JurisdictionUnited States
Federal and Indian Oil and Gas Royalty Valuation and Management
(Feb 2007)


Sarah L. Inderbitzin *
Program Analyst
Office of Enforcement
Minerals Management Service
Lakewood, CO


Sarah L. Inderbitzin is a Program Analyst for the Minerals Management Service's (MMS) Office of Enforcement in Lakewood, Colorado. For 13 years prior to accepting the position with MMS in February 2007, Miss Inderbitzin was the Senior Attorney-Advisor for the Branch of Federal and Indian Royalties, Division of Mineral Resources, in the Office of the Solicitor of the Department of the Interior in Washington, D.C. In that capacity, she represented the MMS in royalty matters.

Miss Inderbitzin received her Bachelor's of Science from the University of Maryland in 1985, a Juris Doctor, with honors, from Georgia State University, College of Law, in 1993, and an LL.M. in Environmental Law from the George Washington University, National Law Center, in 1997.


It is a well-recognized principle that the Secretary of the Department of the Interior (Department) has the authority, and considerable discretion, to establish the value, for royalty purposes, of production from federal oil and gas leases.1 For decades, lessees of federal lands for oil and gas production2 have challenged the Secretary's authority to require lessees to place production into "marketable condition" at no cost to the lessor.3 The most recent litigation over this issue culminated in the Supreme Court denying review of a United States Court of Appeals for the District of Columbia Circuit decision in BP America Production Co. v. Burton,4 upholding the Secretary's broad authority to establish value for royalty purposes and to require lessees to place gas production into marketable condition at no cost to the Federal lessor.5

In 2006, the Minerals Management Service (MMS), collected over $9 billion in royalty payments on federal and Indian oil and gas leases.6 The marketable condition issue involves

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tens of millions of dollars annually. So, it is an issue of significant consequence to the oil and gas producing industry that pays the royalties and the recipients of those royalties, including the federal government, the States who share in the federal government's revenues, and the Indian lessors.7


A. Statutory Authority

The federal mineral leasing statutes were "intended to promote wise development of these natural resources and to obtain for the public a reasonable financial return on assets that `belong' to the public. The Secretary of the Interior is the statutory guardian of this public interest."8 Congress has charged DOI with the responsibility for collecting royalty and other payments from federal leases.9 Under the MLA, lessees must pay royalties at the rate of 12.5 percent of the "amount or value of production removed or sold from the lease."10 In exchange for the right to retain most of the proceeds, lessees bear the costs and risks of exploration and production and related operations.

The Secretary "has rather sweeping authority" to "prescribe such rules and regulations as may be necessary to carry out" the mineral leasing provisions.11 Those regulations have the force and effect of statutes when not in conflict with such statutes.12 The lease terms of virtually all federal leases also reserve to the Secretary the authority to establish the reasonable value of production for royalty purposes, and expressly make the lease subject to DOI regulations.13 In conformity with this statutory provision and the lease terms, DOI has long

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defined the "value of production" for royalty purposes by regulation.14 Courts have consistently recognized DOI's expansive authority to define the value of production and have emphasized that Interior's exercise of that delegated power is owed deference.15

B. The Gross Proceeds Rule

Since at least 1942 for onshore leases, and since federal offshore leasing began in 1954, DOI regulations have provided:

Under no circumstances shall the value of production be less than the gross proceeds accruing to the lessee from the disposition of the produced substances or less than the value computed on the reasonable unit value established by the Secretary.16

Judicial and administrative decisions consistently have upheld the gross proceeds rule, and defined gross proceeds as the total consideration received by the lessee from the sale of gas.17 The only allowable deductions from gross proceeds are for transportation expenses,18 and certain processing activities in the case of wet gas (to extract valuable heavier liquid hydrocarbons entrained in the natural gas stream).19 This aspect of the royalty valuation regulations -- gross proceeds minus certain allowances or deductions to arrive at royalty value -- is not a new concept.20 Even prior to promulgation of the transportation allowance provisions in the 1988 regulations, agency practice in this regard was guided by judicial and administrative cases.21 This is how the Department has implemented the principle of valuation "at or near the lease" - by allowing a deduction for the cost of transporting production away from

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the lease.22 Sales downstream from the lease or unit commonly are the starting point for determining royalty value, with the "value of production saved, removed, or sold" from the lease determined by allowing a deduction for the actual cost of transporting lease production away from the lease.23

The gross proceeds rule provides the "absolute minimum value for computation of royalties."24 As a result, "there is no authority to allow the DOI to assess royalties on a lower basis than gross proceeds."25

C. The Marketable Condition Rule

A second regulation, also promulgated originally in 1954, requires lessees to put gas into marketable condition and to pay royalty on the value of the gas in marketable condition without deduction for the costs of treatment:

The lessee shall put into marketable condition, if commercially feasible, all products produced from the leased land and pay royalty thereon without recourse to the lessor for deductions on account of costs of treatment.26

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Treating gas to put it into marketable condition involves gathering,27 compression,28 dehydration,29 and removal of acid gases.30 The rule was amended and reaffirmed in 1979:

The lessee shall put into marketable condition, if commercially feasible, all products produced from the leased land. In calculating the royalty payment, the lessee may not deduct the costs of treatment.31

Accordingly, the Secretary's rules for valuing gas production from federal leases for royalty purposes have provided since 1954 that the lessee's gross proceeds -- the minimum value for royalty purposes -- consist of the total consideration which the lessee receives for gas in marketable condition. Courts and DOI administrative decisions have consistently upheld the federal marketable condition rule.32

III. Both Judicial and Administrative Decisions Have Upheld the Federal Lessee's Duty to Place Production into Marketable Condition at No Cost to the Lessor

For decades, the Department's royalty valuation program has operated within certain parameters established by the relevant regulations.33 These regulations have been shaped not only by the special expertise of the responsible bureaus, but also by judicial and IBLA decisions.34 What follows is a brief synopsis of relevant judicial and agency decisions that have addressed the deductibility of marketable condition costs in the context of federal leases.35 A review of these decisions makes one thing clear - no case has held or even inferred that the federal government must bear a proportionate share of the federal lessee's costs to place production into marketable condition. Uniformly, these cases either expressly or impliedly state that marketable condition costs are not deductible from the federal lessor's royalty interest. Thus, federal courts have determined the scope of the federal lessee's duty to place production into marketable condition. In the federal context, this obligation is at no cost to the government.

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The Texas Co.,36 was the first administrative case to consider the Department's application of the marketable condition rule. In The Texas Co., the appellant was the lessee of a Federal lease who produced low-pressure gas. The lessee paid another party to gather and compress the gas to the pressure required to enter the purchaser's pipeline. The Texas Co. appealed the U.S. Geological Survey's (USGS - MMS's predecessor agency) denial of a deduction for the costs of gathering and compression. The Acting Solicitor37 held that these costs were not deductible in determining the royalty value of the gas because "[t]he lessee has not shown that the gas can be marketed at the pressure with which it comes from the wells."38

Shortly after The Texas Co. another case arose in which the California Company (Calco) produced gas from a Federal lease, some of which was at a pressure less than pipeline pressure. Calco paid to gather, dehydrate and compress the gas to the required pressure, and deducted the costs of compression, gathering, and dehydration from the sales price. In The California Co., the Department held that these deductions were not allowable.39 Calco then sought judicial review.

In California Co. v. Udall, the court held that the costs of gathering, compression, and dehydration were necessary to put the production into marketable condition.40 The D.C. Circuit explained:

Theoretically, any gas -- any "production" -- is "marketable." We can assume that, if the price were low enough to justify capital expenditures for conditioning equipment, someone would undertake to buy...

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