On January 6, 2015, the Department of the Interior’s Office of Natural Resources Revenue (“ONRR”) issued a proposed regulation that would substantially modify existing regulations in 30 C.F.R. Part 1206 for the valuation for royalty purposes of oil, gas, and coal from federal leases onshore and on the Outer Continental Shelf.  The proposal also would amend ONRR’s royalty valuation regulations for coal production from Indian leases.  While this proposed rule may have certain benefits for industry, ONRR is proposing to eliminate several existing provisions that will hit existing and future lessees in the pocketbook.  ONRR estimates that its proposed changes will increase royalty revenues for the federal government and Indian lessors by approximately $80 million annually.

The proposal  would amend the valuation procedures for gas produced from federal leases, unchanged since 1988, to make them consistent with current ONRR oil valuation regulations.  To value non-arm’s-length dispositions of gas production, ONRR is proposing to replace the existing “benchmark” system, which looks principally to comparable arm’s-length sales in the field or area as the valuation criterion, with a methodology that relies primarily on published index prices, similar to the methodology ONRR adopted for oil valuation in a 2000 regulatory overhaul.  For valuation of arm’s-length sales of gas production, ONRR is proposing a change that would allow lessees to elect either to pay royalties based on their or their affiliates’ “gross proceeds” (less applicable transportation adjustments) even if that sale occurs in a distant market, or to instead pay based on the new index-based methodology that would be applicable to non-arm’s-length dispositions.  ONRR had adopted a similar option for oil valuation in the 2000 revision to relieve lessees from having to “chase” gross proceeds to distant sales points. 

Among  many other proposed changes to valuation procedures for oil and gas, the most costly  would disallow any transportation deduction to move oil or gas production from deep water completions on the Outer Continental Shelf to the first platform.  Amending  the transportation allowance regulations could cost industry $20 million annually.

ONRR also is proposing to revamp valuation procedures for coal production from both federal and Indian leases.  Under the existing regulations, if a coal lessee transfers production to an affiliate in a non-arm’s-length transaction, then the production would be valued by application of  benchmarks that look first to prices in comparable arm’s-length sales in the same area where the mine is located.  ONRR is proposing instead that if a lessee sells or transfers coal to an affiliate under a non-arm’s-length transaction, and the affiliate ultimately re-sells at arm’s-length, then the affiliate resale price establishes the royalty value.  This proposal would significantly increase royalty obligations, and valuation complexities related to transportation allowances, for coal producers whose marketing affiliates are selling coal under arm’s-length contracts in distant markets.  Unlike for oil and gas, ONRR is not providing coal lessees an option to use the valuation procedure for non-arm’s-length dispositions (that currently looks to values in the area where the mine is located) instead of “chasing” gross proceeds to a distant sales point.  With respect to non-arm’s-length dispositions, ONRR is proposing to replace its benchmark process that relies on comparable sales in the area with a provision that would require the lessee to value coal production based on the price of the electricity generated by the coal.

ONRR is also proposing to adopt what the agency denominates as its “default provision.”  Under this provision, there are multiple opportunities for ONRR to elect not to apply the regulatory valuation standards for oil, gas and coal and to instead unilaterally establish a “reasonable” royalty value on a case-by-case basis using a variety of discretionary factors.  This proposal is likely to stimulate significant interest from industry because it diminishes the certainty in the valuation process provided in the existing oil, gas and coal valuation standards, the single most critical underlying principle in those rules.  On the other hand, it may provide a benefit in circumstances where lessees are uncertain how to apply the prescribed valuation provisions to their particular disposition of oil, gas or coal and avoid risk of penalties for improper reporting.

ONRR is accepting comments on the proposed rule until March 9, 2015.  Any company or organization with existing or future interests in federal or Indian oil, gas, or coal leases has a significant vested interest to weigh in on the proposed rule before it becomes final.