Reporting and Paying Royalties on Federal Leases on Takes or Entitlements Basis

AGENCY:

Minerals Management Service (MMS), Interior.

ACTION:

Advance notice of proposed rulemaking and announcement of public meeting.

SUMMARY:

The MMS requests comments and suggestions to assist us in proposing regulations regarding so-called “takes versus entitlements” reporting and payment of royalties when oil and gas production is commingled upstream of the point of royalty measurement.

DATES:

You must submit your comments by June 6, 2006. A public meeting to solicit further comments will be held in Lakewood, Colorado, on Wednesday, May 10, 2006.

ADDRESSES:

Please use the regulation identifier number (RIN), RIN 1010-AC29, in all your correspondence. Submit your comments, suggestions, or objections regarding the advanced notice of the proposed rulemaking by any of the following methods:

By e-mail. mrm.comments@mms.gov. Please include “Attn: RIN 1010-AC29” and your name and return address in your Internet message. If you do not receive a confirmation that we have received your Internet message, call the contact person listed below;

By regular U.S. mail. Minerals Management Service, Minerals Revenue Management, P.O. Box 25165, MS 302B2, Denver, Colorado 80225-0165; or

By overnight mail, courier, or hand-delivery. Minerals Management Service, Minerals Revenue Management, Building 85, Room A-614, Denver Federal Center, West 6th Ave. and Kipling Blvd., Denver, Colorado 80225.

FOR FURTHER INFORMATION CONTACT:

Sharron L. Gebhardt, Lead Regulatory Specialist, Minerals Management Service, Minerals Revenue Management, P.O. Box 25165, MS 302B2, Denver, Colorado 80225-0165, telephone (303) 231-3211, FAX (303) 231-3781, or e-mail Sharron.Gebhardt@mms.gov.

SUPPLEMENTARY INFORMATION:

I. Public Meeting Information

The MMS previously published a notice in the Federal Register on November 29, 2005 (70 FR 228), announcing a public meeting in Houston, Texas, on December 14, 2005. That meeting was attended primarily by offshore producers. The MMS wants to provide additional opportunity for onshore producers to participate in a public meeting. This public meeting will be held in Lakewood, Colorado. See IV, Description of Information Requested, for details.

This second meeting will be held on Wednesday, May 10, 2006, from 9 a.m. to 1 p.m. central time, in the Main Auditorium, Rooms B and C, located in Building 85 on the Denver Federal Center located at West 6th Ave. and Kipling Blvd. in Lakewood, Colorado. For further information, please contact Roman A. Geissel at (303) 231-3226.

II. Public Comment and Meeting Procedures

The MMS may not necessarily consider or include in the Administrative Record, for any proposed rule, comments that MMS receives after the close of the comment period or comments delivered to an address other than those listed in the ADDRESSES section of this document.

A. Written Comment Procedures

We are particularly interested in receiving comments and suggestions about the topics identified in IV, Description of Information Requested. Your written comments should: (1) Be specific; (2) explain the reason for your comments and suggestions; (3) address the issues outlined in this notice; and (4) where possible, refer to the specific provision, section, or paragraph of statutory law, case law, lease term, or existing regulations that you are addressing.

The comments and recommendations that are most useful and have greater likelihood of influencing decisions on the content of a possible future proposed rule are: (1) Comments and recommendations supported by quantitative information or studies; and/or (2) comments that include citations to, and analyses of, the applicable laws, lease terms, and regulations.

B. Public Meeting Procedures

At the public meeting, those attending will be able to comment on the scope, proposed action, and possible alternatives MMS should consider. The purpose of the meeting is to gather comments and input from a variety of stakeholders and the public.

If you do not wish to speak at the meeting but you have views, questions, or concerns with regard to MMS's implementation of section 6(d) of the Federal Oil and Gas Royalty Simplification and Fairness Act (RSFA), Public Law 104-185, Aug. 13, 1996, 110 Stat 1700, 1713-1714, as corrected by Public Law 104-200, Sept. 22, 1996, codified at 30 U.S.C. 1721(k), entitled “Volume Allocations of Oil and Gas Production,” you may submit written statements at the meeting for inclusion in the public record. You may also submit written comments and suggestions regardless of whether you attend or speak at the public meeting. See the ADDRESSES section of this document for instructions on submitting written comments.

Due to Denver Federal Center security requirements, attendees at the meeting will need a picture ID in order to be admitted onto the Denver Federal Center and into Building 85.

The site for the public meeting is accessible to individuals with physical impairments. If you need a special accommodation to participate in the meeting (e.g., interpretive service, assistive listening device, or materials in alternative format), please notify Mr. Geissel no later than 2 weeks prior to the scheduled meeting. Although we will make every effort to accommodate requests received, it may not be possible to satisfy every request.

C. Public Comment Policy

Our practice is to make comments, including names and home addresses of respondents, available for public review at our Denver office during regular business hours and on our website at http://www.mrm.mms.gov/Laws_R_D/FRNotices/FRHome.htm,, or on request to Sharron Gebhardt at (303) 231-3211. Individual respondents may request that we withhold their individual home address from the rulemaking record, which we will honor to the extent allowable by law. There also may be circumstances in which we would withhold from the rulemaking record a respondent's identity, as allowable by law. If you wish us to withhold your name and/or address, you must state this prominently at the beginning of your comments. However, we will not consider anonymous comments. We will make all submissions from organizations or businesses, and from individuals identifying themselves as representatives or officials of organizations or businesses, available for public inspection in their entirety.

III. Description of Information Requested

On August 13, 1996, the President signed RSFA into law. Section 6(d) of RSFA, entitled “Volume Allocations of Oil and Gas Production,” amended section 111 of the Federal Oil and Gas Royalty Management Act of 1982 (FOGRMA), Public Law 97-451-Jan. 12, 1983 (30 U.S.C. 1721), by adding new paragraphs (k)(1)-(5). The proposed rulemaking would implement RSFA amendments to FOGRMA § 111(k)(1)-(4).

Congress enacted these amendments to clarify and resolve the long-standing issues regarding so-called “takes versus entitlements.” Those issues arose primarily where the amount of natural gas taken (“takes”) and sold by a lessee from Federal leases subject to a unit or communitization agreement was not equal to the lessee's entitled share (“entitlements”), based on its ownership interest in leases in the unit or communitization agreement. These imbalances led to numerous questions about who should report and pay on what volumes and for what leases.

To obtain input from parties affected by RSFA amendments to FOGRMA section 111(k)(1)-(4), MMS formed a consultation team comprised of representatives from interested states, oil and gas trade associations, and MMS. The consultation team held meetings on October 30, November 19, and December 6, 1996. The meetings resulted in general agreement on definitions, the reporting requirements for 100-percent Federal units and communitization agreements, the definition of a “marginal property,” and how a marginal property reporting exception would be determined.

Subsequent to those meetings, in the process of trying to develop a proposed rule implementing RSFA amendments to FOGRMA section 111 (k)(1)-(4), an issue arose regarding the commingling of oil and gas production from multiple properties upstream of the point of royalty measurement. For purposes of this discussion:

• A “property” is defined as a lease, unit, or communitization agreement.
• A “100-percent Federal unit or communitization agreement” means any unit or communitization agreement that contains only Federal leases having the same fixed royalty rate and funds distribution.
• A “unit” means a unit participating area, enhanced recovery unit, or field-wide unit.
• A “mixed unit or communitization agreement” means any unit or communitization agreement other than a 100-percent Federal unit or communitization agreement. These are unit or communitization agreements that contain any mixture of Federal, Indian, state or private mineral estates, or that contain all Federal leases with different royalty rates (fixed or variable) or different funds distribution.
• A “stand-alone lease” means a lease or a portion of a lease that is not in a unit or communitization agreement.

The RSFA clearly identifies when it is appropriate to initially report and pay on a “takes” or “entitlements” basis for production from leases, units, or communitization agreements that is not commingled with production from other properties before the royalty measurement point. For instance:

• When taking production from a 100-percent Federal unit or communitization agreement, the lessee(s) must pay on actual takes (30 U.S.C. 1721(k)(1)(A)), or
• When taking production from a mixed Federal unit or communitization agreement, the Federal lessee(s) must pay on entitlements (30 U.S.C. 1721(k)(1)(B)), or
• When taking production from a stand-alone Federal lease, the lessee(s) must pay on takes (30 U.S.C. 1721(k)(1)(C)).

It is important to note that, while RSFA section 6(d) amended FOGRMA by adding section 111(k)(1), which addressed the reporting and payment requirements, the addition of section 111(k)(2) went on to clarify that the requirements outlined in section 111(k)(1) “apply only to requirements for reporting and paying royalties. Nothing in this subsection is intended to alter a lessee's liability for royalties on oil or gas production allocated to the lease, in accordance with the terms of the lease, a unit or communitization agreement, or any other agreement.” Thus, the lessee's ultimate liability to pay royalties on its entitled share of production is not changed.

Commingling adds additional complications to the issue of how to report and pay royalties. Commingling is the combining of production from multiple properties before measurement for royalty purposes. Not only do imbalances between operating rights owners within a property occur, but imbalances between properties also are commonplace. The RSFA provisions added to FOGRMA at 30 U.S.C. 1721(k)(1)-(5) do not address the effect of commingling or commingling imbalances. Thus, that issue must be addressed by rulemaking.

Commingling requires approval of the MMS Offshore Minerals Management program for offshore leases or the Bureau of Land Management for onshore leases. The commingling approval identifies where the volume is measured for royalty purposes and how that volume must be allocated to each property that is subject to the commingling approval. It does not affect how volume is allocated to leases within a unit or communitization agreement. Commingling can be, and often is, approved between properties with the same royalty rate and funds distribution and between properties with different royalty rates or different funds distributions.

Commingling complicates reporting requirements because there is an impact on royalty payments when there are properties with mixed royalty rates or funds distribution upstream of the approved commingling point. For example, assume that production from two stand-alone Federal leases that are not unitized or communitized, each with a different royalty rate, is commingled before the royalty measurement point. Assume that each lease receives a 50 percent allocation of the total measured production (1,000 Mcf) under the commingling approval. The lessee of the lease with a 162 /3 percent royalty rate actually sells (takes) 750 Mcf of gas, and the lessee of the lease with the 121/2 percent royalty rate actually sells (takes) 250 Mcf of gas. Based on the commingling approval, the leases are out of balance. The commingling approval determines the volume deemed to have been removed or sold from each lease upon which the lessees ultimately must pay royalty. Should each lessee pay royalties on its actual sales (takes), the Federal Government initially would be paid more than the royalty ultimately owed. If the sales were reversed, the Federal Government initially would be paid on less than the royalty ultimately owed.

The RSFA prescribes how lessees should initially report and pay royalty on production removed or sold from a lease or unit or communitization agreement. The commingling approval determines the volume removed or sold from the leases or unit or communitization agreements subject to the commingling approval. The RSFA was silent on the effect of commingling approvals. We are asking for your input on several questions regarding RSFA's application to production subject to a commingling approval before the royalty measurement point. Those questions include the following:

(1) Should lessees of a lease or a 100-percent Federal unit or communitization agreement report and pay initially on their takes in a situation where production from that lease or unit or communitization agreement is commingled with other production upstream of the royalty measurement point?

(2) RSFA requires that Federal lessees in mixed unit or communitization agreements report royalties on an entitlements basis, regardless of whether the unit or communitization agreement is subject to a commingling approval. When should MMS treat a commingling approval as the equivalent of a unit or communitization agreement and apply the RSFA reporting and payment provisions on that basis? For example, if all properties measured at the commingling point are 100 percent Federal leases or units or communitization agreements with the same fixed royalty rate and funds distribution, then payments could be made on takes. If one or more of the properties measured at or after the commingling point have different royalty rates (fixed or variable), different funds distribution, or are not 100 percent Federal, all lessees would pay on entitlements.

The three examples presented below illustrate some alternative methodologies to apply the (k)(1)-(4) provisions of RSFA to situations where production is commingled before royalty measurement. For each example, assume there is a stand-alone Federal lease with two lessees (lessee A and lessee B, each of whom owns 50 percent of the working interest), a 100-percent Federal unit or communitization agreement with two lessees (with lessee C owning 75 percent of the combined working interest in the two leases, and lessee D owning the remaining 25 percent), and a state lease, all of which are subject to a commingling approval. (For simplicity, assume that all of the Federal leases have the same royalty rate.) Additionally, assume that for each example, the total commingled production allocated to the properties is 100,000 Mcf of gas. Further assume that, for the month shown in the examples, the stand-alone Federal lease and the state lease are each allocated 25 percent of the commingled production under the commingling approval, and that the Federal unit or communitization agreement is allocated 50 percent. Further, assume that lessee A takes and sells 20,000 Mcf of gas. Assume that lessee B has no takes. Assume that lessee C takes and sells 30,000 Mcf of gas while lessee D takes and sells 23,000 Mcf of gas. Assume that the lessee of the state lease takes and sells 27,000 Mcf of gas. In each example, lessee ownership percentages and liability remain the same, but the volume on which royalty initially must be paid varies, depending on the methodology used. (The numbers used in the following examples are rounded to the nearest whole number.)

By using a pure takes methodology, the volume deemed sold and removed from each lease and the unit or communitization agreement as determined under the commingling approval is not properly accounted for. Under this methodology, MMS could be paid on a volume either greater than or less than that on which the lessees ultimately owe royalty because the takes on which the Federal lessees reported and paid royalty would not always equal the volume on which royalty is due under the commingling approval. In this example, the MMS would be paid royalty on 2,000 Mcf less than the volume on which the Federal lessees ultimately owe royalty because, under the commingling approval, the Federal lessees owe royalty on 75,000 Mcf and, on a pure takes basis, the Federal lessees paid only on 73,000 Mcf. Therefore, adopting this methodology presumably would require each royalty reporter to adjust royalty payments (at least on an annual basis) to its entitled volume (equal to its ownership percentage times the volume allocated to its lease or unit or communitization agreement under the commingling approval).

Reporting on a “pure entitlements” basis ensures that the Federal Government is made whole with respect to royalties but would not allow for initial reporting and payment based on takes if production is commingled before the royalty measurement point. Under this methodology, MMS would be made whole each month because lessees would report and pay on their entitled volume each month, even if a particular lessee (lessee B in this example) took no production. Therefore, an adjustment to the entitled volume, as discussed above for Example 1, would not be necessary.

This methodology would combine takes and entitlements by requiring lessees to report and pay on volumes equal to the sales by the lessee divided by the total sales for the property times the allocated volume under the commingling approval for the property. Consider lessees C and D: In this example, lessee C would report and pay on 28,302 Mcf, even though it actually took 30,000 Mcf, and its entitled volume is 37,500 Mcf. The 28,302 Mcf is computed as follows:

(30,000 Mcf/53,000 Mcf) × 50,000 Mcf = 28,302 Mcf for lessee C, where 53,000 Mcf (total sales for the property) is the sum of 30,000 Mcf (lessee C's total sales) and 23,000 Mcf (lessee D's total sales), and 50,000 Mcf is the allocated volume under the commingling approval for the property. Lessee D's initial reporting and payment would be computed similarly.

Considering lessees A and B: If a lessee took no production (lessee B in this example), it would not have to pay any royalty. However, a lessee (lessee A in this example) could pay royalty on a volume greater than either its actual takes or its entitled share. Under this methodology, MMS would be made whole each month because it would receive royalty based on the total Federal production subject to the commingling approval each month. Therefore, an adjustment to the entitled volume, as discussed above for Example 1, would not be necessary. In Example 3, lessees would have to adjust their payments among themselves.

As explained above, in instances where a lessee pays on “Pure Entitlements” such as Example 2, or “Proportionate Takes” such as Example 3, the lessee may take production that is more or less than its entitled share. In that case, a lessee would need to value its entitled share. The MMS believes that the best means of valuing the entitled share is to apply a volume weighted average of the royalty values to the volumes actually taken to the entitled share volumes undertaken. The MMS requests comments on any other alternatives for valuing such volumes.

In addition, MMS is interested in receiving comments on these three examples describing alternative methodologies. The MMS is also interested in receiving comments on any other alternative methodologies. If you propose a methodology different from those discussed above, please use our example criteria and explain why you believe your methodology is the best alternative. In addition, MMS would like your input on how the various methodologies would affect your business practices, bookkeeping, etc.