MMS considers changes to natural gas royalty rule

April 28, 2003
The Department of the Interior's Minerals Management Service may change its natural gas royalty rule but first wants to hold four public workshops this spring.

The Department of the Interior's Minerals Management Service may change its natural gas royalty rule but first wants to hold four public workshops this spring.

"Although we believe the federal gas valuation rule is providing a fair return on federal resources, it is now 15 years old," said MMS Director Johnnie Burton Apr. 10.

"The natural gas market has changed over those years, and MMS has also gained experience from the 2000 Indian Gas Valuation Rule and from 5 years of taking royalties in kind," she said. "We believe it is time to review and perhaps update the existing rule."

Natural gas traditionally accounts for more than 60% of the agency's federal petroleum royalty revenue. And that royalty money MMS generates is becoming increasingly important for federal and state budgets because of growing deficits.

Under the most recent agency estimate, oil royalties from federal offshore leases are expected to be $1.76 billion in fiscal 2002, which ended Sept. 30, 2001. Offshore gas receipts are anticipated to be $2.94 billion. Onshore, oil royalties are expected to total $157.7 million; gas royalty totals are $550.3 million.

Current rule confusion

When companies sell gas to a nonaffiliated third party, they typically calculate and pay royalty on a gross proceeds basis. They can also deduct from the royalty value the costs of transporting the gas to market. Alternatively, a company may process natural gas in a plant and deduct from the royalty value a "reasonable" processing cost.

When oil and gas companies sell gas to an affiliate, the royalty burden is more difficult to calculate. A company pays royalties based on the first applicable of three internal MMS benchmarks that rely on a number of market indicators, including comparable arm's length contracts in the field or area. The company must then compare that benchmark value to the total proceeds it receives and pay the higher value.

MMS says it wants to see if it can streamline parts of the gas royalty rule so compliance is easier and there are fewer lawsuits. Industry concurs it wants to avoid litigation. Industry says one way to reduce lengthy disputes over cash royalty payments is to expand royalty-in-kind programs in which the government takes a share of the production instead of a cash payment.

MMS currently offers RIK pilot programs, and pending energy legislation would encourage the agency to dramatically expand the practice.

A recent General Accounting Office report, however, suggests that the agency needs to fine-tune the way it manages RIK before making it widespread for most leases.

Past history

Retooling the gas royalty rule is expected to be a less contentious process than what the agency faced 3 years ago when it overhauled its oil valuation system. Industry lost an important legal challenge last year when the Supreme Court refused to review a ruling by the US Court of Appeals for the District of Columbia Circuit in Washington, DC. The appeals court largely affirmed MMS's "duty-to-market" royalty rules. Producers argued that royalty for oil or gas is due on the value of production at the lease, not the value inclusive of value added downstream. The appeals court reversed an earlier district court's decision and ruled that MMS's method of calculating downstream marketing costs was fair. The court did side with the producers on one point: that the cost of reserving space on a natural gas pipeline, i.e., the unused pipeline demand charge, should be considered by MMS.

The agency last tried to update the way it calculates federal gas royalty payments in 1997 to reflect sweeping changes made by the Federal Energy Regulatory Commission in the 1980s to open the wholesale gas market to competition. But some independent producers opposed MMS's idea of using published indexes as a benchmark for some royalty payments. There also was widespread industry opposition to the way the agency wanted to calculate transportation allowances. The agency consequently postponed making changes to the gas rule until legal challenges were exhausted and its pending oil valuation rule was finalized.

That oil regulation links cash royalty payments from some federal leases to published prices in market centers. Previously, the agency typically relied on a company's own posted prices. Industry eventually acknowledged that the system was outdated after MMS and later the US Department of Justice conducted a series of high-profile royalty underpayment investigations in the late 1990s.

MMS recently held a series of workshops to consider technical changes to its 2000 oil valuation rule (OGJ Online, Feb. 20, 2003). Possible revisions include changing the way MMS treats transportation costs and using different published market prices as a benchmark for valuing oil from federal leases. Industry now says it is comfortable using New York Mercantile Exchange crude prices as a benchmark, but it still has issues with the way MMS calculates crude location and quality deductions.

Gas comments solicited

For gas, the agency wants comment on several specific issues. It wants to examine whether it should allow lessees who sell their production to an affiliate the option (for a 2-year period) of basing the royalty value on either a published gas index price or their affiliate's arm's length resale price. The agency also wants comments on the use of NYMEX prices at the Henry Hub rather than published spot prices for natural gas.

Another topic for discussion is expected to be whether MMS should adjust natural gas index prices for location differences between the index pricing point and the lease.

Other items to be discussed include transportation costs and rates of return, allowing lessees to apply natural gas index prices to wellhead gas volumes so producers do not have to trace gas processed to remove natural gas liquids, and valuing and reporting natural gas disposed of under joint operating agreements.