The MMS Royalty Proposal

The U.S. Minerals Management Service stretches too far with its proposal to overhaul oil valuation for federal royalties (OGJ, June 30, 1997, p. 25).

Worried by the theoretical ability of producers to delay realization of oil values until after royalties have been paid, MMS wants to move valuation for royalty purposes away from the lease. The problem with that strategy is that it would move the whole procedure away from an accurate determination of value.

What's proposed

MMS proposes to rigidly define "arm's-length" transactions, sales prices of which would still be assumed to represent value for royalty calculations. For all other transactions, which MMS expects to be most of the total, the agency would apply a burdensome indexing system.

The index for oil produced on federal leases in California and Alaska would combine averages of the price for Alaska North Slope (ANS) crude and spot prices at designated market centers, corrected for quality and location. On federal leases elsewhere in the U.S., the index would replace the ANS price with crude oil futures prices on the New York Mercantile Exchange, with quality and location adjustments.

Much motivation for the MMS initiative apparently comes from a California lawsuit settled by six of seven defendants, all integrated oil companies, for $345 million. The city of Long Beach said the companies understated posted prices on which royalties were based. The seventh defendant, Exxon Corp., beat the case because it didn't own pipelines or refineries in California in the period covered by the allegation.

Suspicion lingers. The Interior Department, of which MMS is a part, began an investigation of the issue in 1994. Last year, James Shaw, associate director for MMS's royalty management program, said companies in California had valued crude moved under intracompany transfers and exchanges according to refining values but based royalties on generally lower posted prices (OGJ, Oct. 28, 1996, p. 19). As a result, MMS said California producers owed it $440 million for royalty underpayments during 1980-94.

Especially in a system that relies on producer declaration for determining value, suspicion by royalty owners is only prudent. MMS exists mainly to ensure that the public, as the royalty owner on federal land, receives fair royalties, promptly paid. There's a difference, however, between proper vigilance and reckless policy-making. MMS seems ready to cross the line.

There is no realistic way for the agency to calibrate physical values of many types of crude, in many locations, to two national benchmarks, one of them a futures contract. The Nymex futures price is an especially unreasonable proxy for local production. It reflects activity by many types of traders in a very active, very structured market. It is useful as a broad market gauge but not as a valuation tool for individual crudes traded in much narrower markets.

Furthermore, quality and location adjustments in the MMS proposal are too rigid. Location and quality spreads vary constantly with the market, just as crude values do. No system of stated differentials can be flexible enough to simulate the market with sufficient precision.

Reasons to reconsider

Those problems and the administrative load that the proposal would impose should be enough to make MMS reconsider its plan. The main drawbacks to the current system are questions about validity of value proxies for non-arm's-length transactions in specific markets. MMS has ways of addressing those questions without replacing a system that's not broken with a more costly one with no hope ever of working.

The agency also should reconsider its apparent premise. What makes it think that, as a royalty owner, it holds claim to value generated significantly distant from the lease? Without a good answer to that question or better ideas about royalty valuation, MMS risks looking like it's just crusading for headlines and easy money.