Producers win take or pay royalties suit

The Washington, D.C., Circuit Court of Appeals has ruled the U.S. Minerals Management Service cannot collect royalties on natural gas contract settlements until the royalties are credited toward the purchase of makeup gas. The opinion came in a long dispute over whether producers owed the federal government royalties on lump sum payments they received from gas pipelines to settle large take or pay liabilities.

Sept. 9, 1996

3 min read

The opinion came in a long dispute over whether producers owed the federal government royalties on lump sum payments they received from gas pipelines to settle large take or pay liabilities.

Twenty-one companies and six trade associations had appealed a lower court ruling they had lost. An Interior Department official said the case involves about $120 million in disputed outstanding royalties.

The official said Interior and the Justice Department have not yet decided whether to appeal the case to the U.S. Supreme Court: "The valuation issues involved are extremely complex, as evinced by the split decision of the three-judge panel and two previous conflicting rulings by different district courts."

Suit background

Following deregulation of gas pipelines in the early 1980s, the lines paid producers to void long term gas supply contracts at higher than market prices.

Pipelines resolved these take or pay contracts with "buydowns" that lowered the contract price of the gas or "buyouts" that ended the contracts.

MMS maintained producers owed royalties on these contract settlements. It argued the value of gas produced from federal lands, for royalty purposes, could not be less than the gross proceeds that the lessee received, including any contract settlements.

The agency revised its position after the Fifth Circuit Court of Appeals ruled in 1988, in Diamond Shamrock Exploration Co. vs. Hodel, that royalties were not due on take or pay settlements unless the gas was taken.

MMS then decided take or pay settlement payments are royalty bearing, while take or pay payments themselves are not royalty bearing until those payments are specifically allocated to gas that is physically taken from the ground.

In the latest ruling, the appeals court said Interior "has failed to give a sufficient nonarbitrary reason for treating the two types of payments differently."

The majority opinion concluded, "Neither take or pay payments nor take or pay settlement payments are royalty bearing unless and until they are credited toward the purchase of makeup gas."

Industry's response

Lew Ward, Independent Petroleum Association of America chairman and president of Ward Petroleum Co., Enid, Okla., said, "The decision is a complete vindication for America's entire natural gas industry.

"This ruling clears away years of confusion and gives the industry and government straightforward guidance on determining the proper value of natural gas royalties."

A spokeswoman for the Natural Gas Supply Association said, "We're very satisfied with the decision, although there is the possibility of appeal. We believe that this firmly establishes that royalties are owed on gas produced on federal lands and sold into the market, and not on ancillary services like transportation."