NON-ARM'S-LENGTH GAS VALUATION STANDARDS - REVISION OR THE STATUS QUO?

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management Book 1
(Feb 2004)
CHAPTER 17B
NON-ARM'S-LENGTH GAS VALUATION STANDARDS - REVISION OR THE STATUS QUO?
Thomas J. Eastment ¹
Baker Botts L.L.P.
Washington, D.C.

This paper examines the current rules of the Minerals Management Service ("MMS") for the valuation of natural gas sold or transferred under non-arm's-length arrangements, and assesses the need for their revision. The analysis focuses in particular on the potential valuation of such gas on the basis of published price indices in the aftermath of the collapse of MMS' negotiated rulemaking, ² the decision of the United States Court of Appeals for the District of Columbia Circuit in Fina, ³ and the recent revelations of the manipulation of published index prices.

A. The Existing Regulations.

MMS defines an "arm's-length contract" in its oil and gas valuation regulations as "a contract or agreement that has been arrived at in the marketplace between independent, non-affiliated persons with opposing economic interests regarding the contract." ⁴ An entity is "affiliated" with another entity when one "controls" the other or when both are under common control. ⁵ MMS presumes that ownership of less than 10 percent does not constitute control, but presumes that ownership of 10 to 50 percent constitutes control. ⁶ Ownership of over 50 percent is deemed to constitute control. ⁷

A presumption of control for ownership interests between 10 and 50 percent, set out in the United States Department of Interior regulations issued under the Surface Mining Control and Reclamation Act of 1977, was rejected in National Mining Ass'n v. United States Dep't of the Interior. ⁸ However, MMS has never eliminated the presumption from its oil and gas valuation regulations.

For gas sold or transferred under non-arm's-length arrangements, value is equal to the higher of the "gross proceeds accruing to the lessee" or a value established under a benchmark system. ⁹ The heart of the benchmark system is the valuation of gas at fair market value. Although arm's-length sales are presumed to reflect fair market value, ¹⁰ non-arm's-length sales prices are accepted as the basis for value only when they are equivalent to arm's-length sales prices. Using prices received in arm's-length transactions, the benchmarks are intended to provide a standardized analytical framework to determine fair market value for gas sold or transferred under non-arm's-length arrangements.

Under the benchmark system, gas sold under non-arm's-length arrangements is valued in accordance with the first applicable of three valuation standards. ¹¹ The first benchmark states:

The gross proceeds accruing to the lessee pursuant to a sale under its non-arm's-length contract . . . 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 other dispositions of like-quality gas in the same field (or, if necessary to obtain a reasonable sample, from the same area). ¹²

To determine whether such non-arm's length contracts are comparable to arm's-length contracts, the following factors are considered: "price, time of execution, duration, market or markets served, terms, quality of gas, volume, and such other factors as may be appropriate to reflect the value of the gas . . . ." ¹³

If the first benchmark standard cannot be applied because of the absence of a reasonable sample of comparable arm's-length contracts in the field or area, the gas is valued according to the second benchmark standard:

A value determined by consideration of 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 of gas, other reliable public sources of price or market information, and other information as to the particular lease operation or the saleability of the gas . . . . ¹⁴

If neither of the first two valuation benchmarks can be applied, the third benchmark provides that lessees must use a "net-back method or any other reasonable method" to determine the value of gas sold. ¹⁵

The objective of the benchmark system, to set royalty for gas sold under non-arm's-length arrangements based on its fair market value, reflects agency case law prior to the 1988 Rules. In Getty Oil Co., ¹⁶ the Interior Board of Land Appeals ("IBLA"), holding that a parent corporation and its wholly-owned subsidiary may enter into a valid contract, opined that:

Although contracts between a parent corporation and its subsidiary may not be at arm's length, they may result in a fair market price. If a transaction is not at arm's length, some other manifestation that the price is nonetheless an accurate portrayal of the article's worth is required. It must be a price which independent buyers in arm's length transactions would be willing to pay. (citation omitted) Inasmuch as the auditors clearly found that the price obtained by Getty pursuant to the gas purchase contract represented fair market value, and recognized that royalty was tendered for the gas . . . at the same rate, it seems clear to us that the price provided . . . was the fair market price. ¹⁷

In Mobil Oil Corp., ¹⁸ the IBLA again held that the appropriate basis for royalties on gas or products sold under non-arm's-length arrangements is fair market value. The IBLA reversed orders of the MMS that assessed additional royalties and penalties for Mobil's alleged underpayment of royalties on natural gas liquid products ("NGLP") derived from natural gas produced on the Outer Continental Shelf ("OCS"). The MMS noted that Mobil's intra-company transfer prices were less than the lowest relevant spot market price, and directed Mobil to pay additional royalties computed on the basis of the average of the lowest and highest relevant spot-market prices.

The valuation of non-arm's-length NGLP was governed by the MMS' "Procedure Paper on Natural Gas NGLP Valuation" ("Procedure Paper"). As the IBLA described it, the MMS Procedure Paper provided that:

where there is no contract or a contract is not at arm's-length, the price used to value the NGLP will be acceptable if it is above the lowest spot market price. If, however, the price is below the lowest spot market price, value for royalty purposes is set by the procedure paper at the average of spot market prices from a relevant geographical area. ¹⁹

The IBLA agreed with Mobil that such an application of the Procedure Paper was unlawful. Quoting its decision in Conoco Inc. ²⁰ the IBLA held that:

'ÝA¨cceptance of any price within the range of the low to the high spot market price Ýeven as low as the lowest market price¨ as constituting fair market value is inconsistent with requiring payment of the average spot market price where the lessee's . . . price is less than the floor value . . . . If the average spot market price rather than the floor price constituted fair market value, then MMS would be without authority under the statute and regulation to accept Ýroyalties based on¨ prices as low as the floor price as the Procedure Paper indicates MMS has done.' ²¹

The IBLA concluded:

Thus, in Conoco, we held that MMS could not justifiably conclude that the average, rather than the lowest, spot market price was fair market value, and that the lowest spot market price should be deemed to constitute fair market value where the settlement price falls below the lowest price. . . . That is the approach which we adopt here. ²²

These cases demonstrate that royalty valuation for gas and liquid products sold under non-arm's-length arrangements was based on available data relating to arm's-length prices well before the 1988 Rules. This reflects the well-founded recognition that such data is the best available measure of fair market value.

B. MMS Effort to Clarify the Benchmarks.

Although the benchmark system adopted in 1988 was soundly founded on the fair market value of gas as reflected in the prices for gas sold under arm's-length arrangements, issues quickly arose in the application of the system. MMS' initial response to these issues was to attempt to clarify the benchmarks in order to address practical difficulties in their application. In particular, the first benchmark looks to the gross proceeds paid under "comparable arm's-length contracts" for purchases or sales of "like-quality gas" in the same field or area. ²³ But MMS and royalty payors quickly realized that lessees have limited access to the gross proceeds received in gas sales to which they are not a party. So where does a lessee look to find comparable arm's-length prices under the first benchmark? And when data is available, what price is used when the available data reflect a range of arm's-length prices? These questions led to the October 1988 and December 1988 Policy Interpretations that clarified that a lessee's non-arm's-length gross proceeds would be accepted as the value for gas provided that they fell within the range of gross proceeds derived under arm's-length contracts, and that the lessee could look to the gross proceeds derived from arm's-length contracts between unaffiliated sellers and affiliated purchasers.

In its October 1988 Policy Interpretation, the Department of the Interior addressed the manner in which MMS will enforce the benchmark system contained in the gas valuation regulations. The Policy Interpretation stated that:

In recognition of the realities of the gas marketplace, it shall be the policy of the Department of Interior that the gross proceeds accruing to a lessee under its non-arm's length contract shall be viewed as meeting the requirements of Ýthe first benchmark standard¨ if they are within the range of the gross proceeds derived from or paid under comparable arm's-length contracts between parties not affiliated with the...