ROYALTY IN KIND: THE CRUDE OIL PURCHASER'S PERSPECTIVE
| Jurisdiction | United States |
(Feb 1998)
ROYALTY IN KIND: THE CRUDE OIL PURCHASER'S PERSPECTIVE
Vice President and General Counsel
Scurlock Permian LLC
Houston, Texas
February, 1998
This paper is intended to present the perspective and comments of an independent crude oil purchaser on the sale and valuation of federal royalty oil with emphasis on the government taking royalty oil in kind. By notice of proposed rulemaking published in the Federal Register on January 24, 1997 (62 Fed. Reg. 3742) and September 22, 1997 (62 Fed. Reg. 49460), the Minerals Management Service (MMS) of the U.S. Department of the Interior has proposed rules to establish the value of royalty on federal royalty oil, that is royalty due the MMS for its share of production on federal leases.
The proposed rules have been suggested due to dissatisfaction of the MMS with posted prices set by various producers, refiners and purchasers. Posted prices are the values assigned to oil by industry participants in the marketplace. By these proposed rules, the MMS would substitute its procedure for the marketplace's assignment of value to oil. The MMS states explicitly in the Federal Register the agency's intent and conclusion:
These changes will decrease reliance on oil posted prices and assign a value to crude oil that better reflects market value. 62 Fed. Reg. 3742
Overview
Generally, domestic oil production is valued at the wellhead. The MMS proposed rules intend to change the location at which oil is valued away from the wellhead, which is the established point of sale where title is transferred, to a location distant from the well, such as a market center or an aggregation point and change pricing methods. Aggregation points will be designated in lists to be published by the MMS. This approach practically ignores the existence of companies such as Scurlock Permian LLC (Scurlock) which purchase oil at the wellhead. Rules which would price oil at locations other than the wellhead based on benchmarks would appear to eliminate Scurlock as a purchaser for federal oil. If this practice were adopted by other oil sellers, Scurlock's existence and that of other midstream companies like Scurlock would be severely threatened. Scurlock submits that this situation is not good for the MMS as well. By taking its royalty in kind, rather than in value, the MMS will avoid the imposition of inaccurate benchmarks and problematic adjustments, and will receive market value by virtue of arm's length first sales conducted by the MMS itself at the lease. Royalty in kind results in the assignment of value to federal oil by the marketplace and mutual agreement, rather than by either the MMS alone or oil companies alone (via posted prices). A royalty-in-kind program would be a competitive bid program.
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Scurlock Competes To Purchase Crude Oil In the Producing Field
Scurlock is one of the largest gatherers and marketers of crude oil in the United States. Scurlock employs over 900 people with operations in 15 states. Scurlock operates more than 2,400 miles of active crude oil gathering lines and pipelines, and a fleet of more than 300 tractor trailers to gather crude oil. Scurlock also has crude oil tankage at 154 onshore terminal locations plus 12 marine terminals. Scurlock is based in Houston, Texas.
Scurlock is a third-party purchaser of crude oil. Scurlock is neither a lessor nor a lessee nor an operator. Scurlock gathers and resells crude oil in downstream markets, moving the oil in its own system via its gathering lines or trucks, or contracting with other companies either to exchange oil or to transport oil as common carriers. As part of their purchase contract obligations, companies like Scurlock often pay federal royalties on behalf of lessees or operators from whom they buy crude oil. Scurlock pays royalties on the same basis as it pays the field production operator and working interest owners. This basis is an arm's-length negotiated price. A portion of Scurlock's crude oil purchases are resold to a refinery affiliate (in our case, Scurlock's parent company, Marathon Ashland Petroleum LLC). The majority of Scurlock's crude purchases, however, are resold to unaffiliated refiners and other buyers in downstream markets. Scurlock's margin, of course, is the difference between the price it pays in the field (or other location) and the price received downstream.
Scurlock and many other companies compete fiercely to purchase crude oil at the lease. Many willing buyers are active not just in the major fields, but also in the hundreds of out-of-the-way locations where crude oil is sold in truckload quantities and where transportation costs of purchased crude are especially high.
Purchasers like Scurlock will buy production volumes from locations which are often remote, aggregate the crude oil into larger volumes in their inventories, and deliver the oil to downstream resale markets. Scurlock is a market for even the marginal producing well. Scurlock's purchasing service provides many lessees with an efficient alternative to the cost of transporting crude oil themselves, which might otherwise prove too expensive for many marginal wells. As a purchaser, Scurlock takes the oil it buys into various inventory locations it maintains, and generally, resells different volumes of oil at other inventory locations it also maintains. A large and costly investment in crude oil inventories is required for this operation. This aggregation service is a key value Scurlock and other midstream marketers add that the proposed rule erroneously fails to consider and recognize, but which would work to the advantage of the MMS if Scurlock could bid to purchase federal oil from the MMS under a royalty-in-kind sales program.
Purchasers Like Scurlock Would Be Seriously Disadvantaged By the Proposed Rule
By its contemplation of benchmarks, indexes based on MMS data, NYMEX differentials, and published spot prices, the MMS is suggesting a rule that disallows negotiated prices in oil valuation. This would create inefficiencies in the general market and would be particularly unfair to midstream companies such as Scurlock. As do other purchasers, Scurlock negotiates with crude oil sellers taking into account various local factors affecting price, including quality, gravity, location, lease access, and numerous competitive factors, including resale market conditions, supply and demand, inventory issues, and other considerations. Another consideration may be that Scurlock, for example, might be willing to pay a higher price for
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contracts with a longer term, such as six months. Of course, if Scurlock's price is not considered adequate, then neither the operator nor the lessee is compelled to sell to Scurlock. Alternatively, non-operators may be able to take their royalty in kind under many leases.
Why should a purchaser be forced to pay royalties based on unrelated NYMEX future sales by unrelated parties in unrelated downstream markets? Scurlock should be able to negotiate or bid for federal lease oil based on Scurlock's unilateral assessment of the value of oil under circumstances where the seller is free to decline Scurlock's offer. Why should Scurlock be forced to let the NYMEX dictate oil prices Scurlock must pay in production fields where circumstances are different and the locations far from Cushing? Again, the lessee or the operator can reject any offer from Scurlock and sell to others. Just as the MMS would argue that posted prices from the majors or purchasers are not acceptable, the purchasers can argue that benchmarks and artificially determined adjustments would be just as objectionable to them. Royalty-in-kind sales would avoid this problem, yet leave the MMS to accept or reject only the price it could obtain in its bid procedure.
Since Scurlock buys oil in arm's-length transactions, the proposed rule for valuation of crude oil using downstream futures prices with artificial transportation adjustments layered on would complicate Scurlock's business activity and greatly increase transactional costs. The MMS should simply look to offers or bids accepted from third-party purchasers as the reference price. The market offered by the third party necessarily reflects and responds to the ultimate resale markets. Competition among the third party purchasers is the best indicator of a fair and true value for crude oil in the field.
Abandoning negotiated or agreed upon prices as a basis for royalty values and imposing NYMEX prices would expose purchasers like Scurlock to aberrant or runaway paper trade activity on the NYMEX. The MMS or other parties are free to buy or sell on the NYMEX and should not impose a synthetic NYMEX trade through Scurlock at no cost or risk to the MMS via these proposed rules. If the MMS wishes to hedge upstream production values using a downstream futures price, it should pay the cost for hedge sales by selling NYMEX contracts through a broker.
The impact of federally imposed prices and related adjustments would likely be much broader than its impact on only the valuation of...
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