Court rejects appeal on regulations used to value oil and gas for royalties

A federal appeals court has ruled against an industry challenge to 2016 regulations on how to establish the value of oil or natural gas for the calculation of royalties owed to the federal government.

The decision by the US Court of Appeals for the Tenth Circuit means increased royalty payments in a couple of different ways. Higher royalties will be paid because of fewer cost deductions from the “gross proceeds” of oil and gas transactions. Or, if a company uses a market price index specifically for gas sales, higher payments will occur because the highest reported price in a given month will be treated as the market price for royalty calculations.

The regulations, from the Interior Department’s Office of Natural Resources Revenue (ONRR), were written by the Obama administration, went into effect at the start of 2017, and were stalled by attempted changes during the Trump administration. After courts overruled the Trump ONRR, the 2016 final rule went into effect in 2019, followed by industry litigation led by the American Petroleum Institute (API).

The US District Court for the District of Wyoming ruled in favor of ONRR Sept. 8, 2021. A three-judge panel of the Tenth Circuit affirmed that ruling Aug. 25.

Central to the case is the fact that, as the Tenth Circuit put it, leasing statutes do not entitle companies to recover, through a deduction called an allowance, all of their transportation and processing expenses. The Mineral Leasing Act of 1920 and the Outer Continental Shelf Lands Act simply require ONRR to base royalty on the value of the oil and gas, “leaving room for the agency to decide what allowances to provide when determining that value,” in the words of the court.

API sued under the Administrative Procedure Act, but the appellate judges said the trade group failed to demonstrate that the 2016 rule violated that law’s prohibitions against arbitrary and capricious rulemaking. ONRR provide adequate reasons for its rule, the court said.

The case is American Petroleum Institute v. Interior.

Fewer allowances, no exceptions

When a company sells oil or gas to an unaffiliated company in what is called an “arm’s length” transaction, the gross proceeds of the deal are subject to royalties after some deductions. Both before and since the 2016 rule came out, the costs of transport from wellheads through gathering lines to a market point were not deductible. Instead they were and still are considered an obligation of the seller to prepare the commodity for the market.

The question of where gathering stops and market movement begins was blurred, however, in the case of offshore operations, where oil and gas might be carried from wellheads to a subsea manifold first, then by a larger line from the manifold to an offshore platform. To promote deepwater drilling, Interior in 1999 began allowing companies to deduct the transportation cost of the movement from manifold to platform.

ONRR ended that deduction with its 2016 rule, saying the transport from manifold to platform was part of the nondeductible gathering expense. The appeals court agreed, saying ONRR had the authority to decide whether a deduction originally intended to promote deepwater work is still needed.

The 2016 rule also simplified the caps on allowances by applying the caps strictly to all new and existing production, with no exceptions. The caps limit transportation allowances to 50% of the value of the oil or gas, and limit processing allowances to 66.6% of the value of the gas streams from the processing. ONRR has the authority to eliminate exceptions, the court ruled.

Gas index pricing

ONRR uses index pricing when a transaction involving natural gas is not at “arm’s length,” on the theory that reported market prices are reasonably objective. ONRR had been using a multifactor benchmark standard, but the 2016 rule makes index method more expensive.

ONRR uses approved trade publications for price information for a market in a particular geographic area, with deductions for transportation and processing. ONRR’s new approach requires the use of price reporting to determine the highest reported monthly price for any location where the gas could have been transported that month.

API argued that the rule does not justify using highest prices rather than average or median prices. The court disagreed. ONRR says plainly that it wants to maximize royalty collection, and indexing to the highest price will bring in more royalties, the court pointed out.

API also objected to the reference to the highest price of any point where the gas could be transported in a given month. That bases pricing on “unattainable hypotheticals that simply…yield more royalty for ONRR, notwithstanding actual constraints on gas movement.”

But the court said ONRR was justified in doing so for “administrative simplicity” and, yes, for higher payments.