CHAPTER 9 MMS VALUATION AND COMPENSATORY ROYALTY ISSUES
| Jurisdiction | United States |
(Mar 1994)
MMS VALUATION AND COMPENSATORY ROYALTY ISSUES
Valuation and Standards Division Minerals Management Service
Denver, Colorado
TABLE OF CONTENTS
Page
I. INTRODUCTION
II. COMPENSATORY ROYALTY ASSESSMENT PROCESS
III. VALUATION OF COMPENSATORY ROYALTY
IV. REPORTING REQUIREMENTS
V. EFFECTS ON MINIMUM ROYALTY AND RENTAL OBLIGATIONS
VI. INTEREST CHARGES
VII. ASSESSMENTS AND PENALTIES
VIII. OTHER COMPENSATORY ROYALTY ISSUES
Valuation Appeals Procedures
Alternative Collection Procedures
Delegation of Audit Authority
Revenue Sharing Effects
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I. INTRODUCTION
This paper explores valuation and other issues involving compensatory royalty that fall under the jurisdiction of the Minerals Management Service's (MMS) Royalty Management Program.
The paper will address the following compensatory royalty assessment issues:
Overview of MMS' compensatory royalty assessment process
How MMS establishes the value of drained production for compensatory royalty assessment purposes
MMS requirements for reporting compensatory royalties
The effect of compensatory royalty assessments on rent and minimum royalty obligations
How MMS determines interest charges on past drainage
Assessments and penalties which may be applicable to compensatory royalty payors
The MMS appeals process for valuation determinations
Alternative collection methods
Delegation of MMS audit functions to States and Indian tribes
The effect of revenue sharing of compensatory royalty assessments
The concepts contained in this paper are applicable to both Federal and Indian leases. The paper addresses compensatory royalty assessment issues only—compensatory royalty agreements are not addressed in this paper.
II. COMPENSATORY ROYALTY ASSESSMENT PROCESS
The Bureau of Land Management (BLM) requests that MMS prepare the compensatory royalty assessment upon completion of their drainage determination case. BLM supplies MMS auditors with the lease number, production history of the offending well, and the drainage factor. The auditors use the information supplied by BLM and
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obtain the necessary valuation information to calculate the initial compensatory royalty assessment. The auditors bill the Federal lessee for the initial compensatory royalty and, after receiving payment, bill the appropriate interest charges. The auditors also notify MMS' Data Management Division of any continuing compensatory royalty obligation. The Data Management Division determines who will be responsible for making the continuing compensatory royalty assessment by contacting the Federal lessee. The lessee or other payor establishes that responsibility in MMS' automated system by filing a Payor Information Form with MMS (see page 9-5). MMS then expects the payor to report compensatory royalties each month until BLM notifies MMS that the offending well has ceased production or that the Federal lessee has drilled a protective well. Additional information regarding MMS reporting requirements for compensatory royalty can be found beginning on page 9-5.
III. VALUATION OF COMPENSATORY ROYALTY
While the BLM determines whether and to what extent drainage has occurred, MMS determines the value of the drained oil and gas.1 The MMS is further responsible for collecting the compensatory royalty assessment and distributing the royalty to the appropriate recipients. MMS' distribution of compensatory royalty revenue to recipients is discussed further on page 9-10.
MMS auditors are responsible for initiating compensatory royalty assessment determinations within 90 days of receiving BLM's final drainage determination. The formula routinely used by MMS' auditors in preparing the assessment is:
| XX. X% of offending well production deemed to be draining Federal lease2 | X | Royalty rate of Federal lease3 | X | Value of historical production |
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The "value of historical production" portion of the formula is determined by reference to sales and production data from the offending well. MMS collects this information from the best available source. When the offending well is on another Federal lease, the necessary information is available within MMS' automated systems. When the offending well is on fee or State land, the information may be obtained from the operator or producer(s). If necessary, MMS may obtain the information from state taxation records or private services. This approach may be required when the assessment takes place years after the initial drainage, and sales and production records are no longer available.
MMS' approach for determining the value of drained production has remained substantially uniform since the inception of BLM's drainage program. However, the revision of MMS' oil and gas valuation regulations, effective March 1988, created subtle changes to the approaches used.4 This paper will speak to the current regulatory environment and highlight the regulatory differences where necessary.
Arm's-Length Contracts
The basic premise behind MMS' revised regulations is that value is best determined by the interaction of competing market forces. Thus, MMS generally accepts the gross proceeds accruing to a lessee under its arm's-length contract for royalty valuation purposes.
Arm's-length contracts, as defined under the regulations, are arrived at in the marketplace between independent, nonaffiliated persons with opposing economic interests. Affiliation exists if one person controls, is controlled by, or is under common control with another person, based on ownership of the voting securities of the entity. Ownership of more than 50 percent constitutes control, 10 through 50 percent creates a presumption of control, and less than 10 percent creates a presumption of noncontrol.5
In drainage cases, the lessee does not actually sell the production, therefore other arm's-length sales must be used to determine the value of the drained production for compensatory royalty purposes.
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Non-Arm's-Length Contracts
The regulations allow gross proceeds derived under non-arm's-length contracts to be used for valuation purposes only when they are equivalent to sales under comparable arm's-length contracts. The reasoning behind this regulation is that non-arm's-length contracts are not negotiated by parties with opposing economic interests and could be structured for the purpose of reducing the royalty burden.
If the sale of production from the offending well is non-arm's-length, MMS will employ the benchmark system under the regulations to value the drained production.6 The benchmark system and the definition of arm's-length contracts first appeared under the 1988 revision to the regulations. Prior regulations contained language that also allowed MMS to challenge non-arm's-length prices for valuation purposes. Those regulations provided for the following:
"The value of production, for the purpose of computing royalty, shall be the estimated reasonable value of the product as determined by the Associate Director due consideration being given to the highest price paid for a part or for a majority of production of like quality in the same field, to the price received by the lessee, to posted prices, and to other relevant matters. Under no circumstances shall the value of production of any of said substances for the purpose of computing royalty be deemed to be less than the gross proceeds accruing to the lessee from the sale thereof or less than the value computed on such reasonable unit value as shall have been determined by the Secretary. In the absence of good reason to the contrary, value computed on the basis of the highest price per barrel, thousand cubic feet, or gallon paid or offered at the time of production in a fair and open market for the major portion of like-quality oil, gas, or other products produced and sold from the field or area where the leased lands are situated will be considered to be a reasonable value."7
This language allowed the MMS considerable discretion in determining the proper value of royalty, including compensatory royalty, especially when non-arm's-length contracts were involved.
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In summary, the value for compensatory royalty purposes is determined by reference to the arm's-length sales value derived from the offending well. If the sales from the offending well are non-arm's-length, the value is determined by reference to comparable arm's-length sales.
After MMS' initial compensatory royalty assessment, the payor is then responsible for determining the compensatory royalty due...
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