POTENTIAL FEDERAL ROYALTY UNBUNDLING REFUNDS INSTITUTE FOR ENERGY LAW 68 TH ANNUAL OIL & GAS LAW CONFERENCE Houston, Texas February 16, 2017 Tim Engel, Esq. King & Spalding LLP NEED FOR UNBUNDLING OF COSTS A problem has long existed for federal royalty payors (particularly for gas production) where third-party invoices for transportation and processing services include both deductible costs and nondeductible costs required to put production in marketable condition. For competitive reasons, third-party service providers refuse to reveal cost information to customers. 2 1
ONRR UNBUNDLING COST ALLOCATIONS Royalty payors must either estimate costs or rely on ONRR Unbundling Cost Allocations (UCAs). Beginning in 2010, ONRR has published percentages of non-deductible and deductible charges based on audits of third-party service providers. The UCAs thus purport to determine what portion of costs are related to putting gas in marketable condition. A number of federal lease gas producers rely on ONRR s UCAs, or have received orders to pay that (subject to further audit) can be satisfied using UCAs. 3 OPEN LEGAL ISSUES IN UCAs ONRR used several legal assumptions in the UCAs that many in industry disagree with, particularly where gas is processed in a cryogenic plant. Courts have not directly addressed these legal issues. These fundamental legal interpretations applied by ONRR include: First, ONRR asserts that plant tailgate boosting costs are never deductible, even when gas has already been placed in marketable condition at no cost to the government (and even when certain reflux compression adds more NGLs); 4 2
OPEN LEGAL ISSUES IN UCAs (cont.) Second, ONRR asserts that even if boosting costs are not deducted, gas must be placed in marketable condition first, before any supplemental transportation or processing deductions are allowable; and Third, ONRR applied a math error in calculating compression costs. Even after gas is put in marketable condition first, costs of any allowable supplemental compression (excluding boosting) are measured by the ratio of (i) the amount of compression added by a particular unit that exceeds pressure needed for marketable condition, to (ii) the total pressure in the system up to that point (as distinguished from the total pressure added by the particular unit). 5 SIX-YEAR STATUTE OF LIMITATIONS ON REFUNDS If a court were to agree with industry on any of the disputed issues, then companies that have paid royalties using the UCAs might be entitled to significant refunds. A six-year statute of limitations period based on any request for a refund of royalties is approaching for certain royalty payments under the UCAs (or estimates using ONRR guidance). Companies might want to think about ways to protect potential refunds from expiring if courts were eventually to decide in industry s favor. 6 3
ONRR s BOOSTING POSITION ONRR takes the position in its UCAs that costs of plant tailgate compression (or boosting ) are never deductible from royalties, even when gas is already in marketable condition at the start of the cryogenic process. In ONRR s view, even if a lessee were to bear all of the costs of placing gas in marketable condition prior to processing, the lessee must do so again at the plant tailgate at no cost to the government. 7 VALUATION REGULATIONS ALLOW DEDUCTIONS FOR BOOSTING ONRR s position is based on 30 C.F.R. 1202.151(b), which provides: A reasonable amount of residue gas shall be allowed royalty free for operation of the processing plant, but no allowance shall be made for boosting residue gas or other expenses incidental to marketing, except as provided in 30 CFR part 1206. But the argument that boosting costs are never deductible renders the phrase except as provided in 30 CFR part 1206 entirely superfluous. 8 4
VALUATION REGULATIONS ALLOW DEDUCTIONS FOR BOOSTING (cont d) Part 1206 states that a lessee must place gas in marketable condition at no cost to the government, but may otherwise deduct the reasonable actual costs of processing. 30 C.F.R. 1206.159(a). Part 1206 further states that a lessee may deduct supplemental costs for compression that exceed the services necessary to place production into marketable condition. 30 C.F.R. 1206.157(f)(9) 9 BOOSTING IS PART OF THE REASONABLE ACTUAL COSTS OF PROCESSING In a cryogenic plant, gas must begin the process at a very high pressure, usually added by a plant inlet compressor. The cryogenic process then requires a major drop in gas pressure to create the extremely cold temperatures (approximately -145 F) necessary to recover NGLs. Frozen liquids are separated from the decompressed gas. 10 5
BOOSTING IS PART OF THE REASONABLE ACTUAL COSTS OF PROCESSING (cont d) The plant tailgate boosting compressor then raises the pressure back to approximately the same pressure that began the process. In a cryogenic plant, without the recompressor, gas could not flow through the plant, a pressure drop could not occur, temperature reduction could not occur, and NGLs could not be recovered. Indeed, NGL processing is initiated by starting the recompressor, which causes the gas to flow through the plant and the pressure to drop downstream of an expander. 11 UNBUNDLING MODEL Compression Added 300 psig + 375 psig + 200 psig + 400 psig = 1,275 psig 12 6
13 ONRR UNBUNDLING INFORMATION 14 7
THE DEVON DECISION ONRR argues that a footnote in the Assistant Secretary's Valuation Determination in Devon Energy Corp. (which involved coalbed methane production and which was affirmed by the D.C. Circuit in 2008) stands for the proposition that the boosting provision at 1202.151(b) creates an exception to the general rule that a lessee need only place gas in marketable condition once at no cost to the government. 15 BUT THAT IS NOT WHAT THE DEVON COURT HELD First, the Devon footnote did not state there was an exception; it stated only that [i]t may be argued that 1202.151(b) creates an exception in some circumstances. Second, the footnote was purely dicta, because the boosting issue was in no way relevant to the Devon decision. Devon involved coalbed methane, which is not processed. No processing plant, and no boosting, were involved. Third, because boosting was not relevant, the footnote ONRR relies upon was never considered by the D.C. Circuit on appeal. And, of course, finally, the statement in the footnote that an exception arguably exists in some circumstances is inconsistent with ONRR s assertion that boosting costs are never deductible. 16 8
REFLUX COMPRESSION 17 REFLUX COMPRESSION 18 9
REFLUX COMPRESSION Supplemental compression used to extract additional NGLs that exceeds compression services necessary to place the residue gas into marketable condition, should be deductible. Even if one were to accept that the Devon decision always prohibits boosting cost deductions, it s hard to justify disallowing costs for reflux compression. 19 CODE OF FEDERAL REGULATIONS ONRR s Revised Oil & Gas Valuation Rule 1206.153(c)(8) Transportation - Other nonallowable costs. Any cost you or your affiliate incur(s) for services you are required to provide at no cost to the lessor, including but not limited to, costs to place your gas, residue gas, or gas plant products into marketable condition disallowed under [1206.146] and costs of boosting residue gas disallowed under 30 CFR 1202.151.(b). 20 10
p y Deductions for Compression Before Gas Was in Marketable Condition 25 For gas produced from the Kitty and Rough Draw Fields (excluding the portion delivered to WBI at Landeck), part of the MTG Booster s compression accounts for the difference in pressure between the outlet of the reciprocating compressors (550-800 psi) and the inlet of the Buckshot Plant (800 psi). Under this approach, therefore, that part of the MTG Booster s compression is one phase of bringing that gas into marketable condition. But it is not practical (and may not be possible) to attempt to allocate the costs of compression at the MTG Booster between that phase of conditioning and the transportation function to which the majority of the costs of compression at the MTG Booster is attributable under this approach. Allowing all of the costs of the MTG Booster gives Devon a slightly greater transportation function than that to which it is technically entitled, but reaches the most practical and fairest result in view of the apparent lack of any practical method to allocate costs of compression at the MTG Booster. 21 THE MATH ERROR Assume gas would be in marketable condition at 700 psig. Assume gas enters a compressor at 400 psig and exits at 800 psig, or 100 psig more than needed. The cost of the additional 100 psig should be 100/400 or 25% of the cost of the relevant compressor. But ONRR calculates the cost at 100/800 or 12.5% of the cost of this compressor. ONRR erroneously uses the total discharge pressure in its denominator. 22 11