UNIT PARTICIPATING AREAS: MONTANA/DAKOTAS
| Jurisdiction | United States |
(Feb 1998)
ROYALTY-IN-KIND: A WIN/WIN SOLUTION
Marathon Oil Company
Houston, Texas
Introduction
Royalty-in-kind (RIK) is a concept whose time has come. A growing interest in a comprehensive RIK program was demonstrated throughout 1997 by the oil and gas industry, the federal government, and state governments. Royalty-in-kind was a common theme in industry's comments to the proposed oil valuation regulations. Likewise, Jim Geringer, Governor of Wyoming, stated in comments to the proposed regulations. "MMS should take all its royalty in kind and have first hand knowledge of the market."1 Public workshops held by the Minerals Management Service (MMS) in March and April were widely attended by all segments of the oil and gas industry and state representatives. MMS also released the final report of its 1997 Royalty in Kind Feasibility Study in September 1997.
RIK received considerable attention in Congress last year as the Subcommittee on Energy and Mineral Resources of the U.S. House of Representatives (Subcommittee) held oversight hearings on the subject on July 31 and September 18. The Subcommittee indicated it was committed to exploring the need for legislation to resolve royalty valuation issues and would thoroughly review royalty-in-kind as a viable solution.
The Need for an RIK Program
The interest expressed by federal lessees in a wide scale royalty-in-kind program is a direct reflection of the demonstrated need for such a program. The most obvious need is to resolve the ongoing and seemingly endless valuation disputes between MMS and industry. As stated by one of the consultants used by MMS to develop the oil valuation regulations proposed in 1997, "The only way to be absolutely certain that a fair market value is received for royalty oil is to take the oil in-kind for sale by the state agency."2 Likewise, the only way for the federal government to be certain it receives fair market value for its royalty production is to take its royalty oil and gas in-kind and sell it in the marketplace.
Disputes between MMS and industry regarding the valuation of crude oil and natural gas have existed for many years and show no signs of abating. Both federal government and industry expend significant resources each year arguing over the value of production through the administrative appeals process and the courts. Furthermore, the parties have spent countless hours working to write new regulations to determine and define market value.
In June 1994 the Secretary of the Interior chartered the Federal Gas Valuation Negotiated
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Rulemaking Committee to resolve many issues facing the valuation of federal gas. The committee's recommendations would have allowed lessees to choose from several options for valuing natural gas for royalty purposes. The options included index prices published in natural gas newsletters, affiliates' arm's-length sale prices, and residue prices applied to the wellhead. A proposed rule was published on November 6, 1995, and all interested parties were given an opportunity to provide comments. In mid-1996 the committee was reconvened and the public comment period was reopened. The proposed rule was withdrawn in April 1997 following the receipt of additional comments, further work by the members of the committee representing MMS, states, and industry, and MMS' cost/benefit analysis of the impact of the proposed rule. Instead, MMS decided to rely on its 1988 regulations to value gas in the post-FERC Order 636 era.
Crude oil valuation has also been the subject of a proposed rulemaking. In January 1997 the Minerals Management Service published a notice of proposed rulemaking for establishing the royalty value of oil produced from federal leases. MMS' stated intent was "to decrease reliance on oil posted prices and to develop valuation rules that better reflect market value."3
In an effort to achieve its purpose, MMS proposed an index-based netback which began with the average of the daily NYMEX futures settle prices for the Domestic Sweet Crude Oil contract for the prompt month. The NYMEX price was to be adjusted using a differential to account for the difference in price between Cushing and the nearest market center. Additional adjustments were to be made for the exchange differential between the applicable market center and an MMS defined aggregation point and transportation costs between the aggregation point and the lease.
As demonstrated by the outpouring of comments to the proposed regulations (over 1,800 pages) the problems inherent in the proposed rule were innumerable. First, the proposed rule was based on controversial market assumptions which were highly disputed. For example, MMS assumed there is no active market for oil at the lease. However, testifying at the class certification hearing in Engwall v. Amerada Hess Corporation, et al. in New Mexico, Professor Joseph P. Kalt of the Harvard University Kennedy School of Government provided evidence of over 850,000 outright arm's-length transactions at the lease in New Mexico, Oklahoma, and Texas during the period 1990-1996. Based on his studies of these transactions, Professor Kalt testified that the market price of crude oil at the lease is influenced by localized supply and demand factors which varied from lease-to-lease and from transaction-to-transaction.4 MMS' assumption that there is not an active market for oil at the lease resulted in a proposed methodology which failed to account for the localized factors influencing market price.
The proposed oil valuation regulations were heavily criticized for a variety of other reasons as well. These reasons include: the limitations of NYMEX itself, inconsistent treatment of localized markets, and unrealistic adjustments to the NYMEX price in an attempt to value production at the lease. Despite MMS' goal to add certainty to the oil valuation process, the proposed regulations potentially could lead to even greater uncertainty and more disputes between MMS and industry regarding the value of oil for royalty purposes. Furthermore, no
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valuation policy will totally eliminate valuation disputes. For this reason, a comprehensive, workable royalty-in-kind program gained widespread support.
Jim Magagna, former Director of the Office of State Lands and Investments, Office of Federal Land Policy, State of Wyoming, recognized the need for an RIK program in his testimony before the Subcommittee last July. He said, "We are not confident that a valuation approach can be devised which will have common geographic applicability. While Wyoming's interest in a royalty in-kind approach precedes this MMS valuation initiative, we believe that the difficulties with oil valuation demonstrated by many of the comments on the proposed rulemaking provide added incentive to all interests to seriously consider royalty in-kind."5
MMS' Royalty-in-Kind Feasibility Study
MMS also studied royalty-in-kind as part of its continuing examination of potential improvements to the nation's mineral royalty management program, and last September it released the final report of its 1997 Royalty in Kind Feasibility Study. In her testimony before the Subcommittee in July, Cynthia L. Quarterman, Director, Minerals Management Service, stated the "primary objective of our current study is to determine if implementation of an RIK program or programs for Federal oil and gas is in the best interests of the United States, and, if so, under what circumstances."6 Quarterman further stated that to be in the best interests of the United States, a royalty-in-kind program must "offer potential revenue neutrality or enhancements to the U.S. Treasury" and "provide extensive administrative relief for MMS and industry."7
The feasibility study concluded that, if implemented correctly, royalty-in-kind programs could be workable, revenue positive, and administratively more efficient. The report recommended further examination and development of detailed royalty-in-kind strategies in the following areas: (1) oil production in Wyoming; (2) natural gas production in the Gulf of Mexico; and (3) 8(g) production offshore Texas. The study concluded an in-kind program for natural gas from the Gulf of Mexico had the most potential for success...
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