Patrick Crow
Energy Policies Editor
In scores of courtrooms and auditors' offices across the U.S., the oil and gas industry is under attack for alleged underpayment of royalties.
There always have been royalty payment disputes within the oil and gas industry, but the latest are large and widespread and threaten to hang over the industry for decades.
U.S. Minerals Management Service has alleged massive royalty underpayments in California and is auditing for similar problems in other states.
A congressional committee says underpayments on federal lands nationwide may total $2 billion.
A half dozen producing states are investigating possible severance tax and royalty revenue underpayments. And private leaseholders have filed a flurry of class-action suits against producers.
Perhaps more significantly, the Justice Department is conducting a nationwide review of how oil companies value crude oil for royalty purposes, in preparation for a possible false claims lawsuit.
Oil operators pay landowners, either private or government, a royalty on the value of oil or gas production. That royalty is sometimes subject to negotiation, but usually is around one eighth. The value of production often is pegged to the prices pipelines or refiners post.
Most of the current suits claim producers entered into marketing arrangements to sell oil and gas at a posted price that was under the fair market price.
That enabled them, the suits allege, to pay royalty and severance taxes on lower-priced oil, thus allowing their affiliate crude trading or refining companies to benefit from the bargain price.
California case
The case that opened the flood of lawsuits and investigations came when California and the city of Long Beach sued seven oil firms in 1975, alleging they kept posted prices (and thus royalty payments) under fair market value.
Six of the companies-ARCO, Chevron Corp., Shell Oil Co., Mobil Oil Corp., Texaco Inc., and Unocal Corp.-later settled out of court for $345 million. The seventh, Exxon Corp., won its suit because it did not own pipelines or a refinery in California at the time.
MMS, the General Accounting Office, and the Internal Revenue Service conducted independent investigations into California crude pricing in the mid-1980s, but MMS said, "The information available at that time was inconclusive in proving that federal oil was undervalued at posted prices.''
Interior formed an inter- agency team in 1994 to investigate the issue, and after it obtained oil company records from the California lawsuit, it ordered specific audits and retained private consultants.
The team's report said, "During the period under review, the bulk of California crude oil production was not sold (at arm's length). Rather, it was moved through intracompany transfers, straight exchanges, and buy/sell contracts. For the relatively small volume of oil that was sold or purchased outright, payments of premiums above posted prices occurred frequently."
Jim Shaw, associate MMS director for the royalty management program, explained that during the 1960s light crude was valued more than heavy crude, but after improvements in refinery hydrocracking and reforming, the value differential narrowed.
However, "In California, that (differential shrinkage) didn't happen, even though the refineries could take more of the heavy crude."
Shaw didn't elaborate, but California producers long have complained that the marketing of Alaskan North Slope (ANS) crude in their state since the late 1970s has helped depress posted prices in California. As a result, California postings no longer reflected the true value of local crudes, producers complained.
"Because the posted price was no longer fair, oil companies began exchanging crude on values other than postings," Shaw said. "They created a shadow value system called the 'Badger exchange,' or the 'three-cut' exchange."
Such systems generally reflected exchanges of crude barrels based on their comparable product yields.
Critics contend the gap between California posted prices and actual market value has made West Coast refining much more profitable than the U.S. average for many years.
MMS audits
Now MMS claims California producers owe it about $440 million for royalty underpayments during 1980-94 (OGJ, July 29, p. 42).
It claims that, for royalty purposes, producers used posted prices that were about $2/bbl too low and then reaped a profit in reselling the crude to others or processing the oil at their refineries.
A federal auditing team had estimated California producers could owe as much as $856 million, based on adjusted ANS crude oil prices during 1978-93. MMS reduced that to $440 million.
The agency has focused its collection efforts on 20 firms that produced 96-97% of the oil in question, although more than 100 firms have held federal onshore and offshore leases in California since 1980. The audits are expected to be completed by next summer.
Shaw said, "The crux of the issue is: Do we have the authority to make them pay royalty on what their affiliate benefited from their own production? We think we do, and they don't think they do.
"We know that nobody wants to take a lot of profit at their producing subsidiary. But we maintain our rules were never intended to let someone use an affiliate to mask the value of the commodity."
He said the case centers on instances where crude moved internally within major companies and royalties were paid based on postings that some of the majors posted.
"Typically, companies have taken the position that the first intracompany transaction, which often is at a posted price, should govern royalty value under MMS regulations."
Shaw said MMS just billed the 10 largest California producers for royalties from September 1983 to February 1988, using ANS crude as the benchmark for valuation. More bills will go out later.
"The strong presumption is that we will get 10 appeals. MMS has 33 months to act on those appeals. Then the companies can appeal to the courts. Of course, the final answers to these issues will be determined in the courts."
For the period beginning Mar. 1, 1988, up to the present, Shaw said auditing will not be complicated.
"We're looking just at crude prices and what premiums the companies may have received over postings. We thought we could do all 20 audits within a year. We will have issued 13-14 subpoenas by the end of October."
Two oil firms already have sued in federal court in Oklahoma to block their subpoenas.
Rule coming
MMS is working on a royalty valuation rule that will ensure the government gets full and fair royalties under an array of market conditions.
It plans to invite comment on a proposed draft rule by yearend. In the case of arms-length sales, the rule would continue to base royalties on crude postings. But for nonarms-length transactions, companies would use market indicators, such as prices on the New York Mercantile Exchange (Nymex).
Shaw said, "The only real question is: 'For nonarms-length sales, under what circumstances do you accept gross proceeds, and how soon do you go to market-based indicators?'"
He said, "In the old days, for years and years, posted prices were what the oil companies did business on. Sometime in the mid to late 1980s-we have a study under way to help us determine when-the business of trading crude moved away from valuations based on postings and moved to Nymex or other valuations.
"While they were doing that, the oil companies continued to pay royalties on postings. Our rules allowed them to use posted prices, if they reflected market values.
"If the royalty was not paid on the premium, that is inexcusable. And there are situations where the oil companies hung to the postings where they should have known better.
"If you were a producer who received $19/bbl based on Nymex, and postings were $18, and you paid royalties on $18, you should have known better."
In natural gas cases, Shaw said an oversupply of production drove prices down during the industry's restructuring, and firms often used spot prices to set values, which are easy to measure.
"As we move forward, the point of valuation is changing. It used to be the pipelines purchased all the gas. Now you might not see a point of valuation until it turns up in electricity in someone's house.
"It's going to become increasingly difficult to find the proper places to value gas. Prospectively, value in gas is probably going to be a bigger challenge to determine than value in oil."
Nationwide look
As a result of the California case, MMS is examining similar oil valuation issues arising in other states and on the Outer Continental Shelf.
It has instructed its auditors to hold open the most recent audit periods and consider the valuation issues in all audits.
MMS Director Cynthia Quarterman pledged, "We are committed to making certain all royalties owed are collected. We will continue to work towards that goal."
But she warns the California underpayments were easier to quantify because the West Coast is a distinct market, while crude is moved in and out of other states more readily.
Nevertheless, she said MMS has noted a disparity between Nymex prices and posted prices for oil and will look for possible undervaluation in the course of continuing audits, which can extend back 6 years.
MMS has targeted the 125 companies representing more than 85% of crude production from federal lands. It will audit half of those this fiscal year, using the agencies of producing states with which it has auditing agreements.
The focus will be on nonarms-length transactions. MMS officials are unsure how much they will find.
MMS recently has issued a procedural guidance for MMS auditors and the states and Indian tribes that conduct audits under agreements with the agency (OGJ, Sept. 2, p. 28).
"This guidance explicitly states that royalties are due on premiums received above posted prices. MMS further instructed its auditors to suspend issuance of audit closure letters to companies, effectively holding open the period from 1989 forward for further examination."
MMS will hire consultants to study the crude valuation practices of operators outside California to determine whether crude postings were a valid basis for royalty valuation purposes prior to the 1990s.
Congressional Report
The Project on Government Oversight (POGO), a nonpartisan, nonprofit watchdog group in Washington, D.C., has seized on the royalty collection issue. POGO maintains oil companies may have underpaid $1.5 billion in federal royalties in California since 1960. It also notes that MMS collected 90% of its royalties outside of California during 1985-95.
It said, "An abundance of evidence exists today proving that oil companies have deliberately undervalued their crude oil east of the Rockies. Oil companies almost always post prices below the crude oil prices quoted on the Nymex, although the Nymex crude oil market is widely believed to represent the fair market value for oil produced east of the Rockies.
"Furthermore, posted prices are often lower than spot market prices. As a matter of fact, bonuses over posted prices are so routinely paid that they are reported in the trade press as the P(osting)-plus market."
It noted crude trading began on Nymex in March 1983, and several commercial services now publish market prices for oil at large trading centers around the U.S.
POGO has issued three reports on royalty underpayments this year and has the ear of Rep. Carolyn Maloney (D-N.Y.).
Maloney persuaded a House Government Reform and Oversight subcommittee, chaired by Rep. Stephen Horn (R-Calif.), to hold a hearing on the subject last June. That committee recently issued a report critical of MMS.
It said MMS has been too slow to collect royalty underpayments and needs both a timetable for action and outside help for its auditing staff.
The report said, "MMS should immediately proceed to examine whether other underpayments have occurred in states other than California."
Shaw admitted MMS struggled until it decided on a course of action. "Since that was determined last July 18, we've met every deadline. We're cranking."
The committee report also was critical of "global settlements" MMS has signed with Exxon and Chevron to resolve an array of royalty disputes, including California underpayments.
It said MMS and the Justice Department should review existing global settlements to determine whether federal financial interests can be salvaged, and prevent future problems with global settlements.
The report also said oil companies' pipelines crossing federal lands in California are required to be common carriers, and MMS should ensure their operations are not monopolistic and "do not harm federal interests by depressing oil royalty revenues and preventing an efficient oil market."
The committee said the Interior Department's Inspector General has criticized MMS for improper procedures during bargaining with oil companies. "During these negotiations, it reduced the estimated value of items to be negotiated by more than $350 million-without documents."
Rep. Maloney plans to file a bill in the next Congress to shift MMS' royalty collection program to the Treasury Department's Financial Management Service.
She said the global settlements with Exxon and Chevron may have cost the U.S. more than $200 million in underpaid royalties and urged Interior to try to reopen them.
"To ensure that we do not face another case where hundreds of millions of dollars are thrown away with no accountability, I will also be introducing legislation that will require any legal settlements entered into by the Department of Interior involving more than $2 million in outstanding claims to be approved by the Office of the Secretary. Clearly, someone must be held accountable."
State cases
The Texas Land Office has sued nine companies-Chevron, Exxon, Mobil, Shell, Texaco, Amoco Corp., Marathon Oil Co., Phillips Petroleum Co., and Union Pacific Resources Corp.-alleging they underpaid royalties on production from school lands.
It said that after it began taking some royalty oil in kind in 1988, it found the crude could be sold $0.07-1.95/bbl above the posted prices.
The Land Office also observed that, in 1993, ARCO voluntarily paid $584 million in back royalties and interest with the explanation that its postings had been lower than its net revenues. ARCO made similar payments to other states and private royalty owners. No other major has done so.
Texas is seeking to certify the state-court case as a class-action suit, which would allow it to cover the interests of both the Land Office and private royalty owners. In May, the Texas Supreme Court rejected oil companies' petition for a dismissal.
Also in Texas, Burlington Resources Co. has agreed to an out-of-court settlement to resolve a class action suit brought by its natural gas royalty owners.
Separately, a class-action lawsuit has been filed in a Houston federal court against 35 large oil companies for allegedly undervaluing crude nationwide and violating federal antitrust laws.
In Alabama, commissioners of five counties have filed lawsuits against major oil companies for alleged underpayment of severance taxes. The state is investigating as well, and private royalty owners have filed a class-action suit.
Alaska has recovered $3.7 million in settlements with 11 oil companies for back royalties and severance taxes.
Colorado producer Jack Grynberg has filed a federal class-action suit against 67 gas pipelines, alleging they underreported the BTU content and volume of gas they bought.
He alleges they did not pay for as much as $6 billion worth of gas. A federal whistleblower law could allow him to recover as much as 30% of any settlement.
In Florida, royalty owners have filed a class-action suit against Exxon, the operator of Jay field in Santa Rosa County.
Louisiana has sued 45 producers for allegedly underpaying severance taxes due to low posted prices. The state reached a $250 million global settlement with Texaco and oil royalty settlements totaling $900,000 with four other firms. It is auditing eight more oil firms for royalty underpayments.
Also in Louisiana, royalty owners have launched a class-action lawsuit against 15 oil producers on royalty issues.
New Mexico has settled with Texaco for $4 million on unpaid royalties and is auditing eight firms for severance taxes.
POGO reports that Colorado, Mississippi, Montana, Oklahoma, Wyoming, and three Indian tribes are examining royalty and severance tax issues.
Royalty owners
James Stafford, president of the National Association of Royalty Owners' (NARO) executive committee, said his group has seen an "epidemic" of royalty cases.
He said his members are very concerned about the issue but are trying to maintain perspective: "They don't want a lynch-mob answer."
For instance, NARO has declined to participate in the Texas case because its auditors questioned the data. "We felt it is impossible to point the finger of blame until there is more definitive evidence."
He said natural gas royalties are a particular problem for NARO members.
"Four out of five people who come in our office complain about something like: 'Why am I not getting the same payment for natural gas from the well on my property as my sister does on her farm next door?' That often is a very good question."
Stafford said, "There are so many assignments right now...the accounting is in chaos. The title will transfer several times before it leaves the lease, and there seems to be some irregularities with shadow companies.
"There are so many different ways of contracting, who knows what's an arms-length transaction, with so many subsidiaries and the pricing differentials in the spot market?"
As a result, he said 500-600 gas royalty owners are suing producers to get accountings. "There's not a royalty owner who had any idea what kind of a natural gas contract his producer or contractor has."
Stafford said, "At one time, we all pointed the finger of blame at the majors, because they were so secretive and had large law departments. That's not true anymore.
"Today the majors aren't the problem as much as the outcrops of independents-all the spinoffs, acquisitions, and overnight successes. Still, the indiscretions or criminal activities are very few."
He said, "We have worked so hard to try to pull the industry together and to combat negative perceptions about the oil industry, that I hate to see a wholesale alarm being raised" about royalty payments.
Stafford warned the industry should take a close look at its royalties and postings "before there is a witch hunt by the government."
Industry mum
Major oil firms, facing litigation and audits, are naturally close-mouthed on the royalty underpayment cases.
But one oil company official said, "We think our posted prices are a true reflection of value. And sometimes we even pay more than our posted prices.
"There may be an isolated problem. I cannot promise you that some of those downstream practices have not taken place in the industry, but the issue is overblown.
"Rep. Maloney may see a big conspiracy, but I don't see any orchestrated effort by the major producers to cheat the royalty owners.
"The fact is there are as many different postings for crude oil as there are models of American cars. It would not be a small undertaking to systematically cheat on them."
He noted that "every lease is different," with widely varying producers, royalty levels, and customers for the oil or gas, so it is unrealistic to expect standardization in any form.
He also said producers usually are bound by lease agreements that call for them to pay the "posted market price" for oil or gas.
He blamed most of the problem on the fact that the federal government and many producing states face tight budgets. They see their royalty revenues declining along with production, and are under pressure to arrest the money drain.
Iceberg tip?
All observers seem to agree that the royalty underpayment controversy has just begun.
POGO's Danielle Brian said, "This clearly is not a partisan issue. Whatever happens in the November election, and whatever the makeup of Congress afterwards, I think you'll see continuing congressional interest in this."
A lobbyist for a major oil company in Washington, D.C., predicted, "This is a sleeper issue that will explode next year-about the time MMS starts issuing huge bills to oil companies-and it's going to become a very big issue."
A lobbyist for an independent agrees. "This is going to get a lot bigger in the next Congress. Legislators are under a lot of pressure to raise money, and this issue lends itself so well to demagoguery.
"Meanwhile, it's going to be a huge drain of resources, and a management challenge for the companies. They have a big problem, but right now they're in the 'Let's roll along, and maybe everyone will forget about it' mode.
"Industry's challenge will be to explain to the public and governments they were caught up in complex accounting issues and that they were not trying to do something illegal or dishonest."
A lobbyist for an independent
"This (royalty underpayments issue) is going to get a lot bigger in the next Congress. Legislators are under a lot of pressure to raise money, and this issue lends itself so well to demagoguery. Meanwhile, it's going to be a huge drain of resources, and a management challenge for the companies. They have a big problem, but right now they're in the 'Let's roll along, and maybe everyone will forget about it' mode. Industry's challenge will be to explain to the public and governments they were caught up in complex accounting issues and that they were not trying to do something illegal or dishonest."
James Shaw, associate MMS director for royalty management
"The crux of the issue is: Do we have the authority to make (producers) pay royalty on what their affiliate benefited from their own production? We think we do, and they don't think they do...We maintain our rules were never intended to let someone use an affiliate to mask the value of the commodity."
An oil company official
"We think our posted prices are a true reflection of value. And sometimes we even pay more than our posted prices. There may be an isolated problem. I cannot promise you that some of those downstream practices have not taken place in the industry, but the issue is overblown."
James Stafford, president of NARO's executive committee
We have worked so hard to try to pull the industry together and to combat negative perceptions about the oil industry, that I hate to see a wholesale alarm being raised about royalty payments. Industry should take a close look at its royalties and postings before there is a witch hunt by the government.
Copyright 1996 Oil & Gas Journal. All Rights Reserved.