IMPACT OF MARGINAL PROPERTIES ON CALIFORNIA ROYALTIES

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management Book 1
(Feb 2004)
CHAPTER 11A
IMPACT OF MARGINAL PROPERTIES ON CALIFORNIA ROYALTIES
Jerry McClain
Special Audit Bureau, Division of Audits
California State Controllers Office
Sacramento, California

The primary focus of our discussion is the provisions for marginal property relief as established by the Royalty Simplification and Fairness Act of 1996 (RSFA). My co-speakers have approached this discussion from the perspective of the actions taken by the Royalty Policy Committee (RPC) Subcommittee on Marginal Properties and the manner in which industry will utilize the alternative accounting relief as proposed by Section 7(b) and 7(c) of RSFA. My co-speakers have succinctly described the Subcommittee's efforts to develop guidelines to enable industry and the states to incorporate the provisions of the marginal property relief to accomplish the objectives of Sections 7(b) and 7(c).

However, I would like to discuss marginal properties from the perspective of the impact that marginal properties have on royalties in the State of California. The stated purpose of granting relief under Section 7 of RSFA is to promote production, reduce administrative costs, and increase net receipts to the United States and the States. From California's perspective, the concept of providing alternative accounting relief under the provisions of Section 7 does not achieve one of the main objectives considered by the provisions, the increase of net receipts to the United States and the States.

Certainly, the marginal property rules were established to provide an incentive for industry to continue operating properties in which there is marginal return on its investment. The concern was that operators would shut-in wells that required enhanced oil recovery rather than incur costs that would yield a marginal profit. By providing relief, i.e. reduced royalty rates for stripper wells or heavy oil, the operator would continue to produce from these marginal properties. It would be reasonable to assume that if operators continue to produce on marginal properties, there would be an increase in net receipts.

At the time that the marginal property provisions were put into place it was a necessary course of action because the United States strategic petroleum reserves were being rapidly depleted and the United States was becoming increasingly dependent on imported oils. However, in the current environment, the United States strategic petroleum reserves are not longer being depleted as rapidly, yet the marginal property provisions that were developed during the period crisis still remain in effect. Today, industry continues to derive the greatest benefit from the marginal property provisions while the net receipts to United States and the States are declining significantly.

Oil royalty revenues paid on federal leases provide a significant source of funding for education in the State of California. Because of the inherent nature of crude oil in California there are a significant number of leases that meet the requirements to qualify as a marginal property. Consequently, since its inception the marginal property rules have had a major impact on California's oil royalty revenues. In our viewpoint, the marginal property provisions should consider other alternatives to increase net receipts.

A marginal property is defined as a lease that produces on average the combined equivalent of less than 15 barrels of oil equivalents (BOE) per well per day or 90 thousand cubic feet of gas per well per day. There are approximately 150 qualifying marginal properties in the State California. These properties consist of non-agreement and agreement properties. The properties all qualify for the stripper-well or heavy oil reduced royalty rates, ranging from 2.1 to 9.3 percent. Based on the royalty relief provided to industry, California's oil royalty revenues continue to decrease and its education funding suffers tremendously.

An analysis was performed for production and royalties paid on the non-agreement properties over the past five years (1998 - 2002). This encompassed 131 leases and the source of the information was the Minerals Revenue Management (MRM) royalty management database. The total production for the marginal properties was 28,903,545 BOE and total royalties paid was $36,996,827 during the period 1998 - 2002. Table I, identifies the total production and royalties paid for California marginal properties.

Of the 131 leases, 20 leases were selected to perform further analysis to determine if production and royalties increased or decreased over the period. These leases were judgmentally selected based on the individual leases total production and royalties paid during period. For purposes of this discussion, these leases are considered as material. The total production and royalties paid for these leases were 25,127,772 BOE and $32,899,000, which represents 96.94% and 88.92% of the marginal property universe, respectively. Table II...