ONRR ROYALTY UPDATE: PROPOSED REGULATIONS FOR OIL AND GAS VALUATION; CIVIL PENALTIES

• Jurisdiction: United States

Federal Offshore Regulatory Enforcement
(Jan 2016)
CHAPTER 13B
ONRR ROYALTY UPDATE: PROPOSED REGULATIONS FOR OIL AND GAS VALUATION; CIVIL PENALTIES

Peter J. Schaumberg
Principal
Beveridge & Diamond PC
Washington, DC

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PETER J. SCHAUMBERG is a principal with Beveridge & Diamond, P.C. in Washington, D.C. His practice focuses on issues related to development of energy resources on the Outer Continental Shelf and on federally managed lands onshore, including oil & gas, solar, wind and geothermal resources, as well as development of coal and hard-rock mineral resources on public lands. He also advises clients with respect to royalty reporting and payment issues for federal mineral leases offshore and onshore, and for Indian leases. Mr. Schaumberg joined Beveridge & Diamond in 2006 after 25 years with the Office of the Solicitor, Department of the Interior. He was the Deputy Associate Solicitor for Mineral Resources, the senior career attorney responsible for providing legal advice to the energy, minerals and royalty programs of the Minerals Management Service (now the Bureau of Ocean Energy Management, the Bureau of Safety and Environmental Enforcement, and the Office of Natural Resources Revenue), and the Bureau of Land Management. Mr. Schaumberg has written and lectured on a wide range of legal topics relating to federal mineral royalties and development of oil & gas, coal, hard-rock minerals, and alternative energy on federally managed lands. He is a member of the American Bar Association's Section of Environment, Energy and Resources and the Rocky Mountain Mineral Law Foundation, and is the Chair of the Public Lands Committee of the DC Bar's Environment, Energy & Natural Resources Section. He earned his J.D., with Honors, in 1975 from George Washington University National Law Center, and his B.A., cum laude, in 1972 from Tulane University. He is admitted to the bars of the District of Columbia and the U.S. Supreme Court.

I. INTRODUCTION

The Office of Natural Resources Revenue ("ONRR") in the U.S. Department of the Interior is responsible for accounting for and collecting royalty payments owed on production from onshore federal and Indian oil and gas leases, and from federal leases on the Outer Continental Shelf ("OCS"). For OCS oil and gas leases issued under the authority of the Outer Continental Shelf Lands Act ("OCSLA"), 43 U.S.C. § 1331 et seq., Congress established minimum royalty rates for oil and gas leases,¹ but provided no detailed guidance relating to the standards the Secretary of the Interior must apply in determining the value for royalty purposes of production from those leases.² The OCS lease form likewise generally reserves the authority to the Secretary of the Interior to establish the value of production for royalty purposes through rulemaking.

ONRR regulations detailing the requirements for lessees to establish the value of their production for royalty purposes are found at 30 C.F.R. Part 1206. ONRR's oil valuation regulations at 30 C.F.R. Part 1206, subpart C, were last significantly revised in 2000, but the gas valuation provisions at 30 C.F.R. Part 1206, subpart D have been in place substantially in their current form since 1988. On January 6, 2015, ONRR issued a Proposed Rule entitled "Consolidated Federal Oil & Gas and Federal & Indian Coal Valuation Reform."³ This rule would significantly alter regulations applicable to gas valuation for royalty reporting and payment by oil and gas lessees on federal lands onshore and on the OCS. It also would materially amend the corresponding regulations governing oil valuation last overhauled in 2000.

ONRR is also proposing to amend its civil penalty regulations applicable to reporting and payment of royalties. Congress enacted the Federal Oil and Gas Royalty Management Act,

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30 U.S.C. § 1701 et seq. ("FOGRMA"), as a response to allegations in the late 1970s and early 1980s that federal and Indian oil and gas lessees effectively were on an "honor system," and that there existed significant underpayment of royalties and theft of production.⁴ The Linowes Commission, which was created to assess the status of royalty payments and accounting, recognized that "[f]urther possibilities exist for 'paper theft.'"⁵ FOGRMA provided the Secretary of the Interior with new auditing, reporting, record keeping, and civil penalty authority - where no civil penalty system previously existed - to address the concerns identified by the Linowes Commission.

The existing ONRR regulations implementing the FOGRMA civil penalty authority in 30 C.F.R. Part 1241 have been largely unchanged since 1999. On May 20, 2014, ONRR issued a Proposed Rule entitled "Amendments to Civil Penalty Regulations."⁶ This proposed rule would establish a comprehensive set of new FOGRMA civil penalty regulations applicable to royalty reporting and payment by federal oil and gas lessees (and other lessees) on federal lands onshore and on the OCS, and on Indian leases. The proposed rule would also codify ONRR's interpretations of its civil penalty authority that the agency has sought to apply in individual cases in recent years.

To put into context the principal changes to the oil valuation, gas valuation and civil penalty regulations that ONRR is proposing, below is a summary of the current regulatory standards and procedures. The ONRR valuation and civil penalty regulations are complex, and a full explication of their existing structure and purpose is beyond the scope of this paper.

A. Gas Valuation

ONRR's existing gas valuation regulations are set out in 30 C.F.R. §§ 1206.151 -.160. The applicable valuation methodology is governed by two threshold considerations, i.e., whether (1) the gas is sold before it is processed at a gas processing plant;⁷ and (2) the disposition of gas and any gas plant products is at arm's-length or non-arm's-length. For gas the lessee sells prior to processing, if the sale is at arm's-length then the lessee's "gross proceeds" (the total consideration it receives for the sale of the gas) generally determine value for royalty purposes.⁸ 30 C.F.R. § 1206.152(b) . The lessee also is entitled to an allowance for the costs of transporting

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the gas from the lease on the OCS to a sales point off the lease, which effectively adjusts the royalty value to the value at the lease. If the lessee pays for transportation under an arm's-length transportation agreement, it may deduct the price it pays the pipeline operator under that agreement. 30 C.F.R. § 1206.157(a) . If the lessee's transportation is non-arm's-length (e.g., the lessee has an ownership interest in the pipeline), then the transportation allowance is based on the lessee's reasonable, actual costs to construct, maintain, and operate the pipeline. 30 C.F.R. § 1206.157(b) .

If the lessee disposes of its gas pursuant to a non-arm's-length transaction, then valuation is based on a hierarchical series of benchmarks, meaning that the first applicable benchmark must be used to determine the royalty value. 30 C.F.R. § 1206.152(c) . The first enumerated benchmark is the lessee's gross proceeds pursuant to its non-arm's-length sale, provided those gross proceeds are equivalent to the gross proceeds under comparable arm's-length purchases or sales in the same field or area. Thus, the lessee may use the proceeds it receives under its non-arms-length transaction provided the lessee can demonstrate comparability to other of its purchases or sales, or those of third-parties, in the same field or area.

If the lessee cannot apply the first benchmark, then the second benchmark determines value through consideration of other relevant information such as sales prices under arm's-length contracts for like-quality gas, posted prices, arm's-length spot sale prices, or other reliable public sources of information. If neither of the first two benchmarks applies, the final benchmark is a net-back method or any other reasonable method to determine value. Under no circumstances may the value of production for royalty purposes be less than the lessee's gross proceeds from its disposition of the gas. 30 C.F.R. § 1206.152(h) .

If the lessee processes its gas prior to sale, then valuation is governed by 30 C.F.R. § 1206.153 . Residue gas and gas plant products that result from processing are valued under the same procedures as unprocessed gas depending on whether the sale is arm's-length (gross proceeds) or non-arm's-length (benchmarks), with applicable allowances for transportation that occurs prior to sale. 30 C.F.R. § 1206.153(b) and (c). The lessee also may deduct an allowance for the costs of processing in determining the value of gas plant products (but generally not for residue gas). If the lessee pays for processing under an arm's-length processing agreement, it may deduct the price it pays the plant operator under that agreement. 30 C.F.R. § 1206.159(a) . If the lessee's processing is non-arm's-length (e.g., the lessee has an ownership interest in the processing plant), then the processing allowance is based on the lessee's reasonable, actual costs to construct, maintain, and operate the plant. 30 C.F.R. § 1206.159(b) . Like with unprocessed gas, under no circumstances may the value for royalty purposes be less than the gross proceeds accruing to the lessee for the residue gas or gas plant products, whether disposed of under an arm's-length or non-arm's-length agreement. 30 C.F.R. § 1206.253(h) . The regulations are structured to provide as much certainty as possible to the lessee on how its production must be valued for royalty purposes, largely by reliance on arm's-length contract prices.

B. Oil Valuation

When ONRR's predecessor, the Minerals Management Service ("MMS"), comprehensively revised the royalty valuation regulations in 1988, the oil valuation regulations were structured functionally the same as the gas valuation regulations - gross proceeds for

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