TRANSPORTATION & PROCESSING Or Marketability v. Transportation, Hatfields v. McCoys, Liberals v. Conservatives, and Other Well-Settled Controversies
| Jurisdiction | United States |
(Feb 2004)
TRANSPORTATION & PROCESSING
Or
Marketability v. Transportation, Hatfields v. McCoys, Liberals v. Conservatives, and Other Well-Settled Controversies
Office of the Solicitor
Department of the Interior
Washington, D.C.
There is an old saying about old soldiers, namely, that they never die, but just fade away. Federal and Indian royalty experience in recent years indicates that some kinds of controversies seem to resist both death and diminution -- they neither die nor fade away. Perhaps this is to be expected when we must determine the relationship between two established principles that have opposite consequences on royalty payments. Thus does the question of whether certain costs are non-deductible costs of putting production into marketable condition or are deductible costs of transportation take its place among America's long-running legal feuds. Some background discussion is appropriate to set the stage for our analysis of the issues.
The various Federal mineral leasing statutes (principally the Mineral Leasing Act (MLA), 30 U.S.C. §§ 181 et seq., the Mineral Leasing Act for Acquired Lands (the "Acquired Lands Act"), 30 U.S.C. §§ 351 et seq., and the Outer Continental Shelf Lands Act (OCSLA), 43 U.S.C. §§ 1331 et seq.), along with the express terms of lease instruments, require a royalty of a specified minimum percentage of the value of the production removed or sold from the lease. E.g., 30 U.S.C. § 226; 43 U.S.C. § 1337(a). Departmental regulations require similar royalty provisions for Indian leases issued under the Indian Mineral Leasing Act, 25 U.S.C. §§ 396a -396d (tribal lands) and 25 U.S.C. § 396 (allotted lands). All of these statutes grant the Secretary of the Interior general rulemaking authority. E.g., 30 U.S.C. § 189 (MLA); 30 U.S.C. § 359 (Acquired Lands Act); 43 U.S.C. § 1334(a) (OCSLA); 25 U.S.C. § 396d (Indian tribal leases); and 25 U.S.C. § 396 (Indian allotted leases). At the same time, almost all the lease instruments reserve to the Secretary the authority to establish the reasonable value of production for royalty purposes.
Minerals Management Service (MMS) regulations, together with applicable judicial and administrative case precedents, establish two obligations that the lessee must undertake at its own expense, without deduction for the costs incurred for these functions when calculating royalty value. These are the requirements to (1) put production into marketable condition, and (2) to market the production. (While not identical, these requirements are related.)
Putting crude oil into marketable condition involves removing basic sediment and water (BS&W). Putting gas into marketable condition may involve, depending on the circumstances, gathering, compression, dehydration, and "sweetening." 2
Sweetening involves removal of so-called "acid gases" -- gases that combine with water vapor to form acid compounds that are damaging to pipelines. The most common is hydrogen sulfide (H%l2%lS) which, when combined with water, forms sulfuric acid (H%l2%lSO%l4%l). (Removing H2S is often called "desulphurization.") Because of the increasing production of coalbed methane, carbon dioxide (CO%l2%l, which combines with water to form carbonic acid (H%l2%l CO%l3%l)) is an increasingly common acid gas. Acid gases, depending on their nature and concentration, also may seriously limit or even prevent practical use of the gas in the absence of treatment to remove these compounds.
Water vapor likewise must be removed from a gas stream as part of preventing the formation of corrosive acid compounds that damage pipelines. Most gas therefore must be dehydrated to a level consistent with pipeline operational requirements.
In addition, most gas comes from the producing wells at pressures less than what is necessary to enter the relevant pipeline that moves the gas to market. If such gas is not compressed, it will not flow into the pipeline because it will be unable to overcome the higher pressure of the relevant pipeline. In most cases, therefore, compression to the pressure of the relevant pipeline is necessary to produce gas as well as to market it.
Finally, gas produced from multiple wells is not marketable or usable until it has been accumulated for treatment and ultimate transport. Accumulation for that purpose is commonly called gathering. Thus, all of the conditioning operations -- gathering, compression, dehydration, and sweetening -- ordinarily are necessary to prepare gas for entry into a pipeline and, therefore, to make it marketable.
At the same time, the regulations and precedents establish two types of allowances -- deductions that the lessee may take under applicable circumstances when calculating royalty value. The first is the cost of transporting production to a sales point remote from the lease or unit. This "transportation allowance" applies to both gas and crude oil. The second deduction is for the costs of processing so-called "wet" or "unprocessed" gas to extract normally liquid hydrocarbons of molecular weight heavier than methane (CH%l4%l) or other valuable royalty-bearing products that are sold after extraction. 3 Obviously, there is no analogous allowance for crude oil.
Analyzing the lessee's duty to market is beyond the scope and purpose of this paper. This paper will focus on the relationship between the requirement to put production into marketable condition and the transportation allowance, in the specific context of gas produced from Federal or Indian leases. Our purpose here is to look at the "line" between putting gas into marketable condition and transportation. 4 Some comments about processing allowance issues will be added.
It is appropriate to begin by examining the marketable condition requirement and the transportation allowance, including applicable precedents.
I. The "Marketable Condition" Requirement
Interior Department regulations governing onshore Federal and Indian oil and gas leases in force since at least 1942, as well as rules governing offshore leases in effect since offshore leasing began under OCSLA in 1954, required 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. (See former 30 C.F.R. § 221.31 (1942-1982), later recodified as 43 C.F.R. § 3162.7-1 , and former 30 C.F.R. § 250.41(b) (1954-1968), redesignated as 30 C.F.R. § 250.42(b) (1969-1987), amended without substantive change in 1979.)
The 1942-1987 onshore and Indian valuation rules and the 1954-1987 offshore rules also contained provisions regarding compression in the context of processing "wet" gas. The regulations granted an allowance against the value of the NGLs for the actual costs of processing, not to exceed two-thirds of the value of the NGLs. In that context, the rules expressly prohibited a deduction for the costs of "boosting" (i.e., compressing) the residue gas, the dry methane left after extraction of the NGLs. (See former 30 C.F.R. § 221.51(b) (1942-1982), later recodified to 30 C.F.R. § 206.106(b) (1983-1987), and former 30 C.F.R. § 250.67(d) (1954-1982), later recodified to the former 30 C.F.R. § 206.152(d) (1983-1987).) These provisions mirrored the general marketable condition requirement.
Important early cases arose in the late 1950s and early 1960s. In The Texas Co., 64 I.D. 76 (1957), the Department held that costs of gathering gas to the central point in the field and of compressing the gas to the pressure required to enter the purchaser's pipeline were not deductible in determining the royalty value of the gas.
Two years later, in The California Company, 66 I.D. 54 (1959), the Department held that the costs of compressing gas to pipeline pressure, gathering, and dehydration were not deductible from the sales price in computing royalty value. The district court upheld the Department's ruling on judicial review. California Co. v. Seaton, 187 F. Supp. 445 (D.D.C. 1960). On appeal, the D.C. Circuit found that Calco was required by regulation to market the gas removed from its leasehold. The court held that the Secretary had acted within his authority in defining "production" (in the statutory phrase "value of the production") as production in marketable condition. The lessee therefore could not deduct its costs of compressing, gathering, and dehydrating the gas so that it could enter the pipeline. California Co. v. Udall, 296 F.2d 384, at 387-88 (D.C. Cir. 1961).
In Placid Oil Co., 70 I.D. 438 (1963), the Federal lessee had contracted with a related entity to perform compression, dehydration, and processing of wet gas. The Department followed The Texas Co. and California Co. v. Udall in disallowing deductions for the costs of gathering and dehydrating high pressure gas and gathering and compressing low pressure gas in computing royalties.
Almost 25 years later, in 1987, one of the Federal offshore...
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