There's never an end to legal complexities of the U.S. natural gas industry. Producers should be focused on competition in a new regulatory regime. Instead, initiatives of the Department of Interior force them to keep worrying about federal royalties they may have to pay on receipts since 1980 for settlement of take or pay disputes.
Interior and its Minerals Management Service have been trying to make money on take or pay settlements since 1985. At that time, pipelines were buying their ways out of obsolete gas purchase contracts as an alternative to paying above-market prices for gas and claims to gas they didn't need.
The issue has entered a new phase in recent months as key court cases begin to be settled. And it is as murky as ever.
The issue revives
Interior's first effort to collect royalties from take or pay settlements ended in apparent failure. In a case styled Diamond Shamrock Exploration Co. vs. Hodel, the Fifth Circuit Court of Appeals ruled in 1988 that producers had to pay royalties only on physical production.
But the issue revived in May 1993, when MMS notified federal leaseholders that it intended to collect royalties on settlement payments attributable to production. Independent Petroleum Association of America led an industry group that challenged the initiative in court and eventually agreed with MMS to await outcome of five test cases. These come from a group of 1,500-1,800 cases MMS expects to audit out of 2,500 take or pay settlement cases it has identified.
So far, courts have ruled in two of the test cases, and the decisions appear to conflict.
In the first case, Samedan Oil Corp. vs. Ada E. Deer and others, the U.S. District Court for the District of Columbia in June upheld an order making the producer pay royalties on take or pay settlement payments from Southern Natural Gas Co. In the second case, a bankruptcy proceeding for Century Offshore Management Corp., the District Court for the Eastern District of Kentucky said Century Management, which owned federal leases off Louisiana, did not owe royalties on its settlement from Enron Gas Marketing Inc.
The central question in both cases is the definition of gross proceeds, upon which royalties are based. In the Century Management case, the court relied on the Diamond Shamrock interpretation and said MMS exceeded its authority in trying to collect royalties from payments other than those for minerals physically severed from the lease. In the Samedan case, the court said MMS's 1993 initiative raised issues that the Diamond Shamrock case didn't address, and that it was right to do so.
The cases and the settlement payments in question aren't identical. For now, the legal technicalities that distinguish them aren't very instructive. For now, says Jim Lawnin, a senior manager for Ernst & Young specializing in litigation support and valuation services, producers and pipelines that received payments to settle take or pay claims must be aware that they face the threat of additional royalty liability. And if the Samedan precedent stands, producers may have to prepare for a future in which the government can claim royalties on any benefit that derives from a federal lease.
Motives clear
The government's motives are clear. Interior, if court decisions go its way, might eventually collect royalties on take or pay settlements totaling $750 million. It would be hollow treasure. Companies facing broad and uncertain royalty liability on federal leases will certainly discount the value of those leases. The discount will take the form of subdued bidding in lease sales and diminished activity on federal land.
At this point, producers can only wait until the test cases are settled, interpreted, and reconciled. In the meantime, they might raise this question with federal officials: If the government is so desperate for royalties, why doesn't it just lease more land?
Copyright 1995 Oil & Gas Journal. All Rights Reserved.
