VALUATION OF AFFILIATE SALES AND JOINT VENTURES: PERSPECTIVES OF AN INDUSTRY SYMPATHIZER

• Jurisdiction: United States

Federal & Indian Oil & Gas Royalty Valuation and Management III
(2000)
CHAPTER 10B
VALUATION OF AFFILIATE SALES AND JOINT VENTURES: PERSPECTIVES OF AN INDUSTRY SYMPATHIZER
L. Poe Leggette ^*
Fulbright & Jaworski L.L.P.
Washington, D.C.

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§ 10B.1 Introduction

The competition cannot even come close. Historically, the single royalty valuation issue most sharply dividing the federal lessor from its lessees concerns the right way to value a sales or transportation transaction between affiliated companies. No issue more quickly brings out the rhetoric and innuendo from the mouths of attorneys.

When the landowner is the government of the United States, is there sound reason for the problem of valuation to be so difficult? Consider the following parable of the affiliate's sale.

There is a certain producer owning a well on a lease in an oil field. In a given month, the producer sells his oil to a third party at the lease in an outright sale for $10 per barrel. No one else of the many selling oil from the same field receives a higher price. Under regulations going back to 1920 through March 2000's new oil value rule, the Department of the Interior (Interior or the Department) has accepted that $10 price, subject only to rare exceptions.

The next month the same producer decides there is money to be made in buying oil in the field and moving it to Cushing, Oklahoma, for resale. The producer creates an affiliate for that purpose. For $10 per barrel, the affiliate buys oil in the field from all unaffiliated producers, but not from its producing affiliate, who sells his barrels at the lease to a third party at the same $10 price. The affiliate spends $1 per barrel moving the oil it bought to Cushing. It resells the oil for $12 per barrel, making a $1 per barrel profit. Under regulations going back to 1920 through March 2000's new oil value rule, the Department of the Interior has accepted the producing affiliate's $10 price, again subject only to rare exceptions. The Department claims no share in the extra $2 of proceeds received or the $1 of profit earned by the affiliate which bought at the lease and sold in Cushing.

In the third month, the same producing company now decides to sell its own oil at the lease to its affiliate at $10 per barrel. (The affiliate is now the purchaser of all oil produced in the field, all bought at $10 per barrel.) The affiliate spends $1 per barrel moving all the oil from the field to Cushing and resells it for $12 per barrel, realizing a $1 per barrel profit. Obviously, because the Department finds $10 per barrel to be the correct value in months one and two, it surely would agree that the value in month three is also $10 per barrel. Unfortunately, however, this is not the case.

Over the last twenty years, the Department has been like Eve. Not Adam's wife, but the schizophrenic made famous in the book titled The Three Faces of Eve. In answer to whether the $10 per barrel in month three would be an acceptable royalty value, it has said "Yes," "Maybe," and

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"Under no circumstances would we ever accept a self-serving, self-dealing sham transaction like that one, for a lessee cannot avoid its duty to pay royalties on its gross proceeds by selling to an affiliate."

To understand how the Department views affiliate sales and how it should view such sales, we begin with some history.

§ 10B.2 Federal Royalty Basics

Under the federal leasing statutes, the Secretary of the Interior is to issue leases with provisions reserving to the government a royalty interest in the "amount or value of production" removed or sold from the lease.¹ For royalty purposes, the cases establish that value "means `reasonable market value'; that price which a product will bring in an open market, between a willing seller and a willing buyer."²

Another tenet of royalty valuation, equally important, has been firmly adhered to for decades: the goal of the Department's rules for valuing oil and gas is to determine the value of production at the wellhead on the lease.³ When first sales have occurred away from the wellhead, the Department has recognized that the movement of the production to the point of sale has added value to it: "the price received for a product at a distance from the point of production is not the value of the product at the point of production because the costs incurred in transporting the product have added value to it."⁴ This point was recently reaffirmed in a district court decision where the court held that, "the government's royalty interest is limited to the value of production at the lease or wellhead, not in value enhancements resulting from downstream activities."⁵

Prior to March 1, 1988, the Department's general regulations on valuing oil and gas for royalty purposes did not expressly distinguish production sold at arm's-length from production sold otherwise.⁶

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Instead, the Interior Board of Land Appeals (IBLA or the Board) fashioned rules of decision to deal with sales of lease production between affiliated parties.

The seminal decision in this area is Getty Oil Co.⁷ There Getty Oil Company (Getty) entered into two agreements with Transcontinental Gas Pipe Line Corporation (Transco), one a sales contract, the other a transportation contract. Under the transportation contract, Transco agreed to ship a portion of the natural gas produced from Getty's offshore lease from the Gulf of Mexico to a connection near a refinery in Delaware. Getty sold the transported gas to its wholly owned subsidiary, which operated the refinery and which used the gas in a hydrocracking process. Under the sales agreement between Getty and its subsidiary, the subsidiary paid Getty the same price for the gas that Transco paid Getty under their sales contract.

The U.S. Geological Survey had assessed additional royalties against Getty on the theory that Getty could have abrogated its contract with its subsidiary at any time and sold the gas at a higher price. Rejecting this argument, IBLA ruled that "a parent corporation and its wholly owned subsidiary may enter into a valid contract."⁸ IBLA found it "error, in the absence of even a suggestion of impropriety, for GS to disregard the validity of Getty's agreement" with its subsidiary. IBLA explained:

Although contracts between a parent corporation and its subsidiary may not be at arm's length, they may result in a fair market price. If a transaction is not at arm's length, some other manifestation that the price is nonetheless an accurate portrayal of the article's

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worth is required. It must be a price which independent buyers in arm's length transactions would be willing to pay.⁹

IBLA found that because the price Getty received from Transco and from its subsidiary were equal, the subsidiary's price reflected the fair market value of the gas.

Getty Oil Co. stands for three propositions, none of which has ever been repudiated in subsequent IBLA decisions. The first is that affiliated corporations are separate legal entities and may lawfully contract with one another.¹⁰ The second is that the Department recognizes that companies form affiliates for a variety of business purposes.¹¹ The Department does not presume that affiliates are formed to evade royalty obligations. The third is that, as to that portion of the gas which Getty sold to its affiliate for use in one of its refineries, the affiliate contract price is the proper value if it is one which the lessee would have received from other unaffiliated buyers.¹²

Although nothing in Getty Oil suggests that the rule should be different when the affiliated purchaser does re-sell the production, the facts in that case did not squarely present the issue. Subsequent IBLA decisions addressed this situation, however. In each one, IBLA compared the non-arm's-length sale with a sale by another producer to a first purchaser. Until its 1993 decision in Santa Fe Energy Products Co.,¹³ and its 1995 decision in Shell Oil Co. (On Reconsideration),¹⁴ IBLA had never followed the approach of comparing the non-arm's-length sale with an affiliate's resale price.

The first proof of this point came in a case concerning the valuation of royalties on zinc concentrates.¹⁵ In Amax Lead Company of Missouri, the issue was how to value zinc sold under a non-arm's-length contract to a smelter in Illinois, which then processed the zinc for shipment and resale in markets on the Atlantic Seaboard.¹⁶ Both the Minerals Management Service (MMS) and the IBLA agreed that the value was to be determined by reference to prices received by unaffiliated producers of zinc who sold the concentrates to the Amax smelter. Neither MMS nor IBLA suggested that the requirement to value royalty based on "the gross value of the minerals,"¹⁷ authorized the Department to compare the proceeds the lessee received with those received by its affiliate upon resale.

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The next case addressing Getty Oil in the context of the resale of oil or gas is one of IBLA's leading precedents in the area of royalty valuation, Transco Exploration Co.¹⁸ In Transco the issue was whether Transco Exploration Company (TXC) had correctly valued the royalty on gas it produced on lease OCS-G 1960 and sold to its affiliate, Transcontinental Gas Pipeline Corporation (Transcontinental), for resale in the interstate gas market. If ever it was the Department's policy to prevent a lessee from avoiding the gross proceeds rule by selling production to an affiliate for resale,¹⁹ then surely here was the case for that policy to be enforced. For without being legally required to do so, TXC over the course of three years routinely agreed to lower the sales price to Transcontinental.²⁰ Yet IBLA did not think it necessary or appropriate to inquire into the price at which Transcontinental resold the gas. Instead, IBLA agreed that MMS correctly had looked to see what other unaffiliated producers who held an interest in the same...