ROYALTY VALUATION AND MANAGEMENT: ROYALTY-IN-KIND UPDATE

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management
(Feb 2007)
CHAPTER 7B
ROYALTY VALUATION AND MANAGEMENT: ROYALTY-IN-KIND UPDATE
Daniel F. Riemer
Manager, Crude Oil Marketing & Property Development
Marathon Oil Company
Houston, Texas

DANIEL F. RIEMER

Daniel F. Riemer is Manager of Crude Oil Marketing & Property Development for Marathon Oil Company, the 4th largest U.S. based integrated oil & gas company and a "top 5" U.S. refiner and marketer. Marathon's worldwide production exceeds 400,000 barrels of oil equivalent per day and the downstream affiliate Marathon Petroleum Company LLC has refining capacity of 974,000 barrels per day.

Dan's current responsibilities include North American liquids marketing, North American gas field services (gathering, compression, transportation and processing contracts) and crude oil derivative activities. He became Crude Oil Marketing & Property Development Manager in March 1993 and has been actively involved in royalty policy matters since that time. Dan received the MMS Corporate Leadership Award in April 2002 for providing assistance to MMS in the implementation of Federal Oil Royalty in Kind pilot programs. He is Chairman of the joint association Royalty Strategy Task Force, which consists of representatives from the American Petroleum Institute (API), the Domestic Petroleum Council (DPC), the Independent Petroleum Association of America (IPAA) and the US Oil & Gas Association (USOGA). Dan was appointed to MMS Royalty Policy Committee (RPC) in November 2004 representing the USOGA, and he was elected chairman of RPC in November 2006.

Dan joined Marathon in 1980 as a Pipeline Engineer after graduating from Valparaiso University with a B.S. degree in Civil Engineering. He has served in a variety of technical, operational and commercial positions in his 26+ years with Marathon.

Table of Contents

I. Introduction

II. The Royalty-in-Kind Debate: Common Concerns

A. The Federal Government Has No Business In The Marketing Arena

B. If They Take Some, They Should Have To Take It All

C. Royalty-In-Kind Should Be a One-Time Election For All Time

D. Royalty-In-Kind Programs Must Be Well Structured or They Will Not Work

E. Tendering Programs Create Markets That Do Not Normally Exist

F. Royalty-In-Kind Should be Regulated

III. Overview of Royalty-In-Kind Programs: Federal, Indian, State and Private

A. Alberta Royalty System

B. Federal Government Royalty-In-Kind Program

C. Navajo Nation

D. Northern Ute Tribe

E. State of Texas - General Land Office

F. University of Texas System - University Lands

G. State of Wyoming

H. State of Alaska

I. State of Louisiana

J. Private

IV. Benchmarking: How Do You Measure Success

V. Conclusion

Appendix A: Reference List

Appendix B: Corporate Leadership Award Recipient List

I. Introduction

This paper reviews the long-standing debate about the merits of Royalty-in-Kind (RIK); describes various RIK programs; and discusses ways to measure success.

Background

Oil and gas leases typically require a lessee to pay royalties based on the value of oil and gas production that is severed and sold from the lease. Most leases contain a provision whereby the lessor can elect to take their royalties in-kind. This provision establishes the right, but not the obligation, for lessors to take their royalty entitlement and market it themselves. RIK supporters assert that additional benefits accrue to a lessor from RIK because administrative and legal costs for audits and disputes are significantly reduced. However, RIK opponents are quick to suggest that disputes would not occur if lessees paid correctly, at which time Lessor and Lessee find cause to point the finger at the inadequacy of the lease terms and the state statutes and the federal regulations that govern royalty payments, but not before payors suggest that "if royalty owners think there is a better price, they should take their production in-kind and market it themselves."

It's all about managing expectations. When royalty owners open the newspaper and see New York Mercantile Exchange (NYMEX) settlement prices for crude oil and natural gas, they develop certain expectations about the size of their royalty check. Most royalty owners do not know how physical markets for crude oil and natural gas work, and they have no concept of the relationship between lease values and published index prices. Oil prices are heavily influenced by location and quality differentials, while gas prices are primarily impacted by transportation and processing costs. There is no mechanical link between lease values and the commodity prices that are traded on the NYMEX. Fair market value at the lease on any given day is best represented by a range of values derived from a variety of market factors. The gap between expected value and actual lease value can often be mitigated through an educational process that requires open and direct communication between lessor and lessee.

II. The RIK Debate: Common Concerns

At a roundtable discussion on proposed MMS regulations sponsored by Representatives George Miller (D-CA) and Carolyn Maloney (D-NY) at the Capital Building on July 21, 1998, Bob Armstrong, Assistant Secretary for Land and Minerals Management, said in his opening remarks that the issue of fair royalty payment is not new, and that the "Department has held 14 hearings and received over 4,000 pages of comments on the proposed rules over the last 2-1/2 years." Common concerns extracted from the hearings and from public comments are summarized in this section.

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A. The Federal Government Has No Business In The Marketing Arena

Representative Carolyn Maloney testified before the Energy and Minerals Resources Subcommittee on July 31, 1997. Rep. Maloney stated that she opposes RIK for several reasons. First, she believes the 1996 Federal Oil and Gas Royalty Simplification and Fairness Act will allow greater clarity and reduce legal fees and challenges once it is fully implemented, eliminating the need for another overhaul. Secondly, since many companies are both producers and marketers, oil companies would get paid to market the oil they had given in-kind to the government. Finally, she does not believe the federal government has the equipment or incentives to become an effective competitor in the oil and gas industry.

At a September 18, 1997 House Oversight hearing on the feasibility to take federal oil and gas royalties in kind, William Henderson, Market Development Representative, Gulf Canada Resources Ltd, testified that as the oil industry in Alberta, Canada was moving towards privatization in 1994, royalty systems were evaluated. RIK was found to maximize revenue with the least operational problems. Henderson explained that an RIK system has many benefits including revenue neutrality, avoidance of favoring production markets, and elimination of the need to interact with all owners of a producing facility. While RIK has been working well in Canada for oil, Henderson said that a royalty-in-kind system for gas would be "onerous due to the nature of the current sales and transportation commitments."

At a hearing on H.R. 3334, the Royalty Enhancement Act of 1998, before the Energy and Minerals Resources Subcommittee on March 19, 1998, Mr. Phil Hawk, President and CEO of Enron Oil Trading & Transportation (EOTT) Corporation, a large independent crude oil gatherer and marketer, testified in support of H.R. 3344. Mr. Hawk stated that using a qualified marketing agent (QMA) for RIK "is the best way to provide the federal government and the MMS with a fair market value for its crude oil."

B. If They Take Some, They Should Have To Take It All

In March of 1998, Representative Mac Thornberry (R-TX) introduced HR 3334, Royalty Enhancement Act of 1998 that would mandate that the "US must take all royalty oil and gas in kind." The bill was supported by the Domestic Petroleum Council (DPC) and the Independent Petroleum Association of America (IPAA), but not the Administration. In a March 19 hearing before the House Resources Subcommittee on Energy and Mineral Resources, MMS Director Cynthia Quarterman stated that the government is already permitted under existing regulations to take royalty-in-kind and therefore "strongly opposes any legislation mandating the US to take its mineral royalties in kind and would recommend that H.R. 3334 be vetoed if presented to the President." Although MMS favors investigating the possibilities for RIK, it still feels "RIK is unproved and risky for royalty collection in the US." Quarterman contended that H.R. 3334 would force the US to relinquish many of its long-established legal rights as lessor while relieving lessees of many of their legal obligations and force the government to take RIK in areas where conditions are unfavorable, causing potential losses of $367 million.

Ed Rothschild, Public Affairs Director for Citizen Action testified at a September 18, 1997 House Oversight hearing on the Feasibility to take Federal Oil and Gas Royalties In-Kind, that there was no interest in RIK until the MMS proposed changing the valuation method for the collection of royalties on oil and gas. He warned that while RIK may work in some cases, it is not a "one-size-fits-all" program. According to Rothschild, RIK may be appropriate for natural gas, but it is not appropriate for oil because it cannot assure competitive prices.

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At a Senate oversight hearing on federal oil valuation regulations of the Minerals Management Service on June 11, 1998 before the Energy Research, Development, Production and Regulation Subcommittee, M. Brian McMahon, a partner in the law firm of McMahon & Spiegel, Los Angelos, California, on behalf of the City of Long Beach and the State of California, commented on his experience in California, that a "mandatory royalty-in-kind legislation is fatally flawed because it falsely assumes major oil companies will bid...