# Federal Oil and Gas Royalty-in-Kind Pilot Programs

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URL: https://www.frixlaw.com/law-library/documents/fr%3A99-17788

## Record

- **Collection:** Federal Register
- **Document type:** Notice
- **Published:** July 13, 1999
- **Citation:** 64 FR 37809

## Text

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

[[Page 37810]]

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

[[Page 37812]]

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]
BILLING CODE 4310-MR-P

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A99-17788. Public record. Not legal advice.