THE FEDERAL OIL AND GAS LEASE MARKETABLE CONDITION RULE: HOW FAR DOWNSTREAM CAN THE GOVERNMENT GO? AN INDUSTRY PRACTITIONER'S PERSPECTIVE

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management
(Feb 2007)
CHAPTER 15C
THE FEDERAL OIL AND GAS LEASE MARKETABLE CONDITION RULE: HOW FAR DOWNSTREAM CAN THE GOVERNMENT GO? AN INDUSTRY PRACTITIONER'S PERSPECTIVE¹
Deborah Bahn Haglund
Attorney, Haglund Law Firm
Dallas, Texas

DEBORAH BAHN HAGLUND

Deborah Bahn Haglund is a principal in the Haglund Law Firm, located in the Dallas-Fort Worth metropolitan area. She specializes in the practice of natural resources law, with a focus on public lands and administrative practice and procedure.

Prior to founding the Haglund Law Firm in March 2000, she was in-house counsel for Mobil Business Resources Corporation. Before joining Mobil, she was a shareholder in the New Orleans office of Liskow & Lewis, where she represented individual companies and industry groups in administrative and judicial proceedings involving governmental and private royalty claims.

Ms. Haglund has written and lectured extensively on Minerals Management Service regulatory topics. She is a member of the Louisiana and Texas State Bar Associations and the Dallas Bar Association. She earned her J.D. in 1978 from Tulane Law School and her B.A. in 1974 from Smith College. She is admitted to the bars of the States of Texas and Louisiana, the Federal District Courts for the Eastern, Western and Middle Districts of Louisiana, the Fifth Circuit Court of Appeals, the Federal Circuit Court of Appeals, the United States Claims Court, and the United States Supreme Court.

I. INTRODUCTION

How far downstream does the marketable condition rule allow the government to go in establishing the value of production for federal royalty purposes? As is illustrated by the three papers in this section, how you answer this question may depend on your perspective.

I think it is fair to say that Ms. Inderbitzin is accurately reflecting the perspective of the federal government when she emphasizes that the Department of the Interior has broad authority, and considerable discretion, to establish the value of production from federal oil and gas leases for royalty purposes. My emphasis, from an industry practitioner's perspective, will be on the fact that this authority, while unquestionably broad, is not unlimited. Thus, my focus will be on the procedural and substantive limitations that protect federal lessees against the unreasonable exercise of unbridled governmental discretion, particularly as regards the government's efforts to push the royalty valuation point further and further downstream through its interpretation and application of the marketable condition rule.

II. INTERIOR'S AUTHORITY TO VALUE PRODUCTION AND LIMITATIONS ON THAT AUTHORITY

The federal government has a right that few, if any, other lessors are able to secure from their mineral lessees: the right to establish minimum values for purpose of calculating the lessee's royalty obligation.² Nevertheless, there are limits -- statutory, regulatory, and contractual -- on the government's authority to establish the value of federal lease production for royalty purposes.³

For example, while courts generally defer to an agency's construction of its authorizing statutes, "if the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress."⁴ The federal leasing statutes expressly state that federal leases must provide for a royalty of

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no less than a specified percentage in amount or value of the production saved, removed, or sold from the lease.⁵ Based on this language, Interior cannot lawfully assess royalties on the value of something other than the production saved, removed, or sold from the lease.⁶

If an agency's authorizing statute is silent or ambiguous with respect to a particular issue, the agency has considerable discretion in implementing the statute. Nevertheless, once the agency exercises its discretion through the promulgation of regulations, the agency is bound to follow its duly promulgated regulations until they are changed in accordance with the procedures set forth in the Administrative Procedure Act ("APA").⁷ Even if the agency does not promulgate a regulation, if it exercises its discretionary authority through an authoritatively adopted interpretation of its regulations, the agency may be required to continue to follow that interpretation until it goes through a formal APA rulemaking.⁸

Finally, federal oil and gas leases are contracts, the terms of which the Department is obligated to follow. Indeed, even Congress is bound to honor the contractual terms of federal oil and gas leases.⁹ And federal leases, as required by the authorizing statutes, typically provide for a royalty on the value of the production saved, removed, or sold from the leased premises.¹⁰

III. KEY CONCEPTS IN FEDERAL ROYALTY VALUATION

The key concepts in federal royalty valuation can be summarized as follows: Federal royalties are due on the value of (1) the production from the leased premises (2) on or near the lease (3) in marketable condition, subject to the additional caveats that (4) the royalty value can never be less than the gross proceeds accruing to the lessee from the sale or disposition of the produced substances less applicable allowances, and (5) marketing costs must be borne solely by the lessee. The focus of this paper will be of the first three of these concepts, and, more particularly, on the tensions between them.¹¹ Moreover, since disputes

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concerning the marketable condition rule typically involve gas valuation, the paper will focus primarily on gas issues.¹²

Because the federal leasing statutes and most federal leases provide for a royalty only on the value of the production saved, removed, or sold from the leased premises, the Department recognized early on that it needed to distinguish between the value of the production from a federal lease and the value of the products that might be obtained from that production through manufacturing.¹³ In the early days of federal oil and gas leasing, gas had no value unless it contained entrained natural-gas gasoline that could be removed and separately marketed. A lessee was not required to process the gas to extract the marketable natural-gas gasoline. If it did, however, the lessee was allowed to deduct the cost of putting the entrained natural-gas liquids into marketable condition as a processing allowance. As stated in Interior's 1926 regulations:

Natural-gas gasoline ... is a manufactured product. The value of the product is contingent upon the value of the raw material and the cost of its manufacture. The Government does not wish to collect royalty on that part of the value which is derived from the cost of manufacturing, inasmuch as the Government's equity is confined to the value of the raw material involved.¹⁴

The residue gas resulting from processing was without value and routinely flared. There was no requirement that the lessee capture the residue gas and place it into marketable condition, much less that it do so at no cost to the federal lessor.¹⁵

The Department also recognized early on that royalties were due only on the value of the production saved, removed or sold from the leased premises. Thus, if gas was transported out of the field where it was produced to a processing plant, the lessee was allowed to deduct the cost of moving the gas from the field to the plant in determining the royalty value of the products resulting from processing.¹⁶

When gas first became a valuable commodity in and of itself, unprocessed gas typically was sold in the field, at or near the well where it was produced, to pipeline companies who would purchase the gas in the field, transport it to downstream markets, and then resell it for a profit. Gas sales contracts between the producers and the purchasing pipelines typically specified a central delivery location in the field, to which the producer had to "gather" the gas. The contracts also typically contained pressure, acid gas and water vapor

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content specifications to ensure that the gas would meet the operational requirements of the purchasing pipeline's transportation system. If gas was produced at a lower pressure that the pressure in the purchaser's pipeline, the gas had to be compressed to a higher pressure or it would not have been able to enter the purchaser's line. The removal of acid gases such as carbon dioxide (CO₂₎ and hydrogen sulfide (H₂S) (commonly called sweetening) and the removal water vapor (dehydration) was also needed for pipeline operational reasons -- to protect the pipelines from the corrosive effect of their combination into acid compounds.¹⁷

The Department took the position that federal lessees were obligated to gather, compress, sweeten, and dehydrate the gas to meet these gas sales contract requirements at their sole expense as part of their obligation to place the gas into marketable condition at no cost to the federal government. Lessees objected that they had no such obligation and that they should not have to bear the entire expense of activities that increased the value of the gas beyond the value of the raw material produced from the leased premises. Nevertheless, the Department prevailed on this issue in agency decisions¹⁸ and ultimately in California Co. v. Udall,¹⁹ where the court held that Interior could reasonably define the term statutory term "production" to mean "production in marketable condition."²⁰

These early decisions were careful, however, to distinguish between non-deductible activities such as field gathering, compression and dehydration, which conditioned the gas for sale, and manufacturing or processing, which was recognized as being deductible.²¹ The decisions also distinguished between the cost of gathering gas to a sales point within the field, the costs of which had to be borne by the lessee as part of its obligation to...