JurisdictionUnited States
Federal & Indian Oil & Gas Royalty Valuation and Management III


Judith M. Matlock
Davis, Graham & Stubbs LLP
Denver, Colorado

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Table of Contents


New Development (Decision in IPAA v. Armstrong ii

I. Introduction

II. The Implied Covenant to Market Outside the Federal Context

A. Purpose of Implied Covenants

B. The Implied Covenant to Market

C. Relationship of the Implied Covenant to Market and the Royalty Clause of a Fee Lease

D. Sales to Affiliates in the Fee Context

E. Conclusions Regarding the Implied Covenant to Market Outside the Federal Context

III. The "Duty to Market" in the Federal Context

A. Federal Royalty Valuation Regulations

B. Downstream Marketing of Oil and Gas and the Role of Affiliates

C. The "Duty to Market" Decisions

1. Arm's-Length Sales
2. Non-Arm's Length Sales
3. New Regulations and the "Duty to Market
4. Status of the "Duty to Market" Decisions and Regulations

D. Comparison of the Duty to Market Decisions and Merrill's Implied Covenant to Market

E. Duties Cannot Be Implied Where Obligations Are Express

F. Duties Cannot Be Express or Implied Which Exceed Statutory Authority (The Ignored Statutory and Historical Precedent)

G. Indian Leases

IV. Conclusion



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New Development

On March 28, 2000, Judge Lamberth issued his decision on the cross-motions for summary judgment of the parties in IP AA v. Armstrong, Civ. No. 98-00531 and API v. Babbitt, Civ. No. 98-00631 (consolidated for briefing) and held that the Amendments to Transportation Allowance Regulations for Federal and Indian Leases to Specify Allowable Costs and Related Amendments to Gas Valuation Regulations, 62 Fed. Reg. 65753 (Dec. 16, 1997) (the "1997 Transportation Amendments") were unlawful and of no force or effect and enjoined the defendants from implementing or enforcing them. The Memorandum Opinion and the Order and Final Judgment are included as Attachment D to this paper.

The purported purpose of the 1997 Transportation Amendments was to provide specific guidance and certainty as to which transportation cost components resulting from implementing FERC Order 636 and previous FERC orders were deductible in the transportation allowance for purposes of calculating federal royalties. The 1997 Transportation Amendments divided transportation costs, as that term is understood by industry, into two categories based upon whether such costs were related to transportation (deductible) or related to marketing (not deductible) in the MMS' view. For example, long term storage was classified as a nondeductible marketing cost The 1997 Transportation Amendments also included amendments to the MMS' gas valuation regulations including the addition of a requirement that the lessee "market the gas for the mutual benefit of the lessee and the [Federal Government/Indian Lessor]."

The plaintiffs argued that the 1997 Transportation Amendments exceeded the Department of the Interior's statutory authority and had no basis in prior regulations or the gas leases themselves. The plaintiffs also argued that the Amendments drew arbitrary distinctions between similar costs and impaired the obligations of existing leases.

The defendants argued that the Amendments were properly enacted and constituted a reasonable interpretation of existing valuation regulations "and the implied covenant of the gas leases."

The Court acknowledged that the Department of the Interior "has the sole authority to `prescribe such rules and regulations as may be necessary to carry out' the leasing provisions" of the mineral leasing statutes. Id. at 3.

However, the Court also recognized, contrary to the defendants' position, that "[m]oving gas away from the wellhead to downstream markets ... entails costs that are not incurred when gas is marketed at the lease" (id. at 6) and that, historically, in the pre-Order 636 era, all costs associated with moving gas to downstream markets were bundled in pipeline rates and were deductible from royalty value when the point of sale was downstream. After reviewing Order 636, the Court concluded, "even though FERC Order 636 had a substantial effect on the identity of gas purchasers from federal and Indian leases, it did not alter the fundamentals of gas sales transactions by gas

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producers, and thus, did not directly alter their obligations under federal and Indian gas Leases." Id. at 8 (emphasis added).

In summarizing the controversy arising out of the Amendments, the court stated that it centered on the Rule's effect on lessees' royalty obligations when they sell gas downstream. The Court stated, "[t]he end result of the Rule is that lessees must now pay a royalty in excess of the value of production they received from the sale." Id. at 12.

The Court stated the following generally recognized principles:

(1) Courts must set aside agency action found to be "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law,"

(2) An agency is constrained by the statutory authority given by Congress, and

(3) Where a statute is silent or ambiguous, a court must defer to the interpretation of the agency that administers the statute "provided that the proffered interpretation is reasonable."

Id. at 17. However, the Court also noted that courts will interpret government contracts (the leases in this case) against the government as the drafter and stated that "no deference is due an agency's interpretation of contracts in which it has a proprietary interest." Id. at 18.

The Court began its analysis with the mineral leasing statutes and noted that there is limiting language in the statutes which limit the collection of royalties to "the value of production saved, removed or sold from the lease." Id. at 19. The Court also stated that the long-standing interpretation of the phrase "value of production" recognized by Interior and affirmed by the Courts was that it refers to value at the wells. Id. The Court cites the Marathon decision (discussed in more detail in the attached paper) in support of the proposition that the government's royalty interest is not in value enhancements resulting from downstream activities. This is noteworthy because the government in the decisions and regulations discussed in the attached paper often cites Marathon as supporting its "duty to market" without acknowledging that in Marathon, the lessee was allowed a deduction for all downstream costs including a reasonable return on an LNG plant.

The Court found that, in light of these established principles, the defendant's "position that it has authority to define value to include downstream costs unrelated to production of the gas" was untenable in that the MMS offered no reasoned basis justifying this departure and did not afford a sufficient explanation as to why Order 636 mandated imposing expanded duties on producers. Id. at 20.

With regard to the alleged "duty to market" offered in support of the defendants' position, the Court noted that, [w]hile according appropriate deference to an agency's reasonable interpretation of its own regulations, court must view such interpretations with skepticism when they affect

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contracts to which the agency is a party." Id. at 22. The Court rejected as unpersuasive the defendant's argument that the lessees duty to market arises from a provision of the gas processing valuation regulations which state that no allowance shall be made for boosting residue gas or other expenses incident to marketing, except as provided in 30 C.F.R. § 206 . The Court correctly noted that the "marketing" referenced in this provision is the duty to put gas into marketable condition and not the "duty to market" set forth in the Amendments. The Court also find that MMS' distinctions between the deductible transportation components and nondeductible marketing components of pipeline transportation were arbitrary and resulted in inconsistencies which the MMS failed to explain. Id. at 24.

Finally, with regard to the MMS' asserted justification for the Amendments on the basis of the implied covenant of gas leases, the Court again noted that "deference to an agency interpretation of a contract may be inappropriate where an agency has a proprietary interest in the contract." Id. at 26. The Court also stated that where the government drafts a contract on a "take-it-or-leave-it basis, the contract is to be strictly construed against the government. Id. at 27.

The Court expressed skepticism as to the existence of an implied covenant to market at no cost in the leases, stating, that "if such an implied duty were so widely recognized and longstanding, common sense suggests that there would be no need to write it in at this late date." Id. at 27. The Court also noted that the MMS acknowledged that the newly-disallowed costs were previously deductible which undercut its assertion that lessees have always known about an implied covenant in the leases. Id.

The Court then reviewed the express terms of various federal and Indian gas lease forms and concluded that they do not support an implied covenant to market gas at no cost. Instead, the Court found that the express terms of the leases lead to the opposite conclusion. The Court concluded that, "[q]uite simply, a duty to market gas at no cost may not be reasonably implied from the four corners of the lease agreements." Id. at 28. The Court stated that, [h]ad the parties contemplated such an expanded duty when the contract was formed, it is likely that they would have expressly addressed it in the leases." Id. The Court then applied the doctrine of contra proferentem to construe the contracts against the defendants as the drafter.

Finally, the court held that the MMS cannot rely on the fact that the lease forms provide that the leases are subject to...

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