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IPAA - Joint Statement Hearing on Valuation and Collection of Oil Royalties

Joint Statement of the American Petroleum Institute, Independent Petroleum Association of America, Domestic Petroleum Council and United States Oil and Gas Association

Hearing on Valuation and Collection of Oil Royalties before the House of Representatives Committee on Government Reform’s Subcommittee on Government Management, Information and Technology

May 19, 1999 

Introduction

Mr. Chairman and members of the Subcommittee, we are appearing today on behalf of the American Petroleum Institute (API), the Independent Petroleum Association of America (IPAA), the Domestic Petroleum Council (DPC) and the United States Oil and Gas association (USOGA). I am David Deal, Assistant General Counsel, American Petroleum Institute. Joining me is Ben Dillon, Vice President, Independent Petroleum Association of America.

Our respective trade associations are national trade associations whose members are actively involved in oil and gas exploration and production on federal lands. Our trade associations’ memberships overlap and, together, our members are responsible for the production of virtually all federal oil and gas production on federal lands and virtually all of the federal royalties paid every month.

MMS Crude Oil Valuation Rulemaking

Over the course of the rulemaking, the MMS has stated that it seeks revised valuation regulations that arrive at the value of production in a way which is simpler and more certain, which decreases the cost of administration, and leads to less controversy, fewer appeals and less litigation. We applaud these objectives and embrace them. But we believe the MMS proposal falls short of reaching them.

At the core of the crude oil valuation rulemaking is the MMS belief that royalty valuation for most crude oil transactions should begin downstream of the lease. In its initial proposal, the downstream starting point was NYMEX futures prices. As modified, the downstream starting point of the MMS proposal is market center spot prices.

We emphasize "starting point" because even the MMS proposal recognizes that adjustments must be made to arrive at a reasonable "value of production" at the lease. Transportation is one important adjustment, but quality and location require other important adjustments too.

In a nutshell, Industry believes that a downstream starting point for valuation is the wrong starting point for most transactions for several reasons. For example, the adjustments contemplated by the MMS fall short of reflecting all downstream additions to value and lead, therefore, to inflated values and inflated royalty obligations. Stated another way, we believe the MMS proposal leads to an outcome at odds with the plain language of the mineral leasing statutes and the terms of the specific contracts or leases under which lessees operate.

We also believe reliance on a downstream index is unnecessary given the active lease market and the availability of comparable sales at or near the lease as a sound measure of value.

We also believe the data reporting apparatus contemplated by the MMS’ proposal is far too onerous. It creates as many ambiguities as it eliminates and lays the basis for unfounded second-guessing of good faith oil marketing decisions. Finally, it denies lessees trying to satisfy their royalty obligations a timely opportunity to obtain reliable MMS determinations early on as to the application of the complex regulations.

Notwithstanding these deep reservations about the proposed valuation rule, we believe the rule can be fixed if certain key changes are made.

Core Issues for Industry

Over the course of the MMS’ present federal crude oil valuation rulemaking, commenced in early 1997, Industry has addressed a variety of issues. Industry has submitted voluminous comments and the MMS has made some important changes to its crude oil valuation proposal.

Within the last year, however, we have sharpened our focus on the remaining core issue areas. While industry had a common view on the rulemaking from the outset, in late 1998 we formed an inter-industry task force that embraces API, IPAA, DPC and USOGA.

This inter-association task force took a hard look at the present MMS proposal and a hard look at industry concerns. Our goal was to focus on the core issues and identify specific recommendations that could ameliorate our concerns yet satisfy the MMS’ rulemaking objectives.

Members of the inter-association task force presented our recommendations at the MMS public workshops held March 23 (Houston), March 24 (Albuquerque) and April 6-7 (Washington, DC). We were encouraged at the MMS staff’s willingness to discuss the substance of the MMS’ present proposal and industry’s recommended changes. We learned more about the MMS’ concerns. And, we believe, the MMS learned more about our concerns and our solutions.

We continue to believe these efforts can lead to a sound resolution of core issues presented by this rulemaking. Toward that end, on April 27 Industry submitted a set of detailed written comments. These comments assemble in one package the elements of industry’s point of view, proposed solutions and answers to specific questions that arose in the course of our discussions.

A copy of the cover letter summarizing these comments is attached to this written statement, and we are submitting for the record a complete set of the comments themselves. But today, we can share with you today the gist of our present thinking.

1. Arm’s Length Transactions.

Although the rulemaking would retain the use of gross proceeds as the valuation of true arm’s length transactions, there remains an important application problem. Lessees need to know with reasonable certainty whether the specific relationship they have with another entity makes that entity an "affiliate" for purposes of the valuation regulations. Without some further clarification, however, lessees would have difficulty determining with reasonable certainty whether the proposed arm’s length or non-arm’s length valuation methodology would apply.

To address this problem, we have urged the MMS to adopt in the regulations more specific criteria to guide lessee application of the control-based definition of "affiliate" at the outset of the process.

2. Non-arm’s length transactions.

For transactions deemed "non-arm’s length, the MMS’ proposed regulations contemplate a three-standard approach: certain limited benchmarks or NYMEX futures prices for the Rocky Mountain region; ANS prices for California and Alaska; and market center spot prices for all (and most) other areas. If one downstream-skewed standard is bad, three are worse. Basically, we believe this approach confounds rather than clarifies the existing regulatory scheme. Moreover, for those companies that operate in many different areas, applying several different valuation standards is unnecessarily burdensome and confusing and at odds with the objective of reasonable certainty.

To address this problem, we have urged the MMS to expand its valuation methodology options to include comparable arm’s length sales as a measure of value if the lessee satisfies prescribed information and sales volume requirements. Since the statutory touchstone is the "value of production," industry believes every reasonable effort should be made to fully employ the many arm’s length sales that do occur. In this way, the MMS could avoid the inherent complications (i.e., adjustments) of using downstream sales or an index as the starting point for valuation.

3. Adjustments off downstream values.

For the situation where some sort of net back is necessary, we have urged the MMS to adopt specific methodologies for the calculation of transportation, location and quality adjustments. These would make it possible to net back from downstream values (index or otherwise) and arrive at a value for royalty purposes which more nearly approaches the value of production at the lease than the MMS proposal now contemplates.

Of these adjustments, transportation is especially significant and, in addition to specific recommendations, we have also suggested that the MMS convene another workshop focused exclusively on transportation to illuminate this complex and contentious issue.

4. Second-guessing.

Industry has urged the MMS to adopt language making it clear that the use of gross proceeds as the valuation methodology by lessees, operating in good faith and engaging in what they believe are arm’s length transactions, would not be set aside in favor of some other methodology (e.g., indexing) simply because some other lessee was able to obtain a higher value for the sale of production.

Such a strong presumption would recognize that the lessee and the lessor have a mutual interest in obtaining the highest price for the sale of production and that a range of prices characterizes "market value." Such a presumption would, of course, in no way shield a lessee from full audit and would not permit demonstrable misconduct.

5. Binding determinations.

In its original proposal, the MMS offered to issue non-binding valuation determinations. However, non-binding determinations do not yield the reasonable certainty lessees need: an adverse determination would not be appealable, yet a favorable determination could not be relied on. Later in the rulemaking, the MMS suggested that the Assistant Secretary or his delegee "may" issue non-binding determinations, but implicit in this approach is the possibility that upon a lessee request, a binding determination may not be issued.

To address this problem, we have urged the MMS to adopt an explicit process by which lessees can procure timely valuation methodology determinations. Such determinations would be akin to IRS letter revenue rulings and the comparable rulings of other agencies. For example, the rulings would be limited to the facts presented. The rulings would have no precedential value. While binding, the rulings would be revocable, in order to reflect court decisions, statutory changes, or changes in agency policy deemed appropriate. In any event, any changes would apply prospectively only.

Conclusion

Overall, adoption of industry’s recommendations as a package would move the MMS proposal closer to realizing a final crude oil valuation rule that satisfies the MMS’ own objectives. A revised rule should and can be workable and fair. A revised rule should and can decrease the cost of administration, decrease appeals and litigation. And a revised rule must satisfy the legal requirement that royalty obligations be based on the value of production at the lease.

To this, we would add only that Congress and the MMS should continue to explore an alternative that can avoid altogether many of the ambiguities inherent in any valuation methodology. If the MMS were to take its royalty in kind, instead of in dollars, valuation questions would avoided altogether and the MMS could try to realize for itself the highest selling price for the crude oil it has taken.

In conclusion, we urge the MMS to carefully consider our rulemaking recommendations. Given the progress that we believe has been made in moving toward a workable final rule in this complex matter, we also suggest the MMS publish a new proposal that captures the many insights and revisions that have emerged during the last year.

Thank you for the opportunity to appear today on this important matter. We welcome any questions members of the Subcommittee may have.

Send comments to Ben Dillon at bdillon@ipaa.org, or call 202.857.4722