CHAPTER 8 FEDERAL NATURAL GAS VALUATION

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management
(Feb 2007)
CHAPTER 8
FEDERAL NATURAL GAS VALUATION
John L. Price
Chief, Office of Enforcement
Minerals Management Service
Denver, Colorado
Judith M. Matlock
Attorney, Davis, Graham & Stubbs, LLP
Denver, Colorado
Bud Hum
Director, Natural Gas Products Marketing
IntercontinentalExchange Services, Inc. (ICE)
Chicago, Illinois

JOHN L. PRICE

John L. Price has over 31 years of experience with Department of the Interior (DOI) mineral leasing programs. He has held a number of technical and managerial positions of increasing responsibility throughout his career. Mr. Price began his career in 1975 and served MMS over the next five years as a Petroleum Engineer in the MMS's Gulf of Mexico OCS Regional office and in its OCS Headquarters office. From late 1980 through 1982, Mr. Price served as the District Supervisor of the Grand Junction Oil and Gas District Office in Grand Junction, Colorado, with responsibility for all oil and gas operations on Federal and Indian lands in Colorado, Kansas, and Nebraska. In January 1983, Mr. Price became the Onshore Oil and Gas Team Lead in designing and developing an automated system for collecting and managing operation and production information for MMS's Royalty Management Program (currently the Minerals Revenue Management program (MRM)). In January 1985, Mr. Price became the Chief of the Oil and Gas Valuation Branch in MRM, overseeing the valuation of oil, gas, and geothermal resources for all Federal onshore and offshore leases and all Indian leases administered by DOI. In late 1992, Mr. Price became a charter member of MRM's Office of Enforcement where he led negotiations to resolve hundreds of disputes between MMS and industry regarding royalty issues. In 1999, Mr. Price joined the MMS Appeals Division in Washington, D.C., attaining the position of Division Chief in late 2000. From March 2004 through February 2006, Mr. Price served as the Project Manager of the OCS Connect Project, MMS's Offshore Minerals Management eGovernment Transformation Project. In March 2006, Mr. Price returned to MRM's Office of Enforcement as the head of that office. Mr. Price is the recipient of the Department of the Interior Honor Awards for Superior Service and Meritorious Service.

JUDITH M. MATLOCK

Judith M. Matlock is a partner in the Energy Group of the Denver law firm of Davis, Graham & Stubbs LLP. She received her Bachelor of Arts degree from the University of Colorado in 1979, graduating magna cum laude. In 1982, she received her Juris Doctor degree from the University of Colorado. She is a member of Phi Beta Kappa, Order of the Coif, and the Denver, Colorado, and American Bar Associations. Since the mid 1980s, her practice has included extensive work involving the transportation, processing and marketing of production giving her a unique perspective on royalty and tax compliance issues involving post-production costs, non-arm's-length transactions (sales, transportation, processing), and accounting system implementation of inconsistent federal, tribal, state and private royalty and production tax requirements. She has negotiated settlements of class action litigation involving private royalties on both conventional and coalbed methane production. She has conducted internal audits for companies to determine their compliance with royalty and tax requirements involving numerous different marketing arrangements. She has also evaluated royalty and tax compliance issues to assist companies in determining the effective net revenue interest and potential liabilities involved in an acquisition. Ms. Matlock also has an extensive background in the more traditional aspects of a natural resources practice. Ms. Matlock has been a member of the Executive Committee of the Rocky Mountain Mineral Law Foundation, served as a trustee of the Foundation, and served as vice chair of the Special Institutes Committee of the Foundation. She has been the program chair for several Foundation Special Institutes and Short Courses including Natural Gas Marketing & Transportation (1991); Practical Natural Gas Marketing Short Course (1993 and 1994); and Negotiating Natural Gas Contracts (1993). She is a frequent lecturer and writer on energy topics including two annual institute papers and 12 special institute papers for the Rocky Mountain Mineral Law Foundation including "The `Duty to Market' Downstream At No Cost To The Lessor (The Alleged Federal `Duty to Market')," Federal and Indian Oil & Gas Royalty Valuation and Management, Paper 2A (Rocky Mt. Min. Law Fdn. 2000); "Post Production Costs," Institute on Natural Gas Transportation & Marketing (Rocky Mt. Min. Law Fdn. 2001); "The Wyoming Class Action Lawsuits" (an update on post-production cost litigation), handout for Independent Petroleum Association of Mountain States, September 2002; and "Royalty Calculation When the Producer/Lessee is Dealing With An Affiliated Entity," Private Oil & Gas Royalties, Paper No. 9 (Rocky Mt. Min. L. Fdn. 2003). She has been listed in Best Lawyers in America - Oil and Gas since 1995 and was selected to the inaugural Lawdragon 500 for her royalty work.

BUD HUM

Bud Hum is the Director of Natural Gas Products Marketing for ICE. He joined ICE in 2001 while the company was in its infancy stage. He is responsible for the physical natural gas markets, customer service and training, product and business development. Armed with over 15 years of energy industry experience, he is well conditioned to respond to the constant changes in the industry and keep ICE at the forefront of electronic trade execution. Prior or joining ICE, Mr. Hum held positions in finance, operations and trading with Natural Gas Clearinghouse, Amoco and Direct Energy. He now uses his market knowledge to develop technology which will help his former colleagues. Beginning his career in the Canadian oil patch, he is now a U.S. citizen and full time resident of Chicago. Mr. Hum holds a Bachelors of Commerce from the University of Alberta.

Special Institute on Federal and Indian Oil & Gas Royalty Valuation and Management

Introduction¹

This topic concerns the question of how to value natural gas production from a federal lease when the production is not sold pursuant to an arm's-length contract. Although the Minerals Management Service ("MMS") has adopted index-based valuation regulations for certain natural gas production from Indian leases² and published values for certain oil production from federal leases,³ it has not adopted similar published values for natural gas production from federal leases, although it has considered the topic as recently as 2005.⁴ Unless and until the MMS adopts index-based valuation for natural gas production from federal leases, at least as to non-arm's-length transactions, the benchmark valuation regulations adopted in 1988 apply.

However, two relatively recent decisions have changed the analysis of non-arm's-length transactions: the decision by the United States Court of Appeals, District of Columbia Circuit, in Fina Oil and Chemical Co. v Norton⁵ ("Fina") and the Interior Board of Land Appeals decision in Vastar Resources, Inc.,⁶ ("Vastar"). Fina puts renewed emphasis on the application of the benchmark valuation regulations. Vastar puts renewed emphasis on what constitutes an arm's-length contract in the first place.

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This paper will provide an overview of the administrative and court decisions involving non-arm's-length sales of federal production before Fina and Vastar, summarize the holdings in Fina and Vastar, and then discuss the application of these decisions to past affiliate sales transactions that are still subject to challenge and to affiliate sales transactions being entered into today.

Decisions on affiliate sales before the 1988 gas valuation regulations

Before the current gas valuation regulations were adopted in 1988, the selling price in a transaction between affiliated companies could be used as the royalty value if it was comparable to the price negotiated between nonaffiliated parties of adverse economic interests. Thus, for example, the IBLA held in Getty Oil Co.,⁷ that a contract, if the same as others with unrelated parties, would be treated as establishing fair market value. Similarly, in PanEastern Exploration Co.,⁸ it was held that where it is determined that the price of gas sold by a wholly owned subsidiary to the parent company was arrived at in an arm's-length manner, the price should have been accepted for royalty computation purposes. And, in Gas Producing Enterprises, Inc.,⁹ it was held that a contract for the sale of gas between a seller lessee company and a purchaser who owns a controlling interest in the seller will be treated as establishing a fair market value if the contract is the same as others with unrelated parties.

When the selling price was not comparable to other arm's-length transactions, value based upon comparable sales was used. For example, in the case of Transco Exploration Co.,¹⁰ Transco Exploration Co., a 15% working interest owner in a federal lease, entered into a gas sales contract with its interstate pipeline affiliate, Transcontinental Gas Pipeline Corporation. The original contract entered into in 1977 was held to represent fair market value because it resulted in a price reflective of the other contracts entered into at that time.¹¹ Specifically, it resulted in a price that was comparable to the prices received by the other working interest owners in the lease.

At issue in the case was the voluntary action of Transco in reducing the price Transcontinental had to pay for Transco's gas. This action was taken in response to the adverse market conditions Transcontinental was experiencing in the early 1980s which were common to many interstate pipelines. The other working interest owners in the lease refused to voluntarily reduce their prices. Instead, through annual price...