MMS again revises royalty valuation rule

The U.S. Minerals Management Service has again revised its proposed rule, which would determine the royalty value of crude oil produced from federal leases.

Ben Dillon, the Independent Petroleum Association of America's vice- president for public resources, said the rule restores arm's length sales for independents as a basis for paying royalties.

"Unfortunately, MMS continues to reject the costs associated with the transactions that get you to that sale, particularly marketing costs. That is a significant issue for many independents," Dillon said.

MMS view

MMS Director Cynthia Quarterman said, "As a whole, this rule addresses the primary concerns of many of the oil and gas companies that have to calculate and pay royalty on crude oil produced from federal leases.

"At the same time, it provides assurance to the federal and state royalty recipients that value will be based on the best indicators of market value available for any given area of the country."

Quarterman said, "It quite simply bases royalty value on the gross proceeds received when oil is sold under an arm's-length contract and on index pricing or other benchmarks in cases when oil is not sold under an arm's-length contract."

MMS said the proposed rule is the culmination of two earlier proposed rules, comments on them, and several workshops.

MMS will accept comments on the proposed rule until Mar. 23. It also plans to hold public hearings on the changes.

Five basics

MMS said the rule is based on five principles of royalty valuation.

It said royalty must be based on the value of production at the lease.

"The rule provides for royalty payments based on no more than the value of production at the lease. Where index prices are used to establish value, actual transportation costs, location differentials, and quality adjustments would be applied in arriving at the value at the lease."

The agency said that, in arm's-length sales, royalty obligations should be based on gross proceeds.

"MMS believes that gross proceeds received under the lessee's or its affiliate's arm's-length contracts remain the superior measure of market value and clarifies this provision in the rule."

It said that, for other than arm's-length contracts, index prices are the best measure of value in most areas of the country.

"MMS believes that index prices are the best indicator of the lease value for oil not sold at arm's length in areas other than the Rocky Mountains.

"For all areas of the country except the Rocky Mountains, MMS is proposing the use of spot prices, adjusted for quality and location. MMS has retained its previous proposal to use Alaskan North Slope spot prices for production from California and Alaska.

"While comparisons show that spot and the New York Mercantile Exchange (Nymex) adjusted values are essentially the same, spot prices have the added benefit of being established closer to the lease, thereby eliminating one step in calculating the differential.

"Only in the Rocky Mountain area, where the production is remote from major market centers and the spot market is thinly traded, is MMS proposing a series of benchmarks, including Nymex, for valuing production not sold at arm's length."

MMS said the lessee has a duty to market at no cost to the lessor.

"Federal lease terms require the lessee to market production at no cost to the lessor. MMS has been consistently upheld on the position that such costs do not result in a value greater than the value of production. The proposed rule is consistent with that position." And MMS said customized regulations for unique producing areas are preferable to a "one size fits all" approach.

"Because California and Alaska and the Rocky Mountain area exhibit particular oil marketing characteristics, MMS does not believe in a single regulatory approach.

"The proposed rule recognizes the geographic differences in the marketplace and proposes different royalty valuation standards for three distinct parts of the country."

Other elements

MMS said economic analyses of the rule's effects show that about two thirds of production in the Gulf of Mexico, which accounts for the largest share (76.7%) of federal oil production, would be subject to index pricing.

It said that, in the Rocky Mountain region, where only 8.5% of the federal oil is produced, value for about two thirds of production would remain on gross proceeds.

In California and Alaska, which account for 14.8% of federal oil production, MMS believes that index-based valuation would apply to about 75% of the production.

Overall, about one-third of federal production nationwide is sold arm's length; the other two thirds of the production would be valued using index prices or benchmarks.

MMS said it would simplify form MMS-4415, the Federal Oil Location Differential Report, with clearer instructions, fewer respondents, and fewer locations for reporting oil aggregation.

It said using spot prices rather than Nymex for most areas of the country would also remove one of the adjustments to the index price.

Rule summary

Gross proceeds will determine the value of oil sold under an arm's-length contract (including sales to affiliates who resell at arm's length) unless: the contract doesn't reflect total consideration; the value is not reasonable due to misconduct; the oil is disposed of under an exchange agreement, except one or more arm's-length exchange agreements-when value is based on the resale after the exchange(s); or the oil is disposed of under a non-competitive crude oil call.

If oil is not sold under an arm's-length contract in California and Alaska, the value would be based on the spot price for Alaskan North Slope crude, adjusted for location and quality.

In the Rocky Mountains, the value would be based on the first applicable of the following: an MMS-approved tendering program; the weighted average of the lessee's/affiliate's arm's-length sales or purchases from the field/area; the Nymex-based price, adjusted for location and quality; or an MMS-approved alternative method.

For the rest of the country, the non-arm's length value would be based on the spot price for the market center nearest the lease, such as Midland, Tex., adjusted for location and quality.

MMS said location, quality, and transportation adjustments for the entire nation would be based on: actual rates or MMS-published rates from market centers to aggregation points; or actual costs of transportation and quality adjustments based on pipeline quality banks, from aggregation points to leases.

It said simplified form MMS-4415 requires information only on exchanges involving federal oil and only from market centers to aggregation points, less data elements than the earlier form, and a third less aggregation points.

Ipams view

Carla Wilson, director of tax and royalty for the Independent Petroleum Association of Mountain States, said, "We're pleased that MMS recognized the uniqueness of Rocky Mountain producers in the rule, but we're disappointed they did not put any new benchmarks in the rule for comparable sales."

Wilson said the rule states that, if producers sell a third of their production to third parties, they can use that price to determine the royalty for their nonarm's-length sales.

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