gas leasing program. A graduate of Yale College and the Louisiana State University Law Center, he has taught, written and lectured extensively on oil and gas subjects. He has been listed in Chambers USA America's Leading Lawyers for Business and The Best Lawyers in America for many years. He is the immediate past-President of the Rocky Mountain Mineral Law Foundation.

I. INTRODUCTION

Not long after the oil and gas industry got its legs in America, royalty disputes between lessors and lessees arose, many of which involved the same issues that oil and gas lawyers litigate today - e.g., whether royalty is owed on flared or lost production; how do you calculate royalties on processed gas; at what point do the lessor and lessee begin to share costs associated with produced hydrocarbons?¹ When the oil and gas industry started making headlines following the Arab oil embargo and the deregulation of oil and gas prices in the 1970s and 1980s, the resulting royalty disputes over deregulated prices, take-or-pay payments, and gas balancing achieved a particularly high profile. Oil and gas professors became testifying experts, lawyers accustomed to seeking justice in the casualty arena discovered a talent for bringing royalty class actions, and we were treated to a series of cases with such lyrical names as Diamond Shamrock, Piney Woods Country Life School, and First Baptist Church of Peyote.²

Eventually, of course, royalty disputes emerged in the federal and Indian leasing program administered by the United States Department of the Interior. For at least seventy-five years, we have seen a steady stream of administrative and judicial decisions involving royalty disputes between the Department of the Interior and the owners of federal oil and gas leases (onshore and offshore) and Indian oil and gas leases.³ Not surprisingly, these federal and Indian royalty disputes

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have concerned the same gamut of substantive royalty issues that arise under state law - e.g., the deductibility of post-production costs,⁴ whether royalty is owed on lost and used hydrocarbons,⁵ and the royalty consequences of take-or-pay payments and gas contract settlements.⁶

But - and here's the point - litigation over royalties owed under oil and gas leases administered by the Department of the Interior are held up to a unique lens that is absent from private royalty disputes governed by state law. When a lessee files a lawsuit challenging a decision by the United States Department of the Interior ordering the lessee to pay additional royalties, the lessee's lawsuit is typically an action for judicial review of final agency action under the Administrative Procedure Act ("APA").⁷ This is principally because the United States has only waived sovereign immunity to be sued in limited circumstances, and a federal lessee must typically rely on the APA's waiver of sovereign immunity as the basis for suing the United States in a royalty dispute.⁸ In turn, this means that federal courts adjudicate these cases based on the following standards unique to the APA:

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The reviewing court shall ... hold unlawful and set aside agency action, findings, and conclusions found to be--

(A) arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law;

(B) contrary to constitutional right, power, privilege, or immunity;

(C) in excess of statutory jurisdiction, authority, or limitations, or short of statutory right;

(D) without observance of procedure required by law;

(E) unsupported by substantial evidence in a case subject to sections 556 and 557 of this title or otherwise reviewed on the record of an agency hearing provided by statute; or

(F) unwarranted by the facts to the extent that the facts are subject to trial de novo by the reviewing court.

5 U.S.C. 706. Numerous federal and Indian royalty decisions have been decided, not by the principles of contract and property law that control royalty disputes between private parties, but based on APA standards that apply to dozens of agencies across the federal government's gigantic administrative state - e.g., APA rulemaking requirements,⁹ deference to Interior based on the APA's "arbitrary and capricious" standard,¹⁰ and rejecting deference where DOI's action contradicts or exceeds clear and unambiguous statutory language.¹¹

Because of this unique way in which disputes over Interior's management of the royalty program are resolved, the large body of case law that is continuously developing in proceedings for judicial review of final action by agencies other than Interior has significant implications for the federal and Indian royalty program. This paper examines a series of (mostly) recent non-

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royalty decisions by the United States Supreme Court that the will likely impact the resolution of federal and Indian royalty disputes.¹²

II. PEREZ V. MORTGAGE BANKERS ASSOCIATION: THE END OF THE PARALYZED VETERANS DOCTRINE

In 1988, the Minerals Management Service (MMS) promulgated new royalty valuation regulations that, for the first time, applied equally to federal onshore and offshore leases.¹³ In addition to unifying all federal leases under one valuation system, these regulations expansively addressed the valuation issues that arise from non-arm's-length dispositions of production, as well as from non-arm's-length transportation of oil and natural gas and non-arm's-length processing of natural gas. One such regulation, involving the deduction of costs of transporting crude oil through a pipeline that the lessee (or its affiliate) owned, authorized the lessee to deduct its "reasonable, actual costs," as calculated pursuant to a complex "actual cost" accounting methodology. 30 CFR 206.105 (1988). However, that same regulation permitted a lessee to use a FERC tariff rate in lieu of the "reasonable, actual cost" calculation under the following conditions:

A lessee may apply to the MMS for an exception from the requirement that it compute actual costs. ... The MMS will grant the exception only if the lessee has a tariff for the transportation system approved by the [FERC] or a State regulatory agency. The MMS shall deny the exception request if it determines that the tariff is excessive as compared to arm'-length transportation charges by pipelines ...

30 CFR 206.105(b)(5) (1988). After having accepted FERC tariff rates for several years in lieu of an "actual cost" calculation, in 1993 MMS began rejecting lessee requests to utilize this regulatory exception. MMS based its new regulatory interpretation on decisions by the FERC concerning that agency's jurisdiction over the transportation of crude oil produced offshore.¹⁴ Reversing the practice that it followed for the first five years that it administered its regulations, MMS began requiring lessees to petition FERC for an affirmation that FERC had jurisdiction over the pipelines that were the subject of the lessee's request for an exception to the required "actual cost" calculation.

Federal lessees challenged MMS's industry-wide change of regulatory interpretation in a series of administrative appeals and judicial review proceedings. In Shell Offshore, Inc. v.

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Babbitt,¹⁵ the Fifth Circuit held that APA rulemaking requirements mandated that Interior first undertake "notice and comment" rulemaking before applying such a change in regulatory interpretation. The appellate court stated:

In the present case, the new "rule" that Shell asserts violates the APA is not a change from a written policy statement or regulation. Rather, it is an alteration of an existing practice. From 1988 through 1993, Interior treated all filed tariffs as approved by the FERC; now it requires lessees in Shell's positon to (as stated in the "Dear Payor" letter ...) "petition FERC" and receive from FERC "a determination affirmatively stating that it has jurisdiction over the pipelines in question". This case is somewhat different from Glickman and Phillips in that the new interpretation of "approved by FERC" does not directly and expressly contradict the regulation itself. Instead it contradicts Interior's prior consistent interpretation of the regulation ... ¹⁶

Faced with similar fact patterns, the D.C. Circuit had twice held - in the Paralyzed Veterans and Alaska Professional Hunter cases - that an agency's reversal of its prior consistent interpretation of a regulation triggered the APA's "notice and comment" rulemaking requirements.¹⁷ Relying on these decisions in Shell Offshore, the Fifth Circuit held:

We agree with the reasoning of the D.C. Circuit; the APA requires an agency to provide an opportunity for notice and comment before substantially altering a well established regulatory interpretation.... Interior's new practice may be a reasonable change in its oversight practices and procedures, but

...