THE LESSEE'S DUTY TO MARKET AT NO COST TO THE LESSOR UNDER FEDERAL AND INDIAN LEASES
| Jurisdiction | United States |
(2000)
THE LESSEE'S DUTY TO MARKET AT NO COST TO THE LESSOR UNDER FEDERAL AND INDIAN LEASES
Office of the Solicitor Department of the Interior
Washington, D.C.
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This paper discusses the duty of lessees under Federal and Indian oil and gas leases to market the production at no cost to the lessor. The views expressed herein are those of the author and are not necessarily the official views of the United States Department of the Interior. The author acknowledges with grateful appreciation the assistance, research, and prior work of Christopher P. Salotti of the Branch of Royalty and Offshore Minerals in the Office of the Solicitor, and Ann D. Navaro of the General Litigation Section, Environment and Natural Resources Division, of the Department of Justice, on which this paper draws heavily.
I. HISTORY AND PRECEDENTS
The obligation of a lessee under a Federal or Indian oil and gas lease to market the production for the mutual benefit of the lessee and the lessor, without deduction for the costs of marketing, has a longer history than many assume—going back almost 60 years, in fact.
The first mention of marketing costs in the Department of the Interior ("DOI") royalty value regulations appeared in 1942, in an amendment to the former 30 C.F.R. 221.51(b) (7 Fed. Reg. 4132 (June 2, 1942)). Title 30 C.F.R. part 221 at that time applied to Federal onshore and Indian leases. After the amendment, section 221.51(b) read:
The present policy is to allow the use of a reasonable amount of dry gas for operation of the gasoline plant, the amount allowed being determined or approved by the supervisor, but no allowance shall be made for boosting residue gas, or other expenses incidental to marketing. (Emphasis added.)
This language reflected and assumed the existence of the implied obligation to market production at no cost to the lessor, as discussed more fully below.1
Industry lawyers have asserted that this regulation applies only to the residue of processed gas and does not extend to an unprocessed gas stream.2 But the validity of this nearly 58-year-old
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rule is not disputed. The necessary conclusion is that costs of marketing methane remaining after heavier liquid hydrocarbons are extracted are not deductible. But to argue that non-deductibility is limited to residue gas after processing, and that the rule does not reflect a broader general lease obligation, one necessarily must assert that DOI specifically intended to allow deduction of the costs of marketing methane that is extracted from "wet" gas, but at the same time specifically intended to disallow deductions for the cost of marketing methane that was "dry" when produced and of liquid hydrocarbons (propane, butane, etc.) extracted from "wet" gas.
Aside from the fact that there is no evidence of such an intent on the agency's part, such a position ignores the obvious purpose of the regulation. Because the rule allows some gas to be used royalty-free to operate a processing plant, and allows certain processing costs as one of the limited deductions from royalty value, it clarifies that other costs commonly incurred after processing at the plant—specifically, compression and marketing—are not deductible. The regulation does not have a counterpart for unprocessed gas simply because there is no possibility for confusion in that context. There is no processing plant, and there are no processing costs to take into account in valuing unprocessed gas. It is readily apparent that the rule reflects and is based on a general duty to market production at no cost to the lessor that already existed.
The next discussion of what we today call marketing costs occurs in one of the early precedential Federal royalty cases, United States v. General Petroleum Corp., 73 F. Supp. 225 (S.D. Cal. 1946), aff'd sub nom., Continental Oil Co. v. United States, 184 F.2d 802 (9th Cir. 1950). In that case, the district court addressed the lessee's claim that certain costs paid to a sales broker should be deducted in determining the royalty value of production. The Kettleman North Dome Association ("Kenda") sold gas to Southern Fuel Company ("Southern") under a sales contract assigned to Kenda by Pacific Western Oil Company and Kettleman Oil Corporation. Kenda also assumed a collateral agreement under which Pacific Western and Kettleman had agreed to pay a one-cent-per-thousand cubic feet ("Mcf") commission to a broker named Long who facilitated completion of the sales contract (the "Long commission"). Kenda sold the gas pursuant to the contract and received payment for the sale. However, before paying the other lessees their shares of the sales proceeds, Kenda deducted the amount paid as the Long Commission.
The lessees argued that the "gross receipts" on which royalties were due was the amount Kenda paid to them, i.e., the amount received by Kenda, less the "Long commission". The government asserted that the Long commission should be disregarded, and that royalty was owed on the amount received by Kenda without deducting the Long commission. The lessees asserted that
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the government was asserting a royalty on more than the lessee's actual receipts, specifically, on their receipts plus the Long commission, which the lessees argued they had neither received nor paid. The court disagreed, and held:
[T]he Long commission is an item of concern only between the lessees and Kenda; that it does not affect the royalty relations of the government with the lessees. The gross field realizations of the lessees within the meaning of the order of June 7, 1937, are the sums actually paid over by Southern Fuel Company to Kenda. That from such sums certain amounts were deducted in fulfillment of a contract for payment of a commission to Long is of no moment in determining the lessees' gross receipts.
73 F. Supp. at 257. The Ninth Circuit affirmed in Continental Oil. In the appeal, the lessees apparently did not contest this aspect of the District Court's holding.
Approximately 15 years after the District Court's decision in General Petroleum, the Court of Appeals for the District of Columbia Circuit decided California Co. v. Udall, 296 F.2d 384 (D.C. Cir. 1961). (This case sometimes is known as the "Romere Pass gathering case.") The court noted near the beginning of its analysis that "[a]ppellant admits that it has a duty to market gas removed from these leaseholds." It went on to state that "the lessee was obliged to market the product," noting that the rule then in force regarding waste prevention (part of the former 30 C.F.R. 221.35 ) reflected that duty. 296 F.2d at 387. In holding that the Secretary had authority to define "production" as production in marketable condition (in that case, production that had been gathered), the Court plainly viewed the conditioning obligation as additional to and in furtherance of the lessee's already existing duty to market.
The 1988 royalty valuation rules contained three references to the implied covenant to market production. The rules provide that MMS may require the lessee to value production under the non-arm's-length "benchmarks" if MMS determines that the gross proceeds accruing to the lessee under an arm's-length contract do not reflect the reasonable value of production "because the lessee otherwise has breached its duty to the lessor to market the production for the mutual benefit of the lessee and the lessor." 30 C.F.R. 206.102(b)(1)(iii) (crude oil), 206.152(b)(1)(iii)(unprocessed gas), and 206.153(b)(1)(iii)(processed gas).3 These provisions have never been challenged and have been in effect for 12 years.
Lessees sought to deduct costs of marketing in two cases that came up through the Department's administrative appeals process in the latter 1980s. In Walter Oil and Gas Corp., 111
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IBLA 260 (1989), the lessee of Federal leases on the offshore Louisiana Outer Continental Shelf ("OCS") contracted with an independent marketer to locate buyers for the lessee's gas, negotiate sales contracts, and monitor gas sales. Walter then sought MMS approval to deduct the amounts it paid to its marketer from royalty value. The Interior Board of Land Appeals ("IBLA," or "the Board") upheld MMS' denial of the requested cost deduction. The Board rejected Walter's argument that it could deduct the marketing fees on the theory that the regulations didn't specifically prohibit it from doing so. The Board held that the only allowances recognized under the rules were for transportation costs and (in the case of "wet" gas) processing costs. Citing California Co. v. Udall, the Board held that "[t]he lessee has a duty to market the gas." 111 IBLA 265. It held that a lessee may either use its own employees or hire an independent marketer to find markets for the gas, but in neither event could it deduct the costs from royalty value. Id. Walter did not seek judicial review of the Board's decision.
Just two weeks after the Walter decision, in Arco Oil and Gas Co., 112 IBLA 8 (1989), the IBLA considered another situation where a Federal lessee-producer on the offshore Texas OCS had hired a marketing agent. The marketing agent identified and arranged for commercial customers, arranged for aggregating nominations of customers on the pipeline, dealt with the local distribution company involved, and arranged for transportation downstream of the delivery point. The Board first summarized Arco's arguments, which closely track the arguments industry is making today:
Arco maintains that the marketing arrangement with Unifield enhances Arco's ability to market the government's share of production at a higher price than otherwise may be attainable for sale of production at the wellhead (Statement of Reasons (SOR) at 2). While Arco concedes that the lessee has an obligation to market production at the lease for the benefit of both...
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