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Appendix A

Before The United States Of America Department Of The Interior Minerals Management Service  
Further Supplementary Proposed Rule for Establishing Oil Value for Royalty Due on Federal Leases

Declaration of JOSEPH P. KALT and KENNETH W. GRANT
Harvard University and Lexecon Inc.
January 31, 2000

1. Introduction And Background

Joseph P. Kalt is a Senior Economist and Kenneth W. Grant is a Senior Consultant with Lexecon Inc. (Lexecon), a private consulting firm with offices in Cambridge, Massachusetts, and Chicago, Illinois. Our business address is One Mifflin Place, Cambridge, MA 02138. In addition to his affiliation with Lexecon, Professor Kalt is the Ford Foundation Professor of International Political Economy at Harvard University’s John F. Kennedy School of Government, where he has responsibility for teaching graduate courses in the economics of public policy and antitrust and regulation. Copies of our curricula vitae are attached as Exhibit A to this declaration.

We are submitting this declaration in response to the Further Supplementary Proposed Rule regarding Establishing Oil Value for Royalty Due on Federal Leases ("Proposed Rule") issued by the Minerals Management Service ("MMS") of the Department of the Interior ("DOI") on December 30, 1999, and published at 64 Fed. Reg. 73820. This declaration is being made at the request of the American Petroleum Institute. We have previously submitted comments in this matter, and we have been retained by a number of integrated and non-integrated oil companies in connection with past and pending litigation involving crude oil pricing and royalty payments. Professor Kalt has also provided written and oral testimony before the United States Congress concerning the collection of royalties from Federal and Outer Continental Shelf oil leases.

2. Summary Of Findings

In this most recent rulemaking, the MMS asserts that there are generally not competitive markets for crude oil at the lease. This assertion underlies the latest proposal to amend the current regulations concerning the valuation of crude oil produced from Federal leases that is not otherwise disposed of in outright transactions. That is, the MMS proffers its claim regarding the absence of competition in the field as key justification for rejecting the use of outright, comparable transactions, i.e., field-level purchases and sales between unaffiliated parties, for the purposes of valuing Federal crude oil. With MMS’ asserting that actual prices struck in arm’s-length commerce are apparently "tainted" by a purported lack of competition, the MMS then claims that it is justified in turning to a methodology of Federal royalty valuation that is based on downstream spot market indices.

We have reviewed the MMS’ notice of proposed rulemaking in light of sound economic analysis, industry practices concerning the purchase and sale of crude oil at both the lease and downstream market centers, and relevant data. In particular, we have conducted an intensive examination of the domestic market that exists for crude oil at the lease. As part of this research, we have analyzed voluminous data and evidence concerning the market for crude oil at the lease, such as the number of buyers and sellers; the nature of and economic functions served by the various market participants and the types of transactions they utilize; and the posting of crude oil prices. These data come from public sources as well as course-of-business records from over two dozen companies—including independent producers, integrated and non-integrated refiners, and independent marketing companies—and cover much of the 1980s and 1990s. It includes over four million outright, third-party purchase and sale transactions for crude oil at the lease as recorded in the course of business. These outright lease-level transactions demonstrate ongoing, non-idiosyncratic, arm’s-length commerce, commonly accounting for as much as 10 to 25% of a given field’s production. These data encompass leases located in every domestic crude oil producing region in the United States, including the Gulf of Mexico, the mid-continent states, California, and the Rocky Mountain Region.

Being at odds with directly relevant evidence and founded on principles that are inconsistent in process and substance with sound public policy, the MMS’ spot market-based methodology for valuing crude oil produced from Federal leases is not economically valid as an approach to arriving at market value at the lease of the public’s oil. Indeed, the methodology has the effect of enabling the MMS in its role as mineral owner to reach into downstream, post-production components of the chain of value-adding activities that take crude oil from its raw material state to ultimate use in refined form by consumers. While it is perhaps understandable that the MMS would, like any seller of a resource, seek to increase its take, this reaching downstream is wholly inconsistent with the economics of fair market valuation of a mineral lessor’s resource.

The MMS’ assertion of a lack of a competitive market for crude oil in the field relies on unsubstantiated claims, contradictory arguments, and the misinterpretation of significant facts relating to the domestic crude oil market’s structure and conduct. As the evidence presented below shows, there exists a highly competitive market at the lease. This lease-level commerce involves numerous major and minor, integrated and non-integrated producers on the supply side, and numerous large and small, integrated and non-integrated refiners, plus a very large number of independent marketers and brokers on the buying side. It includes significant and recurring volumes of crude oil at the lease moving in outright (i.e., cash-on-the-barrel) transactions between unrelated buyers and sellers with access to the information and competition that allows each to protect their interests. MMS’ conclusions to the contrary reflect faulty reasoning, misinterpretation of data, and use of sources at odds with principles of sound public policymaking by a public agent.

3. ANALYSIS

In support of its efforts to rewrite Federal regulations governing the valuation of crude oil produced from Federal leases, the MMS contends that a general lack of competitive and transparent markets at the lease makes the use of comparable, outright transactions inferior to the use of downstream, spot-based index prices in establishing the fair market value of such crude oil for the purposes of paying Federal royalties. In particular, the MMS asserts that there is generally not a large number of sellers of crude oil at the lease and, where such sellers exist, they often control a large share of the production sold from a given lease or field. In addition, the MMS states that it believes that at a given lease or field there exists a limited number of buyers and sellers. Finally, MMS argues that the proprietary nature of lease-level transactions prevents lessees from knowing the prices at which other lease holders sell their crude oil.

Market Competitiveness at the Lease

These arguments not only defy basic economic reasoning, they stand in contrast to readily available information. For example, offering the assertion of a limited number of sellers as evidence of the lack of competition at the lease is internally inconsistent with what the MMS and its consultants have proclaimed in litigation closely related to this matter—namely that transactions at the lease do not fully and accurately reflect fair market value. To wit, observed prices are too low. A lack of competition among sellers, however, implies, if anything, prices that are higher than fair market value. Thus if, as the MMS alleges, a limited number of sellers at the lease were the cause of the purported stifling of competition, the economic consequences of such seller concentration and market power would be to raise the prices at the lease above their competitive level. In fact, in other minerals leasing contexts, the Federal Government has recognized that supply-side market power inappropriately elevates resource prices.

The assertion that a single seller (or operator) may control a majority of the production at a given lease or field is similarly economically inconsistent with MMS’ conclusions that lease-level transaction prices are inordinately low. Moreover, concentration of production at a particular lease or field is not evidence of market power, and MMS’ insinuations to the contrary reveal a disturbing misunderstanding of the concept of "relevant market"— a definition that is central to competition analysis. As set out in the U.S. Department of Justice and Federal Trade Commission’s Horizontal Merger Guidelines, one cannot draw conclusions regarding prospects for market power without assessing the boundaries of the relevant market—i.e., the universe of those who compete. Neither the evidence nor the MMS’ consultants support a contention that an individual lease or an individual field is a relevant market. Rather, a given oil field is typically made up of many leases whose producers are in competition with each other; and producers in individual oil fields are similarly drawn into competition with producers from other oil fields as buyers exercise their abilities to shop from field to field to meet their needs. A lease or a field is not a relevant market under such conditions. Inferences about a lack of competition based (by the MMS) on allegations of concentration of production at the lease level violate basic and well-tested principles of economics.

Publicly available data clearly indicate that there exist thousands of sellers of crude oil who participate in lease-level transactions, and the vast majority of these are not integrated into the refining segment of the industry. Figure 1 shows, for example, nearly seventy-five producers operating in the Gulf of Mexico in the 1990s. Additionally, Figure 2 offers a sample of two hundred of the more than one thousand operators producing crude oil in the states of Texas, New Mexico, Oklahoma, and Louisiana. Figure 3 shows a sample of more than three hundred operators located in the Rocky Mountain Region.

The overwhelming majority of the companies listed in the Figures above own no refineries and do not participate in downstream transactions, i.e., they specialize in the production and sale of crude oil at the lease. In light of such evidence, it is not plausible that there exists an anti-competitive paucity of sellers who operate in lease-level commerce. The proper interpretation of the data is that such companies, particularly those specializing in the production of crude oil, have the proper incentive to seek the most favorable terms, including prices for crude oil in the field that are as high as possible.

In similar fashion, the MMS’ assertions regarding a purported lack of competition among buyers at the lease is unsupported by the economic principles of competition analysis and the facts of the marketplace. The MMS appears to argue that competition is lacking at the lease level of commerce because there is only a "limited number of buyers" (as if competition requires unlimited numbers of buyers?). This, again, reflects a discouraging lack of understanding of (or, perhaps, failure to use) the economics of competition.

Basic economic principles demonstrate that in order to properly assess the competitive conditions of a market, one must consider not only the number of participants currently existing within that market, but also the role played by new entrants who can be attracted into a market when prices diverge from competitive levels. The presence of numerous buyers in a market acts to ensure the competitiveness of that market (on the buying side). Even where the number of buyers actually making purchases in a market at any point in time is small (or, "limited"), the prospective attraction of new buyers provides competitive discipline. Entry is the antidote to market power under such conditions.

The evidence is clear that lease-level commerce in crude oil is not plagued by a lack of competition among buyers. There is generally a large number of buyers at individual oil fields and, in any event, it is clear that entry into buying at the lease is not subject to barriers to entry that would allow the exercise of monopsonistic or oligopsonistic market power. Thus, lease-level commerce is subject to competition among a large number of actual and potential, i.e., entering, buyers. Indeed, the MMS recognizes that the last decade or so has witnessed "entry and expansion of resellers, traders, and brokers"; and that this "may be seen as increasing the level of competition." With numerous buyers who can come and go from the particular locations where crude oil is sold at the lease, the resulting discipline of entry means that there is, indeed, "a general rule" of the type missed by the MMS: The absence of competition-impeding barriers to entry by buyers at the lease means, by the basic principles of antitrust economics, that "as a general rule a competitive market exists."

The foregoing conclusions are readily apparent in the data. Figure 4, for example, shows a sample of three hundred first purchasers, i.e., those companies having taken title to crude oil at the lease, operating in the states of Louisiana, New Mexico, Oklahoma, and Texas in the 1990s. Figure 5 lists a sample of over fifty companies actively buying crude oil at the lease in the Rocky Mountain Region in the 1990s. Figure 5 also shows similar data—with similar implications—for the State of California and the Gulf of Mexico. Not only are many buyers active in each producing region, but it is also the case that the lack of anticompetitive barriers to entry means that a reseller or marketer, for example, operating in one region can add to or alter its operations so as to operate in other regions. Thus, a number of the buyers in Figures 4 and 5 operating in one region show up as operating in another region. The result is that the buying of crude oil cannot plausibly or responsibly be asserted to be subject to a lack of competition that would justify the MMS’ rejection of information on prices drawn from the transactions that occur at the lease level of commerce.

In fact, this conclusion holds even if relevant markets were defined, as the MMS seems to suggest, as individual fields. To illustrate, Figure 6 shows the companies purchasing crude oil at the lease during the 1990s in the Cowden producing area of West Texas. The data, as compiled by the State of Texas, stands in direct contradiction to the MMS’ assertion of the lack of buyers at the lease. In the 1990s, there were over fifty purchasers of crude oil in the Cowden field alone, ranging from vertically integrated large and small refiners to companies specializing in the downstream and marketing functions. It is not plausible that a lack of competition amongst these numerous buyers, in general, and the various resellers, in particular, taints the performance of the market in which Cowden supplies are sought by buyers. An asserted lack of competitive discipline is further contradicted by the observation that there is no general barrier to entry that would prevent any number of competitors of the type shown in Figures 4 and 5 from entering the competition to purchase crude oil in the Cowden area were prices somehow to be depressed by those buyers shown in Figure 6. MMS’ assertions that competition for purchasing crude oil at the lease is restricted to so few buyers as to make lease-level commerce less than competitive are economically baseless.

Prices at the Lease

Taken together, Figures 1 through 6 show the diversity of participants engaging in the lease-level marketplace for crude oil—a market which includes such disparate entities as independent producers, trucking and transportation companies, marketers, brokers, independent refiners, and vertically integrated companies all competing for the purchase and sale of crude oil in the field. Notwithstanding the clear implausibility of exercising market power in this setting and the rise of specialists such as resellers and marketers (as acknowledged by MMS), MMS seems to suggest that competition is lacking because "lessees usually will not know the prices at which other lease interest holders sell their oil," and buyers are not "perfectly informed about the prices of different sellers." This again, however, speaks to misunderstanding of the economics of competition.

Effective competition does not require that all market participants be perfectly or even similarly informed, particularly in a marketplace populated by specialist brokers, resellers, marketers and other traders. The action of these specialists—who make it their business to chase customers, seek out information, and locate favorable transactions—serves to lubricate the market with information. Each individual market participant then does not need to invest in trying to be perfectly informed. Rather, the individual seller—say, an independent producer—can turn to the services of a specialist agent to carry out transactions. The competition among such specialists (as well as the other buyers in the market) is the protection that individual market participants need. Such protection is the very economic function of specialist marketing and trading agents.

The MMS states that "generally there is no price transparency at the lease or field level." This is incorrect. Even if individual transaction prices negotiated between lease buyer and lease seller generally are not publicly available, posted prices for crude oil at the lease are publicly available and widely distributed and accessed. That is, posted prices are transparent. Moreover, as we discuss below, posted prices are widely used as the basis for arm’s-length transactions at the well. The MMS is implicitly rejecting the use of posted prices because, for example, MMS apparently believes that posted prices are not meaningfully employed in actual transactions and/or they are tainted by the asserted (albeit, without credible support) lack of competition in lease-level commerce. Such presumptions do not need to go untested against evidence.

As noted in Section II above, we have collected data on more than four million outright third-party transactions at the lease as recorded in course-of-business records of over three hundred companies that engage in such commerce. These companies range from very large vertically integrated major oil companies to independent producers and independent refiners to independent marketers. The data cover the 1980s and 1990s, with the bulk concentrated in the 1990s. With these data, we can examine the pricing of crude oil in outright lease-level transactions, and we can investigate whether transparent posted prices are set at fair market value based on comparisons to prices in comparable arm’s-length commerce.

The competition for crude oil at the lease gives rise to a range of prices in outright arm’s-length transactions. To illustrate, Figure 7 shows the prices struck in more than 3,800 outright transactions for the Amos Draw field in Wyoming over 1988-98. As parties negotiate their individual transactions, they produce a span of prices at any point in time as shown in Figure 7. The position of this span, or range, moves higher or lower over time as overall market supply and demand forces put upward or downward pressure on prices (e.g., the price-raising effects of the Gulf War are clearly evident in the second half of 1990 in Figure 7).

The general pattern produced under the competitive conditions governing Amos Draw, Wyoming, is repeated again and again across the oil fields of the United States. Figure 8 shows similar data on more than 12,000 outright third-party lease-level transactions for the Cowden producing area, located in the West Texas portion of the Permian Basin producing region. In fact, while the number of sample points varies from field to field, a similar pattern is exhibited in every major crude producing region in the lower forty-eight states (see Figure 9), including the Gulf of Mexico (Figure 10). The "general rule" which the MMS asserts does not exist is that there is steady, ongoing arm’s-length commerce under which crude oil is bought and sold outright at the lease. This commerce takes place under conditions in which numerous sellers have access to numerous buyers, and buyers are not blocked from entering the market to compete for access to crude oil. These are precisely the conditions that render the use of arm’s-length comparable transactions valid as measures of fair market value.

The prices struck in a particular oil field at any point in time commonly span a range in excess of a dollar per barrel or more, even after such transactions have been adjusted for directly measurable factors, such as gravity, sulfur, and the timing (within the month) of the price determination. To illustrate, Figures 11 and 12 show the prices struck in outright, arm’s-length, lease-level transactions in the Amos Draw and Cowden fields, respectively, after adjusting all transactions to common bases for gravity, sulfur, and payment timing. Even after accounting for such factors, prices in outright transactions struck within a given month commonly span a range of up to $3-$4 in the case of Amos Draw and $2-$3 in the case of Cowden.

The repeated finding that prices struck in outright arm’s-length transactions at the lease create a range of prices at any point in time is a product of the competitive reality that operates in U.S. oil fields. Prices for crude oil bought and sold in outright transactions at the lease lie within a range because the competitive conditions of the marketplace force a tailoring of such transactions to fit the particular desires and capabilities of the parties to individual transactions. As these desires and capabilities vary from transaction to transaction within the context of particular supply and demand factors for particular crude oils at particular leases, price variation is created within comparable transactions. Even similar quality crude oils in the same field are commonly observed to transact at different prices at given points in time. Such factors as whether a crude is trucked or gathered by pipeline, the strategic objectives of the bargaining parties, the reputations of the transacting parties, volumes aggregated by the seller, particular physical attributes of the oil beyond gravity and sulfur, and the paperwork burdens involved with dealing with particular sellers all play a role in determining the price associated with a particular seller’s crude at a particular lease at a particular point in time.

The fact that competition at the lease generates a range of prices in comparable arm’s-length transactions means that the fair market value of crude oil at any point in time at any particular lease is properly conceived of as a range, rather than a single value. In each transaction, the buyer and the seller are properly taken to be concerned with their own interest, with buyers preferring lower prices and sellers preferring higher prices. Moreover, each transaction is struck within the context of multiple sellers in the market competing to attract buyers, and multiple buyers competing to find attractive arrangements with sellers. It is precisely under such conditions that the marketplace forces of supply and demand are able to work, pushing prices in individual transactions to fair market value for those transactions. The result is that a price struck anywhere within the range revealed by the transactions struck by comparably situated buyers and sellers is properly concluded to reflect fair market value for that transaction.

In fact, this economic principle is well-established in public policy. The Internal Revenue Service, for example, in setting out the principle that the fair market value of a transaction (e.g., a transfer between two affiliates of the same parent company) is to be assessed by reference to arm’s-length comparable transactions notes that measurement of arm’s-length comparables "may produce a number of results from which a range of reliable results may be derived. A taxpayer will not be subject to adjustment if its results fall within such range (arms’ length [sic] range)." The MMS itself has recognized this same principle for decades.

Posted Prices

As noted, MMS is concerned that an individual royalty payor may not know the particularities of other parties’ arm’s-length transactions. Yet, posted prices for particular crude oils at particular locations are readily discernible. It would be improper to reject (as MMS has) the use of posted prices as measures of fair market value if posted prices lie within the range that defines fair market value at each lease.

How do posted prices compare to the broader sample of prices struck in outright transactions at the lease? As a general rule, based on repeated results for oil field after oil field in the U.S., posted prices lie within the range of prices struck in arm’s-length comparable transactions. To illustrate, Figures 13 and 14 map both high and low posted prices for the Amos Draw and Cowden fields, respectively, against the outright field-level transactions in those fields. The results are regularly observed in well-functioning crude oil markets. Specifically, posted prices (and transactions at posted price) commonly lie within the range of prices that defines market value, as observed in outright purchases and sales of crude oil in the field. Moreover, this conclusion is not confined to onshore producing areas. The same pattern is revealed offshore. To illustrate, Figure 15 shows the case of Eugene Island 330 in the Gulf of Mexico. Here, as elsewhere, the range of posted prices clearly lies within the band of outright transactions prices occurring at the lease (i.e., at the platform).

The repeated finding that posted prices lie within the range of arm’s-length transaction prices that defines fair market value is not surprising given that substantial numbers of outright transactions occur at posted prices. This can be seen by inspecting Figures 13 through 15, where it is frequently the case that outright third-party purchases and sales at the lease are struck at prices that lie right on the lines indicating posted prices. Overall, for those observations within our data that provide the underlying pricing basis, approximately one-third of such transactions are at a posted price. For the Cowden and Amos Draw fields, approximately three-quarters of all such transactions shown in Figures 13 and 14 are at a posted price. In the offshore case of Eugene Island shown in Figure 15, virtually all of the arm’s-length transactions are at a posted price.

These results belie often asserted (e.g., by MMS’ consultants) contentions to the effect that posted prices are merely arbitrary placeholders used in intracompany transfers and intercompany buy-sell (volumetric exchange) transactions and do not reflect fair market value. The fact that large numbers of outright arm’s-length sales of crude oil are done at posted prices in field after field and month after month means, economically, that posted prices are subject to the same disciplining forces of competition as operate to set prices negotiated at other than posted price levels and that form the overall range of market value. Failure to grasp this result of basic economic reasoning is a profound flaw in the MMS’ analysis.

That posted prices are utilized so extensively in such transactions by market participants is a reflection of the fact that the posting of prices economizes on negotiation prices. Not every seller and buyer are interested in negotiating afresh the prices in their transactions. With competition among the multiplicity of buyers making such negotiation available if posted prices are seen by either buyer or seller to be out of step with fair market value, posted prices are disciplined and can be rationally relied upon by buyers and sellers to simplify their negotiations. The result is that, when transactions are struck at posted prices and posted prices lie within the range of observed outright transactions, the proper conclusion to draw is that such transactions are taking place at market value. Indeed, from the perspective of an "outsider" to others’ transactions, posted prices lying within the range of prices struck in ongoing, outright, arm’s-length commerce at the lease offer direct and transparent evidence of fair market value. The same evidence on the relationship between posted prices and comparable arm’s-length transaction prices at the lease means that posted prices cannot properly be summarily rejected, as the MMS is attempting to do, as measures of the fair market value of crude oil in the field.

4. IMPLICATIONS FOR MMS’ PROPOSED RULE

In setting forth its new proposed procedures for valuing crude oil for Federal royalty purposes, the MMS is markedly inconsistent. On the one hand, crude oil sold outright at the lease would be permitted to be valued at its sales price. On the other hand, the MMS concludes that lease-level sales prices are affected by a purported lack of competition. In so far as the underlying purpose of Federal leasing policy is to garner fair market value upon relinquishment of the public’s oil resources, this is an internal contradiction.

Going further, the MMS recognizes that even vertically integrated producers do not transact all of their crude oil at the lease via internal transfers to downstream company affiliates. Rather, it is common for such producers to sell crude oil outright at the lease to third-parties, and a number of vertically integrated companies have adopted explicit procedures to validate intracompany transfer prices by going to the market and effectively auctioning off ongoing volumes of their production to third parties and utilizing the price results to establish their internal transfer prices (and royalty payments). Such procedures are directly reflective of the basic economic principles applicable to valuing internal firm transfers at market value. Yet the MMS rules would only permit internal transfer prices to be validated for royalty purposes by a company’s arm’s-length transactions if the company sells at least the majority of its equity production outright to third parties or purchases a quantity equal to 50% of its production; but even this comparable sales provision is limited to the Rocky Mountain Region.

More generally, the MMS rejects the use of prices struck in arm’s-length comparable outright sales at the lease, in part, because "the majority of Federal lease oil is not sold at arms’ length [sic] at or near the lease" and it believes the overall volume of outright commerce is too small to yield reliable reflections of market value. The question of what constitutes enough outright sales (purchases) for such transactions to be reliable as indicators of market value, however, is not a matter of numeric volume or share. As noted by the MMS’ Payor Handbook, outright transactions at a particular level of commerce (e.g., at the wellhead) are reliable in whatever volume to the extent they reveal the workings of the forces of supply and demand in determining prices. Clearly, the MMS has failed to perform the kind of analysis implied by economics associated with such trade. The proper criterion is the determination that there is ongoing commerce under competitive conditions by which crude oil is transacted at arm’s length at the lease. Such commerce allows the forces of supply and demand to operate and reveal fair market values through the prices struck by the parties engaging in such commerce.

As Figures 1 through 6 and 7 through 15 make obvious, there is no question that there is ongoing commerce under competitive conditions by which crude oil is transacted at arm’s length at the lease in U.S. oil fields. The millions of transactions in our data set represent millions of instances in which sellers and buyers of crude oil have gone to the market, tested its waters, and found the resulting prices to be acceptable. The MMS itself has relied on data from the Interagency Task Force ("IAT"), in which the MMS took part, indicating that outright transactions at the lease in California, for example, amount to roughly 20% of total production. In California, 20% of production amounts to approximately 200 thousand barrels per day, or over 70 million barrels per year. Our course-of-business data on outright lease-level transactions, representing a fraction of the entire marketplace, indicate that 15 to 25% of any given individual field’s production is moving in outright lease-level commerce, with some fields going much higher. The MMS’ conclusion that there is too little lease-level commerce to be assured that the forces of supply and demand are playing their roles in determining fair market value is wholly unfounded.

At the core of MMS’ new rules is the rejection of pricing in lease-level commerce in favor of a methodology that relies on netting back to the lease from index prices quoted at downstream trade centers. Such index pricing would generally be applicable to all but that crude oil that is sold outright at the lease. Such an approach to valuation is inconsistent with both proper economic policies for royalty valuation and sound public policy. When data such as that presented in Figures 7 through 15 exist, the proper and preferred methodology for determining the market value of crude oil at the lease is through the use of outright comparable transactions.

This principle is recognized widely in our public policies. In valuations of intracompany transfers for tax purposes, for example, the Internal Revenue Service rules explicitly reflect the standard of arm’s-length comparables. In particular, the IRS code states that "a controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result). However, because identical transactions can rarely be located, whether a transaction produces an arm’s length result generally will be determined by reference to the results of comparable transactions under comparable circumstances."

According to the MMS, the lack of competition at the lease "makes the attempt to find comparable sales transactions inferior to the use of index prices." Not only is this endorsement of index prices contradicted by the evidence regarding market competitiveness, but it also reflects an unsound process by which a public agency has retained and placed primary reliance on consultants (and their evidence) who are participants in contentious and well-known antitrust and valuation-related litigation—particularly in California crude oil markets. The MMS, in fact, adopts the position of plaintiffs in such litigation that "posted prices no longer reflected market value." Yet MMS must be aware that in both instances in which the matters have been taken to juries (after presentation of extensive evidence and testimony), California plaintiffs’ claims have been explicitly rejected. Indeed, the use of a downstream ANS index price for valuing crude oil at California leases has been explicitly rejected in the face of data presented on outright arm’s-length transactions at those leases. From a public policy perspective, such procedures and methods of analysis by a public agency are contrary to the public’s overriding interest in maintaining public confidence in a fair and impartial administrative system.

In order to implement its index pricing methodology, the MMS would rely upon spot prices quoted by news services for various trade centers and other locations. Downstream spot prices, however, fail the test of comparability along several important dimensions. These include, but are not limited to, physical quality, transactional quality, timing, location, and level of commerce. For example, spot price indices for a given crude stream, such as West Texas Intermediate (WTI), are priced according to a well-defined gravity and sulfur content. Crude oil transactions at the lease, however, cover varying quality attributes beyond just gravity and sulfur, including such contaminants and undesirable characteristics as carbon, metals, nitrogen, and heavy product yields. Moreover, the term "WTI crude oil" implies substantially different transactional attributes when used at downstream levels of commerce, such as the trade center spot transactions advocated by the MMS, as compared to field-level transactions. Cushing, Oklahoma (where WTI spot prices are quoted), for example, stands as one of the principal trade centers in the mid-continent region, with available storage capacity exceeding twenty million barrels. In contrast, the average Federal lease produces sixty-five barrels per day. From the perspective of market value, the implied need to deal in small volumes when purchasing crude oil is a decrement, and aggregation by marketers and integrated companies at trade centers adds value to crude oil transactions.

It is also the case that spot prices represent the value of crude oil delivered in the future, typically thirty days forward. Consequently, the price formulation rests upon the expectations of the value of the crude oil at a downstream market center thirty days into the future. This timing introduces yet additional variation between market center indices and posted prices. Indeed, the MMS’ methodology lacks any mechanism for determining the value of crude in the field at the time of the crude’s production and sale in the field.

Clearly, crude oil sitting in storage in Cushing, to take one example, is not located in the same field or producing area as crude oil at the lease. Localized supply and demand factors, however, can and do impart significant differences between two crude oils at different locations being transacted at the same time. The same holds when comparing prices at different levels of commerce—i.e., when comparing upstream wellhead versus downstream trade center transactions. This is clearly demonstrated by the data of Figure 16, which graphs prices struck in outright transactions for crude oil in the Cushing field, located near Cushing, Oklahoma, relative to Platt’s reported spot price for WTI crude delivered to the Cushing trade center. The latter is represented by the "zero line" in the figure, and prices at the producing field are shown as the "dots" (i.e., deviations from the spot price). As the data reveal, Platt’s reported prices at the market center typically exceed the prices struck in arm’s-length transactions in the field by on the order of $1-$2 per barrel. Neither a lack of transactions and competition nor the adjustment for transportation costs can explain this result, and the MMS’ new rules lack any mechanism for accounting for the obvious non-comparability and inaccuracy involved in using downstream trade center prices to measure upstream crude values at the lease.

The reasonable conclusion to be drawn from data such as in Figure 16 (whose pattern is repeated for oil field after oil field) is not that prices struck in outright field-level transactions fail to reflect current market values for crude oil in the field. The reasonable conclusion is that field-level transactions are subject to different supply and demand forces that impart significant differences to their respective values as compared to trade centers. In particular, crude oil transactions in market centers and other downstream locations reflect the value added by the provision of wholesale or "middleman" services, such as aggregation; storage; the bearing of risk and loss during post-production handling, transportation and marketing; transaction negotiation; and the like. It is not surprising that, with such value added to crude oil flows by the time they reach trade centers, crude oil of any given quality generally sells for higher prices at trade centers than at the lease (after adjusting for transportation costs).

The lesson from the evidence presented is that comparing crude oil transactions which occur under different terms and conditions at different levels of commerce with different qualities and different quantities is the archetypal "apples to oranges" comparison that produces inaccurate measures of market value in the field. The supply and demand forces that establish the market value of apples are not the same as the supply and demand forces that establish the value of oranges. As Figure 16 makes clear, basing royalties on trade center value would enable the MMS to claim value added downstream of the wellhead by post-production activities. The data on arm’s-length transactions demonstrate that the marketplace draws the production/post-production boundary at the well and compensates oil production at that point.

The MMS argues that such evidence merely "clouds the real issue" as the "lessor is entitled to its royalty share of the total value derived from the production regardless of how the lessee chooses to dispose it." This argument fails basic economic principles and stands in contrast to sound public policy. The existence of competitive outright transactions in the field distinguishes the value attributable to the production of crude oil and post-production, downstream services. The lessor of a raw material facing competitive conditions, as those described above, is able to extract no more than market value for what the lessor has brought to the production chain in which that raw material is used. This means that fair market royalties do not levy claim to value added beyond the point of production of the raw material—i.e., the wellhead in the case of crude oil. As discussed above, the use of arm’s-length transactions between unrelated parties to draw the boundaries between the value stages of a vertically integrated firm’s operations is grounded in the economics of market value. It also underlies the IRS’ approach to allocating income among constituent stages of an integrated supply chain (see above).

To levy claim beyond that which the royalty owner can reasonably expect to receive in well-functioning markets is to improperly impact decisions firms face regarding the appropriate functions in which the firm is to engage. Laying claim to downstream value-added for crude oil disposed of through buy/sells, exchanges, or affiliate transfers raises the cost to vertically integrated firms of doing business in the downstream segments of the industry. Because vertical integration can be an efficient mode of organization, taxing that mode will have adverse effects on oil production and, ultimately, the public’s interest in resource development.

5. Conclusion

The MMS’ trade-center-based methodology, as well its underlying reasoning, are at odds with directly relevant evidence. Consequently, it is invalid as an approach to arriving at fair market value for crude oil disposed of in non-outright transactions. The data from over four million outright transactions between unaffiliated buyers and sellers reveal the existence of a competitive market for the purchase and sale of crude oil at the lease. The economics of such transactions create the proper presumption that the observed prices offer the best indication of market value for crude oil in the field. In sum, the MMS has no sound economic basis for rejecting the use of such prices in the determination of the value of crude oil produced from Federal leases.

Under 28 U.S.C. 1746, I declare under penalty of perjury that the
foregoing is true and correct to the best of my knowledge.

______________________

Dr. Joseph Kalt

Under 28 U.S.C. 1746, I declare under penalty of perjury that the
foregoing is true and correct to the best of my knowledge.

______________________

Kenneth Grant