FEDERAL GAS VALUATION - REVISITING AN OLD FRIEND IN A NEW MILLENNIUM 1

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management Book 1
(Feb 2004)
CHAPTER 17A
FEDERAL GAS VALUATION - REVISITING AN OLD FRIEND IN A NEW MILLENNIUM 1
Lawrence E. Cobb
Minerals Management Service
Denver, Colorado

Federal Gas Valuation Regulations - A Brief Look Back

The Federal gas valuation regulations turn sweet sixteen in two weeks. They haven't so much learned to drive but rather to survive. Their counterparts, the Federal oil rule and the Indian gas rule, have already been transformed into markedly different market-based regulations. Effective since March 1, 1988, the Federal gas regulations essentially tie the value of non-arm's-length transactions to a benchmark system to determine market value for royalty purposes. Value for arm's-length transactions is based on the gross proceeds accruing to the lessee from the disposition of the gas.

The first benchmark provides that the lessee's gross proceeds received under its non-arm's-length contract establish value if they are equivalent to the gross proceeds accruing under comparable arm's-length contracts in the same field or area. Only if the first benchmark does not apply would the lessee then employ the second benchmark. The second benchmark provides for a value determined by other information relevant in valuing like-quality gas, such as non-equivalent arm's-length gross proceeds, arm's-length spot prices, or other public sources of price or market information. ²

While the benchmarks have been the pillar of non-arm's-length valuation, they have been the subject of much controversy and debate over the years. In fact, shortly after they were published, the Department issued clarifying guidance regarding their applicability where sellers and purchasers in the producing field were either affiliated or not affiliated with the lessee. These types of questions led to a whole range of questions under the first benchmark regarding what constitutes a "comparable" arm's-length contract in the field or area:

1. What contract factors, such as price, term, volume, and market served, etc. should be considered when evaluating comparability?

2. What about availability of comparable contract data?

3. How is value determined if there is a "range" of gross proceeds under comparable arm's-length contracts?

4. What are the expectations for lessees to obtain, or attempt to obtain, comparable sales data? How do MMS auditors collect, verify, or even assess the necessary data to determine value?

5. When is the first benchmark deemed inapplicable so that the second benchmark can be used?

To date, though, no alternative method has been able to successfully replace that system. In late 1991, MMS published a proposed rule in the Federal Register to address some of these concerns. ³ This proposal never was finalized, but eventually led to the creation of the Federal Gas Valuation Negotiated Rulemaking Committee in 1993.

The Federal Gas Valuation "Reg Neg", as it was commonly called, was a pioneering effort chartered by the Secretary of the Interior to involve States, major and independent producers, and MMS in a consensus-building decision-making effort to simplify and streamline gas valuation in non-arm's-length situations. The Federal Reg Neg Committee convened for a 2-year period and developed several proposals in the areas of index-based gas valuation, transportation, processing, unit agreement production allocation, and allowance reporting. In the fall of 1995, a proposed rule was published in the Federal Register outlining the proposed initiatives. ⁴ The proposals contained several methods for valuing gas, including options to trace arm's-length gross proceeds under resale and the use of multiple index points.

However, there were still concerns among various constituent groups that index pricing may not capture fair market value. There were questions whether index prices had fully matured in the marketplace and how much of the overall gas market they represented only a small portion of sales in the market (spot sales were believed to be less than 30 percent of the total market). A limited discussion also arose regarding the vulnerability of index prices being misreported because of their impact on market positions. Manipulation of the election process (choosing the gross proceeds or index method) also presented some worries. Chief amongst the concerns was that the election process would skew the royalty...