THE FEDERAL ROYALTY IN KIND PROGRAM: 10 YEARS OF DEVELOPMENT, SUCCESS, AND BUSINESS PLANNING FOR THE FUTURE

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management
(Feb 2007)
CHAPTER 7A
THE FEDERAL ROYALTY IN KIND PROGRAM: 10 YEARS OF DEVELOPMENT, SUCCESS, AND BUSINESS PLANNING FOR THE FUTURE
Gregory W. Smith
Minerals Management Service
Denver, Colorado
Lucy Querques Denett
Minerals Management Service
Washington, D.C.

I. INTRODUCTION

This paper describes the development of the royalty in kind (RIK) program managed by the Minerals Management Service (MMS); the current status of the program; and associated future plans and objectives. Much of this paper was also included in an MMS report to Congress submitted in September 2006 pursuant to the requirements of Section 342 of the Energy Policy Act of 2005.

1. Background

The Minerals Management Service (MMS), a bureau of the Department of the Interior, is responsible for the management of the Nation's energy and mineral resources on the Outer Continental Shelf (OCS) and for ensuring that all revenues from Federal and Indian mineral leases are effectively, efficiently, and accurately collected, accounted for, and disbursed to recipients. These substantial revenues, which average more than $8 billion annually, are disbursed to 38 States, 41 Indian Tribes, the Department's Office of Trust Funds Management on behalf of some 30,000 individual Indian royalty owners, and to U. S. Treasury accounts.

The Minerals Revenue Management (MRM) is the program component of the MMS responsible for managing revenues derived from leases issued for the development of mineral resources from onshore Federal and Indian lands and the OCS. Royalties paid for mineral production removed from leased lands represent the principal source of revenues managed by MRM. For oil and gas leases, these production royalties are paid either in value or in kind. Royalties in value (RIV) are paid in cash to the MRM. Royalties in kind (RIK) are paid, at the discretion of the Government, by delivery of oil and gas to MRM for competitive sale in the marketplace. The OCS Lands Act of 1953, as amended, and the Mineral Leasing Act of 1920, as amended, authorize the collection of production royalties either in value or in kind for Federal lands leased for development onshore and on the OCS. Furthermore, the terms of virtually all Federal oil and gas leases provide for royalties to be paid in value or in kind at the discretion of the lessor. The Energy Policy Act of 2005 provides additional statutory requirements to support the operation and funding of a program for managing Federal oil and gas royalties in kind.

This paper comprehensively describes the actions taken by the MMS to develop business processes and automated systems to fully support its RIK capability, which is used in tandem with its RIV approach, and MMS' future RIK business operation plans and objectives. The MMS has devoted nearly ten years to the development of its capability to support a robust RIK business operation that, when fully integrated with the RIV approach, forms the

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consummate asset management strategy for Federal oil and gas revenues. This paper provides an introductory overview of the initial pilot phase beginning with a discussion of the 1997 RIK Feasibility Study and then detailing a series of key RIK pilot projects designed to assess the benefits of the RIK approach and to further develop an understanding of the business requirements for managing a Federal RIK operation. The results of these pilots shaped MMS' understanding of the RIK approach and provided the basis for proceeding with the development of the RIK Road Map to the Future published in January 2001.

As further discussed in this paper, the Road Map set forth the strategic direction and presented actions to develop the capability needed to transition the RIK approach from pilot projects to an operational activity over a 3 year period. With the completion of the Road Map implementation actions described in this report, the MMS prepared for a transition of the RIK pilot program to a permanent operational activity. Senior MMS management engaged the Lukens Energy Group of Houston, Texas to perform an independent assessment of the RIK capability that had been installed, and to provide recommendations for improvement. With the benefit of this assessment, the MMS senior management proceeded with a strategic planning effort to develop the Five Year Royalty in Kind Business Plan (Five Year Plan) which was published in May 2004. The Five Year Plan provides the management framework and a series of actions that will evolve the Federal RIK program for fiscal years 2005 through 2009.

This paper provides a detailed discussion of the Five Year Plan including:

• Key action elements and the current status of implementation.

• Progress on expansion of commercial operations.

• RIK program performance metrics and the substantial benefits realized by the Government.

• Future RIK business operations plans and objectives.

The paper discusses the current status of the RIK program, and then concludes with an overview of a recently issued MRM program-wide Strategic Business Plan that addresses RIK operations through fiscal year 2012.

II. DEVELOPMENT OF THE RIK OPERATIONS CAPABILITY

The Department of the Interior has used the RIK approach in its Small Refiner Program since the 1970s. This Program was designed to support the domestic small refiners by providing a reliable source of supply of crude oil at equitable prices. In the mid-1990s, the MMS began exploring the potential for a more broadly applied RIK operation to increase efficiencies, decrease conflict and enhance revenues generated from oil and gas production royalties.

1. Initial Pilot Phase

In 1997, the MMS initiated a feasibility study of the U. S. Government taking its oil and gas royalties in kind rather than in value and competitively selling the commodities in the

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marketplace. The study was conducted to evaluate the merits of an RIK approach and was included in the MRM Program Reengineering Initiative. The study was also responsive to a Congressional directive, included in MMS' Fiscal Year 1997 Budget Appropriations Committee Reports, to consider additional pilot projects for both onshore and offshore oil and gas leases. The final report, titled 1997 Royalty-in-Kind Feasibility Study was issued in August 1997.

The study aimed to determine if the implementation of a Federal RIK program would be in the best interest of the United States, and, if so, under what circumstances. The scope of the study included an examination of other governmental RIK programs, public workshops and a survey of natural gas marketing companies. The RIK Feasibility Study Team concluded that, under the right circumstances, RIK could be workable, revenue neutral or positive, and administratively more efficient for the MMS and industry. As recommended by the Study Team, MMS established a series of pilot projects to test these conclusions.

2. Wyoming Crude Oil RIK Pilot

In 1998, MMS and the State of Wyoming collaborated in the design and implementation of the first major RIK pilot project. The pilot involved the sale of crude oil of different qualities produced from Federal leases in the Powder River and Big Horn Basins of Wyoming. The first competitive sale was for a six-month period beginning October 1998 and involved Federal lease RIK production. Subsequent sales involved increasing volumes of production, reaching over 6,000 barrels per day, and also included the addition of RIK production from State of Wyoming leased lands. An interim evaluation of the pilot results conducted by the State of Wyoming and MMS for the period October 1998 through March 2000 concluded that the pilot had successfully demonstrated that taking crude oil production in kind at the lease and selling it through a competitive bid process is a viable alternative to the historical method of taking royalties in value in some circumstances. Further, the pilot observed that the RIK approach reduced the period of value uncertainty for MMS and lessees from years to months; increased royalty receipts over what would have otherwise been received if collected in value; and provided for streamlined processes that would yield administrative savings for MMS and industry. This pilot has evolved into a steady-state operation jointly managed by the MMS and State of Wyoming.

3. Texas 8(g) Natural Gas RIK Pilot

In 1998, MMS in partnership with the Texas General Land Office (GLO) initiated the second RIK pilot project involving natural gas production from Federal oil and gas leases in the Texas "8(g)" zone of the Gulf of Mexico. [The "8(g)" zone refers to the area within three miles seaward of state waters, where approximately 27 percent of oil and gas lease revenues are shared with the coastal state] The pilot goals included exploration of methods to market RIK natural gas and learning from GLO's long-standing RIK experience. Competitive sales began in June 1999 and reached volume deliveries of approximately 55,000 MMBtu per day. An interim evaluation of the pilot results conducted by the State of Texas and MMS for the period June 1999 through December 2000 concluded that the RIK approach was viable in the administration of natural gas royalties and that the selective use of RIK provided modest increases in revenue to the MMS and additional administrative benefits for the government

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and industry. This pilot was later incorporated into a broader Gulf of Mexico RIK gas pilot.

4. General Services Administration Natural Gas RIK Pilot

Under this pilot, the MMS and General Services Administration (GSA) entered into an agreement in 1999 to take RIK natural gas from several Federal leases off the Texas coast. The gas was provided to the GSA for use in its facilities. The pilot involved a series of gas-exchange transactions between the MMS, an exchange contractor, and the GSA. Natural gas deliveries under the...