ROYALTY RELIEF AND INCENTIVES

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management
(Feb 2007)
CHAPTER 10A
ROYALTY RELIEF AND INCENTIVES
Geoffrey Health ¹
Assistant Solicitor, Division of Mineral Resources
Branch of Federal & Indian Royalties
Office of the Solicitor, Department of the Interior
Washington, D.C.

GEOFFREY HEATH

Geoffrey Heath is an Assistant Solicitor with the Division of Mineral Resources, Branch of Federal & Indian Royalties, Office of the Solicitor, Department of the Interior, in Washington, D.C.

Over the last several years, various types of royalty relief programs and production incentives have become very important, and in some cases have garnered considerable unfavorable attention in the media. Several agency rulemakings as well as congressional enactments have created an interesting and rather complicated patchwork of royalty relief and production incentive provisions.

In the present economic and legal environment, the onshore royalty relief programs play only a relatively small role. The offshore royalty relief programs under both specific statutory provisions and MMS regulations dominate the royalty relief landscape in terms of both covered production and monetary consequence. Nevertheless, a brief overview of the development of statutory and regulatory royalty relief provisions for both onshore and offshore leases helps in understanding the scheme in force today, including the principal provisions that this paper will discuss in greater depth.

I. GENERAL ONSHORE AND OFFSHORE ROYALTY RELIEF AUTHORITY AND ASSOCIATED RULES

A. Onshore

The Mineral Leasing Act (MLA), applicable to onshore leases, was amended in August 1946 to add the relevant provisions of 30 U.S.C. § 209, which (as subsequently amended) provides in part as follows:

The Secretary of the Interior, for the purpose of encouraging the greatest ultimate recovery of coal, oil, gas, oil shale, gilsonite . . . phosphate, sodium, potassium, and sulfur, and in the interest of conservation of natural resources, is authorized to waive, suspend, or reduce the rental, or minimum royalty, or reduce the royalty on an entire leasehold, or on any tract or portion thereof segregated for royalty purposes, whenever in his judgment it is necessary to do so in order to promote development, or whenever in his judgment the leases cannot be successfully operated under the terms provided therein. . . . (Emphasis added.)

This authority is the source of three royalty relief provisions in the Bureau of Land Management (BLM) regulations. These are:

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1. The case-by-case provisions of 43 C.F.R. § 3103.4-1, under which a royalty rate reduction may be granted upon an applicant's showing by production and financial data that it is necessary to promote development or that the leases cannot be successfully operated under their terms only one of which is relevant to current production. This reiterates the general MLA statutory standard.

2. The "stripper well" royalty rate reduction provisions of 43 C.F.R. § 3103.4-2. This program first came into effect in 1992. 57 Fed. Reg. 35,968 (August 11, 1992). Under this rule, a stripper well property eligible for a reduced royalty rate is a lease or segregated portion thereof that produces an average of less than 15 barrels of oil per eligible well per well-day. BLM published a notice on July 21, 2005 (70 Fed. Reg. 42,093) that the stripper well royalty rate reduction rule would be terminated under section 3103.4-2(b)(5) effective February 1, 2006. The Energy Policy Act of 2005 (enacted less than three weeks after BLM's termination notice was published) effectively substituted statutory marginal property royalty relief provisions for the stripper well program, as discussed below.

3. The "heavy oil" royalty rate reduction provisions of 43 C.F.R. § 3103.4-3. This program came into effect in March 1996. 61 Fed. Reg. 4748 (Feb. 8, 1996). BLM published a notice on April 27, 2005 (70 Fed. Reg. 21,810) that the heavy oil royalty relief rule would be terminated under section 3103.4-3(b)(6)(i) effective November 1, 2005. This was based on BLM's determination that the average oil price (based on the West Texas Intermediate (WTI) crude average posted prices and adjusted for inflation) remained above the $24 per barrel threshold provided in the regulation for six consecutive months.

Because both the stripper well and heavy oil programs have been discontinued, the case-by-case royalty relief available upon application and sufficient showing under 43 C.F.R. § 3103.4-1 is the only one of the three onshore royalty relief programs promulgated under the MLA's authority that is relevant to current production.

B. Offshore

The Outer Continental Shelf Lands Act (OCSLA) amendments of 1978 enacted section 8(a)(3), originally codified as 43 U.S.C. § 1337(a)(3).² It reads:

The Secretary may, in order to promote increased production on the lease area, through direct, secondary, or tertiary recovery means, reduce or eliminate any royalty or net profit share set forth in the lease for such area.

Under this general authority to promote increased production on producing leases, the Department promulgated a rule that restated the statutory standard and established a case-by-case application procedure. An applicant had to submit cost, income, and production data and "all other facts tending to show whether the wells can be successfully operated under the royalty or

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net profit share fixed in the lease." Former 30 C.F.R. § 203.50 (1995) (first promulgated in 1979).

OCSLA section 8(a)(3)'s royalty relief authority to promote increased production was expanded with the enactment of section 302 of the Deep Water Royalty Relief Act of 1995, (DWRRA), Pub. L. No. 104-58, Title III, 109 Stat. 563, 563-565. (The DWRRA is discussed extensively below.) Section 302 first redesignated section 8(a)(3), quoted above, as subparagraph (A) (section 8(a)(3)(A), 43 U.S.C. § 1337(a)(3)(A)). It then added a new subparagraph (B) (43 U.S.C. § 1337(a)(3)(B)). For leases in the Gulf of Mexico west of 87 degrees, 30 minutes West longitude, the new subparagraph (B) extended the permissible purposes of general discretionary royalty reduction beyond increasing production to include promoting development or encouraging production of marginal resources on either producing or non-producing leases. (This provision applies generally to leases within the covered geographic area and is not limited to leases located in what the DWRRA defined as deep water.)

Applying the authority of both subparagraphs (A) and (B), in a final rule published on January 16, 1998 (63 Fed. Reg. 2605, as corrected at 63 Fed. Reg. 57,249 (Oct. 27, 1998)), MMS replaced the former 30 C.F.R. § 203.50 with new provisions regarding "end-of-life" leases. 30 C.F.R. §§ 203.50 - 203.56 and 203.81 - 203.84 (1998-present). An "end-of-life" lease is one with an average daily production of at least 100 barrels of oil equivalent ("BOE") per month in at least 12 of the past 15 months. 30 C.F.R. § 203.51(a). To qualify for a royalty rate reduction under the new rule, a lessee must show in its application that the sum of royalty payments in the most recent 12 months (the "qualifying months") exceeded 75 percent of the sum of net revenues. 30 C.F.R. §§ 203.52 and 203.51(a). Section 203.54 includes a price threshold. The lessee will owe royalty on a given month's production if the difference between the weighted average of the New York Mercantile Exchange (NYMEX) daily closing prices for light sweet crude oil for the most recent12 full calendar months and the weighted average of the daily NYMEX closing prices during the qualifying 12 months exceeds 25 percent.

Subsequently, on January 15, 2002 (67 Fed. Reg. 1862), MMS added a provision for royalty relief in special circumstances. 30 C.F.R. § 203.80. A lessee may obtain royalty relief apart from end-of-life and deep water royalty relief (discussed below) if it serves the statutory purposes for relief and the formal relief programs provide inadequate encouragement to increase production or development. Under section 203.80, a lease or project must have two or more of five identified characteristics to qualify for relief. (For example, a lessee may show that it can recover enough additional resources to produce for at least a year more than would be profitable without royalty relief, or valuable facilities exist that MMS would not expect a successor lessee to use, etc.)

MMS has granted approximately 12 applications for reduction in royalty rates under the end-of-life and special circumstances provisions since the mid-1990s. Of those, eight involved leases or units offshore of California, six of which involve end-of-life situations. The other two situations in the Pacific and the four situations in the Gulf of Mexico involve special circumstances relief.

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The end-of-life and special circumstance royalty relief provisions have played a comparatively minor role in royalty relief. The bulk of royalty relief granted up to this point under either statute or regulation has been deep water royalty relief.

II. DEEP WATER ROYALTY RELIEF UNDER THE DEEP WATER ROYALTY RELIEF ACT OF 1995 AND THE ENERGY POLICY ACT OF 2005

The DWRRA was enacted on November 28, 1995. Its substantive sections are sections 302, 303, and 304. Section 302's amendments as they pertain to OCSLA section 8(a)(3)(A) and (B) were discussed above. Section 302 also added a new subparagraph (C) that addressed leases in deep water already in existence on the date of the statute's enactment.

A. Leases Issued before November 28, 1995

The new subparagraph (C) (43 U.S.C. § 1337(a)(3)(C)) addressed deep water leases (leases located in 200 meters of water or more) in the Gulf of Mexico west of 87 degrees, 30 minutes West longitude that were in existence on the date of enactment of the DWRRA -- i.e., deep water leases issued before November 28, 1995. It added...