Royalty valuation rule changes loom
Patrick CrowThe U.S. Department of Interior's Minerals Management Service (MMS) is preparing to revise its controversial oil royalty valuation rule, but changes are unlikely to appease most oil firms.
Energy Policies Editor
The agency is attempting to shift producers holding federal leases away from using posted prices to calculate their royalty payments; instead, MMS wants to base most royalties on monthly average New York Mercantile Exchange (Nymex) crude futures prices, less adjustments for crude quality and location (OGJ, Jan. 27, 1997, p. 36).
MMS took the action in response to alleged royalty underpayments (OGJ, Oct. 28, 1996, p. 19), but industry groups say the cure is worse than the disease.
Although the MMS rule would affect only 3% of U.S. production, producers fear it could become the standard for private royalty calculations, as well. MMS estimates the rule would result in increased federal royalty collections of $50-100 million/year.
Public hearings were held on the proposal in Lakewood, Colo., and in Houston this spring, drawing large crowds. Two dozen oil firms and associations have filed 1,951 pages of comments opposing the regulation.
Last week, MMS was preparing to issue an amended rule that grants some exemptions sought by independent producers. It then will reopen the entire proposed rule for public comment for 30 days.
MMS officials haven't decided what to do after that. They could revamp and repropose their rule or proceed to issue a final rule later this year.
There are rumblings within industry that unless MMS extensively changes the proposed rule, a lawsuit will be filed to block issuance of a final rule.
MMS observed, "Industry chose not to participate in any negotiated rulemaking on this issue because of their involvement in private litigation involving crude oil valuation."
What it does
MMS explained its current oil valuation rules may not reflect actual value of produced oil, and it proposed a system that would base most royalties on the monthly average Nymex futures price at Cushing, Okla.
The rule, published in the Jan. 24 Federal Register, would allow some royalties to be paid on the gross proceeds that a producer receives in an arm's-length transaction.
MMS said, "Because of the frequency of oil exchange agreements, reciprocal deals between crude oil buyers and sellers, and other factors where the real consideration for the transaction could be hidden, arm's-length contract prices will be used as royalty value only by producers who do not also purchase crude oil.
"Where a company's affiliate takes the production and sells it at arm's length, value would be based on the affiliate's proceeds, or optimally, Nymex or spot prices adjusted for location and quality differences.
"For all other non-arm's-length transactions, or where no sales occur, the value would be determined by index prices, either Nymex or spot prices, adjusted for location and quality differences."
For production in California and Alaska, the value would be set on Alaskan North Slope (ANS) prices adjusted for location and quality differentials.
The proposed rule would not apply to Indian leases, since MMS has developed a separate rule for those. However, MMS said a number of tribes have asked it to delay that proposed rulemaking for further consultation.
The proposed rule also contains two other significant provisions: Valuation of oil taken in kind by the government (some is taken and made available to small refiners) would be tied to Nymex and spot prices; and lessees no longer could use Federal Energy Regulatory Commission (FERC) tariffs as a transportation allowance in moving their own oil but would have to make actual cost calculations.
Nymex standard
MMS said it searched for indicators to best reflect current market prices and settled on Nymex for several reasons.
"It represents the price for a widely traded domestic crude (West Texas intermediate at Cushing, Okla.), and it is the most widely accepted benchmark of crude oil worldwide.
"Because of the sheer volume of oil futures contracts traded on Nymex and the low possibility that any one party could unduly influence prices, the Nymex futures prices generally are considered the best single indicator of market value. Also, Nymex prices are regarded by many of the experts MMS consulted to be the best available measure of oil value.
"The most difficult problem... would be to make appropriate location and quality adjustments when comparing the Nymex crude with the crude produced."
The agency said where lessees report value based on their arm's-length proceeds, they would be able to deduct their actual costs to transport production to the point of sale.
MMS also proposed three location and quality adjustments against index prices: a differential between the index pricing point (WTI at Cushing) and the appropriate market center (for example, sweet light Louisiana at St. James, La.); a differential between the market center and major aggregation points, based on a rate either published by MMS or a rate contained in the lessee's arms-length exchange agreement; and actual transportation costs from the aggregation point to the lease.
The rule listed about 300 market center locations from which adjustments would be made.
Adjustments example
The agency said some production from more remote areas will not physically reach a market center. For instance, a Wyoming sour crude producer might move his oil directly to a Salt Lake City refinery.
"In this case, West Texas sour crude at Midland, Tex., might represent the crude oil/market center combination nearest to the oil produced. The market center-index pricing point location/ quality differential would then be the difference in the spot price between WTI at Cushing and West Texas sour at Midland, as published in an MMS-approved publication.
"In addition to that adjustment, the producer would be entitled to an allowance for the actual transportation costs from the lease in Wyoming to Salt Lake City.
"MMS believes this method is the best way to calculate the differences in value between the lease and the index pricing point due to location, quality, and transportation when the production is not actually moved to a market center."
But Jack Blomstrom, with Eighty-Eight Oil Co., Casper, Wyo., said that example shows MMS's lack of market experience. He said virtually no Wyoming sour makes its way to the Salt Lake City market, and there is little similarity between West Texas sour and Wyoming sour.
Blomstrom said the Texas crude averages 1.9% sulfur and 34° gravity, while the Wyoming asphaltic sour is 2.4% sulfur and about 21°.
"The gravity differential alone, which is not considered in this example at all between West Texas sour and Wyoming asphaltic sour, would be $2.40/bbl. If MMS values its royalty oil without factoring in the gravity differential, it will receive a windfall."
Changes coming
Independent producers particularly complained that MMS would require use of the Nymex index, rather than arms-length sales, if another producer had a "call" on output from a particular lease.
Often, they said, majors will sell a lease to an independent but retain a right to purchase the production. MMS said calls are similar to "multiple dealings between the parties" and thus are suspect transactions.
The Independent Petroleum Association of Mountain States (Ipams) said MMS is ignoring the reality of the role and function of a call on farmouts.
Ipams said, "These dealings are arm's length, made on an isolated basis, and not always made with an integrated major oil company that is also in the business of refining crude oil.
"In fact, most of the time, the Rocky Mountain independent producer obtains farmouts from other independents or mid-size, non-major companies that do not have refining affiliates."
Ipams said the rule would apply even if calls are not exercised, and frequently they are not. And, it said, most calls have provisions that require the holder of the call to match a higher price offered by a third party.
The MMS rule would not permit use of arms-length sales if a lessee had bought crude oil within the previous 2 years. MMS said, "Multiple dealings between the same participants, while apparently at arm's length, may be suspect concerning the contractual price terms."
Ipams said, "Even under the MMS' own theory, an exchange must involve a contemporaneous exchange of equivalent volumes to be suspect. The 2-year rule, on the other hand, amounts to using cannons to kill flies."
It argued, "Producers who have never seen an exchange agreement still buy oil for use as load oil and field fuel. There is no justification under the MMS's market theory to go back even 1 month, let alone 24 months, to disqualify an arms-length contract."
Agency officials have relented on those two points, and the revised rule will delete the crude oil purchase provisions for independents. MMS said only calls involving noncompetitive pricing will be subject to non-arm's-length valuation. Exchanges of crude will be valued at the arm's-length resale price or benchmarks.
MMS officials said those changes will allow more small independent producers to pay royalties on the basis of gross proceeds.
But they planned to retain the Nymex standard for non-arm's-length sales, noting that producers often use it themselves to set prices in sales and exchange contracts.
Duty to market
Independents also have complained of an "oppressive" provision establishing a duty for them to market crude. The provision was included in an MMS amendment to its rules last year and then in the latest proposal.
"What concerns Ipams members is the implication that failure by a producer to market production in such a manner as to earn the highest price possible, however far downstream of the lease, would constitute a breach of this new duty to market.
"Of paramount concern is that auditors will apply this new marketing standard long after the actual sale and require additional royalties and interest on a value higher than that received for the production because the auditor believed the producer should have marketed the production differently to obtain a higher price.
"Ipams still holds that the creating of this new duty to market violates applicable statutes and lease terms. Moreover, MMS' retention of this concept will likely hobble the rule in litigation for many years to come."
The American Petroleum Institute (API) said there is no existing statutory requirement for a federal lessee to market production away from the lease at no cost to the government.
Regulations require the producer to place the oil in marketable condition at no cost to the federal government, but API said the added costs of improving or transporting the oil should be borne by both the lessor and the lessee.
Oil groups critical
API claimed the rule would impose substantial costs, uncertainty, and inequities on oil firms.
"It contemplates new filing requirements that would cause the lessees and the MMS to incur significant filings and necessitate costly revisions of complex administrative, accounting, and recordkeeping systems.
"The cost impact alone, irrespective of the many other procedural, factual, legal, and workability flaws of the proposals, justifies an MMS reassessment."
API and five other oil groups filed a Freedom of Information Act request in February to determine what data MMS used as a foundation for its rule. API said those records show "The proposal is shot through with core assumptions and conclusions whose bases are either not clearly disclosed or are undisclosed altogether."
The Independent Petroleum Association of America said, "Oil producers simply want certainty. They want to know that once they sell their oil, they'll also be paying royalties based on the value they received for that oil, not on some national average price they didn't receive. In effect, we could be paying higher royalty rates, and that makes wells uneconomic to operate."
Ipams said MMS has written the definition of arm's-length transactions so narrowly in the proposed rule that it virtually eliminates them.
"To subject small independent producers in the Rocky Mountain region to a Nymex-based valuation methodology is ludicrous. Moreover, the valuation methodology proposed by MMS fails to even approximate the value of production sold at or near the lease."
Nymex faulted
API said MMS considered using futures or spot prices for royalty valuation when the current oil regulations were drafted in 1987 and rejected them as unworkable. It said that has not changed.
API said, "The difference between market value at the lease and the price of crude oil at market centers based on a Nymex future price generally reflects value added to the crude oil.
"This added value comes about because of several downstream marketing functions, including the development of marketing information and expertise regarding types of crude oil, customer preferences for crude oil, and transaction handling costs.
"Netting back from market center transaction prices without recognizing the value added by marketing functions produces a higher, but inaccurate value. Even adjusting the netback methodology for gravity, sulfur, and timing, the numbers are still inaccurate because they may not reflect the particular supply and demand factors in many individual transactions."
It observed that the Department of Energy has abandoned the use of spot prices in selling 45,000 b/d of its crude from the Elk Hills Naval Petroleum Reserve in California because it concluded they were unreliable.
API said MMS's proposal to use ANS prices for valuing California production, simply because large volumes of ANS crude are sold there, is also unrealistic.
"For example, the quality of ANS crude is significantly different than California OCS federal crude produced from the Santa Ynez unit. Whereas the API gravity on ANS is approximately 30? with a 1% sulfur level, Santa Ynez Unit (crude) is less than 19? with a 5% sulfur level. Yet, under the proposal there is no adjustment for the quality differential between the California crude and the ANS spot price when the California crude is sold at a market center."
API said the Nymex futures price is substantially different from the value of crude oil at the lease and cannot be adjusted by means of a "one-size-fits- all" methodology to arrive at market value at the lease.
It noted the Nymex crude futures contracts are commodity instruments, not a contract to sell an actual barrel of crude, and on a good trading day 150,000 contracts can change hands-equal to 150 million b/d of crude or more than 23 times U.S. production.
It said buyers and sellers use the contracts to lock in oil prices and thus avoid the risk that the market price will change significantly in the future. Quotes can be affected by speculation and timing.
API said, "While it is true that various entities may look at Nymex crude oil futures contract prices in the course of valuing crude oil for physical purchases or sales, there is no simple, mechanistic relationship between Nymex futures prices and the value of specific non-Nymex crude oils."
Royalty in kind
Almost all producers have urged MMS to simply take its share of oil as royalty in kind (RIK), or take and sell some of its RIK oil to establish benchmark prices.
MMS is wary about that because its Gulf of Mexico RIK gas pilot project lost money. But it held hearings last March on a RIK program and has investigated how the program works in Alberta.
The Domestic Petroleum Council, representing 17 mid-sized oil firms, said, "As owners of about 3% of domestic U.S. production, MMS would be, in effect, one of the largest producers of crude oil in the country. It could use its market power over its aggregated volumes of oil in an effort to obtain higher prices at downstream market centers.
"It could also dramatically shrink the size of MMS' workforce. The needs for auditors and legal staff to process administrative appeals would decline dramatically."
The Rocky Mountain Oil & Gas Association (Rmoga) said MMS should "simply mandate that all federal lessees deliver the appropriate percentage of crude oil at or near the lease to the federal government for its disposal. The federal government either becomes a player or contracts with an aggregator/marketer to sell its share of the product at market prices.
"This would eliminate many of the regulatory/reporting requirements that currently cost the private sector billions of dollars annually.
"There is a real-life, real-time example already in operation. Alberta Oil takes all of the province's product in kind and markets it through aggregator/marketers, eliminating the need for thousands of employees and millions of forms.
"This assures the province it is receiving the prevailing price for its oil, thus protecting the treasury and the taxpayers. The province of Alberta understands the oil and gas market and has accepted both the risk and the reward, and it is paying off handsomely for the Canadian taxpayer."
Ipams agreed:
"One way for MMS to validate and verify prices in a given field or area would be for MMS to take some of its crude oil in kind at the lease and sell it on the open market. This would give MMS the opportunity to see the real market rather than relying on calculations of a netback from the Nymex."
API said if MMS takes oil RIK, that should satisfy the lessee's full royalty obligation. MMS should take all its oil (and not leave some in the ground), bear all marketing costs, and the delivery point should be on or near the lease, it added.
MMS has authority to take oil RIK now, but industry groups may propose a bill to clarify those powers.
No single price
DPC said MMS should recognize that "There is and has long been a vibrant market for crude oil at the lease. The sales transactions occurring at these points offer the best evidence of the value of royalty oil at the wellhead."
DPC said MMS wrongly assumes that fair market value is a single price.
"The vast majority of pricing provisions in sales contracts remains related to prices listed in crude oil price bulletins, or postings. While postings may be a final price offered for oil, perhaps more often they serve as benchmarks from which fair market prices are negotiated.
"Accordingly, if MMS were to select 10 oil fields at random and prepare a chart for 1995-96 plotting the arm's- length values on which federal lessees paid royalties against the posted prices for the fields, the chances are good that MMS would find a band of values in each field for each month.
"Some would be below the posted prices, as can be the case with low-gravity, sour crude oils in the Rocky Mountain region. Some would be at those prices, and some above the highest posted price."
DPC said the three most likely reasons for the differences would be that different qualities of crude oils in different areas face different balances of supply and demand. Also, some sales would be under term contracts while others would be under spot contracts. And willing buyers and willing sellers often negotiate different prices for essentially similar commodities.
It said perhaps MMS did not intend to suggest there is a national fair market price for oil, but that is how the rule reads: "The agency has inappropriately abandoned its well-founded recognition that free markets produce multiple fair market prices."
Fine-tuning urged
Most oil groups have urged MMS to modify the current system rather than venture into a new one.
Rmoga said, "While not perfect, the current regulatory system used to value production at the wellhead, as established by willing buyers and sellers with opposite economic interests, continues to adequately serve both the regulators and the regulated because the 1988 rules are fundamentally sound.
"MMS and industry can work to improve and streamline the current system. Draconian measures to fix that which doesn't need to be fixed are unnecessary."
IPAA summed up industry's perception of the regulation: "The proposed rule is based on an irrational suspicion of legitimate arm's-length transactions."
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