CHAPTER 8 FEDERAL ROYALTY VALUE—A "COAL" APPROACH

• Jurisdiction: United States

Royalty Valuation and Management
(Mar 1988)
CHAPTER 8
FEDERAL ROYALTY VALUE—A "COAL" APPROACH
Donald E. Coovert
AMAX Coal Company
Indianapolis, Indiana

Table Of Contents

SYNOPSIS

Industry Proposal Development 8-1 Through

Valuation Point Comparison 8-3 Through

Valuation Benchmark 8-5 Through

Depletion Based Administration:

Current Use—Kentucky, Montana 8-7 Through

Efficiency Comparison 8-8 Through

Backup Procedures 8-11 Through

Administrative Conclusion

MMS Reaction 8-12 Through

Net Value Comparison 8-13 Through

Value Example—Government Role 8-14 Through

The Real Issue (Coal, Gas, Oil Comparisons):

Is Equal Really Equal? 8-17 Through

Excessive Government Burden on Coal

DOI Fiduciary Responsibility 8-20 Through

Footnotes 8-23 Through 8-24

NCA Fiscal Impact Analysis Summary 8-25 Through

MMS Fiscal Impact Analysis Summary 8-31 Through

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[Page 8-1]

Coal industry reaction to proposed coal valuation rules published by the Minerals Management Service (MMS) January 15, 1987 was one of extreme displeasure. The MMS pronouncement in the Preamble to the proposal that coal rules were being "formatted compatibly with other leasable minerals" had clearly been exceeded. Coal valuation rules were not only being formatted compatibly but were, in fact, being forced into the same mold based upon the erroneous assumption that coal is nothing more than solid gas and oil. The preoccupation with gas and oil concepts such as contract specific administration and "take or pay" payments clearly demonstrated a total lack of understanding of coal production and marketing. Subsequent meetings with MMS technicians have unfortunately convinced most coal and utility representatives (including me) that not only is there an acute lack of knowledge at MMS with respect to coal production, but also an equally acute unwillingness to learn.

Public gas and oil leasing and royalty policy over the years has evolved consistently with private sector practices. The private sector concept of a 1/8 royalty share of the value of production became the basis for public gas and oil royalty policy. Contrast this to the evolution of public coal leasing policy which has thus far ignored private sector coal practices and developed as an extension of gas and oil policy, completely without regard for economic or energy policy consequences.

Private sector coal leasing practices vary widely in response to the realities of coal production and marketing. There are many different types and qualities of coal. Production and marketing of these coals are drastically impacted by a multitude of factors, including environmental considerations and transportation. It can be said with reasonable certainty that the average private sector royalty rate is much less than the standard 12 1/2% prevalent in both public and private gas and oil leasing. It is also apparent that the private sector base to which the rate applies in substantially less than "gross proceeds". The vast majority of private sector ad valorem coal leases provides for the reduction of gross proceeds by the amount of reimbursements for most, if not all, directly levied government taxes, fees and royalties. A typical private coal lease reads in part as follows:

"Net Realization" — The gross realization from all recoverable coal mined and sold from a Coal Area by the Operator after deducting therefrom (a) sales agents' commissions, and (b) any tax (other than federal income tax) or other governmental charge which may be imposed upon an Operator or its sales agents by the United States or any state or any governmental authority, upon the sale of said coal or the privilege of selling the same, or engaging in the commerce of producing and selling the coal or mining the same or any compensatory use tax, however the tax may be denominated, such taxes to be computed at the rate prevailing at the time of any such sale or transaction.

[Page 8-2]

INDUSTRY VALUATION ALTERNATIVE

Subsequent to the publishing of proposed rules, various meetings were held between industry representatives, the Department of Interior and various legislators and Congressional staff. Coal representatives were appalled that MMS ignored most of the recommendations of the Linowes Commission with respect to value¹ and the vast majority of input from the coal industry by proceeding to draft coal valuation rules as an extension of gas and oil valuation concepts. MMS totally disregarded the economic impact of its proposed policies, as well as private sector coal leasing practices. In response, the coal industry was told by Department of Interior officials and members of Congress that criticism without alternative proposals would not yield positive results. Given the devastating nature of the potential impact, coal producers took the advice seriously.

During the first half of 1987, several joint meetings were held between the major federal coal producers and consumers of federal coal, the purpose of which was to develop an alternative valuation concept based upon the following criteria:

1. Administrative practicality and efficiency.

2. Private sector coal leasing practices.

3. Valuation concepts as set forth in the Linowes Commission Report.

During these meetings, numerous alternatives were explored in depth. Included among the alternatives were royalties based on heat content, as well as several variations of the MMS proposal modified to reflect private sector practices. After much deliberation, a proposal evolved based upon an efficient administrative procedure that would produce valuation in a manner highly consistent with private sector practices. The alternative proposal was rapidly endorsed by all major federal coal producers and consumers. After the industry proposal had been "fleshed out," it was formally presented to the Department of Interior as a public comment July 21, 1987. At that time, the proposal was formally endorsed by the following organizations:

Edison Electric Institute

American Public Power Association

National Rural Electric Cooperative Association

National Coal Association

American Mining Congress

Western Fuels Association, Inc.

The proposal is based upon three fundamental concepts, which are:

1. A fixed royalty attachment and valuation point immediately after coal has physically achieved marketable condition and prior to any further handling or beneficiation.

2. The use of a pre-existing benchmark on which to base the royalty valuation calculation, namely, federal income tax depletable income.

3. Elimination of the offensive practice of compounding royalty on itself and other government imposed levies.

[Page 8-3]

VALUATION POINT

MMS Approach

The rules proposed by MMS in January deal with the valuation point issue by allowing it to float.² Conceptually, the idea is that, over time, coal technology will evolve to the point that coal will be routinely refined, liquefied or gasified to achieve marketable condition. Therefore, royalty should attach to the refined product value based upon the downstream, post-beneficiated price. A deduction might be allowed for the direct costs of beneficiation and part of the depreciation related to beneficiation facilities, or a partial return on beneficiation facility capital investment, but not both.³ To complicate matters further, the deduction will undergo serious additional scrutiny if it exceeds 50% of the downstream price. The bottom line result of this proposed policy will almost always be the inclusion of a substantial part of the value added by downstream processes occurring after coal has physically achieved marketability.

The MMS proposal infers that royalty may attach much earlier in the production process than the downstream valuation point if coal is removed from the ground and stored, by providing for the possibility of requiring a bond to cover royalty liability related to a coal stockpile.⁴ It is difficult to understand why the lessor would have a right to require a bond if royalty has not yet attached to the coal. It is equally difficult to understand how attachment can occur at any point other than the valuation point.

Industry Approach

The coal industry believes the point of royalty attachment and the valuation point should always be one and the same. Further, in determining the valuation/attachment point, consideration must be given to more than maximizing today's federal royalty revenues without regard to the damaging impact such a policy will have upon long-term federal coal production. Private sector coal leasing practices must be given a higher priority than public gas and oil practices. Also, federal royalty valuation policy must not ignore U.S. long range energy policy which, by most accounts, is based on the fundamental concept of developing domestic energy sources and moving toward energy independence.⁵ The industry valuation point proposal takes all of these factors into consideration.

The specifics of the industry proposal are simple. The point of royalty attachment and the valuation point should simultaneously occur immediately after coal has been removed from the ground and processed to the point that it is first marketable (given current technology and marketing practices). In today's market, the vast majority of federal coal first achieves marketability after it has been removed, crushed and sized. Royalty should attach at this point. Royalty value should be determined at this point. Downstream activity, beneficiation or transportation should have nothing to do with the value of produced and marketable federal coal for royalty purposes.

One of the many advantages to this approach is that, in tandem with the use of depletable income as the valuation starting point, a relatively simple netback method can be applied to remove the small amount of handling that normally occurs at a mine after marketability has been achieved and before depletable income is calculated. This netback concept is based upon the...