TREATMENT OF PRODUCT EXCHANGES AND BUY-SELL CONTRACTS UNDER THE DEPARTMENT OF INTERIOR VALUATION REGULATIONS
| Jurisdiction | United States |
(2000)
TREATMENT OF PRODUCT EXCHANGES AND BUY-SELL CONTRACTS UNDER THE DEPARTMENT OF INTERIOR VALUATION REGULATIONS
Office of Enforcement Royalty Management Program Minerals Management Service
Denver, Colorado
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Regulatory Framework
Background
The Secretary of the Interior has the power to set the value of crude oil produced from federal or Indian oil and gas leases. For the period under consideration in this paper, the Secretary exercised that discretion by promulgating regulations. For oil produced from federal or Indian leases during the period prior to March 1, 1988, the regulations were found at 30 C.F.R. § 206.103 (1987) for onshore leases and § 206.150 (1987) for offshore leases. For onshore leases, the regulations set "[t]he value of production, for the purpose of computing royalty" for onshore leases to be:
The estimated reasonable value of the product determined by the Associate Director due consideration being given to the highest price paid for a part or for a majority of production of like quality in the same field, to the price received by the lessee, to posted prices, and to other relevant matters. Under no circumstances shall the value of production ... be deemed to be less than the gross proceeds accruing to the lessee from the sale thereof or less than the value computed on such reasonable basis as shall have been determined by the Secretary. In the absence of good reason to the contrary, value computed on the basis of the highest price per barrel ... paid or offered at the time of production in a fair and open market for the major portion of like-quality oil ... produced and sold from the field or area where the leased lands are situated will be considered to be a reasonable value. 30 C.F.R. § 206.103 (1986).
The section applicable to offshore leases is similar. It sets the value of production from leases on the outer continental shelf as "never ... less than the fair market value." It continues:
The value used in the computation of royalty shall be determined by the Director. In establishing value, the Director shall consider: (a) The highest price paid for a part or for a majority of like-quality products produced from the same field or area; (b) the price received by the lessee; (c) posted prices; (d) regulated prices; and (e) other relevant matters. 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. 30 C.F.R. § 206.150 (1986).
While the regulations in effect for production prior to 1988 allow considerable discretion, they both require a value based on the higher of proceeds ("gross proceeds") or market ("market value" or "highest price paid for a major portion"). Unlike private leases, which usually either provide for the payment of royalty based on market value or proceeds, the regulations applicable to federal and Indian leases generally provide for value to be based on the higher of the two.
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The codified regulations were supplemented by Notices to Lessees published by the Conservation Division of the U.S. Geological Survey (USGS), the predecessor agency to the Minerals Management Service (MMS). In particular, USGS published a Notice to Lessees and Operators of Federal Onshore Oil and Gas Leases (NTL-1) (February 1, 1977), and a Notice to Lessees and Operators of Indian Oil and Gas Leases (NTL-1A) (April 1, 1977).
In NTL-1, the Conservation Division delegated the authority to value crude oil to the Regional Supervisor.1 It limited that authority to the same factors listed in the regulation above. During a period when the price of crude oil was regulated, it required the value be at least "gross proceeds accruing to the operator" or "the highest price legally obtainable for production from the lease." Like the rules that follow, the NTL allowed an application for the establishment of royalty value, submitted by each operator and working interest owner. The application was required to be "accurate and complete." Failure to file an accurate and complete application would "result in the Supervisor establishing a royalty value equal to the highest price paid for like quality production in the field or area, assessing liquidated damages, or taking other appropriate action to bring about compliance."2
During the 1980s, after the formation of the MMS, the Department of the Interior (Interior) promulgated new valuation regulations for the valuation of crude oil. The process took many years while Interior worked with interested parties: including States and Indians that either share in Federal royalties (States) or are the beneficial owners of the royalty estate (Indians); oil producing companies, which are lessees of Federal and Indian leases; and Congressional committees. The final rule was published in January 1988 and was effective for production beginning March 1, 1988.
Interior explained that the purpose of the new regulations was to clarify and simplify the payment of royalties. As MMS stated when it published the regulations:
The MMS is revising the current regulations regarding the valuation of oil to accomplish the following: ...
(4) Clarification that royalty is to be paid on all consideration received by lessees, less applicable allowances, for lease production.
(5) Creation of regulations to guide the lessee in the determination of allowable transportation costs to aid in the calculation of proper royalty due the lessor.
53 FR 1184 (Jan. 15, 1988).
The rules also were intended to base value for royalty purposes on the market value of the product exchanged in a free and open market between a willing buyer and a willing seller. They had two basic propositions: (1) for transactions that were arm's-length transactions
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between a willing buyer and a willing seller, value was generally to be the "gross proceeds accruing to the lessee,"3 and (2) for other transactions, value was to be based on a series of benchmarks, each of which was meant to approximate the market value.4
Under the first principle, "gross proceeds" are given an expansive meaning in the regulations, which follows the gloss given to the term under the previous set of regulations.5 The expansive meaning of gross proceeds has been repeatedly upheld in litigation.6 In addition, Interior explained that in determining what was gross proceeds, MMS would "examine whether the contract reflects the total consideration actually transferred either directly or indirectly from the buyer to the seller for the oil." If there was additional consideration, there were two possible outcomes. Either MMS could add the other consideration to the contract price to reach the total consideration, or MMS could require the production to be valued according to the benchmarks.7 Interior explained in the preamble to the rule that if total consideration could be valued, that would be used to measure the gross proceeds, otherwise, the benchmarks could be used. Interior determined that a lessee must use the second through fifth benchmarks if the contract did not reflect reasonable value due to misconduct between the parties, or because the lessee had breached its duty to the lessor to market the production for their mutual benefit.8
Second, for dispositions other than sales at arm's-length,9 value was to be based on a series of benchmarks, which the lessee was expected to apply. The lessee was required to use the first applicable of the benchmarks. A lessee must follow the benchmarks in lexicographic order. The first one must be followed before the second may be used, etc. Each benchmark is intended to mimic either the gross proceeds or the market value of the oil (or both). The first benchmark is the one that MMS expected to be followed the most often. It requires the lessee to value the oil that must be valued under a benchmark (either non-arm's-length dispositions, or dispositions for which additional consideration was received, but which would not be valued under (b)(1)(ii)) by the lessee's actual arm's-length transactions. More particularly, this benchmark requires the lessee to use the weighted average of all its arm's-length sales and purchases, whether sold or purchased
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under sales contracts or posted prices, to value to other oil in the same field or from the same area for which benchmark valuation applies. The value must also be comparable to other people's posted prices used in arm's-length transactions or other people's arm's-length contract prices.
The second benchmark would then require a lessee to use the arithmetic average of other person's contemporaneous posted prices actually used in arm's-length transactions in the same field or from the same area. The third benchmark requires the lessee to use the arithmetic average of other person's arm's-length contract prices. The fourth benchmark requires the lessee to propose a method that uses arm's-length spot prices from the same field or area or other relevant matters. The fifth benchmark requires the lessee to use a net-back method or other reasonable method to compute value.10 It is important to note that the rules also make it clear that the meaning of lessee for these rules is either the actual lessee or its affiliate or agent that provides marketing services for the lessee.11
It is important to note that while industry commenters referred to the benchmark system as one based on posted prices, MMS did not simply accept any posted price, but insisted that the lessee use its posted prices (and other contract sales and purchases) only if they were used in arm's-length contracts (involving significant quantities of production from the field). For example one industry commenter declared that they:
strongly support the...
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