DEDUCTIBLE TRANSPORTATION AND PROCESSING COSTS: SOME CURRENT AND NOT-SO-CURRENT ISSUES

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management Book 1
(Feb 2004)
CHAPTER 10A
DEDUCTIBLE TRANSPORTATION AND PROCESSING COSTS: SOME CURRENT AND NOT-SO-CURRENT ISSUES
L. Poe Leggette
Dimitri L. Seletzky
Fulbright & Jaworski L.L.P.
Washington, D.C.

Poe Leggette joined the Washington, D.C., office of Fulbright & Jaworski L.L.P. as a partner in 1998. His practice involves judicial and administrative litigation concerning natural resources development on federal and Indian lands. He regularly counsels oil and gas and mining companies on obtaining and operating leases on federal and Indian lands. He also defends oil and gas companies accused of violating the False Claims Act.

Mr. Leggette represents companies and trade associations in litigation over mineral development of federal and Indian lands, onshore and offshore. He also counsels companies on compliance with offshore safety and environmental requirements.

Prior to his private practice, Mr. Leggette served as assistant solicitor for the U.S. Department of Interior. While with the Department of Interior, he was author or co-author of virtually all briefs filed in the federal courts on outer continental shelf issues, obtaining, among other things, two Supreme Court reversals of unfavorable Ninth Circuit decisions.

Dimitri Seletzky joined the Washington, D.C. office of Fulbright & Jaworski L.L.P. in 1999. As counsel in the Litigation Department, his practice primarily focuses on judicial and adminstrative litigation concerning natural resources produced from federal and Indian lands, including the Outer Continental Shelf. Mr. Seletzky received his B.A. in 1992 from St. John's College in Annapolis, Maryland, and his J.D., magna cum laude, in 1998 from the University of Baltimore School of Law. He was admitted to practice law in Maryland in 1998 and the District of Columbia in 1999.

I. INTRODUCTION

It has long been settled that federal oil and gas lessees' royalties are "to be calculated at values at the wells, not at the pipe line destination . . . ." ¹ Most recently, the Department of the Interior's ("Department") Minerals Management Service ("MMS") affirmed this principle in its proposed amendments to the 2000 federal oil valuation regulations. ² As we all know, however, oil and gas cannot always be marketed at the well. ³ Moreover, gas is often not marketed in a raw, unprocessed state, but rather is commonly processed to separate natural gas liquids from the gas stream prior to sale. Accordingly, the Department has long confronted the problem of how to value oil or gas when the first market in which it can be sold is away from the lease at which it is produced and when the value of the raw product has been enhanced through processing.

The Department's long experience with permitting lessees to take transportation and processing allowances has resulted in answers to many of the questions that have arisen regarding what specific kinds of costs may be deducted and what may not. And, where specific questions remain unanswered, or where new issues arise, the body of rules and cases that has developed contains many examples that may be useful in determining whether a particular cost may be deducted or not. As we shall see, the Department's decisions, although not perfectly consistent in result, are generally consistent in using a function-based analysis, holding costs to be deductible when they demonstrably serve a transportation or processing purpose. Thus, while not containing the answer to every question which may confront an in-house counsel, a company accountant, or a regulator regarding whether particular costs have been treated as transportation or processing costs, this paper is intended to collect the leading rules and decisions useful in this area to frame, if not definitively answer, the hard questions.

II. HISTORICAL BACKGROUND REGARDING PROCESSING AND TRANSPORTATION DEDUCTIONS

A. The Gas Processing Allowance Prior to the 1988 Gas Valuation Rules

In 1926, the Department first addressed the issue of royalties on natural gas liquids (then called "gasoline") extracted by processing (then called "manufacturing") a natural gas stream. ⁴ Clarifying that lessees had no duty to manufacture the gas at no cost to the lessor, the Department explained that it did "not wish to collect royalty on that part of the value which is derived from the cost of manufacturing, inasmuch as the Government's equity is confined to the value of the raw material involved." ⁵ Accordingly, the Department assumed that the cost of manufacture would equal two-thirds of the value of the gasoline, meaning that the Department would claim as royalty one-sixth "of one-third of the market value" of the gasoline. ⁶ However, the Department recognized that "Ýa¨dverse climatic and economic conditions in certain portions of the Rocky Mountain district result in unusually high operating and marketing costs." ⁷ Therefore, upon a "proper showing" by the lessee, the Department would agree to assess even less royalty on the gasoline. ⁸

Regulations promulgated subsequently to the 1926 regulations have consistently included allowances for natural gas processing, although there has been some variation in the precise terms of the allowances. In revised regulations promulgated in 1936, however, the discretionary component of the regulations appears to have been removed. The revised rule simply mandated that "Ýa¨ royalty as provided in the lease shall be paid on the value of one-third (or the lessee's portion if greater than one-third) of all casinghead or natural gasoline extracted from the gas produced from the leasehold. The value of the remainder is an allowance for the cost of manufacture, and no royalty thereon is required." ⁹ In 1954, when the Department first enacted rules governing the valuation of production from the offshore lands leased pursuant to the 1953 Outer Continental Shelf Lands Act, ¹⁰ a somewhat different rule was applied. Processed gas was to be valued based on the full value of residue gas plus "the value of 50 percent (or the net proceeds received by the lessee if greater than 50 percent) of all natural gasoline, butane, propane, or other substances extracted from the casing-head gas." ¹¹

B. Transportation Allowances Prior to the 1988 Oil and Gas Valuation Rules

The origins of the Department's policy of allowing deductions for transportation costs to the point of sale or other valuation point are murkier than the origins of processing allowances. This is so because the policy of permitting transportation allowances originated as a matter of departmental practice that was not, like gas processing, specified by regulation. An express requirement that the Department allow a deduction for the reasonable, actual costs of transportation did not appear in the Department's oil and gas value rules until MMS published the 1988 oil and gas valuation rules. ¹²

As early as the seminal 1957 marketable condition case The Texas Co., the Department was careful to distinguish intra-field transportation from transportation from the field to a market away from the field, suggesting in dicta that the latter was deductible. ¹³ By 1963, the Department would state outright that "Ýo¨il and gas leases executed pursuant to the Mineral Leasing Act have been construed to allow for the deduction of transportation costs in the computation of market values and royalty interests." ¹⁴ And by 1981, the Interior Board of Land Appeal was confidently holding that, when there was no market at the lease, "Ýi¨t has long been considered reasonable with respect to oil produced onshore or offshore to deduct a transportation allowance from the market value of the oil at the nearest open market to determine value at the wellhead . . . , the point where the oil would ordinarily be sold and valued." ¹⁵

For as long as it has permitted lessees to take transportation allowances, the only setting in which the Department prevented lessees from deducting costs of transportation to markets away from the lease or field has been where the transportation was "beyond the point of the nearest potential market." ¹⁶ The purported reason behind this exception to the rule was "the potential for abuse if a deduction were allowed for the costs of transporting oil beyond the nearest available market." ¹⁷ In any event, the denial of a deduction for costs for transportation beyond the nearest available market was never grounded on any express or implied Departmental power to choose which portions of transportation it will pay its share of and which it will demand for free. ¹⁸ Instead, the denial was founded on the valuation principle that "if there is no open market in the place where an article would ordinarily be sold, then the market value of such article in the nearest open market, less the cost of transportation to such open market, becomes the market value of the article in question." ¹⁹

III. TRANSPORTATION AND PROCESSING DEDUCTIONS UNDER THE CURRENT OIL AND GAS VALUATION RULES

As we have seen, the Department's history of allowing deductions for transportation costs results from its longstanding position that the value of production for royalty purposes is confined to the production's value at the lease from which it is produced. The Department accepts that "the price received for a product at a distance from the point of production is not the value of the product at the point of production because the costs incurred in transporting the product have added value to it." ²⁰ Thus the Department allows a deduction for the costs of transportation away from the lease in order to net out the value added by transportation and derive value at the lease. ²¹ Similarly, because processing of natural gas adds value to production above its value at the lease, the Department allows a deduction for the cost of processing. ²²

In keeping with these principles, the valuation rules promulgated in 1988...