High Stakes in Royalty Disputes

Oil producers and the federal government have found themselves in an escalating battle over the method of valuing and paying royalties. The U.S. Department of the Interior’s Mineral Management Service appears to be ignoring longstanding precedent to seek additional royalties from oil producers that extract oil from government-owned land.

For years, producers have relied on a set of regulations to guide their calculation of royalties due the government. Though the regulations depend on several variables, the methods are predictable. Until recently, MMS and oil producers operated under this arrangement without incident.

Now, based on what appears to be a new interpretation of the existing regulations, MMS is questioning producers’ royalty calculation methods. The new interpretation treats producers with suspicion and assumes that the oil companies may have been manipulating the value of oil to keep royalty payments low. Understandably, producers are alarmed at the new climate and a quick resolution is not in sight.

In recent years, the government has begun to reevaluate the method by which royalties are calculated and paid to the government on oil production. MMS has questioned the longstanding industry practice by oil producers of using an affiliated company to market their oil production. Here is how it works: A producing company owns oil production that it sells to an affiliate “at the lease.” Typically the price paid by the affiliate to the producing company is a price tied to “posted” prices in the area of the production, such posted prices either being prices posted by the parent company or other nonrelated producers in the area. The affiliate in turn markets the production downstream, typically aggregating production from several sources and arranging and paying for transportation to marketing centers where the production is resold. Many times, the affiliates take responsibility for aspects of marketing for which the producing company does not, including acquiring and blending production to make it suitable for resale and trading in the futures market. For its efforts and the concomitant risks involved, the affiliate may be able to sell its oil at a price higher than the price it paid to its producer parent at the lease. This type of affiliated transaction has long been sanctioned by the MMS.

Posted Prices

The current MMS regulations that apply to oil production were promulgated in 1988 as part of the oil valuation regulations, 30 C.F.R. §§206.100 through 206.106. Under the regulatory procedures for valuing oil, the value of the production to be used in calculating royalties depends on whether the oil is sold in an arm’s-length transaction or not. In a nonaffiliated or arm’s-length sale, the regulations require royalties to be based on the gross proceeds of the producing company. In a non-arm’slength transaction, producers selling to an affiliate that buys additional oil production from other sources are required to pay royalties based upon a) their posted price, if the producer has an established posted price; b) the arithmetic average of third-party postings; c) the arithmetic average of arm’s-length sales prices; or d) a net-back price.

However, the MMS has recently begun to attack the use of posted prices as a benchmark in non-arm’s-length transactions, arguing that posted prices do not reflect the market value. The MMS’ position is troubling when viewed in light of the longstanding precedent favoring the use of posted prices. The use of posted prices is consistent with longstanding policy of the Department of the Interior that non-arm’s-length sales can result in a fair market price being paid.

Interestingly, with the enactment of the MMS regulations in 1988, the MMS specifically selected posted prices as the benchmark to serve as the market barometer, apparently believing such would ensure that a fair market price was paid. This fact is echoed in the comments made by the MMS in connection with the implementation of the 1988 regulations. The MMS’ position remained constant even with the understanding that the use of posted prices (or any other benchmark) might not result in the highest market price. In addition, the reliance upon posted prices as an adequate measure of the market value of production has been acknowledged as apappropriate by several courts that have addressed the issue.

New Regulations

Notwithstanding these facts, in recent years, the MMS has expressed dissatisfaction with the use of posted prices for purposes of valuing royalties. Accordingly, the MMS has proposed new regulations that, if enacted, would eliminate the posted price benchmark and replace it with an index price. The MMS contends that index prices, such as the NYMEX New York Mercantile Exchange, are more accurate barometers of the true market value of the production than posted prices. Producers and marketers of oil dispute the contention that an index price can accurately reflect the value of the oil at the lease, where the oil is produced and often sold. As the argument goes, index pricing fails to account for the value that is added to the production by the affiliate in terms of aggregating volumes, blending production to obtain desired sweetness or gravity, as well as arranging and paying for transportation to a marketing center and negotiating the sale of the production. These efforts involve risks and, without a doubt, add value to the production that cannot be attributable to the value of the production at the lease.

The producers and marketers believe it is disingenuous for the MMS to try to capture this added value as royalties due on production at the lease. The MMS’ proposed regulations, not surprisingly, have met with a flurry of opposition by producers and independent marketers and have not yet been enacted.

Evidencing impatience prior to enactment of its new regulations, the MMS has sought to abrogate the use of posted prices by imposing a construction of the existing regulations that, if successful, would avoid the posted price benchmarks altogether. The MMS’ efforts to correct the perceived inequitable valuation mechanism has manifested itself in several ways.

The MMS has initiated audits of producers claiming it is due additional royalties based upon its new interpretation of the existing regulations. One way the MMS does this is by seeking to ignore the corporate distinctions between the producers and their affiliates. This is done by assuming that the affiliated company and the parent should be considered the “lessee” as defined in the regulations. By ignoring the corporate distinctions, the MMS believes it can tie valuation to benchmarks other than posted prices. The producers contend that this argument ignores the plain language of the regulations and existing MMS precedent that recognizes nonarm’s-length transactions with affiliated companies. Why else, the producers ask, would the regulations contain specific, separate provisions that expressly apply to non-arm’s-length sales if sales to the affiliate are excluded from the analysis? Not surprisingly, many producers have questioned the MMS’ ability to impose such a strained interpretation of the existing regulations and its attempt to impose, retroactively, regulations that have not yet been enacted.

At the same time that some producers have clashed with the MMS in response to the audits, the government has begun to escalate the fight. Some of the producers have recently found themselves the subject of an investigation by the U.S. Department of Justice on alleged violations of the False Claims Act, which comes with a threat of treble damages and criminal charges. The Justice Department has alleged that producers of oil and/or gas have violated the False Claims Act because they have not paid the proper amount of royalties. This allegation again rests on the assumption that a producer is not entitled to rely upon its posted prices or the posted prices of other non-affiliated producers because the posted prices do not reflect market value.

Increasing the pressure on producers, the government recently intervened in a qui tam action pending in the U.S. District Court in Lufkin, which also seeks damages based upon the same strained arguments. Regardless of its impetus, the government’s prosecution of producers for conduct approved of under existing federal regulations, longstanding MMS policy and court precedent sets the stage for an interesting fight.