[Federal Register Volume 64, Number 133 (Tuesday, July 13, 1999)]
[Notices]
[Pages 37809-37812]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-17788]


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DEPARTMENT OF THE INTERIOR

Minerals Management Service


Federal Oil and Gas Royalty-in-Kind Pilot Programs

AGENCY: Minerals Management Service, Interior.

ACTION: Notice of intent.

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SUMMARY: This is to give notice that the Minerals Management Service 
(MMS) intends to adhere to certain practices in exercising the options 
available to the Secretary of the Interior to take the government's 
royalty share of production in kind from Federal oil and gas leases. In 
particular, we would like to set forth the background and a general 
outline of how we are proceeding and what is expected of lessees and 
operators in connection with MMS's royalty-in-kind (RIK) projects. The 
purpose of these projects is to test the feasibility and examine the 
revenue effects of different ways of taking and disposing of RIK 
production. We welcome any comments you may have on the information 
provided in this Notice.

DATES: Comments must be submitted on or before September 13, 1999.

ADDRESSES: If you wish to comment, you may submit your comments by any 
one of several methods. You may mail comments to Bonn Macy, Special 
Assistant to the Director, Minerals Management Service, 1849 C Street, 
NW, MS 4230, Washington, DC 20225. You may also comment via the 
Internet (E-mail) to Bonn.M[email protected]. Please submit Internet comments 
as a WordPerfect 6.0 or an MS Word 97 document (earlier versions of 
these formats are acceptable) avoiding the use of special characters 
and any form of encryption. Please also include your name and return 
address and phone number in your Internet message. If you do not 
receive a confirmation from the system that we have received your 
Internet message, contact Bonn Macy directly at (202) 208-3827.

FOR FURTHER INFORMATION CONTACT: Mr. Bonn J. Macy, Minerals Management 
Service, 1849 C Street, NW, MS 4230, Washington, D.C. 20240-0001; 
telephone number (202) 208-3827; fax (202) 208-3918; e-mail 
Bonn.M[email protected].

COMMENTS: Written comments on this notice should be addressed to Mr. 
Bonn J. Macy at the address given in the Addresses section of the 
notice.

SUPPLEMENTARY INFORMATION: The contents of this Notice will be 
discussed at a Public meeting held on July 20, 1999, in Houston, Texas. 
Please refer to the Federal Register Notice published July 1, 1999, for 
further information. We will post public comments after the comment 
period closes on the Internet at http://www.rmp.mms.gov. You may 
arrange to view paper copies of the comments by contacting Bonn Macy, 
Special Assistant to the Director, Minerals Management Service, (202) 
208-3827, FAX (202) 208-3918.

Background

    The Department of the Interior has managed mineral leasing on 
Federal lands since the Mineral Leasing Act was passed in 1920 (30 
U.S.C. 181, et seq. (1994) (MLA). Under the terms of standard Federal 
oil and gas leases, the government is entitled to a share (royalty) of 
production removed or sold from the lease. The terms ``in value'' and 
``in kind'' refer to the manner in which a mineral owner (lessor) 
receives the royalty share from the producer (lessee). Like most other 
royalty owners, the U.S. Government has, for the most part, 
historically received its royalty share ``in value,'' that is, in cash 
as a percentage of the sales proceeds received by the lessee.
    For most onshore Federal leases, the MLA provides in relevant part 
at 30 U.S.C. 192 that all royalty accruing to the United States under 
any oil or gas lease or permit under this chapter on demand of the 
Secretary of the Interior shall be paid in oil or gas.
    For most offshore leases, the Outer Continental Shelf Lands Act, as 
amended (OCSLA) provides in relevant part at 43 U.S.C. 1353(a)(1) 
(1994) that, with some minor exceptions, all royalties or net profit 
shares, or both, accruing to the United States under any oil and gas 
lease issued or maintained in accordance with this subchapter, shall, 
on demand of the Secretary, be paid in oil or gas.
    Section 2 of a typical onshore Federal lease form provides in part 
that ``Lessor reserves the right to specify whether royalty is to be 
paid in value or in kind.'' (October 1992, Form BLM-3100-11). By 
section 6 of the offshore lease form, the lessor reserves ``the right 
to

[[Page 37810]]

determine whether royalty will be taken in the amount or the value of 
production.'' (February 1971, Form MMS-2005, and subsequent versions).
    Over the years, the Secretary's authority to take RIK has rarely 
been used. One exception has been the ongoing RIK program that MMS 
currently operates for certain ``eligible refiners'' as authorized by 
specific provisions of the MLA at 30 U.S.C. 192 (1994) and the OCSLA at 
43 U.S.C. 1353(b)(2) (1994). Also, during Calendar Year 1995, MMS 
operated a voluntary RIK pilot in which we took and sold by competitive 
bid at the lease approximately 45.6 billion cubic feet of natural gas 
from 14 lessees covering 79 leases in the Gulf of Mexico. This initial 
pilot provided valuable experience with the operational aspects of 
working with producers and marketers, as well as useful information on 
the revenue implications of taking gas in kind.
    As a general matter, the collection of royalties in cash as a 
percentage of the value of production has worked well in most cases. 
However, as will be discussed below, there are a number of reasons that 
make it worthwhile now to examine whether the government should receive 
at least some of its royalties ``in kind'' by taking physical volumes 
of oil or gas for sale to the public or for transfer to other Federal 
agencies.
    First, dramatic changes in the energy industry have been occurring 
over the past 10 to 15 years that may present opportunities for MMS to 
provide greater certainty and simplify its royalty management programs. 
Rapidly changing market structures over this period have resulted in 
product price volatilities and the expansion of active trading in 
markets across the country with the corresponding development of 
representative spot prices.
    Traditional long-term contracts between producers and pipeline and 
refiner purchasers have been increasingly replaced by short-term 
trading by new market participants, such as brokers and resellers. 
Further, many sellers now regularly use futures markets for risk 
management and obtain real-time market information directly using 
personal computers and telecommunications links.
    For natural gas, these structural changes have been facilitated by 
the Federal Energy Regulatory Commission's deregulation of the natural 
gas transportation industry and the evolving deregulation of retail 
natural gas and electricity markets.
    The challenges presented by these evolving market structures, the 
``unbundling'' of gas transportation services, and changing business 
practices overall present unique opportunities for us to reexamine the 
way we manage the revenues earned from the public's oil and gas assets.
    Members of Congress, representatives from industry, the public, and 
State and other Federal agencies have urged MMS over the last few years 
to consider the potential advantages that might be achieved by taking 
Federal oil and gas royalties in kind. Over this time, MMS's own 
examination of RIK suggests that these potential benefits may exist in 
select cases where conditions favorable to RIK exist.
    MMS's stakeholders have focused on a number of possible benefits. 
As an alternative to the royalty system based on the percent of 
proceeds, a successfully targeted RIK program might provide improved 
certainty, administrative efficiencies, and other cost savings. 
Fulfillment of the royalty obligation by the delivery of physical 
volumes of oil or gas could decrease the need for extensive reporting, 
verification, and auditing of lessee sales proceeds. This could benefit 
industry as well as government and the public. A second possible 
benefit is that, in select circumstances, taking product in kind and 
selling to the market directly might yield more revenues for the public 
than taking a percentage of a given lessee's sale price. In other 
cases, we might be able to take RIK and transfer it for direct 
consumption in other Federal agencies and realize real savings in 
Federal energy costs.
    In response to these possibilities and the interest in them, MMS 
has structured several pilot projects to demonstrate whether taking 
royalties in kind can actually deliver the potential benefits to the 
taxpayer. The agency has solicited participation from affected States 
and consulted with industry in their development.
    Currently, we have an oil RIK program operating in conjunction with 
the State of Wyoming involving 3400 bbls. of royalty crude oil per day, 
and a small pilot underway with the State of Texas General Land Office 
(GLO). The GLO program uses production from natural gas leases in the 
8(g) zone off the coast of Texas in the Gulf of Mexico. A natural gas 
pilot in the Federal waters of the Gulf of Mexico will begin in October 
1999 and could involve as much as 800 million cubic feet of gas per day 
over a 3-to 4-year period. Through the experience gained by these pilot 
projects, we hope to acquire a better understanding of the key factors 
that determine RIK success.
    For example, the pilots could demonstrate that the RIK option works 
best where leases have certain production characteristics, and where 
regional markets or transportation arrangements are particularly suited 
to RIK, as well as demonstrate which methods used to market the RIK 
production provide the greatest benefit. Depending on the logistics and 
efficiencies involved, certain production may be more attractive if 
consumed directly by the government.
    Hands-on experience with these pilot projects should give us a good 
basis for determining whether or not RIK is viable for the Federal 
Government, and, if so, how, when, and where it makes sense to exercise 
the Secretary's RIK option.
    The authorizing provisions of the MLA and the OCSLA and the 
relevant lease provisions effectively give the Secretary complete 
discretion to elect to take the royalty share of production from an oil 
and gas lease in kind.
    Both the MLA and the OCSLA provide that RIK production so taken may 
either be sold to the public (including to eligible refiners) under 
certain prescribed terms or be retained or transferred to agencies of 
the Federal Government.
    Public sales of onshore RIK production must be made by an offer for 
sale ``upon notice and advertisement on sealed bids or at public 
auction'' (30 U.S.C. 192 (1998)) and offshore RIK production must be 
sold ``by competitive bidding for * * * not less than its fair market 
value.''(43 U.S.C. 1353 (b)(1) and (b)(2) (1998)).

Public Auctions and Competitive Bidding

    One objective of the pilots is to evaluate the relative merits of 
different bidding methods so we can identify the most effective and 
appropriate ways for the government to secure a competitive market 
price for our public assets, as we are required to do by law. In 
offering RIK production for sale to the public, we intend to consider 
using any bidding procedure or format that brings us the best return in 
open and competitive sales.
    To assure conformity with the statutory terms ``public auction'' 
and ``competitive bidding,'' we would require a bidding format that 
affords equal access for all qualified potential purchasers and leads 
to sales made in response to the highest or best bid.
    In most cases, we intend to announce the availability of royalty 
production for sale by advertisement of a ``notice of availability.'' 
Over the past several years, MMS has found that use of its Internet 
Home Page is an effective means to rapidly disseminate

[[Page 37811]]

information to the oil and gas industry and to the public at large. We 
continue to use this communication method as well as placing public 
notices in industry trade journals, on commercial electronic bulletin 
boards, and other media. In certain cases, especially for sales of 
natural gas, MMS may invite companies to apply for prequalification as 
a potential purchaser. Subsequent notices of availability would be sent 
to prequalified companies.
    A notice of availability will identify the production to be made 
available to the public, the general terms and procedures for any sale, 
and will include bidder qualification information to determine who may 
bid in a given sale. Ordinarily, any person would be permitted to bid 
who is eligible under the terms and conditions specific to the 
particular bid offering at hand. In this regard, we expect that each 
notice of availability or solicitation to prequalify as a potential 
purchaser will prescribe certain minimum financial qualifications for 
participation in the bidding, and indicate the procedure for 
prequalifying as a buyer before any sale. Potential buyers may 
prequalify at any time, but must be prequalified in order to bid for 
RIK production.

Lessee/Operator Responsibilities

    In any situation involving the taking of RIK production, the 
managing operator of the property will be an active participant in the 
transaction.
    Essentially, the lessee or operator is required to satisfy its 
royalty obligation by delivery of a volume of ``royalty production''--
that is, the royalty share to which the Federal Government is entitled 
to take as a royalty--in the form of physical volumes. The amount of 
royalty oil, gas, or other products that MMS takes in kind in partial 
or full satisfaction of a lessee's royalty or net profit share 
obligations will be determined by whatever lease interest the lessee 
holds under an applicable mineral leasing law. Generally, royalty 
production equals that portion of production from or allocated to a 
Federal lease multiplied by that lease's royalty rate.
    When we decide to take RIK from a property, we will give the lessee 
and operator adequate advance notice sufficient to minimize disruption 
to the operator's planning for transportation and sales of its share of 
the production stream. This will generally mean a 30-day prior written 
notice before we would begin taking or stop taking RIK production from 
a property.
    Unless further experience dictates otherwise, it is our present 
intention that where we decide to take a lease's royalty production in 
kind, we will take all such royalty production from the lease in kind 
until we give notice to the contrary.
    In the pilots operated to date, we have set out the terms under 
which we expect to conduct specific RIK transactions in a ``Dear 
Operator Letter'' to all affected parties. The ``Dear Operator Letter'' 
generally prescribes terms of delivery, methods for resolving 
imbalances, and lessee reporting and communication requirements. This 
approach, together with public meetings held in advance of particular 
sales and close coordination with operators, has worked well by 
anticipating and resolving specific problems.
    A primary responsibility of the operator will be to deliver the 
royalty production to MMS in ``marketable condition'' as is currently 
required by the lease and regulations for payment of royalties in 
value. Accordingly, royalty production delivered by an operator must be 
in a condition that would be accepted by a purchaser under a sales 
contract typical for the field or area. This has long been considered 
an obligation imposed by the terms of Federal leases and is reflected 
in the royalty value regulations at 30 CFR Part 206, including the 
definition of ``marketable condition'' set forth at 30 CFR 206.151. It 
will continue to be the lessee's obligation to perform and bear all 
costs of gathering, dehydration, separation, compression, sweetening, 
or other processes that MMS will require in connection with the 
delivery of RIK production.
    It is also expected that the operator will deliver royalty 
production to the lessor at the same frequency that it is produced and 
moved through the royalty meter, without interruption, unless 
specifically approved by MMS.
    In general, natural gas taken in kind must be delivered on a daily 
basis, unless other arrangements are approved by MMS. This is 
consistent with industry practice so that purchasers are able to make 
necessary transportation and other arrangements. Approval for less than 
daily delivery of natural gas may be provided on a case-by-case basis. 
We do recognize that in some cases, it may be necessary to delay 
delivery of crude oil for as long as a month to permit aggregation of 
saleable quantities of production from lower-producing properties.
    Operators are also expected to use the same measurement and 
reporting standards applicable to the payment and reporting of 
royalties in value as prescribed in the existing regulations at 30 CFR 
202 for RIK oil and gas.
    It is also expected that lessees, operators, or others dealing in 
royalty production would retain all related records for a period of 7 
years after the records are generated unless MMS notifies the record 
holder that a longer retention period is required. That is the same 
period currently applicable to lessees paying royalties as a percentage 
of value under 30 U.S.C. 1724(f).

Offshore Fair Market Value

    The RIK provisions of the OCSLA direct that the public sale of 
offshore RIK production must be made for not less than its ``fair 
market value.''
    As a generic term, ``fair market value'' is generally considered by 
economists to be the price received by a willing and knowledgeable 
seller not obligated to sell from a willing and knowledgeable buyer not 
obligated to buy. For offshore RIK sales, however, the OCSLA prescribes 
a very specific definition of that term. Section 1331(o) of 43 U.S.C. 
(1994) defines ``fair market value'' for purposes of RIK sales to be 
essentially the average unit price received for production from the 
same lease or, in some circumstances, from leases sold in the same 
region during the period.
    The 43 U.S.C. 1331(o) (1994) definition states that the term ``fair 
market value'' means the value of any mineral (1) computed at a unit 
price equivalent to the average unit price at which such mineral was 
sold pursuant to a lease during the period for which any royalty or net 
profit share is accrued or reserved to the United States pursuant to 
such lease, or (2) if there were no such sales, or if the Secretary 
finds that there were an insufficient number of such sales to equitably 
determine such value, computed at the average unit price at which such 
mineral was sold pursuant to other leases in the same region of the 
Outer Continental Shelf during such period, or (3) if there were no 
sales of such mineral from such region during such period, or if the 
Secretary finds that there are an insufficient number of such sales to 
equitably determine such value, at an appropriate price determined by 
the Secretary.
    Under this statutory definition, the first applicable paragraph (1) 
of the provision seems to require that offshore RIK production taken by 
the Secretary must be sold for at least as much as the average unit 
price for which the lessee sold the nonroyalty share of production from 
that lease.
    In cases where there were no other sales from the same lease or 
where the Secretary finds that there were an insufficient number of 
such sales to equitably determine such a value, the

[[Page 37812]]

fair market value floor may be computed under the next paragraph, 
paragraph (2). That paragraph provides that fair market value may be 
computed with reference to average unit prices in sales from ``other 
leases in the same region.'' Finally if a value cannot be equitably 
determined under paragraphs (1) or (2), an appropriate price may be 
determined by the Secretary. In operating the RIK pilot projects that 
involve public sales of offshore production, we intend to comply with 
the OCSLA requirement not to sell RIK production for less than its fair 
market value as defined by that statute. However, we anticipate that 
there may well be instances in which it may be impractical or otherwise 
inequitable to determine actual average prices from a lease or region 
during the same period in which an RIK sale is to be made. Strict 
conformance with paragraph (1) of the definition would require knowing 
at the time of the RIK sale what the lessees' actual concurrent sales 
prices were for the nonroyalty share of production from the lease. 
Applying paragraph (2) of the definition would also require 
instantaneous knowledge of the sales prices of other lessees in the 
region.
    In theory, we could require that all RIK purchase prices be subject 
to post-sale adjustments when the lease price information becomes 
available to MMS. In our view, this would be excessively burdensome to 
all concerned and would effectively discourage, if not eliminate, 
participation in RIK sales. If bidders did participate, they would 
necessarily bid a lower price for the royalty production than they 
would otherwise because of the risk of post-sale adjustment, 
particularly if this adjustment could be made well after the actual 
sale. It is clear that such a process would not only be inequitable to 
potential purchasers, but could not effectively capture a fair market 
value as that term is intended and conventionally understood.
    In those instances where it is not possible, practical, or 
equitable to determine--contemporaneous with an RIK sale--average 
prices from a lease or the region, we believe we can reliably estimate 
these values very closely. These close estimates would allow us to 
proceed under paragraph (3) of the OCSLA ``fair market value'' 
definition to ``determine such value, at an appropriate price 
determined by the Secretary'' in a way that assures consistency with 
the intent not to sell RIK production for less than the price obtained 
by the lessee for its share.
    In preparation for each sale of royalty oil or gas from identified 
Federal leases, MMS would develop a reference price for each specific 
lease that is consistent with the OCSLA ``fair market value'' 
requirement. To establish this reference price, MMS would analyze the 
pricing relationships for sales in the area and/or market centers 
appropriate for sales of production from those leases. One source of 
data for the analysis would be actual historical prices for royalty 
purposes for the identified leases, or if none are available, from 
leases in the same area. Other data used in the analysis could include 
published index prices and bids MMS may have received on other 
offerings of its royalty oil or gas from that area, as well as the many 
other factors that could influence the determination of fair market 
value. These might include: responses to other sales of similar Federal 
royalty production, seasonality, infrastructural changes (temporary and 
permanent), and other variable market conditions.
    Our analysis of pricing relationships in the market would produce 
an estimate of the price the lessee will receive. This would form the 
basis for the lease's reference price. During a sale, this lease 
reference price would serve as our reserve price, below which bids to 
purchase RIK production from the lease would be considered inadequate.
    To verify that the pricing relationship between lessees' sales 
prices and the market continues, MMS will require occasional reporting 
by lessees of sales prices on leases from which MMS is taking 
production in kind. These reported prices would only be used for 
information and analytical purposes, are necessary to assure that we 
continue to receive fair market value for RIK sales, and will not be 
available for any other use.

Transfer of RIK Oil and Gas to Other Federal Agencies

    As authorized by statute, we also plan to transfer royalty 
production taken in kind to other Federal agencies for direct 
consumption by the government. The Federal Government's energy 
requirements are large and are in excess of its royalty share of oil 
and gas production.
    While geography and logistics prevent efficient implementation in 
all locations where oil and gas are consumed, there are enormous 
opportunities to build energy supply relationships within the Federal 
Government. These internal supply relationships have the potential to 
generate significant synergies and lower the total cost of energy 
consumed by the Federal Government.
    For onshore, the MLA provides in 30 U.S.C. 192 that the Secretary 
may offer RIK for sale ``except whenever in his judgment it is 
desirable to retain the same for the use of the United States * * *'' 
The OCSLA provides specific authority to the Secretary at 43 U.S.C. 
1353(a)(3) to transfer RIK production to other Federal agencies, 
stating that, title to any royalty, net profit share, or purchased oil 
or gas may be transferred, upon request, by the Secretary to the 
Secretary of Defense, to the Administrator of the General Services 
Administration, or to the Secretary of Energy, for disposal within the 
Federal Government.
    We have already developed and implemented innovative arrangements 
involving the transfer of RIK crude oil to the Department of Energy for 
the Strategic Petroleum Reserve and transfer of natural gas to the 
General Services Administration (GSA) for use in Federal facilities. We 
plan to further explore the potential associated with direct, internal 
consumption of royalty oil and gas production taken in kind, and expand 
our relationship with GSA and other Federal agencies as appropriate.
    The general principles set forth here are intended to allow 
flexible operation of RIK programs to adapt the technique efficiently 
to the wide range of conditions that exist in Federal oil and gas 
producing areas. MMS firmly believes our approach is market-responsive, 
consistent with best industry practices, economically and 
administratively efficient, and minimally disruptive to lessees and 
operators. We welcome comments from the public on any and all aspects 
of this notice.

    Dated: July 8, 1999.
Walter D. Cruickshank,
Associate Director for Policy and Management Improvement.
[FR Doc. 99-17788 Filed 7-12-99; 8:45 am]
BILLING CODE 4310-MR-P