Industry, MMS in tough battle over royalty in-kind legislation

Preparing to testify at a recent House subcommittee hearing on royalty in-kind are, seated from left to right, MMS Director Cynthia Quarterman, Debbie Gibbs-Tschudy, head of the MMS royalty valuation division, and Rodger Vicenti, acting president of the Jicarilla Apache Tribe.

MMS Director Cynthia Quarterman Royalty in-kind is "unproved and risky for royalty collection in the U.S." [8,282 bytes]
Independent Diemer True illustrates the complexity of the Minerals Management Service's pending royalty valuation rule at a Washington, D.C., press conference. [9,892 bytes]
Rep. Billy Tauzin (R-La.) "The very simple thing to do is to say to the government, 'take your share of royalty oil and market it yourself and get your value.' Then nobody has to fight anymore about what the value is." [7,581 bytes]
Scope of Federal royalty process [74,155 bytes]

If simple answers are possible to complex problems, then royalty in-kind would seem to be the solution to the U.S. Minerals Management Service's quest to get full value for its royalty oil.

MMS says industry's price postings system no longer reflects the true value of oil production from 72,000 federal leases, and as a result operators have been underpaying some royalties. Paid in cash, the royalties are generally an eighth onshore and a sixth offshore.

The federal agency has proposed, and twice revised, a complex rule for setting the royalty value of crude at the lease (OGJ, Feb. 16, 1998, p. 36).

Producers claim that the proposed rule is reminiscent of the federal government's regulations setting crude and products prices in the 1970s and, like them, will spawn thousands of administrative appeals and civil lawsuits. They are pushing for what they see as a simple alternative: a law to require the government to actually take and sell its own royalty crude to ensure that it gets the best possible price.

But MMS has flatly rejected the blanket royalty in-kind (RIK) legislation pending in Congress.

Industry says MMS's objections are rooted in bureaucratic self-preservation, since RIK could cost the agency hundreds of jobs.

The deeper conflict between industry and MMS on RIK is the same one underlying the oil royalty rulemaking: who pays the costs of upgrading, moving, and marketing federal oil and gas.

Need cited

Both sides agree that the current royalty system is not working.

MMS has tried to avoid using lease postings in its new royalty rule.

The Domestic Petroleum Council, a group of medium-sized oil companies, said, "The current federal oil and gas royalty program is a mess. Regardless of their commitment to pay the federal government every penny owed in royalties, under the current royalty program, our members face constant uncertainty and threat of audit, non-productive re-examination of royalty valuation decisions, and litigation."

Rep. Mac Thornberry (R-Tex.) agreed that the current valuation rule "is complicated and provides no certainty for the states, the taxpayers, or the oil and gas industry.

"Litigation and confrontation do not benefit anyone. And while we cannot put a dollar figure on the government's past, present, and future legal battles with the oil and gas industry, I think it is safe to assume those costs will be substantial."

The congressman said Texas and Alberta have crafted workable RIK programs. He said the Canadian province uses only 33 people to run a 150,000 b/d program (see related story, p. 25).

The Independent Petroleum Association of America (IPAA) said, "For independent producers, RIK takes away the uncertainty involved with determining royalty values. It is the simplest and most certain way to avoid second-guessing and royalty disputes that waste time and money for the federal government, the domestic industry, taxpayers, and consumers."

Prospects

Thornberry and Rep. Barbara Cubin (R-Wyo.) introduced the RIK bill in the House of Representatives.

Cubin chairs the House Resources Committee's energy and minerals subcommittee, which has held two hearings on "The Royalty Enhancement Act of 1998" (H.R. 3334). Markups were pending.

Sen. Don Nickles (R-Okla.) has filed a RIK bill in the Senate, but it has not advanced to the hearing stage.

At the House hearings, Thornberry and Cubin charged MMS with misrepresenting the content and intent of H.R. 3334 (OGJ, Mar. 30, 1998, p. 33).

Cubin remarked, "The rhetoric has escalated beyond a rational discourse of the merits of this bill, almost to the point of name-calling between government and industry."

Oil associations see RIK as the ultimate answer to problems posed by the oil royalty rule, but haven't given up on winning improvements to the latter.

Sen. Kay Bailey Hutchison (R-Tex.) has used a rider on an appropriations bill to prohibit MMS from issuing the royalty regulation for the rest of this fiscal year, or until Oct. 1 (OGJ, May 11, 1998, p. 34).

Last week, Sen. Pete Domenici (R-N.M.) said senators will try to insert language in the 1999 Interior Appropriations bill to prohibit MMS from issuing a final rule until Oct. 1, 1999, unless it "first enters into negotiations with oil producers and reports back to Congress."

Congressional aides say it appears unlikely that stand-alone RIK legislation will pass this year. Even if both houses acted quickly, too few legislative days remain before Congress adjourns in October. And if one were passed, MMS Director Cynthia Quarterman said the Interior Department would ask President Bill Clinton to veto it.

RIK theoretically could be attached as a rider to unrelated "must-pass" legislation, but those opportunities are few.

Another hurdle is whether the Congressional Budget Office (CBO) will score the bill as saving, or costing, the government money. Cubin declared, "I have no intention of moving a bill that does not score positively under the rules of the CBO."

Typically, CBO would not score the bill until it is reported on by the full Resources committee.

An oil lobbyist said, "We're clearly into the next Congress. It may take until then for MMS to finish sorting out its royalty rule, and that goes hand-in-hand with RIK."

The bill

H.R. 3334 would require the U.S. to take 100% of its royalty share in-kind at the applicable delivery point for all onshore and offshore leases.

MMS would retain a "qualified marketing agent" (QMA) who would aggregate and sell federal royalty oil in a region at the best possible price.

As is currently the case, the lessee would assume the costs of gathering the production and placing the oil and gas in marketable condition. The U.S. would pay the cost of transporting its share of production from the lease and the costs of marketing its royalty oil and gas.

The bill has an arbitration mechanism for resolving transportation disputes. Other provisions cover production imbalances, oil shipments other than by pipeline, and reporting requirements.

The legislation retains an existing program that offers federal royalty oil to eligible small refiners. The bill does not apply to production from Indian lands.

MMS objections

Quarterman has objected to RIK as being "unproved and risky for royalty collection in the U.S."

She said H.R. 3334 would force the U.S. to relinquish many of its long-established legal rights to lessees and would require the government to take RIK in areas where conditions are unfavorable.

"This legislation relies on an unproven premise that aggregating crude oil volumes taken as RIK would enhance royalty revenues, including revenues from leases with de minimis production.

"Contrary to that premise, MMS has been told repeatedly by many producers that aggregating crude oil does not significantly enhance value, and we concur with that assessment.

"The administrative costs of taking small volumes from numerous leases would almost certainly more than offset any revenue enhancement. That is probably why the Texas General Land Office does not take royalties in-kind from wells producing less than 10 b/d and why the Alberta crude oil RIK program requires the producer to bear those administrative costs."

MMS said a nationwide RIK program would cost the U.S. $183-374 million/year, depending on assumptions. It said gathering and transportation would cost $76-135 million, processing $4-8 million, treatment $85-178 million, marketing $17-46 million, and other items as much as $7.2 million.

"These cost increases are offset by only a maximum of $7.3 million in annual administrative savings and $35 million in maximum theoretical revenue 'uplift' due to RIK implementation," said Quarterman.

She added that RIK probably would not reduce the number of price disputes between government and industry. "You're simply shifting who we litigate with from the producer to the qualified marketing agent."

Technical points

MMS raised an array of other objections to H.R. 3334.

Quarterman said the bill would replace the current requirement for lessees to place oil and gas production in a condition acceptable to purchasers with one acceptable to transporters.

"The initial transporter is often owned by the lessee or its affiliate. Thus the bill creates the potential for the lessee to self-define marketable condition."

She said the bill would move the dividing line between gathering and transportation closer to the wellhead, shifting costs from producers to the government.

"The bill would require the U.S. to begin paying for transportation of non-royalty-bearing substances (water) in bulk production volumes moved from the lease. Movement of bulk production downstream of the lease is a growing phenomenon that would require the U.S. to assume an increasingly large cost burden compared to today."

She said the bill's "marketable condition" provision would shift to the government much of the cost of cleaning and decontaminating production, plus other field services.

"All costs to market oil and gas production would be assumed by the U.S. under the bill, while, under the current royalty system, these costs-which are substantial-are now borne by lessees.

"Ironically, the bill would actually create marketing costs (to be borne by the U.S.) in many cases where there now are currently not such costs" (e.g., for the substantial volumes of crude oil production simply moved from major producers to their own refineries).

Industry rebuttal

Oil groups retained Barents Group LLC, a Washington, D.C., consulting firm, to examine MMS's evaluation of H.R. 3334.

Barents said the MMS review "was flawed in its method and analysis andellipseled to wrong conclusions. These errors and incorrect assumptions suggest that MMS misunderstands the intent and operation of the proposed RIK program.

"Moreover, the MMS findings are skewed concerning the implications of a federal RIK program for the federal budget. MMS has claimed that the bill would lead to an annual revenue loss for the government of as much as $500 million.

"However, Barents Group's analysis suggests that, if MMS corrected its analytical errors, the agency would find that the federal government would not lose money."

For instance, it said MMS ignored the revenue gains that result as valuation disputes disappear. Barents estimated that gain to be $113 million in the first year and $915 million in the first decade.

"MMS alleges the bill forces the government to incur marketing costs that it does not incur today. But any such increase in cost would likely be offset by an even greater uplift in value as QMAs, working on behalf of the government, compete in the marketplace to get the best price for royalty oil and natural gas.

"MMS claims the bill would lead to disputes with marketers and lead to substantial administrative costs. Whether such disputes occur, however, is largely within the control of MMS (since it) would have virtually complete control over how the contracts with QMAs are structured.

"The MMS analysis also discusses gross federal royalty effects, although these effects would be shared with the states. For federal evaluation purposes, only the net federal share had budgetary effects.

"And, although federal budget analysis is always conducted in current dollars, MMS appears to analyze the impact in constant dollars when estimating for periods of more than a single year."

In just three areas, said Barents, the MMS cost estimates were off by $374 million. The firm concluded that the legislation would result in a net revenue gain for the government.

Industry's views

Independent oil producers and major integrated firms have been united in favor of RIK. Last fall, 23 domestic oil and gas associations told Congress they support RIK.

Ironically, oil lobbyists note that the Clinton administration itself proposed a switch to RIK in its "Reinventing Government" proposal in 1992. At that time, it concluded that RIK could streamline royalty collections and enhance revenues.

IPAA said, "By hiring private marketers to sell oil and gas it takes in-kind, the federal government will likely increase its revenues.

"Marketers from the private sector will use their expertise to aggregate large volumes of oil and gas and will have the market-based incentive to get the best possible price for the federal government."

IPAA said the current "army of accountants, auditors, and clerical staff" at MMS costs the government more than $60 million/year.

"Under a RIK system, MMS will only need to supervise a handful of marketers, thus reducing the administrative burden and the number of federal employees that will be necessary to account for oil and gas royalties."

IPAA said oil and gas producers want a RIK program that is at least revenue-neutral. And it noted that CBO will not credit savings from staff reductions, so any revenue-positive assessment would mean even greater overall savings.

"MMS is concerned about giving up control and authority and facing future staff reductions. It is human nature for this federal bureaucracy to want to hold onto the royalty collection program in the face of increased federal downsizing."

IPAA noted that MMS has the legal authority now to take royalty in-kind, but it lacks "the regulatory and legislative tools that it needs to market oil and gas."

Benefits seen

Diemer True, chairman of IPAA's Land and Royalty Committee, testified at the House resources hearing in May. He is a partner in True Oil Co., Casper, Wyo. He said RIK should be a revenue-positive proposition for the American taxpayer.

"If H.R. 3334 falls short of this goal, IPAA stands ready to work with the administration, Congress, states, and other trade associations to make improvements to this legislation," said True.

"We believe much of the current criticism of H.R. 3334 stems from either a misinterpretation of the legislation or minor design problems that can be easily resolved."

True said lease law requires royalties to be paid on the value of production removed or sold from the lease, and RIK is a response to the pending oil valuation rule.

"MMS is ignoring this legal mandate and is attempting to assess royalties on values downstream of the lease and without full consideration of all the costs and risks associated with these markets. Simply put, it proposes to assess royalties on values in the wrong markets.

"The agency is trying to move the starting point for royalty valuation as far from the leases as it can. MMS might argue that after 'netback' (allowing costs to be deducted), the result ends up with a value at the lease.

"Nothing could be further from the truth," added True. "For example, MMS disregards the fact there are costs associated with marketing. By not recognizing these costs, MMS clearly is attempting to collect royalties on more than the value of oil and gas at the lease.

"MMS wants it both ways: on the one hand, it says royalty in-kind will cost the government money because the agency will have to pay to market the production. On the other hand, it says industry is required to pay royalties on the value of crude after it has been sent downstream.

"If MMS recognizes these marketing costs for itself, why doesn't it recognize them for industry?"

True also insisted that RIK will not work without QMAs. "RIK cannot be administered by government employees. You have to take it into the marketplace to maximize royalty volumes."

Majors agree

Fred Hagemeyer, Marathon Oil Co.'s manager of royalty affairs, testified for the American Petroleum Institute.

He said that aggregation often would enhance the value of the government's production: "For example, aggregating the government's oil and gas royalty volumes from the Gulf of Mexico would give the government as large a volume as any other producer in the gulf. "Moreover, the competition for that sizable market share of supply is likely to be vigorous, with many buyers and sellers."

Hagemeyer said the lessee should continue to be responsible for gathering costs for royalty purposes, and the government should continue to be responsible for the transportation costs.

"The bill should clearly delineate the movements that constitute gathering from the movements that constitute transportation."

Hagemeyer said the bill should be clarified to note that the government should not be charged for the transportation of produced water from offshore platforms when it is mixed with the oil stream.

Gas processing costs can be contentious, but Hagemeyer said H.R. 3334 would have the government and plant owner negotiate those.

He said processing is usually far off-lease; it purifies gas and is distinct from treatment, which is performed close to the lease and serves the purpose of putting production in marketable condition. Treatment costs are not deductible under current royalty rules.

Duty to market

MMS's interpretation of the lessee's duty to place production in marketable condition is being contested.

Poe Leggette, a Washington, D.C., attorney representing oil groups, said industry disagrees with MMS's claim that the law is "well settled that marketing expenses necessary to market production from a federal lease must be performed at no cost to the lessor."

MMS applied that theory when it issued a final gas valuation rule last December and when it drafted the pending oil valuation rule.

Leggette said, "The gas rule prohibits the deduction of many transportation costs that were previously included in bundled Federal Energy Regulatory Commission tariffs on the theory that those costs are really marketing costs. The oil rule is also designed to impose royalties on added valuation from midstream marketing activities under the same theory.

"IPAA and the Domestic Petroleum Council have strongly objected to this codification of the duty to market because, although the duty is ostensibly for the mutual benefit of the lessor and lessee, the lessor does not share in the cost."

The two trade associations have sued in federal court to challenge the final gas transportation rule (OGJ, Mar. 9, 1998, p. 34).

Leggette said, "Recent decisions of the Interior Board of Land Appeals have also endorsed the lessee's duty to market." He said that, in a case involving Texaco Inc., the board ruled that a federal lessee's duty to put lease production into a marketable condition includes removing hydrogen sulfide from gas.

"The board further held that the costs of sweetening the gas are not deductible from the lessee's royalty base, no matter who performs the sweetening. In other words, the lessee always bears the cost, and the department receives the benefit of royalties based on the improved quality of the production."

Quarterman said, "The dispute here is simple and is not whether the lessee has the duty to market production at no cost to the lessor. The industry's principal disagreement with MMS is whether those costs incurred downstream of the lease that MMS disallows as marketing costs are actually necessary to transport production.

"It is a purely technical disagreement over which costs should or should not be deducted from royalty payments. The MMS has consistently maintained that marketing costs are not deductible."

States' role

The RIK issue also involves the major producing states in the West.

They receive half the royalties from federal oil and gas production in their states but must pay half the collection costs.

For years, western states have complained that those federal administrative costs are much too high and thus are unnecessarily reducing the states' share of royalties.

Wyoming Gov. Jim Geringer has supported H.R. 3334 both as governor and as chairman of the Interstate Oil and Gas Compact Commission. Wyoming shares in more federal oil royalties than any other state.

Geringer said H.R. 3334 would simplify the royalty collection process, decrease administrative costs for both MMS and industry, provide certainty in royalty valuation, decrease the costs of audits and subsequent appeals, and achieve a fair and equitable market value for the products.

He said a successful RIK program would allow state governments to act separately from the federal government and it should reduce companies' administrative costs for marginal wells, helping to keep them in production.

But Quarterman said several states have raised concerns about H.R. 3334, including Texas, New Mexico, Louisiana, California, and Alaska.

Pilot projects

MMS is not necessarily opposed to RIK under its own terms.

The agency conducted a gas RIK pilot project in the Gulf of Mexico in 1995, which it later concluded was a money loser.

MMS and industry agree that the agency made some key mistakes.

IPAA explained, "MMS failed to use the expertise of private-sector marketers whose skill in aggregation and trading could have brought the government a much better price than it received. Instead, it used its own staff, which made the mistake of selling its product directly at the wellhead instead of at a point further downstream, where higher prices are received."

MMS completed a feasibility study for other RIK pilots last August. Discussing it before a House subcommittee, Quarterman testified, "Under favorable circumstances, RIK programs could be workable, revenue-neutral or positive, and administratively more efficient for MMS and industry."

Now MMS is developing three more RIK pilots. The most advanced is a plan to take onshore production from federal leases in Wyoming. The 2-year pilot project would be launched Oct. 1.

It also is considering a pilot for gas from leases off Texas beginning Oct. 1. A larger Gulf of Mexico gas RIK would begin next year.

True is pessimistic about the upcoming pilots, which he said are too similar to the first pilot.

"In the past, MMS used its own staff who ignored the downstream marketplace. These same design flaws are resurfacing into the government's next round of pilot programs.

True added, "They just don't understand the marketing of crude oil. I don't think the pilot projects will be fruitful."

Compromise

At a House hearing, Rep. Billy Tauzin (R-La.) urged MMS to rethink its position on RIK and consider compromising.

He said, "The government is trying with an intricate, complicated rulemaking to determine royalty value. And we end up with a diagram of a government rulemaking that looks like a Dungeons and Dragons chart to me.

"The very simple thing to do is to say to the government, 'take your share of royalty oil and market it yourself and get your value.' Then nobody has to fight anymore about what the value is."

He told Quarterman, "To let the government have the best of both worlds, to take the higher value when it suits you and force the oil company to yield on the costs when you think that helps your situation, is an untenable situation."

Cubin and Thornberry also urged MMS to offer constructive changes for their RIK bill.

Rep. Cubin stressed that the bill was not intended "to overturn precedents regarding proper processing and transportation allowances, or to give treatment cost deductions that are not granted under current practices. We've said all along that is just not the case."

She also conceded that she was willing to consider alternatives to mandated RIK.

But Cubin warned MMS that it must work with Congress on RIK or it may not be allowed to promulgate its oil royalty valuation regulation in October.

"If the Department of the Interior believes it can simply stall away the fiscal year and publish a final oil valuation rule without further consultation with the committee, they will not have learned anything from their previous indifference to Congress, and quite possibly (will) find themselves stymied for fiscal 1999 as well.

"I'm ready to do my job to broker a compromise, but there has to be some willingness among the parties to negotiate, and I haven't seen much of that, quite frankly."