CHAPTER 9 FEDERAL COAL VALUATION—GROSS REALIZATION

• Jurisdiction: United States

Royalty Valuation and Management
(Mar 1988)
CHAPTER 9
FEDERAL COAL VALUATION—GROSS REALIZATION
Terry O'Connor
Peabody Holding Company, Inc.
Denver, Colorado

On January 15, 1987, the Minerals Management Service of the United States Department of the Interior ("MMS") proposed new rules to govern the valuation of coal on federal and Indian lands for royalty purposes. These proposed regulations, as described later in this paper, have created one of the most exercised outcries of resistance and revolt from the western coal mining community, as well as from those utilities which purchase such western federal coal, as any regulatory issue which has arisen from the Potomac bureaucracy — at least in the last decade — even with the possible inclusion of the initial and permanent surface mining regulations which were promulgated pursuant to SMCRA.

In order to understand this issue in its proper perspective, a summary of the legal and political events leading up to the royalty valuation revolt would be appropriate.

HISTORICAL BACKGROUND

Prior to 1976, virtually all of the federal coal leases issued in the United States contained a royalty calculated upon a cents per ton basis ranging anywhere from $0.05 to $0.20 per ton, depending upon the date of lease issuance and whether the coal would be mined by surface or by underground methods. However, when Congress enacted the Federal Coal Leasing Amendments Act of 1976¹ ("FCLAA") over President Ford's veto by

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amending the Mineral Lands Leasing Act of 1920 ("MLLA"), a dramatic turn of events was "set in concrete." Pursuant to Section 7 of FCLAA, any federal coal lease issued thereafter is required to contain a royalty of not less than 12 1/2% of value as defined by regulation, except that the Secretary of the Interior may determine a lesser amount in the case of coal recovered by underground mining operations (30 U.S.C. 207(a)). By regulation, the Secretary of the Interior established the minimum underground rate at 8% of value (43 CFR 3473.3-2(a)(3)). Fifty percent of all such royalty payments are returned directly to the state from which the coal is produced, and another 40% is earmarked for western water projects. The remaining 10% is retained by the U.S. government (30 U.S.C. 191).

While the impact of this statutory change was not immediate, its actual financial effects have commenced to be felt in a significant way in the last few years, and both coal producers and utility purchasers have realized that, in some cases, this change from a cents per ton to a "12 1/2% (or 8%) of value" basis will have serious escalating and inflationary impacts on coal and electrical generation costs. In fact, some coal companies have reported publicly that this change can result in up to a 2,000% increase in royalty payment obligations as their pre-FCLAA leases are readjusted to post-FCLAA terms.²

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While one can argue the pros or the cons of a straight cents per ton royalty, the one item upon which there is virtually universal agreement is that a cents per ton royalty is easier to calculate and to administer than a percent of value royalty. Everyone knows how to calculate a cents per ton royalty, but how does one determine 12 1/2% of "value?"

The Bureau of Land Management of the Department of the Interior ("BLM") promulgated regulations several years ago to interpret and implement Section 7 of FCLAA. The relevant regulation (43 CFR 3485.2(f)) states as follows:

"Where federal royalty is calculated on a percentage basis, the value of coal for federal royalty purposes shall be the gross value at the point of sale, normally the mine...."

30 CFR Section 203.200(f) contains virtually identical regulations for MMS.

Thus, one can see that, in preparing and promulgating regulations to implement Section 7 of FCLAA, the Department of the Interior defined the statutory word "value" to mean "gross value." However, as a matter of policy in implementing this

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regulation, the Department of the Interior historically has made an even larger quantum jump in treating "gross value" as "gross realization." As a result, items such as the Black Lung fee, the Abandoned Mine Reclamation ("AMR") fee under SMCRA, state severance taxes and even the royalty itself have been treated as part of gross realization, and MMS has required that percentage royalties be paid on these governmental fees. The attached table shows a hypothetical royalty calculation for a Montana surface coal mine producing federal coal under that policy. It shows that the effective royalty rate, when calculated to include these various federal, state and local taxes and fees, as well as the royalty itself, yields an effective rate of 21.2% — nearly double the statutory 12 1/2% rate.

This "back door" method of raising revenues has caused cries of protest from the western coal mining community. However, despite the inequities of such an "aggressive" method of calculation, the Interior Board of Land Appeals ("IBLA") has upheld this method of calculation in a number of cases, including Knife River Mining Co., 43 IBLA 104, 86 I.D. 472 (1979), and Peabody Coal Company, 53 IBLA 261 (1981). In Knife River, IBLA held that the AML fee must be included as a part of gross value of the coal for royalty computation purposes when the selling price is increased by the amount of the fee as a result of a pass through provision in the applicable coal supply agreement. In Peabody, IBLA upheld the royalty on the AML fee on Indian leases even though the fee was reimbursable from

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customers under different provisions of coal supply agreements than pricing provisions.

However, the federal courts never have addressed this issue with regard to coal, although they have with regard to natural gas in Hoover and Bracken Energies, Inc. v. DOI, 723 F.2d 1488 (10th Cir. 1983) cert. denied 103 Sup. Ct. 93 (1984). In Hoover and Bracken, the U.S. Tenth Circuit Court of Appeals held that the value of natural gas extracted from federal leases for royalty production purposes includes the Oklahoma severance tax, despite the fact that the oil and gas lessee was not paying the tax, but the gas purchaser was making the severance tax payments directly to the state. Thus, the U.S. government contends that the case stands for the proposition that reasonable value actually may exceed gross proceeds in some circumstances. (See also Wheless Drilling Company, 13 IBLA 21, 80 I.D. 599 (1973), Shell Oil Company, 52 IBLA 15, 88 I.D. 1 (1981) involving the deductibility of transportation charges in natural gas contracts, Amoco Production Company, 29 IBLA 234 (1977), Kerr-McGee Oil Industries, Inc., 70 I.D. 464 (1963) and Kerr-McGee v. Bokun Corp., 453 F.2d 1067 (10th Cir. 1972).)

Unfortunately, all of these reported cases have reached the same result, to wit: While the courts themselves may not endorse this means of revenue maximization, nevertheless, broad discretion is given to the Secretary of the Interior to implement statutory provisions...