Kick'em When They're Down: ONRR Releases
Proposed Federal Oil & Gas and Federal & Indian Coal Valuation Reform

In a time of declining oil prices, the Department of the Interior (DOI) through the Office of Natural Resources Revenue (ONRR) recently announced on January 6th a proposed rulemaking for royalty valuations on Federal oil and gas leases and Federal and Indian coal leases. See 80 Fed. Reg. 608, available at http://www.onrr.gov. Comments pertaining to the proposed rule must be submitted to ONRR on or before March 9, 2015. Preceding the proposed rule, ONRR published Advanced Notices of Proposed Rulemaking in 2011 (ANPR) and conducted a series of public workshops concerning the valuation of oil, gas and coal royalties. Comments on the ANPR and workshops focused heavily on the use of index prices and on transportation and processing allowances. However, important changes proposed in the rule only tangentially relate to these topics and were not covered in the ANPRs or the ONRR workshops.

Creation of Discretionary Default Royalty Values and Allowances

One of the most notable changes proposed by ONRR is the creation of a "default provision" which would allow ONRR to "exercise considerable discretion" to establish a royalty valuation when "(1) a contract does not reflect total consideration, (2) the gross proceeds accruing to you or your affiliate under a contract do not reflect reasonable consideration due to misconduct or breach of the duty to market for the mutual benefit of the lessee and the lessor, or (3) it cannot ascertain the correct value of production because of a variety of factors, including but not limited to, a lessee's failure to provide documents." 80 Fed. Reg. 609-610 (emphasis added). The proposed rule includes an expansive definition of the term "misconduct," which would most likely include simple reporting mistakes. 80 Fed. Reg. 621. Similar provisions would allow ONRR to establish the values of a lessee's transportation, processing, and coal washing allowances.

This novel concept of a default valuation mechanism would afford ONRR with considerable discretion to adjust royalty values. Assuming that this discretion is properly authorized and not arbitrary or capricious, the values established under the default provision would be difficult for payors to successfully challenge. In addition, the default provision would be used to penalize payors for simple reporting errors.

These changes follow ONRR's May 20, 2014 proposed rulemaking on Amendments to Civil Penalty Regulations, which seeks to broaden ONRR's enforcement authority under the Federal Oil and Gas Royalty Management Act (FOGRMA). ONRR's commentary to the January 6, 2015 proposed rule, however, states the default valuations and allowances established by ONRR for payor "misconduct" would be "different than, and in addition to, any violations subject to civil penalties under FOGRMA . . . and its implementing regulations." 80 Fed. Reg. 621. The default provisions for royalty valuations and allowances will apply to Federal oil and gas leases and Federal and Indian coal leases.

  • In determining a default royalty value, ONRR will use a list of discretionary factors which include:
  • The value of like-quality oil, gas and coal from nearby leases, plants or mines;
  • Public sources of market information;
  • Information reported to ONRR on various ONRR reporting forms; and
  • "Any information ONRR deems relevant" regarding the lease.

In its commentary to these factors, ONRR explains in the context of oil leases that the new default provision will allow "ONRR to consider any criteria [it] deem[s] relevant, as well as criteria similar to the current gas valuation benchmarks under 30 CFR 1206.152(c)(1) and (2) and 1206.153(c)(1) and (2)." 80 Fed. Reg. 614.

The Elimination of Benchmarks for Gas and Coal Royalty Valuations

In stark contrast to the above, the proposed rule eliminates the valuation benchmarks currently used to value gas royalties for non-arm's-length sales from Federal oil and gas leases. The elimination of these benchmarks was discussed in the ANPR and at the 2011 workshops, and is said to be proposed to offer greater simplicity and clarity to payors and ONRR. In lieu of utilizing benchmarks, ONRR intends to value these royalties based on gross proceeds from the first arm's-length resales ("affiliate resales"), index prices, or weighted average pool prices. ONRR similarly proposes to eliminate the use of benchmarks to value royalties for non-arm's-length sales from Federal and Indian coal leases, and intends to similarly base these royalties on affiliate resales. ONRR also proposes to "value sales of coal between cooperative members using the first arm's-length sale or a netback methodology." 80 Fed. Reg. 609.

Other Noteworthy Changes

Other notable changes proposed in the rule include:

  • Eliminating reporting of transportation factors for oil royalties

30 C.F.R. § 1206.110(g) currently allows payors to report their oil transportation allowances by using transportation factors, in lieu of reporting itemized transportation costs. ONRR would like to eliminate the use of transportation factors under the current rules, and require payors to report their actual transportation costs as allowances.

  • Eliminating line fill and pipeline losses as part of non-arm's-length transportation allowance

ONRR intends to eliminate the ability for payors to include line fill and pipeline loss expenses as a component of their non-arm's-length transportation allowances. ONRR takes the position that these expenses are part of the cost to market oil and gas, and should be disallowed as deductions.

  • Written Contract Requirements

ONRR plans on requiring payors to have written sales and transportation contracts, which can be submitted to ONRR. ONRR's commentary to the proposed rule explains that "[w]ithout the applicable sales, transportation, and/or processing contracts, neither the lessee nor ONRR can verify that Federal royalties are properly paid." 80 Fed. Reg. 622. If a payor does not have a written agreement in place, ONRR intends to use its discretion to determine the applicable royalty value or transportation or processing allowance under the proposed default provisions discussed above.

In addition, ONRR specifically wishes to receive comments on: creating standardized "schedules" for transportation and processing allowances, and ideas on reassessing royalties for non-arm's-length royalty valuations.

Comments regarding any of the above can be submitted to ONRR on or before March 9, 2015.