FEDERAL AND INDIAN LEASE ROYALTY VALUATION IN THE CONTEXT OF "JOINT VENTURE" AFFILIATE SALES

• Jurisdiction: United States

Federal & Indian Oil & Gas Royalty Valuation and Management III
(2000)
CHAPTER 10A
FEDERAL AND INDIAN LEASE ROYALTY VALUATION IN THE CONTEXT OF "JOINT VENTURE" AFFILIATE SALES
Geoffrey Heath
Office of the Solicitor Department of the Interior
Washington, D.C.

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This paper discusses the valuation for royalty purposes of oil and gas produced from Federal and Indian leases in the context of sales by producers to so-called "joint venture" affiliates — i.e. affiliates that are not wholly-owned by (or do not wholly own) the producer, or that are not are not wholly-owned subsidiaries of the same corporate parent that owns 100 percent of the producer. The views expressed herein are those of the author and are not necessarily the official views of the United States Department of the Interior.

I. INTRODUCTION

Establishing the value of oil or gas for royalty purposes in situations where lessees sell or transfer production to an affiliated entity has involved controversy between the Department of the Interior ("DOI" or "the Department") and Federal and Indian oil and gas lessees for at least two decades. To put the controversy in context, it is appropriate to review the scheme of the current valuation rules.

The 1988 valuation rules for both oil and gas prescribed different measures of value for non-arm's-length dispositions than for production sold at arm's length. For production sold at arm's length, the 1988 rules adopted the gross proceeds derived from the sale as the measure of value (not just the minimum value). 30 C.F.R. 206.102(b) (crude oil), 206.152(b) (unprocessed gas), and 206.153(b) (processed gas).¹

For dispositions other than arm's-length sales, the 1988 rules adopted a series of "benchmarks" that provided more objective indicia of market value than simply relying on a lessee's non-arm's-length price. The benchmarks were listed in hierarchical order, and the rule provided that the lessee was to use the first benchmark that applied.

For crude oil, the benchmarks are as follows:

1. The lessee's contemporaneous posted prices or oil sales contract prices used in arm's-length transactions for purchases or sales of significant quantities of like-quality oil in the same field (or, if necessary to obtain a reasonable sample, from the same are); provided, however, that those posted prices or oil sales contract prices are comparable to other contemporaneous posted prices or oil sales contract prices used in arm's-length transactions for purchases or sales of significant quantities of

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like-quality oil in the same field (or, if necessary to obtain a reasonable sample, from the same area). (Criteria for evaluating comparability then followed.)

2. The arithmetic average of contemporaneous posted prices used in arm's-length transactions by persons other than the lessee for purchases or sales of significant quantities of like-quality oil in the same field (or, if necessary to obtain a reasonable sample, from the same area).

3. The arithmetic average of other contemporaneous arm's-length contract prices for purchases or sales of significant quantities of like-quality oil in the same area or nearby areas.

4. Prices received for arm's-length spot sales of significant quantities of like-quality oil from the same field (or, if necessary to obtain a reasonable sample, from the same area), and other relevant matters.

5. A net-back method or any other reasonable method to determine value.

30 C.F.R. 206.102(c)(1)-(5) .² The first two benchmarks use posted prices, but the posted price must be actually used as the price in arm's-length purchases or sales of significant quantities of like-quality oil produced from the same field or area. The first benchmark uses the lessee's own posting if it meets that requirement and if it also is comparable to other contemporaneous posted prices meeting the same requirement. The second benchmark looks to the average of other parties' postings if they meet the foundational requirement.

For natural gas produced from Federal leases, the benchmarks for both unprocessed gas and processed gas are as follows:

1. The lessee's gross proceeds under its non-arm's-length sale or disposition, provided that those gross proceeds are equivalent to the gross proceeds derived from, or paid under, comparable arm's-length contracts for purchases, sales, or dispositions of like-quality gas in the same field (or, if necessary to obtain a reasonable sample, from the same area). (Criteria for determining comparability then followed.)

2. A value determined by considering other information relevant in valuing like-quality gas, including gross proceeds under arm's-length contracts for like-quality gas in the same field or nearby fields or areas, posted prices for gas, prices received in arm's-length spot sales, and other reliable public sources of price or market information.

3. A net-back method or any other reasonable method to determine value.

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30 C.F.R. 206.152(h) (unprocessed gas) and 206.153(h) (processed gas).³ Under these benchmarks, as a practical matter, if the lessee's non-arm's-length proceeds are not equivalent to arm's-length gross proceeds under comparable arm's-length contracts, the value ultimately determined would depend on the facts and what other information is available. In many cases, the most practical alternative under the second benchmark may be to use spot prices. We will return to a discussion of the benchmarks below.

Both the oil and gas rules contain a provision that under no circumstances shall the value of production be less than the gross proceeds accruing to the lessee, less applicable allowances (i.e., transportation and processing allowances).⁴ In the context on non-wholly-owned or non-wholly-commonly-owned affiliate sales, this provision may have a different effect than in the context of transfers to wholly-owned or wholly-commonly-owned affiliates. (For a complete discussion of oil valuation in the context of transfers to wholly-owned or wholly-commonly-owned affiliates, including the role and effect of the gross proceeds requirement, see the decision of the Assistant Secretary for Land and Minerals Management, in which the Secretary concurred, in Texaco Exploration and Production, Inc., Docket No. MMS-92-0306-O&G (May 18, 1999).⁵ )

II. DETERMINING WHETHER A CONTRACT IS AT ARM'S LENGTH

The first issue that arises in the context of sales or transfers to so-called "joint venture" affiliates is whether the contract between the lessee-producer and an entity in which it owns an interest is a non-arm's-length...