The U.S. Department of the Interior's Office of Natural Resources Revenue (ONRR) is requesting public comments through July 28, 2011, on potentially sweeping changes in the way oil and gas is valued for royalty purposes. Particularly open to change are ONRR's gas valuation regulations in place since 1988.

For years industry had urged Interior to take more of its oil and gas royalties in kind and sell the production on the open market, thereby eliminating costly disputes over how production is valued. But after a 10-year program under which the majority of federal gas royalties were taken in kind, Interior scrapped the program under political pressure in 2009. Interior returned to its “cumbersome” and administratively “costly” valuation regulations. As a result, “ONRR must analyze literally hundreds of thousands of sales, transportation, and processing transactions each month.” ONRR now seeks “greater simplicity, certainty, clarity, and consistence” in these valuation regulations

“ONRR intends that the final regulations will be revenue neutral,” which undoubtedly will lead to debates over whether new proposed measures reflecting market value of oil and gas removed or sold from the lease could lead to some reductions in royalty values. Over the years legal battles have been won and lost over whether value had been added after production stages and when market prices are determined downstream. Two types of value-added deductions are available — for transportation and processing costs. But these deductible costs are often bundled with nondeductible costs of placing product in “marketable condition” by third-party service providers, and no clear method exists under the regulations for separating them.

Such admittedly “cumbersome” regulations necessarily lead to artificial royalty valuations. Yet, because inefficiencies distort market values under the current regulatory regime, removing inefficiencies cannot as a matter of basic economic principle be perfectly revenue neutral.

ONRR seeks comments on four major buckets:

A.Use of Index and Spot Prices to Value Oil and Gas — ONRR thinks that indexes are becoming more refined and markets more liquid. ONRR seeks comments on —

  • How accurate and efficient is the current use of index prices to value royalties, particularly for oil?
  • Should value for both oil and gas be based on first-of-month index prices, daily spot prices, or a mix?
  • How should geographic areas not covered by index prices, or with limited spot market activity, be handled?
  • Is market concentration in certain areas of the country a problem? and
  • Should indexes be used even to value oil and gas that is sold arm's-length at a different price?

B.Transportation Allowances — ONRR seeks comments on valuation methods that include eliminating the need for payors to track transportation costs.

  • If indexes were used, ONRR broadly asks how should location differentials be accounted for.
  • Should ONRR consider a fixed differential, for example, or a fixed percentage deduction from index values?
  • Should a fixed differential be applied to an entire area, or to a certain pipeline; would a flat percentage differential (perhaps with a cap) be preferable (applied regionally or nationwide)?

C.Gas Processing Allowances -- ONRR is considering an adjustment or “bump” in an index price when gas is processed. This adjustment could be based on:

  • Gas quality;
  • A differential between gas and liquids prices (similar to a “frac spread” or “processing margin”); and/or
  • Individual plant factors such as shrinkage and unique plant processing costs.

ONRR notes it might calculate this adjustment on a monthly basis (published on its website), and apply it nationwide, regionally or on a plant-specific basis.

D.“Other Alternatives” — Finally, ONRR asks a wide-open question — what “other methodologies” would simplify reporting, and reduce costs and disputes?

Industry has welcomed ONRR's review. API noted the “disproportionate number of disputes with huge revenue implications” under current regulations, and public benefits from “greater certainty, transparency, and predictability in the process.” With history as a guide, however, the main obstacle to reform will likely be objections by state government recipients of federal revenues who find that a market-based pricing mechanism could, at one time or another, lead to reduced royalty calculations — even if they are generally neutral over the long term. If the current system is as flawed as nearly everyone acknowledges, then a better system should cause some change in royalty values, and cannot be perfectly “revenue-neutral.”