FEDERAL OIL VALUATION: WHERE HAVE WE BEEN?

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management Book 1
(Feb 2004)
CHAPTER 8A
FEDERAL OIL VALUATION: WHERE HAVE WE BEEN?
David T. Deal
Fulbright & Jaworski L.L.P.
Washington, D.C.
TABLE OF CONTENTS

I. GROWING IMPORTANCE OF FEDERAL ROYALTIES

II. FEDERAL OIL VALUATION RULEMAKING: 1980-2003

A. Pre-1988 Valuation

1. Federal Mineral Leasing Statutes

2. Department of the Interior Product Valuation Guidance and Regulations

3. Linowes Commission

4. Federal Oil and Gas Royalty Management Act

B. 1988 Rulemaking (1986-1988)

1. Royalty Management Advisory Committee

2. 1988 Oil Valuation Rule

C. Bridging Events (1988-1996)

1. Royalty-in-Kind

2. Federal Oil and Gas Royalty Simplification and Fairness Act

3. Interagency Report on Valuation of Oil

D. 2000 Rulemaking (1997-2000)

1. False Claims Act Litigation

2. 2000 Oil Valuation Rule

I. Growing Importance of Federal Royalties

The United States is the third largest oil producer behind only Saudi Arabia and Russia, a fact masked by this nation's increasingly huge energy demand and its need to import now over 60 percent of its crude oil supply. The over 2 billion barrels of oil per year produced domestically comes from about 555,000 individual wells. Stripper wells, producing on average only 2 barrels per day, account for nearly 15 percent of the total. Although major oil companies employ most exploration and production workers, independent producers account for nearly 40 percent of oil production.

Overall, domestic oil production is on the decline, peaking at 9.6 million barrels per day in 1970 and dropping to 5.7 million barrels per day in 2002. Oil is produced in 33 of the 50 states with the heaviest concentration in 5 states and the Outer Continental Shelf (OCS). While state, private and Native American lands still account for most domestic oil production, oil production on federal lands now accounts for about 30 percent of domestic crude oil production, up sharply from less than 15 percent in 1980. About 2,000 offshore leases account for about 75 percent of federal oil production, about 24,000 onshore leases for the remaining 25 percent. For Fiscal Year 2003, federal oil and gas royalties totaled about $5.6 billion, $4.08 billion from federal gas and about $1.52 billion from federal oil. ¹

Other economic, technological and policy factors underscore the significance of oil produced from federal lands. State coffers, full not too many years ago, have fallen very low, exacerbating state reliance on federal royalty dollars. For federal production onshore in the lower 48 states, states get 50 percent of the royalties collected for federal production within their borders; ² for Alaska the share is 90 percent. ³ For federal offshore production, OCS royalties are not shared with the states generally, although since 1985 coastal states get 27 percent of the royalties for adjacent federal production on the OCS production within three miles of their seaward boundaries. ⁴

Because of dramatic improvements in exploration technology (e.g., 3-D seismic imaging) and production technology (e.g., directional drilling), current reserve estimates have been adjusted upward and show that about 129 billion barrels of oil remain to be produced in the United States, with 103 billion barrels in frontier areas, of which about 99 billion barrels are on federal lands. ⁵ Indeed, with DOE's Energy Information Agency predicting that by 2025 overall domestic crude oil production will fall by 18 percent, against dramatic increases in energy demand, ⁶ the spotlight on federal oil production is brighter than ever.

However, massive tracts of federal public lands are not open to oil exploration or production for environmental reasons: all or part of every OCS region (the Atlantic Coast, the Pacific Coast and the Gulf of Mexico) and myriad onshore lands designated as wilderness or the equivalent. Some of these excluded areas are subject to moratoria imposed to prevent energy development for environmental reasons. Other excluded areas have been classified under special statutes or authorities and dedicated to specific uses that preclude oil and gas development: wilderness, national parks, national monuments, marine sanctuaries, military areas, etc. These withdrawals of federal lands put an estimated 1/3 of the recoverable oil reserves off limits, at least for now.

Bottom line: Federal crude oil production and the associated royalty collections are increasing, although not as fast as they could, and federal royalty collection can be expected to intensify in the future.

II. Federal Oil Valuation Rulemaking: 1980-2003⁷

A. Pre-1988 Valuation

1. Federal Mineral Leasing Statutes. The Mineral Leasing Act (MLA) ⁸ and the Outer Continental Shelf Lands Act (OCSLA) ⁹ are the starting point for valuation of production on federal lands for royalty purposes. The MLA prescribes "royalty at a rate of not less than 12.5 percent in amount or value of the production removed or sold from the lease." ¹⁰ Although the OCSLA prescribes a variety of bidding systems allowing of some different royalty arrangements, ¹¹ it similarly prescribes that royalty shall be "in amount or value of the production saved, removed, or sold." ¹² And while the OCSLA like the MLA prescribes a minimum royalty rate of 12%p1/2%p percent, most OCS leases prescribe a royalty rate of 16 2/3 percent, probably tracking the royalty rates employed in pre-OCSLA state-managed offshore leases.

Conspicuously absent, however, in either the MLA or OCSLA is any language which articulates what the term "value" means. ¹³ While agency decisions must satisfy the generally applicable requirements of the Administrative Procedure Act, ¹⁴ this long-standing, but undefined, production-oriented royalty language leaves the Secretary to exercise general authority to issue guidance and regulations addressing valuation of production and the calculation of royalty payments. Notwithstanding occasional legislative initiatives, this royalty language has gone unchanged, which explains why Minerals Management Service (MMS) valuation rulemaking, guidance, agency adjudications, internal policies and court decisions are so important in determining the specifics of royalty obligations.

2. Department of the Interior Product Valuation Guidance and Regulations. Prior to the 1988 rulemaking, product valuation had undergone a complex evolution. ¹⁵ Although the entry of public lands for extraction of "petroleum or other mineral oils" was technically possible under 19%gth%g century mining laws, the Oil Placer Act of 1897 ¹⁶ brought an end to that until the MLA was enacted in 1920.

There follows for the next 68 years a history involving several predecessors to the MMS, ¹⁷ and a tangle of regulations, guidance, Notices-to-Lessees, agency decisions and court decisions within which are embedded precursors of many of the valuation principles still prominent on the product valuation landscape. For example, a marketable condition-like provision appears in the Bureau of Mines 1921 and 1923 regulations. ¹⁸ Provisions for marketable condition and gross proceeds as a minimum value appear in the USGS regulations of 1936. ¹⁹ Allusions to "the price received by the lessee," "posted prices," and "other relevant matters" as measures of value appear in the USGS regulations of 1942 and 1954. ²⁰

Over this same period, several key agency and court decisions affecting oil (and gas) valuation today emerged as well: Continental Oil Co. v United States, ²¹ California Co. v. Udall, ²² Wheless Drilling Company, ²³ Hoover & Bracken, ²⁴ Marathon Oil Company v. Andrus, ²⁵ and Amoco Production Co. v. Andrus. ²⁶

3. Linowes Commission. Establishment of the Linowes Commission in 1981 and publication of its Report "Fiscal Accountability of the Nation's Energy Resources" (Linowes Commission Report) in 1982 began the transition to modern royalty valuation. While its formation was triggered by reports of oil theft on Indian lands, the Commission's proceedings and report were not so limited. The Commission Report's recommendations fell into several categories, ²⁷ but devoted little energy to valuation per se. It observed that gas valuation seemed to pose the greatest difficulty, that valuation problems occurred more often where non-arm's length transactions or regulated prices were involved, and that industry needed - and sought - production valuation guidance. ²⁸

4. Federal Oil and Gas Royalty Management Act. One recommendation the Linowes Commission did make was the drafting of an Omnibus Royalty Management Improvement Act, and in 1983 Congress enacted the Federal Oil and Gas Royalty Management Act (FOGRMA). ²⁹ Consistent with the Linowes Commission Report, the FOGRMA that emerged did not address oil and gas valuation per se but directed the Secretary to establish a "comprehensive inspection, collection and fiscal and production accounting and auditing system to provide the capability to accurately determine oil and gas royalties, interest, fines, penalties, fees, deposits, and other payments owed, and to collect and account for such amounts in a timely manner." While the Administration bill had suggested to Congress a valuation provision that would have prescribed gross proceeds as the standard for valuation, ³⁰ FOGRMA left untouched the core royalty language of the federal mineral leasing statutes.

B. 1988 Rulemaking (1986-1988)

1. Royalty Management Advisory Committee. Pursuant to the enactment of FOGRMA, the Secretary set about assembling the comprehensive royalty management system. Among other things, he established in 1986 a Royalty Management Advisory Committee (RMAC). Chaired by Charles J. Mankin, then Director of the Oklahoma Geological Survey and a member of the Linowes Commission, the 31-member RMAC, included representatives of industry, the states, Indian tribes and the public. Prior to the 1988 rulemaking, RMAC met several times to address the...