Issues » Comments on Rules and Regulations

January 30, 2000

Lucy Querques Denett
Associate Director, Minerals Management Service
United States Department of the Interior
1849 C Street, NW
Washington, DC 20240

Minerals Management Service Further Supplementary
Proposal for Royalty Due on Federal Leases
64 FR 73820 (December 30, 1999)

Dear Lucy:

On behalf of the American Petroleum Institute, the Independent Petroleum Association of America, the Domestic Petroleum Council and the U.S. Oil and Gas Association, we welcome the opportunity to file these comments on the MMS’ December 30, 1999 proposal. In these comments we are joined by the Independent Petroleum Association of Mountain States, the Western States Petroleum Association and the California Independent Producers Association. Together our members account for virtually all of the royalties paid for oil production on Federal lands, onshore and offshore.

Our two volume comments augment the discussions held at the MMS public workshops held January 18 (Denver), January 19 (Houston), and January 20, 2000 (Washington, DC) and we incorporate by reference the many earlier comments filed by industry associations and individual companies in the course of this protracted rulemaking.

Our comments add important new information to the rulemaking record: Professor Kalt’s declaration (Appendix A) shows there is a market at the lease, that comparable sales are viable measures of value and that market center spot prices are not. Mr. Deal’s letter (Appendix B) describes the deep implications of the August 1999 City of Long Beach verdict. Professor Lowe’s paper (Appendix C) shows that basing royalties on values greater than the value of production at the lease is antithetical to well-established oil and gas law. The Swanson report (Appendix D) offers a rationale for calculating rate of return for transportation allowance purposes. Finally, the Van Vactor report (Appendix E), shows that ANS spot prices are especially problematic for valuation of California crudes, but emphasizes that the MMS’ proposed indexing methodology is problematic more generally.

The highlights of our attached detailed comments are as follows:

Part I Underlying Assumptions

Our comments show that from the outset the MMS oil valuation rulemaking has been based on three erroneous core assumptions. In rebutting these wrong assumptions, we show that:

• Record evidence establishes conclusively that an active, competitive market does exist at the lease.
• The City of Long Beach verdict shatters the premise that use of posted prices results in underpayment of royalties.
• Federal and state oil and gas law, Federal contract law, and recent Federal administrative law shows that the MMS cannot lawfully assert that there exists a duty to market free of charge.

Part II Core Issues

Our comments offer several suggestions for addressing the core substantive issues that emerged during the rulemaking:

• For arm’s length contracts, the MMS should clarify several key definitions: "area," "affiliate" and "exchange agreement."
• For non-arm’s length contracts, the MMS should abandon its presumptive use of spot prices in lieu of other better measures of value (e.g., comparable sales, tendering programs) and abandon regional differences in valuation standards (i.e., ANS spot prices for California and Alaska, unduly limited benchmarks for the Rocky Mountain Region), and clarify certain key terms ("index pricing point," "reasonable royalty value," etc.). However, indexing should be permitted as an option for a wide universe of arm’s length transactions where tracing is impracticable.
• For transportation allowances, the MMS should recognize FERC tariffs or their equivalent, adopt a rate of return at least equal to twice the Standard & Poors BBB rate and, as proposed by the MMS, allow depreciation to start anew upon a change in ownership.
• For location/quality adjustments, the MMS should abandon, as it has proposed, Form MMS-4415 or any equivalent to eliminate the unnecessary collection and reporting of data, and clarify certain important details of its procedures for calculation of location/quality adjustments.
• For binding determinations, the MMS should broaden the universe of areas for which binding determinations are available, make assurances that necessary rescissions or modifications are prospective only, agree to issue them on an expeditious basis, make them appealable and preserve several aspects of the existing regulations.
• For second-guessing, the MMS should adopt and apply the principle that the mere existence of a higher selling price somewhere does not call into question the validity of the proceeds received in any transaction.

Part III Procedural and Timing Matters

Our comments urge the MMS to reexamine certain procedural and timing dimensions of the oil valuation rulemaking:

• The MMS should postpone completion of the oil valuation rulemaking until the circumstances surrounding payment of $700,000 to two Federal officials during therulemaking are fully explained, either by convening its own public assessment or awaiting completion of the pending Congressionally-initiated investigation.
• The MMS should reexamine the economic impact of its proposed rule and more accurately estimate the administrative cost of compliance and royalty revenue impacts. Despite MMS claims, the economic impact is likely to exceed the $100 million threshold that triggers various Federal procedural requirements such as the Small Business Regulatory Enforcement Fairness Act. In addition, we concur with OMB that the proposed rule "raises novel legal or policy issues" deserving of OMB scrutiny under Executive Order 12866.
• The MMS should take the time needed to fully assess the public comments it receives which include substantial new information. Once the MMS promulgates the new rule, it should establish an effective date consistent with the time needed by Industry to make the system changes required and obtain the MMS approvals needed for implementation.

IV. Royalty-in-Kind

• The MMS should continue a vigorous exploration of a comprehensive royalty-in-kind program to replace, to the fullest extent possible, inherently complex and uncertain valuation procedures, existing or revised. The MMS’ ongoing RIK pilot studies are encouraging and Industry will continue to participate fully.

In proposing to abandon the existing benchmarks altogether (except for limited use in the Rocky Mountain Region), the MMS would cast aside a powerful and efficient tool, the marketplace at or near the lease, and replace it with an inherently more complicated indexing system. Indexing depends on netback and creates uncertainty, perpetuates disputes, and leads to inaccurate determinations of value. Moreover, the MMS’ flawed valuation initiative would drive producers to revamp sound business practices, especially in the midstream marketing arena.

Our recommendations would move the MMS closer to a final crude oil valuation rule that is workable and fair, while decreasing the cost of administration, decreasing appeals and litigation, and satisfying the legal requirement that royalty obligations be based on the value of production at the lease. Our recommendations also minimize the need for unnecessarily disruptive changes in the business practices among producers.

We urge the MMS to carefully consider these recommendations and welcome any further questions you might have in order to reach a satisfactory resolution of this important rulemaking.

Sincerely,

Originally Signed by the Following:

David T. Deal Ben Dillon
American Petroleum Institute Independent Petroleum Association of America

William F. Whitsitt
Albert Modiano
Domestic Petroleum Council US Oil & Gas Association

Carla Wilson
Catherine Reheis
Independent Petroleum Association
Western States Petroleum Association of Mountain States

Dan Kramer
California Independent Producers Association

c: D. Guzy

Comments of the American Petroleum Institute, Independent Petroleum Association of America, Domestic Petroleum Council,
U.S. Oil and Gas Association,
Independent Petroleum Association of Mountain States,
Western States Petroleum Association,
California Independent Producers Association
on
Minerals Management Service’s Further Supplementary
Proposal for Royalty Due on Federal Leases,
64 FR 73820 (December 30, 1999)

1. Underlying Assumptions
1. Active Market at the Lease
2. No Systematic Underpayment of Royalties
3. No Duty to Market Free of Charge
1. Bounds on MMS Statutory Authority
2. Limits on MMS Contract Authority
3. Inconsistent with MMS Regulatory Practice
4. Inconsistent with IBLA Decisions
5. Inconsistent with State Oil and Gas Law
6. Violative of Non-Delegation Doctrine
2. Core Issues
1. Arm’s Length Contracts
1. Definition of "Affiliate"
2. Definition of "Area"
3. Definition of "Exchange Agreement"
4. Definition of "Gross Proceeds"
5. Inconsistent Valuation
6. Indexing v. Tracing
2. Non-arms Length Contracts
1. Spot Prices v. Comparable Sales
2. Regional Differences
3. Tendering
4. Index Pricing Point
5. Reasonable Royalty Value
3. Transportation Allowances
1. FERC Tariffs
2. Rate of Return and Cost of Capital
3. Depreciation
4. Minimum Cost
4. Quality and Location Adjustments
1. Elimination of Form MMS-4415
2. Adjustments for Location/Quality
5. Binding Determinations
1. Mandatory Determinations
2. Expeditious Determinations
3. Binding and Prospective Nature of Determinations
4. Default Valuation Methodologies
5. Alternative Valuation Methodologies
6. Second-Guessing
3. Procedural Matters
1. Irregularity of Payments During Rulemaking
2. Economic Impact
3. Consideration of Comments and Effective Date of Regulations
4. Royalty-In-Kind Is the Preferred Solution

List of Appendices

Appendix A: Declaration of Joseph K. Kalt, Ford Foundation Professor of International Political Economy, John F. Kennedy School of Government, Harvard University and Kenneth Grant, Senior Consultant, Lexecon Inc.

Appendix B: Letter of API Assistant General Counsel, David T. Deal, to Associate Director for Royalty Management, Lucy Querques Denett, November 4, 1999, on Implications of the August 1999 Jury Verdict in City of Long Beach v. Exxon Litigation.

Appendix C: "The Royalty Bargain," by John Lowe, George Hutchison Professor of Energy Law, Southern Methodist University.

Appendix D: "A Recommended Rate of Return Methodology for Calculation of Transportation Allowances in Non-Arm’s Length Crude Transportation Arrangements, by Elizabeth H, Crowe and Carl V. Swanson, Swanson Energy Group.

Appendix E: "Pricing Royalty Crude Oil," bySamuel A. Van Vactor, President, Economic Insight, Inc.

To complement industry participation in the Minerals Management Service ("MMS") January 2000 public workshops, the associations listed above ("Industry") submit these comments on the MMS’ December 30, 1999 proposal ("Proposal"). To the extent possible, these comments do not repeat the voluminous comments we submitted earlier in the rulemaking that we incorporate by reference. These comments do, however, include Appendices "A" through "E"containing extensive new materials generated in the course of this rulemaking.

1. Underlying Assumptions

Throughout this rulemaking the MMS has relied on several core assumptions as the foundation for its downstream-oriented valuation proposal: the factual assumption that there is no active market at the lease; the factual assumption that posted prices have led to systemic underpayment of royalties; and the legal assumption that lessees have a duty to market free of charge away from the lease. Despite voluminous and compelling industry comments and testimony during this rulemaking and some MMS changes to the original proposal, these erroneous core assumptions have gone unchanged and, for that reason, are addressed once again below.

1. Active Market at the Lease

In its Proposal the MMS asserts that industry comments submitted during the rulemaking have not yet demonstrated that "as a general rule a competitive market exists at the lease." Proposal ("Prop.") at 73820. While too numerous to cite in these comments, the administrative record for this rulemaking is already full of comments from large and small producers, crude oil marketers and respected economists that vigorously support the thesis that there is an active market at the lease.

This active market at the lease makes it unnecessary, except in extraordinary circumstances, to use netback-type valuation methodologies like the market center spot price methodology proposed by the MMS. This active market at the lease makes the universe of arm’s length transactions far larger than the MMS rulemaking implies. This fact would make more transactions eligible for valuation as arm’s length transactions themselves and should also make it practicable for valuation of most non-arm’s length transactions through use of comparable sales and without recourse to the MMS’ flawed indexing approach.

The Kalt Declaration amplifies information submitted by Industry earlier in the rulemaking and draws on over 4 million outright transactions inclusive of 300 different companies across every domestic crude oil producing region, including the Gulf of Mexico, the mid-continent states, California and the Rocky Mountain Region. The Kalt Declaration shows that there exists a highly competitive market at the lease. Kalt Declaration at 6-11. It debunks the MMS notion that there is no price transparency and shows that comparable prices are a sound measure of value and are relied on by the Internal revenue Service. Kalt Declaration at 12-18, 25.

The Kalt Declaration flatly disagrees with the MMS’ assumptions that outright sales are too few to rely on for valuation purposes, concluding, for example, that 15-25% of any given field’s production is moving in outright lease-level commerce, with some fields going much higher. Kalt Declaration at 24. It also concludes that the MMS’ spot market-based valuation methodology for valuation of oil from Federal leases is not economically valid and markedly inferior to using comparable sales at the lease. Kalt Declaration at 4. Whereas field-level transactions reflect local supply and demand forces, crude oil transactions at market centers reflect the value added by post-production middleman services, such as aggregation, storage, bearing risk and loss during post-production handling, transportation and marketing, transaction negotiation, etc. Kalt Declaration at 28-29.

Overall, the Kalt Declaration shows that 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." Kalt Declaration at 5.

The market in fact "includes significant and recurring volumes of crude oil at the lease moving in outright (i.e., cash-on-the-barrel) transactions between unrelated, well-informed buyers and sellers with access to the information and competition that allows each to protect their interests." Id.

The plain implication of this information is that there is a market at the lease and that use of downstream spot prices as the presumptive methodology for valuation of non-arm’s length transactions unnecessarily injects downstream variables into the calculation and can lead to overvaluation through capture of post-production additions to value.

2. No Systematic Underpayment of Royalties

In its Proposal the MMS plainly adheres to the view that posted prices are no longer a reliable indicator of market value and that their continued use leads to underpayment of royalties.Prop. at 73820-21. Conspicuously absent from its present rationale, however, is any recognition, let alone assessment, of the implications of the August 1999 jury verdict in City of Long Beach. As API’s November 1999 letter points out, the Long Beach litigation was used as recently as the Department of the Interior’s May 1999 testimony before Senator Nickles. Yet now, after a California jury has rejected government criticism of posted prices and the substitution of Alaska North Slope ("ANS") spot prices for royalty valuation of crude oil, the MMS treats the Long Beach as irrelevant, even though it was the antecedent for the MMS’ oil valuation rulemaking.

Use of posted prices aside, the MMS continues to ignore what has been a cornerstone of industry comments from early in of the rulemaking: industry accedes to the future elimination of posted prices for Federal royalty purposes, provided that the substituted valuation methodology arrives at a reasonable "value of production" at the lease on which to base royalties. The elimination of posted prices, however, should not lead to the substitution of indexing as the valuation methodology for non-arm’s length transactions when other truer to the statute and less costly measures of the "value of production" at the lease are available.

3. No Duty to Market Free of Charge

In its Proposal the MMS states anew its opinion that lessees have a duty to "place oil in marketable condition and market the oil for the mutual benefit of the lessee and lessor at no cost to the Federal Government (emphasis supplied)" even if that marketing occurs distant from the lease. Prop. at 73822-24, 73832; ó 206.106 at 73845. The MMS’ position trivializes the difference between the duty to put production in marketable condition and duty to market and includes claims that its rulemaking is directed at a methodology which will arrive at the "value of production at the lease." In fact, the MMS’ duty to market position is the foundation for an indexing methodology which, when coupled with plainly inadequate allowances and adjustments, leads to overstated values of production and overstated royalty obligations.

Inasmuch as the duty to market free of charge issue is now before a federal court in pending litigation, our comments below are summary in nature. They draw on a combination of oil and gas law and more general principles of statutory construction, some of which are laid out in substantial detail in the Industry briefs filed in the pending duty to market litigation. All of these principles, some more directly than others, point in the same direction: whether as regulator or proprietor, in overstating the value of production the MMS’ downstream-oriented rule unlawfully overstates the royalty obligation.

1. Bounds on MMS Statutory Authority

It is axiomatic that the governing statutes define the Department of the Interior's ("Department") ability to issue leases, regulate leased lands and determine royalty valuation. California Co. v. Udall, 296 F.2d 384, 386. The MMS may only impose a duty on lessees that is authorized by the governing statutes. The governing mineral leasing statutory authority requires a lessee to pay royalty on a percent of the value of production at the lease. See Mineral Lands Leasing Act ("MLA"), 30 U.S.C. ó 226(b)(1)(A) (MMS' grant of oil and gas leases is conditioned upon payment of royalty "in amount or value of the production removed or sold from the lease"); Outer Continental Shelf Lands Act, 43 U.S.C. óó 1335(a)(8), 1337(a) and 1337(b)(3) (lessee pays royalty "in amount or value of the production saved, removed, or sold" from leased premises).

Courts have interpreted these statutory provisions to mean that royalty should be based on the value of production at the lease. See, e.g., United States v. General Petroleum Corp., 73 F. Supp. at 235, 237 (holding that "value of production" under MLA refers to value of oil and gas at the wellhead); Marathon Oil Co. v. United States, 604 F. Supp. 1375, 1384 (D. Alaska 1985), aff'd, 807 F.2d 759 (9th Cir. 1986), cert. denied, 480 U.S. 940 (1987) (upholding netback accounting methodology, which allows lessees to calculate and pay royalty based on wellhead value of production where sales are not made at the wellhead; appropriately deducted costs include both transportation and "marketing" costs); Beartooth Oil and Gas Co. v. Lujan, Cause No. CV92-99-BLG-RWA (D. Wyo. 1993) (concluding that marketable condition rule does not require lessee to condition gas so that it is suitable for markets downstream of the wellhead).

Moreover, the MMS' own decisions and pronouncements corroborate the view that MMS' royalty interest lies in the value of production at the lease, and not in the enhanced value attributable to downstream activities free of cost. See Petro-Lewis Corp., 108 IBLA 20 (1989) (appropriate royalty must reflect market price at the lease); See also 52 FR 30776, 30797 (August 17, 1987) (noting that royalty values need be "adjusted for transportation and/or processing to determine value at the lease).

The implied duty to market that the MMS contends already exists does not exist and far exceeds the duties that MMS may impose under the governing statutes. Because royalty is due under the governing statutory terms on the value of oil and gas production at the lease, MMS has no authority to demand a royalty interest in value downstream of the lease without fully deducting the added costs of marketing downstream. While the costs of marketing at the lease are not deductible, the added costs associated with marketing away from the lease, real or imputed (for transfers by a producer to its refiner) by the MMS through use of a downstream index, cannot be included in the value of production for royalty purposes if they enhance the "value of production." The MMS cannot lawfully claim the windfall values added by downstream marketing.

In two closely related cases, reversing two Clean Air Act reformulated gasoline rules issued by EPA, the D.C. Circuit rejected sweeping agency claims of deference for interpretation of a federal statute.See API v. USEPA, 52 F.3d 1113 (D.C. Cir.1995) (RFG Ethanol ) and API v. USEPA, __ F.3d __ (D.C. Cir. Jan. 4, 2000) ( RFG Opt-in). Both of these cases emphasize the "plain meaning" of the statute in overturning agency initiatives that strayed into Congress’ legislative prerogatives.

In this rulemaking, what the governing mineral leasing statutes lack in the extraordinary detail offered by the Clean Air Act, they make up for through use of well-accepted terms of art: royalty is due on the "value of production." And "production," in oil and gas leasing parlance, means the oil as severed from the ground. What production does not mean is the crude oil after it leaves the lease and becomes the subject of several value-adding activities: transportation, storage, blending, inventory management, trading costs, risk management, refining, etc. "If the meaning of [the governing statute] is clear, then the court must give effect to that meaning." RFG Ethanol at 1119, citing Chevron U.S.A. Inc. v. Natural Resources Defense Council, 467 U.S. 837, 843 n. 9.

To the extent that MMS’ valuation methodology captures the value added by this post-production activity away from the lease, it is unlawful. And since the MMS’ proposed valuation approach employs a downstream starting point with patently inadequate transportation allowances and other adjustments that together inflate the value of production and inflate the royalty obligation, it is unlawful. As the D.C. Circuit put it best and most simply: Congress "meant what it said." RFG Opt-in slip op. at 6.

2. Limits on MMS Contract Authority

The plain bounds of the governing mineral leasing statutes place clear limits on the MMS’ contract authority. The Proposal would impose a requirement that lessees under Federal oil leases bear all of the additional marketing costs attributable to sales at downstream markets. The Proposal indicates that MMS has based this requirement on a covenant to market that it claims is implied in all oil and gas leases. Prop. at 73822. Contrary to MMS' claims, however, the MMS' existing regulations only impose upon lessees an express duty to market gas in order to avoid waste. See California Co. v. Udall, 296 F.2d 384, 387 (D. C. Cir. 1961) (citing 30 CFR. ó 221.35, presently codified at 30 CFR ó 202.150(c)). This express duty to market does not by its terms impose a duty on lessees to market production downstream of the lease at no cost to the lessor; there is no applicable authority that supports MMS' imposition of such an implied duty.

The Federal government has no authority to imply contractual duties. As the drafter of its leases, the MMS must be held to the express language of the lease, and cannot imply additional duties under the lease. As a general matter, contracts are to be construed against the drafter. See United States v. Seckinger, 397 U.S. 203, 216 (1970); Peter Kiewit Sons' Co. v. United States, 109 Ct. Cl. 390, 418 (1948). As the drafter of the federal lease terms, the MMS cannot now claim that implied duties should be imposed where it failed to spell out the duties expressly when drafting the lease.

With the exception of the general implied duties of good faith and fair dealing, the courts have properly declined to imply increased royalty obligations on Federal oil and gas leases that are not found in the express terms of the lease. See United States v. General Petroleum Corp., 73 F. Supp. 225, 234-38 (S.D. Cal. 1946), aff'd. sub nom., Continental Oil Co. v. United States, 184 F.2d 802, 809-810 (9th Cir. 1950). In Continental Oil Co., the Ninth Circuit Court of Appeals affirmed the district court's holding that leases are private, contractual matters, and as such, the Secretary cannot unilaterally imply obligations into the terms of a lease. See Continental Oil Co., 184 F.2d at 810.

The IBLA has also recognized that royalty obligations of a lessee under a Federal oil and gas lease are defined by terms expressly stated in the lease. In fact, the IBLA has specifically determined that the duty to market "is 'not a covenant read into the lease by implication' but rather is an affirmative duty expressly imposed under the terms of the lease via the incorporation of the Department's regulations into the lease." Viersen & Cochran, 134 IBLA 155, 164 n. 8 (1995) (citing The Texas Co., 64 I.D. 76, 79-80 (1957)). The IBLA's recent decision in Viersen & Cochran confirms that, as a general proposition, MMS may not impose an expanded duty to market on its lessees by implication.

These limitations on MMS’ authority are especially true for existing leases.Such an imposition directly contradicts federal contract law. See General Petroleum Corp., 73 F. Supp. at 234, 250 (when the Federal government executes a lease, the lease becomes a "private, contractual matter" and the "government's role is taken to be no different from that of any private lessor or proprietor"); United States v. Winstar Corp., 64 F.3d 1531 (Fed. Cir. 1995), aff'd. 518 U.S. 839, 869-906 (1996). In addition, the Fifth Amendment and fundamental due process rights prohibit the Federal government from annulling previously created contract rights. See Perry v. U.S., 294 U.S. 339, 353-54 (1935); Lynch v. United States, 292 U.S. 571, 579-80 (1934). See also United States Trust Co. v. New Jersey, 431 U.S. 1, 25-26 n. 25 (1977). Courts interpreting Federal and Indian leases have also held that MMS may not adversely affect the rights of existing lessees through future or subsequent legislation or regulation. Conoco Inc. v. United States, 35 Fed. Cl. 309, rev'd. on other grounds sub nom., Marathon Oil Co. v. United States, 158 F.3d 1253 (Fed. Cir. 1998), cert. granted, _ U.S._, 120 S.Ct. 494 (1999); United States v. Wichita Indus. Inc., 390 F. Supp. 1154, 1157 (W.D. Okla. 1974) (holding that MMS was precluded from modifying its methodology for valuing royalty through subsequent regulation).

The terms of the MMS' lease forms not only fail to support the Proposal; they expressly foreclose MMS from imposing new royalty obligations on existing leases by new regulations. Therefore, even if the MMS had the statutory authority to impose an expanded duty to market on lessees, it would have no authority to impose such a duty under leases executed prior to the effective date of a new rule.

3. Inconsistent with Past MMS Regulatory Practice

The Proposal is not consistent with MMS' existing regulations and regulatory practices. Wherever possible, MMS has historically calculated royalty value on the gross proceeds of the sale of production, regardless of whether the sale occurred on the lease or at a downstream point. MMS' regulations have not imposed a duty to market downstream of the wellhead at no cost to the lessor, and MMS has not before required that the lessee bear all of the additional marketing costs attributable to sales at downstream markets.

The expansive Proposal contradicts MMS' longstanding acceptance of the gross proceeds received in a wellhead sale as reflecting royalty value. If the gross proceeds at the wellhead are an acceptable measure of royalty value, then any downstream costs incurred -- whether transportation or marketing -- may never be a permissible addition to royalty value -- whether the transaction is arm’s length or non-arm’s length. Such costs are not the lessee's sole responsibility, and they are properly shared with the lessor by inclusion in any deduction from the gross proceeds received in a sale downstream of the lease.

MMS' own decisions and pronouncements are consistent with the view that MMS' royalty interest rests in the value of production at the lease, and not in the enhanced value attributable to downstream activities. In establishing transportation allowances for downstream costs, MMS has expressly acknowledged that royalty is valued at the lease. In 1988 the MMS made comprehensive revisions to its royalty regulations pertaining to Indian and Federal offshore and onshore leases. See 53 FR 1230 (Jan. 15, 1988). These regulations established specific provisions permitting deductions from gross proceeds of the cost of transporting production from the lease to a point of sale. 53 FR 1230, 1259-66 (January 15, 1988). In response to isolated comments during the rulemaking leading to the 1988 rules urging the MMS to provide no transportation allowances, the MMS properly responded:

The MMS believes generally that royalty should be free of cost. However, values may have to be adjusted for transportation and/or processing to determine value at the lease. The MMS believes that the policy of granting transportation allowances to properly value lease production is appropriate and should continue.

52 FR 30776, 30797 (Aug. 17, 1987) (emphasis added). See also Petro-Lewis Corp., 108 IBLA 20 (1989) (permitting deduction of downstream electric generation costs so that royalty may be valued by the market price at the lease). The MMS wrongly cites the decision in Marathon Oil Co. v. United States to show that its gross proceeds rule permits MMS to base royalty on downstream sales prices. What Marathon does illustrate is that higher downstream sales prices must be adjusted to yield a royalty value at the lease by allowing deductions for costs attributable to selling the production at a downstream sales point. Marathon, 604 F. Supp. at 1384.

All downstream costs are incurred by a lessee to enhance the value of production after it leaves the lease. This benefits both the lessor and lessee. By failing to allow full deductions for all such post-production costs, whether they be transportation or marketing-related, MMS unlawfully claims an interest in value greater than the value of production at the lease.

4. Inconsistent with IBLA Decisions

The Proposal cites several Interior Board of Land Appeals ("IBLA") decisions for the purported "well-established principle that lessees have the obligation to market lease production for the mutual benefit of the lessee and lessor, without deduction for the costs of marketing." Prop. at 73822.

In its selective citation of IBLA decisions, MMS fails to include the IBLA's decision in Viersen & Cochran, 134 IBLA 155, 164 n. 8 (1995), which as noted above holds that the MMS may not impose an expanded duty to market on its lessees by implication. More fundamental, the MMS would bootstrap its position through decisions of its own appeals board to support the application of the implied duty to market. The IBLA decisions, without more, do not support the Proposal; pronouncements of an agency's own appeals board do not form an independent foundation for an agency regulation.

Even if IBLA decisions could be relied upon to substantiate the proposed rule, the IBLA decisions cited in the Proposal fail to support the imposition of an expanded duty to market free of charge to the lessor. The Proposal refers to Walter Oil and Gas Corp., 111 IBLA 260 (1989) and Arco Oil & Gas Co., 112 IBLA 8 (1989) for the proposition that the IBLA requires lessees to market production for the mutual benefit of the lessee and lessor without deductions for the cost of marketing. Prop. at 73822. However, these cases do not address the question of whether the duty to market entails the additional marketing costs that may arise in marketing downstream of the lease.

Walter Oil addressed the issue of a producer who sought to shift the costs of marketing gas at the lease by retaining an independent marketer to perform the marketing function. Arco required the lessee to include a marketing fee received from a gas purchaser as part of its gross proceeds subject to royalty. The IBLA concluded that the lessee "would have borne similar costs attributable to the creation and development of markets regardless whether production was sold on or adjacent to the lease." Arco, 112 IBLA at 11. Thus, Arco is also inapplicable to the issue of the duty to market production downstream of the lease. Moreover, Arco is inconsistent with the IBLA's own subsequent decision in Viersen & Cochran, where the IBLA rejected the applicability of implied duties under Federal oil and gas lease.

The Proposal cites several other IBLA decisions in support of its claim that marketing costs are not deductible. Prop. at 73822. But these cases rely upon the inapplicable Walter and Arco decisions and, therefore, add nothing to the ultimate issue of whether MMS may invoke an implied covenant to market. In sum, there is no relevant and determinant IBLA authority to support MMS' position that lessees have an obligation to market downstream of the lease at no cost to the lessor, or that lessees must add to royalty value the additional costs of downstream marketing borne by lessee's production purchasers.

5. Inconsistent with State Oil and Gas Law

The Proposal asserts that an implied covenant to market exists with respect to "virtually all oil and gas leases, whether the leases are private, federal, or State leases." Preamble at 73822. As shown above, MMS has not demonstrated why this statement is true for Federal leases. The Proposal also fails to explain how State case law supports this position. In fact, Professor Lowe’s paper shows that State courts have taken a more limited view of the scope of the duty to market than that asserted by the Proposal.

These state courts have been careful to ensure that an implied duty is not so broad as to contradict express terms in the lease or to expand the royalty interest beyond the reasonable intent of the parties under the lease. See e.g., Danciger Oil & Refining Co. v. Powell, 154 S.W.2d 632, 635 (Tex. 1941); Williamson v. Elf Aquitaine, Inc., 138 F.3d 546, 551 (5th Cir. 1998) (implied covenants are inapplicable when contracts contain express provisions). In large measure, the State cases involve the question of whether a lessee has the duty to place production in marketable condition. However, this debate has no relevance to Federal law inasmuch as MMS regulations already impose an express duty to place production in marketable condition. California Co. v. Udall upheld this obligation on grounds that royalty is due on the value of production at the lease and production is not complete until production is in marketable condition. California v. Udall, 296 F.2d at 387.

As the MMS itself recognizes, the duty to market and the duty to place production in marketable condition are not synonymous, Prop. at 73824. Unlike the MMS, however, State cases do not trivialize the difference, and do not support MMS’ effort to impose an implied obligation on lessees to market downstream at no cost to lessors.

6. Violative of Constitutional Non-Delegation Doctrine

In American Trucking Ass’ns. V. USEPA, 175 F.3d 1027 (DC Cir. 1999), the court remanded EPA’s recent revisions to its national ambient air quality standards (NAAQS) invoking, among other things, the non-delegation doctrine. Although the non-delegation doctrine in its early years was employed to strike down statutes for which Congress had not established sufficient standards for delegation to agencies charged with its implementation, it has also been used to curb an agency from interpreting statutes so broadly that it gives itself unfettered lawmaking ability.

In remanding the EPA NAAQS regulations, the DC Circuit held that EPA had not developed an "intelligible principle" for application of the governing statute. American Trucking, 175 F.3d at 1034-38. In this case, the MMS has abandoned an intelligible principle that had existed for several years, namely, that royalty is due on the "value of production." By adopting for flawed reasons a valuation methodology that employs for the sales of most federal oil production a downstream starting point coupled with plainly inadequate allowances and adjustments, the MMS overvalues production and overstates lessees’ royalty obligation. In so doing, the MMS would impose a de facto increase in the royalty rate, a decision that remains within the province of Congress, a legislative choice outside the province of the MMS and therefore unlawful.

2. Core Issues

To the fullest extent possible, the comments that follow incorporate by reference Industry comments and other materials filed earlier in the rulemaking.

1. Arm’s Length Contracts

The Proposal includes several definitions, many of which have been revised to differ from existing regulations or prior proposals in this rulemaking. However, Industry urges the MMS to make several changes.

1. Definition of "Affiliate"

Industry favors the proposed definition insofar as it would eliminate the presumption in favor of control for the 10-50% zone, using the factors listed instead as the basis for MMS consideration of control. However, we suggest the MMS include in the preamble to any final rule any guidance that further clarifies what the phrase "controlled by" means. For example, at the January 19, 2000 in Houston, the MMS Associate Director stated that non-working interest owners who have an affiliate would not be deemed an affiliate of the producer.

2. Definition of "Area"

As proposed, ó206.101 would define "area" to mean "a geographic region at lest as large as the limits of an oil field, in which oil has similar quality, economic, and legal characteristics." While nothing in the Preamble suggests any intent to change the meaning of the term as presently defined, Pr.73825, attempting to rewrite the ó206.101 definitions in "plain English" leads to an important ambiguity.

The existing definition states that "area" means "a geographic region at lease as large as the defined limits of an oil and/or gas field . . . (emphasis supplied)." If the MMS is intending to abandon its reliance of the limits of oil and gas fields as "defined" by the States, it should say so, as this would be a substantive change affecting comparable sales, major portion, etc. If that is not MMS' intent, then the definition should be left as it is in the existing rule to avoid confusion and ambiguity.

Additional confusion and ambiguity is injected as a result of the preamble's use of the term "area" in a way that is inconsistent with the proposed regulatory definition of the term. For example, the preamble refers to "the Texas, Gulf Coast, or Mid-continent areas." Pr. at 73830. Since the definition limits an "area" to geographic regions "in which oil has similar quality, economic, and legal characteristics," it is incongruous to refer to a statewide or regional geographic region as being an "area." Indeed, the IBLA itself previously recognized that that the relevant field or area for the purposes of making value comparisons cannot be the entire Gulf of Mexico:

Without embarking on a point-by-point refutation of appellants' assertions, we would suggest that the contention that the entire Gulf of Mexico is the relevant area for comparison of prices borders on the ludicrous.

Transco Exploration Co. & TXP Operating Co., 110 IBLA 282, 337 n.33 (1989). The MMS seems to recognize this in its discussion of its change of "Rocky Mountain Area" to "Rocky Mountain Region". Preamble at 73827. Nonetheless, without a clarification to correct the ambiguity created by the preamble's reference to "the Texas, Gulf Coast, or Mid-continent areas," the concept of "area" may invite second-guessing and misapplication by MMS auditors.

The regulatory limitation that an "area" be defined to include only areas where the oil has similar quality, economic, and legal characteristics is important because several provisions in the Proposal make sense only if "area" is defined as it is in the Proposal, i.e., "a geographic region at least as large as the limits of an oil field, in which oil has similar quality, economic, and legal characteristics." Some examples:

First, the benchmarks for the Rocky Mountain Region provide for the use of the unadjusted volume-weighted average gross proceeds accruing to the seller in all of the lessee's and its affiliates' arm's-length sales or purchases, not just those that may be considered comparable by quality or volume. In response to comments that this would result in improper valuation of some oil that was significantly different in quality than that associated with the "average'' oil, MMS explained "we believe that production in the same field or area generally would be similar in quality." If "area" could be defined as an entire state, the commenter's point would be well taken.

Second, as proposed, ó206.112(f) addresses situations where the lessee may not have access to differentials between the lease and the alternate disposal point or market center, or the lessee may not have access to the actual transportation costs from the lease to the alternate disposal point or market center. In such cases, MMS would permit the lessee to request approval for a transportation allowance or quality adjustment. In determining the allowance for transportation from the lease to the alternate disposal point or market center, MMS would look to transportation costs and quality adjustments reported for other oil production in the same field or area, or to available information for similar transportation situations. If MMS were without regulatory constraint and could define "area" as an entire state, the transportation costs could be very dissimilar, and this provision would not make sense.

Third, as proposed, ó206.111 provides: "The fact that the cost you or your affiliate incur in an arm's length transaction is higher than other measures of transportation costs, such as rates paid by others in the field or area, is insufficient to establish breach of the duty to market unless MMS finds additional evidence that you or your affiliate acted unreasonably or in bad faith in transporting oil from the lease." This assumes "area" is defined in such a way that the transportation costs will be comparable.

Fourth, as proposed "marketable condition" is defined in ó206.101 to mean "oil sufficiently free from impurities and otherwise in a condition a purchaser will accept under a sales contract typical for the field or area." This makes sense only if "area" is defined in terms of comparable production.

For all of these reasons, we propose that the MMS include in the preamble to the final rule interpretive guidance that the MMS' determination of an "area" will be consistent with the regulatory definition of the term, which requires an "area" to be defined to include only geographic regions "in which oil has similar quality, economic, and legal characteristics." At the very least, we propose that the preamble to the final rule should eliminate all references to statewide or regional "areas" similar to the references in the preamble to the Proposal.

3. Definition of "Exchange Agreement"

Industry suggests that exchanges for product ("EFPs") and exchanges of produced oil for similar oil produced in different months ("Time Trades") be simply deleted from this definition since they are not germane to valuation of production. In addition, it appears that MMS plans to use exchange agreements only to extract location differentials. EFP is associated with satisfaction of a NYMEX contract and would most likely not have a differential; a Time Trade by definition would not provide a reliable location differential.

4. Definition of "Gross Proceeds"

Consistent with the Industry view that there is no duty to market free of charge, Industry suggests that the term "marketing" be deleted from the litany of activities "which the lessee must perform at no cost to the Federal Government." Consistent with this suggestion, Industry urges the MMS to make conforming changes to ó206.106 by eliminating the phrases "and market the oil" and "to market the oil."

5. Inconsistent Valuation

The Proposal creates an inconsistency that must be corrected. Under proposed

ó 206.102(a)(2), a lessee entering into a non-arm’s length exchange then selling in an arm’s length transaction, would calculate royalty under ó206.103 using the applicable index. However, under proposed ó206.102(d)(1), a lessee also entering a non-arm’s length exchange, then either directly, or through an affiliate, selling the oil in an arm’s length transaction, can base royalty on gross proceeds or index.

6. Indexing v. Tracing

The Proposal would allow use of indexing in lieu of gross proceeds under certain circumstances where tracing would not be cost-efficient. Prop. at 73824. Specifically, such use of indexing would be limited to situations where a lessee has entered into an exchange agreement or multiple sequential exchange agreements and where the lessee or an affiliate ultimately sells the production under an arm’s length contract. ó206.102(d)(1) and (2). Such use of indexing would be further limited by the requirement that the election must apply to all of the lessee’s production and may not be changed more often than every two years. ó206.102(d)(1)(ii) at 73844.

While the comments in the succeeding section make it clear that Industry opposes the presumptive use of indexing for non-arm’s length transactions, its optional use has some benefits. Industry suggests that consistent with the MMS’ cost-efficiency objective, Industry suggests this option be adjusted in three respects: First, indexing should be available for any arm’s length transaction, not only those involving affiliates; if tracing is difficult where affiliates are involved, it is even more difficult, and sometimes impossible, where non-affiliates are involved. Second, indexing should be available on a field-by-field basis, not all production. Especially for lessees whose production spans many areas, the production itself and the circumstances of the sales may differ radically, making an all or nothing approach impracticable. Third, indexing should not be limited to a universal two-year period; the indexing term should be tailored to conform to contract term circumstances. None of these suggestions, however, should eliminate the use of tracing where volumes are low enough to make it a practicable option.

2. Non-Arm’s Length Contracts

Overall, the Proposal represents no appreciable change in the MMS point of view on valuation of non-arm’s length transactions. The MMS remains wedded to spot prices generally, Prop. at 73821 and ó206.103(c) at 73845, continues to promote ANS spot prices for Alaska and California, Prop. at 73830 and ó206.102(a) at 73844, and offers a slightly modified hybrid scheme for the Rocky Mountain Region. Prop. at 73824, 73830-31 and ó206.103(b) at 73844-45. In so doing, the MMS rejects the modified comparable sales approach of industry, strongly favoring a downstream indexing approach with its purported "transparency" as the device for capturing value added away from the lease.

1. Spot Prices v. Comparable Sales

Prior industry comments showed that while spot prices for natural gas could be a useful measure of the value of production for royalty purposes, spot prices for crude oil could not because of several fundamental differences between oil and gas. But, as before, in the Proposal the MMS has yet to respond to industry’s rationale for disfavoring use of oil spot prices.

More fundamental, the MMS’ professed reason for considering indices at all is its deeply rooted view that comparable sales are categorically an inadequate measure of value. Prop. at 73824. However, information provided by Industry early in this rulemaking and additional information with these comments belies the MMS’ flawed assumption. There is an active, competitive market at the lease and the MMS should take full advantage of comparable sales to facilitate the estimation of the value of production for non-arm’s length transactions.

In addition, the MMS’ latest proposal for valuation of oil on Indian leases contemplates majority pricing for individual areas which inherently involves use of comparable sales to arrive at a value of production for royalty purpose. 65 FR 403 (January 5, 2000); ó206.52(c). However, nowhere in its Proposal does the MMS explain why comparable sales have such utility for crude oil on Indian leases (which have a statutorily higher standard for valuation) yet are not appropriate for valuation of crude oil on federal leases.

2. Regional differences

As to regional differences in valuation methodology, the MMS has yet to respond to the industry observation that non-uniform standards impose an especially difficult burden for companies operating across several regions. In addition, prior Industry comments showed that ANS spot prices were an especially poor measure of value for Alaska and California. Moreover, the MMS has yet to explain, in view of the August 1999 City of Long Beach decision, why ANS--or any--spot prices are necessary at all.

Consistent with the information previously submitted in this rulemaking, the Van Vactor Report shows that ANS spot prices are a poor starting point for valuation of California crudes. For example, the Van Vactor Report explains that the relative values between ANS spot prices and California crudes fluctuates substantially, Van Vactor Report at 3, 4-7, that the gravity-price differentials published in posting bulletins and used by pipelines for shipping California crudes should not be used to determine value differences between fields and that the separation of transportation costs and quality differentials contemplated in the MMS’ proposed valuation methodology would be very cumbersome to apply. Id. at 4, 12-15.

The Van Vactor Report also observes that the MMS’ index-driven valuation methodolgy is unfit for the crude oil market generally because oil is shipped in many directions, and its price is subject to so many factors: supply and demand, quality, location of the sale, transportation alternatives, logistical considerations, and the configuration of refineries prepared to process the feedstock. Id. at 3-4, 7-12 .

Overall, the Van Vactor Report shows that the MMS’ proposed methodology is not simpler but far more complicated and less accurate than the comparable sales methodology proposed by Industry. Id. 4, 16-17.

As to the Rocky Mountain Region, while the Proposal makes some changes in its hybrid scheme, the proposed scheme is still flawed. First, any weighted volume average benchmark should be normalized for gravity. Second, the volume threshold for the second benchmark is too high; typically, for a field or area, the producer is selling only to its affiliate. Finally, the constraints on tendering are unduly limiting.

3. Tendering

While the Proposal would allow unduly limited tendering for the Rocky Mountain Region, no tendering would be allowed elsewhere. Industry strongly urges the MMS to reconsider this limitation. Several companies have thoroughly explored the use of tendering and information presented to the MMS plainly shows that the MMS’ reservations about the methodology are wrong. For example, we understand that in May 1998 Conoco, an API member, submitted to the MMS detailed accounts of its tendering program showing beyond any doubt that the values used for royalty purposes were based on substantial volumes, far in excess of any reasonable sampling percentage that might be required. At the very least, the MMS should confirm that sales resulting from a lessee’s tendering program, even if not usable as comparable sales for the valuation of other production, still qualify as arm’s length sales under ó206.102 for valuation of the production covered by the tendering sales themselves.

4. Index pricing point

The preamble to the final regulation or ó206.103 itself should be clarified to reconcile the Preamble statement ("The index pricing point would be the one nearest the lease."), Prop. at 73836, with the presumably clearer statement ("There may be cases where the nearest market center may not be the appropriate one for you to use because the quality of production better matches that typically traded at another more distant market center. In such cases, you could use this more distant market center to value your production."). Prop. at 73831.

5. Reasonable royalty value

The MMS should amend ó206.103(d) to delete the phrase "or no longer represents reasonable royalty value." Preserving this language invites unbounded second-guessing and on its face is incongruous with the establishment of an index or other acceptable measure for valuation purposes.

3. Transportation Allowances

Throughout this rulemaking transportation has been a core issue. While the MMS recognizes that allowances are appropriate for transportation, if not other post-production activity, the MMS has rejected the Industry suggestion that a special workshop be convened to sort out the many issues in this complex area. Nonetheless, the MMS seeks comments on several key transportation elements: rate of return, cost of capital, 10% of investment minimum, etc. Prop. At 73834.

1. FERC Tariffs

The MMS would reject out of hand Industry’s suggestion that a "value of service" approach using a measure like FERC tariffs be employed in lieu of the superficially appealing, but patently unfair actual cost approach. Prop. At 73834-35. In prior comments, Industry has addressed the myriad legal flaws of the MMS approach, pointing out that rejection of FERC tariffs is based on an erroneous reading of certain FERC decisions on oil pipeline jurisdiction, violates the nondiscrimination provisions of OCS Lands Act óó 5(e) and (f), violates the interagency cooperation provisions of OCS Lands Act ó 5(a), undercuts the OCS development policies of the Deep Water Royalty Relief Act and the OCS lands Act ó8(a), and penalizes producers who also own pipelines. In addition, MMS rejection of FERC tariffs for the Federal lands Proposal is inconsistent with its pending Indian proposal where the MMS proposes to use FERC tariffs to establish location differentials. 65 FR 403, 409 (January 5, 2000).

2. Rate of Return and Cost of Capital

The MMS has expressly requested comments regarding the determination of an appropriate rate of return to be reflected in the transportation allowance under non-arm’s-length arrangements for movement of oil produced from Federal lands to a point of sale off the lease. Prop. At 73834. Based on a study prepared for the industry associations joining in these comments, Industry recommends that the MMS adopt a representative composite industry cost of capital equal to two times the Standard & Poor’s BBB industrial bond rate.

This recommendation is based on the Swanson Report’s review of current data concerning capital structure and cost of capital for companies engaged in upstream oil production activities, as well as the practices of other regulatory agencies involved in setting cost-based rates for public utilities. As discussed in more detail in the Swanson Report, current data suggest that a capital structure of 30% debt and 70% equity would be a conservative measure of a median ratio for the producing industry, particularly given that equity ratios for integrated oil companies are generally higher than 70%. Swanson Report at 1,6.

As estimated by independent analysts, using either a capital asset pricing method (CAPM) or discounted cash flow (DCF) method, the industry composite range for the cost of equity capital of oil and gas companies for 1998 and 1999

ranges from 7.1% to 17.3%. Using 13% for equity capital and the 1999 S&P BBB yield of 7.4%, combined with a 30/70 debt/equity ratio, produces an effective weighted average cost of capital (WACC) of 16.2% or 2.2 times the BBB rate. This assumes a 35% federal income tax rate. Swanson Report at 1,3-4.

Oil pipelines, which are financed by parent companies using both debt and equity, incur an income tax expense on the portion of the return associated with the equity investment. This expense should be included in the cost of capital when determining the transportation allowance computed by the MMS. The data and reasoning on which this conclusion is based are presented more fully in Section II of the Swanson Energy Report. Swanson Report at 1,4-5.

Given these results, we conclude that a cost of capital of 2 times the BBB bond rate is a reasonable reflection of the actual capital costs incurred by domestic oil transporters, particularly the offshore oil pipelines to which the transportation allowance would largely pertain.

3. Depreciation

Commendably, the MMS now proposes that the depreciation schedule start anew upon a change in pipeline ownership. Prop. at 73834; ó206.111(g)(2) at 73847.

4. Minimum Cost

Commendably, the MMS now proposes that, even after a pipeline is fully depreciated, the lessee may continue to include in the calculation of transportation allowances a minimum cost in the nature of a management fee. While ten percent multiplied by the rate of return falls well short of an adequate management fee, this is an improvement over existing ó206.111(g)(3) which provides no such minimum cost. Prop at 73834; ó206.111(g)(3) at 73847.

4. Quality and Location Adjustments

1. Elimination of Form 4415

Commendably, after two rejections by OMB, the MMS has abandoned its ill-conceived Form MMS-4415 which would have required voluminous data that would have been difficult and in some cases impossible to collect. Prop. at 73825. More fundamental, the data collected would have been largely irrelevant to necessary value determinations.

2. Adjustments for Location/Quality

To the extent comparable sales are employed for valuation of non-arm’s length transactions, adjustments for quality off a downstream index such as spot prices would be unnecessary altogether. Nonetheless, the Proposal raises several questions that need clarification before quality differentials can be applied to spot prices:

First, the MMS should affirm that the elimination of NYMEX prices as an index or starting point is acceptable. However, NYMEX prices are still necessary to calculate premiums and discounts for fixed and flat index prices such as Platt’s assessments. In the industry, the time spread relationship between the prompt month, second month and third month NYMEX contracts is referred to as the "roll" or "calendar month average." The roll should be added to or subtracted from the prompt month settle price (depending on whether NYMEX prices are rising or falling) to determine calendar month prices.

Second, the MMS should clarify whether it intends to use calendar month prices, trade month prices or both. Will the same methodology be applied to each of the three Regions or will it be different?

Third, the MMS should clarify which publications and which grades or market centers would be approved. Does the requirement to use the market center nearest the lease with crude oil most similar in quality to lessee’s oil apply to all three Regions? If the lessee believes that applying the index price nearest the lease is an unreasonable value, how would the quality differential between the nearest index price and the lease crude oil be determined? This applies anytime a lessee’s oil does not become part of a stream that has a published price. Examples include the High Island system, Gulf Coast pipelines that terminate at barge terminals, and Rocky Mountain production and California production. In each case, gravity and sulfur adjustments may be necessary.

Fourth, for situations where the lessee must request approvals of location/quality adjustments, the MMS should specify in any final rule the factors it would consider in reviewing adjustment requests and whether its decision is appealable.

5. Binding Determinations

Prior Industry comments have documented the need for increased certainty in value determinations, something that lies at the heart of a lessee’s royalty obligations and all the more important under the Proposal because of its novelty and complexity. Certain provisions in the Proposal rules would make it impossible for lessees to pay their royalties accurately and on time unless they first are able to obtain a value determination from the MMS. Even under the existing rules, Industry’s concerns about reliable and timely valuation determinations are not speculative.

Prompted by allegations of past underpayments, and agreeing with the MMS’ avowed objectives of certainty and reduction of disputes, Industry offered several recommendations for a process by which lessees could obtain up front the information it needs to make accurate, timely and undisputed royalty payments: that the MMS be required to issue binding determinations of value upon the request of the lessee; that such determinations be issued within a prescribed time limit with default to the lessee’s methodology; and that such determinations be appealable.

While the Proposal on binding determinations has some positive aspects, the Proposal would reject most of industry ‘s recommendations, Prop. at 73833, and offer lessees in many cases only the illusion of a meaningful process for valuation determinations. Unaccountably, the Proposal would also eliminate some positive aspects of the existing regulations.

1. Mandatory Determinations

For example, under proposed ó206.101, if there is ownership or common ownership of between 10 and 50 percent between two parties, the parties would not know whether they are affiliates unless and until MMS makes a determination regarding whether there is control under the circumstances. This determination is critical because radically different valuation methodologies would apply depending on whether the parties are affiliates. At its recent workshops, the MMS confirmed that a lessee would have to use the value determination process to obtain a decision from MMS regarding control in a 10-50% ownership situation.

Yet, the Proposal does not compel the MMS to make these determinations, much less make them timely. The Proposal makes it clear that that there would be no regulatory requirement that MMS issue a value determination in response to a lessee’s request. Instead, the Proposal states that the MMS "will reply," ó206.107(b) but that that "reply" may simply inform the lessee that no determination will be issued. ó206.107(b)(3). Indeed, the Proposal adds further that the MMS typically would not provide a value determination when the request is based on a hypothetical situation, when the request is inherently factual or with respect to matters that are the subject of pending litigation or administrative appeals. ó206.107 at 73845. What categories are left for MMS determination? A "reply" that says that MMS will not tell you how its regulations should be interpreted and applied does a lessee little good.

Beyond the categorical exclusions in the Proposal itself, MMS statements at the January 19, 2000 workshop in Houston indicate that the MMS considers certain other decisions under the rules to be outside the value determination process altogether. For example, the MMS explained that MMS determinations on a lessee’s request to exceed the percentage of value limitations on transportation allowances are not value determinations under the regulations. The final rule should clarify what decisions do and what decisions do not come within the value determination procedure. Moreover, for such non-value determination decisions, as we have for other key decisions, we urge the MMS to add a provision expressly requiring the MMS to issue a decision, requiring it to issue a decision expeditiously, and requiring it to make its decisions appealable. Otherwise, lessees will not be able to pay their royalties correctly and on time.

2. Expeditious Determinations

Whereas existing regulations require the MMS to issue value determinations "expeditiously," 30 CFR ó206.102(g), the Proposal states that "MMS will reply to requests expeditiously,"(emphasis supplied), Pr. at ó206.107(b). Under the Proposal, as pointed out above, a "reply" may or may not lead to a determnation. An expeditious reply that says that MMS will not tell you how its regulations should be interpreted and applied does a lessee little good.

3. Binding and Prospective Nature of Determinations

In those seemingly rare instances where the Assistant Secretary issues a determination, proposed ó206.107(c)(1) would make it binding on the lessee and the MMS, but only until the Assistant Secretary modifies or rescinds it. The Proposal’s statement that "as a general matter, value determinations may be changed only prospectively," Prop. at 73833, is inadequate. While retroactive determinations of value may be appropriate for the circumstances identified under ó206.107(f) (actual or constructive fraud) – situations for which Industry has never sought relief – the MMS should confirm that modifications or rescissions under ó206.107(e) are necessarily prospective only.

Moreover, with respect to staff determinations that, according to the Proposal, would be binding on the MMS, the MMS should make it clear that these determinations are also binding, at least retroactively, on the Department as a whole. In this regard, we appreciate the assurance given by the Associate Director at the January 19, 2000 Houston workshop that staff determinations would not be subject to retroactive rescission or modification by the Assistant Secretary unless facts were misrepresented or later changed, even if the Assistant Secretary disagrees with the legal interpretations on which the staff determination was based. We urge the MMS to amend the Proposal to make staff determinations binding on the entire Department; at the very least, the MMS should include the same assurance in the preamble to a final rule.

4. Default Valuation Methodologies

Under existing regulations, the lessee may now use the value determination method it proposes until MMS issues a value determination. See 30 CFR ó206.102(g). With no default provision regarding control, lessees would not know which valuation rules to apply unless and until MMS makes the required determination.

Yet, the Proposal would eliminate the existing provision that expressly allows lessees to continue to pay royalties based on their own proposal until MMS issues a decision on the lessee’s request for a determination. See 30 CFR ó206.102(g). While the MMS stated at its recent workshops that lessees would not be subject to penalties for willfully and knowingly violating the regulations for ignoring staff determinations, the deletion of this provision creates ambiguity with significant consequences. The MMS should eliminate this ambiguity and clarify that a lessee can pay its royalties in accordance with its proposed methodology until the Assistant Secretary issues an appealable decision. The MMS should also clarify that a lessee’s decision not to follow a non-binding MMS staff determination would not be construed as a "knowing and willful" violation of agency regulations which could later be the basis for a spurious False Claims Act claim by the government or a private relator. Alternatively, Industry urges the MMS to make staff determinations appealable.

Without the clarifications suggested above, a lessee that receives a "non-binding" staff determination with which the lessee disagrees would be faced with a Hobson’s choice. Even though the determination would not be "binding" on the lessee, it would inform the lessee of how MMS is interpreting its regulations. If the lessee disregards the determination after being told of MMS’ interpretation, it possibly could be subject to penalties for willful and knowing noncompliance with the agency’s regulations.

If the lessee follows the non-binding guidance, even though it disagrees, in order to avoid the possibility of penalties, it is unlikely that an appealable order would ever be issued to the lessee, leaving the lessee with no opportunity to challenge the agency’s interpretation. If the lessee does want to challenge the agency’s interpretation, it would be forced to ignore the non-binding determination so that an appealable order will eventually be issued, but with the risk that penalties would be imposed. To require lessees to subject themselves to the possible imposition of penalties in order to challenge determinations with which they disagree, even if lawful, is hardly sound policy.

5. Alternative Valuation Methodologies

The Proposal would also jettison without meaningful explanation, the existing provision expressly stating that "MMS may use any of the valuation criteria authorized by this subpart" in determining value in response to a lessee’s proposal. See 30 CFR ó206.102(g). We urge the MMS to preserve this provision. This gives the MMS the necessary flexibility to determine value using alternate methodologies without requiring it to do so.

In sum, the MMS needs to come to grips with the valuation determination situation. While the Proposal tenders several reasons why binding determinations are impracticable or inappropriate as the basis for its sharply limited provisions, the simple fact is that lessees cannot fairly be expected to satisfy royalty obligations when the author of the complex valuation regulations refuses to offer reliable interpretations.

6. Second-Guessing

In its Proposal the MMS alludes to the present language of ó206.102(b)(1)(iii) and asserts that "It is longstanding MMS policy to rely on arm’s-length prices as the best measure of value, and we have no intention of changing this." Prop. at 73829.

Nonetheless, the MMS proposes to amend ó206.102(c)(ii) in two respects. As to proposed ó206.102(c)(ii)(B) alone, Industry questions whether the addition of the term "unreasonably" without any bounds leaves open the possibility of second-guessing. On the other hand, proposed ó206.102(c)(ii)(A) should be sufficient if the MMS staff and auditors honor it: " MMS will not use this provision to simply substitute its judgment of the market value of the oil for the proceeds received by the seller under an arm’s-length sales contract."

In this regard, we urge the MMS to include in the preamble to a final rule the MMS’ guidance on the specific questions that surfaced at the January 2000 workshops.

Question No. 1

Where lessee receives an offer to sell at index minus or posting plus, selects the former, then concludes later that the former would have been the better business decision, will MMS second-guess the indexing decision? MMS Answer: No.

Question No. 2

Where lessee A takes his production share at the lease, but the operator/lessee B sells his share downstream at a higher price, will lessee A’s transaction be second-guessed? MMS Answer: No.

Question No.3

Where lessee A is selling production at arm’s length at the lease at a price lower than its neighbor lessee B who is engaging in downstream marketing activities, will the MMS assess royalties on lessee A pegged to the selling price received by lessee B? MMS Answer: No.

Other questions might include the following:

Question No. 4

Where the non-operating working interest sells to the operator, will this be treated as an arm’s length sale irrespective of how the operator disposes of the production? Answer: No?

3. Procedural and Timing Matters
1. Irregularities of Payments During Rulemaking

At the May 18, 1999 hearing of the Senate Energy and Natural Resources Committee and the May 19, 1999 hearing of the House Subcommittee on Government Management, Information and Technology, members of Congress heard uncontested testimony that False Claims Act proceeds amounting to $700,000 had been shared with two government officials linked to Department of Energy and Department of the Interior oil valuation policy initiatives leading up to the present rulemaking. Members of Congress underscored the gravity of these revelations and the Department of the Interior itself acknowledged that "ethical questions" had been raised. These facts prompted members of Congress to initiate an investigation of this highly irregular situation.

Although the Department of the Interior contends these highly unusual payments have no bearing on the oil valuation rulemaking, there has yet to be a full airing of the situation. Although Industry is not privy to the results of the ongoing investigation, the two federal officials who received the amounts in question were plainly involved in royalty matters during the period 1994-1997, a formative stage in the Department’s deliberations when key assumptions were adopted and the overall course of the rulemaking was set.

While the MMS Proposal differs in some important respects from the MMS’ original January 1997 proposal, the essential character of the MMS rulemaking approach and its underlying rationale has gone virtually unchanged. Thus, it is necessary and appropriate to discern the nature of the two federal officials’ involvement in the oil valuation rulemaking before the MMS finalizes its current proposal in order to conclusively determine whether and to what extent their involvement tainted the rulemaking. See Hercules, Inc. v. EPA, 598 F.2d 91, 123 (D.C. Cir.1978) (requiring an agency to provide explanations of its decision making and final actions whenever there has been a strong showing of improper behavior that may have influenced the agency actions).

To accomplish this important investigation, the Department could itself conduct a public hearing, pursuant to its broad investigatory powers under the Federal Oil and Gas Royalty Management Act, 30 USC ó 1717(a) to examine the propriety of the payments made and determine what influence, if any, the uncontested payments had on the conduct of the rulemaking.

In the alternative, as Senator Nickles has already suggested, the Department should postpone completion of the rulemaking until the ongoing Congressionally-sponsored investigation of the payments to Federal officials has been completed. Failure to stay the rulemaking until such investigations are complete jeopardizes the validity of the MMS’ actions. See HBO, Inc. v. FCC, FCC, 567 F.2d 9, 54-555 (D.C. Cir.) (failure to disclose and address relevant information renders an agency’s action arbitrary and improper), cert. denied, 98 S.Ct. 111, 434 U.S. 829 (1977); Natural Resources Defense Council, Inc. v. Hodel, 618 F. Supp. 848 (E.D.Cal.1985)(requiring reasoned agency response to comments raised during rulemaking); Idaho Farm Bureau Federation v. Babbitt, 58 F.3d 1392 (9^th Cir.1995)(accuracy and validity of details associated with rulemaking are particularly crucial and must be appropriately addressed before any rule is finalized).

In sum, Industry urges the Department to postpone completion of the oil valuation rulemaking until the circumstances surrounding the payments to Federal officials have been aired and their implications on the rulemaking fully assessed.

2. Economic Impact

In its discussion of procedural matters, the MMS asserts that the Proposal would have a net economic impact of $63.5 million. Prop. at 73838. Although the MMS describes its methodology for arriving at this estimate in its December 1999 "Threshold Analysis" document, Industry questions the MMS’ calculation of administrative cost to industry and the expected increase in royalty revenues.

While estimates of the royalty revenue impact are difficult to quantify, given the complexity and novelty of the Proposal, the MMS’ indexing approach and its underlying duty to market free of charge theory plainly lead to large -- and unlawful -- increases in royalty obligations. One relevant comparison, however, is the MMS’ evaluation of its similar and likewise pending Indian oil valuation proposal that leads the MMS to anticipate an increase of 10 percent in Indian royalties. If a comparable estimate were made for the Federal proposal, even adjusted to reflect the somewhat different standard for Indian royalties, the net impact would seem to be far higher than the $100 million used for many Federal procedural requirements (e.g., "economically significant action" under E.O. 12866, "major rule" under Small Business Regulatory Enforcement Act ("SBRFA"). Whatever the actual increase in revenues amounts to, any increase attributable to using a value greater than the value of production at the lease is unlawful.

Economic impact aside, the MMS acknowledges that the Office of Management and Budget ("OMB") has determined that the Proposal "raises novel legal or policy issues’’ which itself is sufficient to trigger Executive Order 12866. Prop. at 73838. Industry certainly concurs with OMB. Similarly, the administrative record for this rulemaking is shot through with compelling comments and testimony that make it clear that the MMS’ novel approach to valuation of crude oil interferes significantly with the market, especially companies that are active in the midstream marketing arena and may have to abandon innovative strategies and investment, impacts that themselves trigger SBREFA.

Accordingly, Industry believes Executive Order 12866 and SBRFA apply. In addition, under separate cover comments on the Paperwork Reduction Act will be submitted to OMB.

3. Consideration of Comments and Effective Date of Final Regulations

As recently as the MMS’ January 20, 2000 workshop, the Associate Director made it clear that the MMS planned to publish final oil valuation regulations on March 15, 2000 when the existing Congressional moratorium expires. While we understand the interest in bringing this protracted rulemaking to an end, we urge the MMS to take the time it needs to fully assess the public comments it receives, especially the substantial new information Industry has provided. Only then can it avert the conclusion-oriented character of its most recent pronouncements.

Irrespective of the promulgation date of any new oil valuation regulations, Industry further urges the MMS to establish an effective date that reflects the widespread systems changes that might be necessary because of the new rule. For example, once a final rule is promulgated, each affected company would have to perform several tasks which could not have been performed earlier: evaluate rule and train employees; determine what valuation methodology applies to each of its properties; develop recommendations for location/quality differentials and obtain MMS approval thereof; attempt to obtain cost information from affiliated or common carrier pipelines and calculate transportation rates; build or modify systems to reflect any differences between lease-based and index-based methodologies. While the rulemaking has been protracted, fundamental questions have been at issue which have made it imperative for some companies to delay implementation of system changes that might not be necessary under a final rule.

4. Royalty-in-Kind: the Better Solution

From the outset of this rulemaking, Industry has observed that any valuation methodology is problematic, at least for non-arm’s length transactions, because it requires that value be imputed through reference to some measure of value, whether it be the benchmarks of the existing regulations or the indices of the MMS’ various proposals to amend the existing regulations. Royalty-in-kind (RIK) could avert this problem altogether since it short circuits the value calculation process and puts a royalty share in the hands of the government for disposal as it sees fit. Commendably, the MMS with the support of many states and all of Industry is exploring this alternative through the conduct of pilot programs.