Federal Oil and Gas Royalty-in-Kind Pilot Programs

DEPARTMENT OF THE INTERIOR

Minerals Management Service

Federal Oil and Gas Royalty-in-Kind Pilot Programs

AGENCY: Minerals Management Service, Interior.

ACTION: Notice of intent.

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SUMMARY: This is to give notice that the Minerals Management Service

(MMS) intends to adhere to certain practices in exercising the options

available to the Secretary of the Interior to take the government's

royalty share of production in kind from Federal oil and gas leases. In

particular, we would like to set forth the background and a general

outline of how we are proceeding and what is expected of lessees and

operators in connection with MMS's royalty-in-kind (RIK) projects. The

purpose of these projects is to test the feasibility and examine the

revenue effects of different ways of taking and disposing of RIK

production. We welcome any comments you may have on the information

provided in this Notice.

DATES: Comments must be submitted on or before September 13, 1999.

ADDRESSES: If you wish to comment, you may submit your comments by any

one of several methods. You may mail comments to Bonn Macy, Special

Assistant to the Director, Minerals Management Service, 1849 C Street,

NW, MS 4230, Washington, DC 20225. You may also comment via the

Internet (E-mail) to Bonn.M[email protected]. Please submit Internet comments

as a WordPerfect 6.0 or an MS Word 97 document (earlier versions of

these formats are acceptable) avoiding the use of special characters

and any form of encryption. Please also include your name and return

address and phone number in your Internet message. If you do not

receive a confirmation from the system that we have received your

Internet message, contact Bonn Macy directly at (202) 208-3827.

FOR FURTHER INFORMATION CONTACT: Mr. Bonn J. Macy, Minerals Management

Service, 1849 C Street, NW, MS 4230, Washington, D.C. 20240-0001;

telephone number (202) 208-3827; fax (202) 208-3918; e-mail

Bonn.M[email protected].

COMMENTS: Written comments on this notice should be addressed to Mr.

Bonn J. Macy at the address given in the Addresses section of the

notice.

SUPPLEMENTARY INFORMATION: The contents of this Notice will be

discussed at a Public meeting held on July 20, 1999, in Houston, Texas.

Please refer to the Federal Register Notice published July 1, 1999, for

further information. We will post public comments after the comment

period closes on the Internet at http://www.rmp.mms.gov. You may

arrange to view paper copies of the comments by contacting Bonn Macy,

Special Assistant to the Director, Minerals Management Service, (202)

208-3827, FAX (202) 208-3918.

Background

The Department of the Interior has managed mineral leasing on

Federal lands since the Mineral Leasing Act was passed in 1920 (30

U.S.C. 181, et seq. (1994) (MLA). Under the terms of standard Federal

oil and gas leases, the government is entitled to a share (royalty) of

production removed or sold from the lease. The terms ``in value'' and

``in kind'' refer to the manner in which a mineral owner (lessor)

receives the royalty share from the producer (lessee). Like most other

royalty owners, the U.S. Government has, for the most part,

historically received its royalty share ``in value,'' that is, in cash

as a percentage of the sales proceeds received by the lessee.

For most onshore Federal leases, the MLA provides in relevant part

at 30 U.S.C. 192 that all royalty accruing to the United States under

any oil or gas lease or permit under this chapter on demand of the

Secretary of the Interior shall be paid in oil or gas.

For most offshore leases, the Outer Continental Shelf Lands Act, as

amended (OCSLA) provides in relevant part at 43 U.S.C. 1353(a)(1)

(1994) that, with some minor exceptions, all royalties or net profit

shares, or both, accruing to the United States under any oil and gas

lease issued or maintained in accordance with this subchapter, shall,

on demand of the Secretary, be paid in oil or gas.

Section 2 of a typical onshore Federal lease form provides in part

that ``Lessor reserves the right to specify whether royalty is to be

paid in value or in kind.'' (October 1992, Form BLM-3100-11). By

section 6 of the offshore lease form, the lessor reserves ``the right

to

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determine whether royalty will be taken in the amount or the value of

production.'' (February 1971, Form MMS-2005, and subsequent versions).

Over the years, the Secretary's authority to take RIK has rarely

been used. One exception has been the ongoing RIK program that MMS

currently operates for certain ``eligible refiners'' as authorized by

specific provisions of the MLA at 30 U.S.C. 192 (1994) and the OCSLA at

43 U.S.C. 1353(b)(2) (1994). Also, during Calendar Year 1995, MMS

operated a voluntary RIK pilot in which we took and sold by competitive

bid at the lease approximately 45.6 billion cubic feet of natural gas

from 14 lessees covering 79 leases in the Gulf of Mexico. This initial

pilot provided valuable experience with the operational aspects of

working with producers and marketers, as well as useful information on

the revenue implications of taking gas in kind.

As a general matter, the collection of royalties in cash as a

percentage of the value of production has worked well in most cases.

However, as will be discussed below, there are a number of reasons that

make it worthwhile now to examine whether the government should receive

at least some of its royalties ``in kind'' by taking physical volumes

of oil or gas for sale to the public or for transfer to other Federal

agencies.

First, dramatic changes in the energy industry have been occurring

over the past 10 to 15 years that may present opportunities for MMS to

provide greater certainty and simplify its royalty management programs.

Rapidly changing market structures over this period have resulted in

product price volatilities and the expansion of active trading in

markets across the country with the corresponding development of

representative spot prices.

Traditional long-term contracts between producers and pipeline and

refiner purchasers have been increasingly replaced by short-term

trading by new market participants, such as brokers and resellers.

Further, many sellers now regularly use futures markets for risk

management and obtain real-time market information directly using

personal computers and telecommunications links.

For natural gas, these structural changes have been facilitated by

the Federal Energy Regulatory Commission's deregulation of the natural

gas transportation industry and the evolving deregulation of retail

natural gas and electricity markets.

The challenges presented by these evolving market structures, the

``unbundling'' of gas transportation services, and changing business

practices overall present unique opportunities for us to reexamine the

way we manage the revenues earned from the public's oil and gas assets.

Members of Congress, representatives from industry, the public, and

State and other Federal agencies have urged MMS over the last few years

to consider the potential advantages that might be achieved by taking

Federal oil and gas royalties in kind. Over this time, MMS's own

examination of RIK suggests that these potential benefits may exist in

select cases where conditions favorable to RIK exist.

MMS's stakeholders have focused on a number of possible benefits.

As an alternative to the royalty system based on the percent of

proceeds, a successfully targeted RIK program might provide improved

certainty, administrative efficiencies, and other cost savings.

Fulfillment of the royalty obligation by the delivery of physical

volumes of oil or gas could decrease the need for extensive reporting,

verification, and auditing of lessee sales proceeds. This could benefit

industry as well as government and the public. A second possible

benefit is that, in select circumstances, taking product in kind and

selling to the market directly might yield more revenues for the public

than taking a percentage of a given lessee's sale price. In other

cases, we might be able to take RIK and transfer it for direct

consumption in other Federal agencies and realize real savings in

Federal energy costs.

In response to these possibilities and the interest in them, MMS

has structured several pilot projects to demonstrate whether taking

royalties in kind can actually deliver the potential benefits to the

taxpayer. The agency has solicited participation from affected States

and consulted with industry in their development.

Currently, we have an oil RIK program operating in conjunction with

the State of Wyoming involving 3400 bbls. of royalty crude oil per day,

and a small pilot underway with the State of Texas General Land Office

(GLO). The GLO program uses production from natural gas leases in the

8(g) zone off the coast of Texas in the Gulf of Mexico. A natural gas

pilot in the Federal waters of the Gulf of Mexico will begin in October

1999 and could involve as much as 800 million cubic feet of gas per day

over a 3-to 4-year period. Through the experience gained by these pilot

projects, we hope to acquire a better understanding of the key factors

that determine RIK success.

For example, the pilots could demonstrate that the RIK option works

best where leases have certain production characteristics, and where

regional markets or transportation arrangements are particularly suited

to RIK, as well as demonstrate which methods used to market the RIK

production provide the greatest benefit. Depending on the logistics and

efficiencies involved, certain production may be more attractive if

consumed directly by the government.

Hands-on experience with these pilot projects should give us a good

basis for determining whether or not RIK is viable for the Federal

Government, and, if so, how, when, and where it makes sense to exercise

the Secretary's RIK option.

The authorizing provisions of the MLA and the OCSLA and the

relevant lease provisions effectively give the Secretary complete

discretion to elect to take the royalty share of production from an oil

and gas lease in kind.

Both the MLA and the OCSLA provide that RIK production so taken may

either be sold to the public (including to eligible refiners) under

certain prescribed terms or be retained or transferred to agencies of

the Federal Government.

Public sales of onshore RIK production must be made by an offer for

sale ``upon notice and advertisement on sealed bids or at public

auction'' (30 U.S.C. 192 (1998)) and offshore RIK production must be

sold ``by competitive bidding for * * * not less than its fair market

value.''(43 U.S.C. 1353 (b)(1) and (b)(2) (1998)).

Public Auctions and Competitive Bidding

One objective of the pilots is to evaluate the relative merits of

different bidding methods so we can identify the most effective and

appropriate ways for the government to secure a competitive market

price for our public assets, as we are required to do by law. In

offering RIK production for sale to the public, we intend to consider

using any bidding procedure or format that brings us the best return in

open and competitive sales.

To assure conformity with the statutory terms ``public auction''

and ``competitive bidding,'' we would require a bidding format that

affords equal access for all qualified potential purchasers and leads

to sales made in response to the highest or best bid.

In most cases, we intend to announce the availability of royalty

production for sale by advertisement of a ``notice of availability.''

Over the past several years, MMS has found that use of its Internet

Home Page is an effective means to rapidly disseminate

[[Page 37811]]

information to the oil and gas industry and to the public at large. We

continue to use this communication method as well as placing public

notices in industry trade journals, on commercial electronic bulletin

boards, and other media. In certain cases, especially for sales of

natural gas, MMS may invite companies to apply for prequalification as

a potential purchaser. Subsequent notices of availability would be sent

to prequalified companies.

A notice of availability will identify the production to be made

available to the public, the general terms and procedures for any sale,

and will include bidder qualification information to determine who may

bid in a given sale. Ordinarily, any person would be permitted to bid

who is eligible under the terms and conditions specific to the

particular bid offering at hand. In this regard, we expect that each

notice of availability or solicitation to prequalify as a potential

purchaser will prescribe certain minimum financial qualifications for

participation in the bidding, and indicate the procedure for

prequalifying as a buyer before any sale. Potential buyers may

prequalify at any time, but must be prequalified in order to bid for

RIK production.

Lessee/Operator Responsibilities

In any situation involving the taking of RIK production, the

managing operator of the property will be an active participant in the

transaction.

Essentially, the lessee or operator is required to satisfy its

royalty obligation by delivery of a volume of ``royalty production''--

that is, the royalty share to which the Federal Government is entitled

to take as a royalty--in the form of physical volumes. The amount of

royalty oil, gas, or other products that MMS takes in kind in partial

or full satisfaction of a lessee's royalty or net profit share

obligations will be determined by whatever lease interest the lessee

holds under an applicable mineral leasing law. Generally, royalty

production equals that portion of production from or allocated to a

Federal lease multiplied by that lease's royalty rate.

When we decide to take RIK from a property, we will give the lessee

and operator adequate advance notice sufficient to minimize disruption

to the operator's planning for transportation and sales of its share of

the production stream. This will generally mean a 30-day prior written

notice before we would begin taking or stop taking RIK production from

a property.

Unless further experience dictates otherwise, it is our present

intention that where we decide to take a lease's royalty production in

kind, we will take all such royalty production from the lease in kind

until we give notice to the contrary.

In the pilots operated to date, we have set out the terms under

which we expect to conduct specific RIK transactions in a ``Dear

Operator Letter'' to all affected parties. The ``Dear Operator Letter''

generally prescribes terms of delivery, methods for resolving

imbalances, and lessee reporting and communication requirements. This

approach, together with public meetings held in advance of particular

sales and close coordination with operators, has worked well by

anticipating and resolving specific problems.

A primary responsibility of the operator will be to deliver the

royalty production to MMS in ``marketable condition'' as is currently

required by the lease and regulations for payment of royalties in

value. Accordingly, royalty production delivered by an operator must be

in a condition that would be accepted by a purchaser under a sales

contract typical for the field or area. This has long been considered

an obligation imposed by the terms of Federal leases and is reflected

in the royalty value regulations at 30 CFR Part 206, including the

definition of ``marketable condition'' set forth at 30 CFR 206.151. It

will continue to be the lessee's obligation to perform and bear all

costs of gathering, dehydration, separation, compression, sweetening,

or other processes that MMS will require in connection with the

delivery of RIK production.

It is also expected that the operator will deliver royalty

production to the lessor at the same frequency that it is produced and

moved through the royalty meter, without interruption, unless

specifically approved by MMS.

In general, natural gas taken in kind must be delivered on a daily

basis, unless other arrangements are approved by MMS. This is

consistent with industry practice so that purchasers are able to make

necessary transportation and other arrangements. Approval for less than

daily delivery of natural gas may be provided on a case-by-case basis.

We do recognize that in some cases, it may be necessary to delay

delivery of crude oil for as long as a month to permit aggregation of

saleable quantities of production from lower-producing properties.

Operators are also expected to use the same measurement and

reporting standards applicable to the payment and reporting of

royalties in value as prescribed in the existing regulations at 30 CFR

202 for RIK oil and gas.

It is also expected that lessees, operators, or others dealing in

royalty production would retain all related records for a period of 7

years after the records are generated unless MMS notifies the record

holder that a longer retention period is required. That is the same

period currently applicable to lessees paying royalties as a percentage

of value under 30 U.S.C. 1724(f).

Offshore Fair Market Value

The RIK provisions of the OCSLA direct that the public sale of

offshore RIK production must be made for not less than its ``fair

market value.''

As a generic term, ``fair market value'' is generally considered by

economists to be the price received by a willing and knowledgeable

seller not obligated to sell from a willing and knowledgeable buyer not

obligated to buy. For offshore RIK sales, however, the OCSLA prescribes

a very specific definition of that term. Section 1331(o) of 43 U.S.C.

(1994) defines ``fair market value'' for purposes of RIK sales to be

essentially the average unit price received for production from the

same lease or, in some circumstances, from leases sold in the same

region during the period.

The 43 U.S.C. 1331(o) (1994) definition states that the term ``fair

market value'' means the value of any mineral (1) computed at a unit

price equivalent to the average unit price at which such mineral was

sold pursuant to a lease during the period for which any royalty or net

profit share is accrued or reserved to the United States pursuant to

such lease, or (2) if there were no such sales, or if the Secretary

finds that there were an insufficient number of such sales to equitably

determine such value, computed at the average unit price at which such

mineral was sold pursuant to other leases in the same region of the

Outer Continental Shelf during such period, or (3) if there were no

sales of such mineral from such region during such period, or if the

Secretary finds that there are an insufficient number of such sales to

equitably determine such value, at an appropriate price determined by

the Secretary.

Under this statutory definition, the first applicable paragraph (1)

of the provision seems to require that offshore RIK production taken by

the Secretary must be sold for at least as much as the average unit

price for which the lessee sold the nonroyalty share of production from

that lease.

In cases where there were no other sales from the same lease or

where the Secretary finds that there were an insufficient number of

such sales to equitably determine such a value, the

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fair market value floor may be computed under the next paragraph,

paragraph (2). That paragraph provides that fair market value may be

computed with reference to average unit prices in sales from ``other

leases in the same region.'' Finally if a value cannot be equitably

determined under paragraphs (1) or (2), an appropriate price may be

determined by the Secretary. In operating the RIK pilot projects that

involve public sales of offshore production, we intend to comply with

the OCSLA requirement not to sell RIK production for less than its fair

market value as defined by that statute. However, we anticipate that

there may well be instances in which it may be impractical or otherwise

inequitable to determine actual average prices from a lease or region

during the same period in which an RIK sale is to be made. Strict

conformance with paragraph (1) of the definition would require knowing

at the time of the RIK sale what the lessees' actual concurrent sales

prices were for the nonroyalty share of production from the lease.

Applying paragraph (2) of the definition would also require

instantaneous knowledge of the sales prices of other lessees in the

region.

In theory, we could require that all RIK purchase prices be subject

to post-sale adjustments when the lease price information becomes

available to MMS. In our view, this would be excessively burdensome to

all concerned and would effectively discourage, if not eliminate,

participation in RIK sales. If bidders did participate, they would

necessarily bid a lower price for the royalty production than they

would otherwise because of the risk of post-sale adjustment,

particularly if this adjustment could be made well after the actual

sale. It is clear that such a process would not only be inequitable to

potential purchasers, but could not effectively capture a fair market

value as that term is intended and conventionally understood.

In those instances where it is not possible, practical, or

equitable to determine--contemporaneous with an RIK sale--average

prices from a lease or the region, we believe we can reliably estimate

these values very closely. These close estimates would allow us to

proceed under paragraph (3) of the OCSLA ``fair market value''

definition to ``determine such value, at an appropriate price

determined by the Secretary'' in a way that assures consistency with

the intent not to sell RIK production for less than the price obtained

by the lessee for its share.

In preparation for each sale of royalty oil or gas from identified

Federal leases, MMS would develop a reference price for each specific

lease that is consistent with the OCSLA ``fair market value''

requirement. To establish this reference price, MMS would analyze the

pricing relationships for sales in the area and/or market centers

appropriate for sales of production from those leases. One source of

data for the analysis would be actual historical prices for royalty

purposes for the identified leases, or if none are available, from

leases in the same area. Other data used in the analysis could include

published index prices and bids MMS may have received on other

offerings of its royalty oil or gas from that area, as well as the many

other factors that could influence the determination of fair market

value. These might include: responses to other sales of similar Federal

royalty production, seasonality, infrastructural changes (temporary and

permanent), and other variable market conditions.

Our analysis of pricing relationships in the market would produce

an estimate of the price the lessee will receive. This would form the

basis for the lease's reference price. During a sale, this lease

reference price would serve as our reserve price, below which bids to

purchase RIK production from the lease would be considered inadequate.

To verify that the pricing relationship between lessees' sales

prices and the market continues, MMS will require occasional reporting

by lessees of sales prices on leases from which MMS is taking

production in kind. These reported prices would only be used for

information and analytical purposes, are necessary to assure that we

continue to receive fair market value for RIK sales, and will not be

available for any other use.

Transfer of RIK Oil and Gas to Other Federal Agencies

As authorized by statute, we also plan to transfer royalty

production taken in kind to other Federal agencies for direct

consumption by the government. The Federal Government's energy

requirements are large and are in excess of its royalty share of oil

and gas production.

While geography and logistics prevent efficient implementation in

all locations where oil and gas are consumed, there are enormous

opportunities to build energy supply relationships within the Federal

Government. These internal supply relationships have the potential to

generate significant synergies and lower the total cost of energy

consumed by the Federal Government.

For onshore, the MLA provides in 30 U.S.C. 192 that the Secretary

may offer RIK for sale ``except whenever in his judgment it is

desirable to retain the same for the use of the United States * * *''

The OCSLA provides specific authority to the Secretary at 43 U.S.C.

1353(a)(3) to transfer RIK production to other Federal agencies,

stating that, title to any royalty, net profit share, or purchased oil

or gas may be transferred, upon request, by the Secretary to the

Secretary of Defense, to the Administrator of the General Services

Administration, or to the Secretary of Energy, for disposal within the

Federal Government.

We have already developed and implemented innovative arrangements

involving the transfer of RIK crude oil to the Department of Energy for

the Strategic Petroleum Reserve and transfer of natural gas to the

General Services Administration (GSA) for use in Federal facilities. We

plan to further explore the potential associated with direct, internal

consumption of royalty oil and gas production taken in kind, and expand

our relationship with GSA and other Federal agencies as appropriate.

The general principles set forth here are intended to allow

flexible operation of RIK programs to adapt the technique efficiently

to the wide range of conditions that exist in Federal oil and gas

producing areas. MMS firmly believes our approach is market-responsive,

consistent with best industry practices, economically and

administratively efficient, and minimally disruptive to lessees and

operators. We welcome comments from the public on any and all aspects

of this notice.

Dated: July 8, 1999.

Walter D. Cruickshank,

Associate Director for Policy and Management Improvement.

[FR Doc. 99-17788 Filed 7-12-99; 8:45 am]

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