MMS Report on Oil Valuation Rulemaking

House Report 105-337 on the Department of the Interior and Related Agencies Appropriations, 1998, requests a report from the Minerals Management Service (MMS) prior to finalizing its oil valuation regulation on its efforts to consult with industry and States concerning the rulemaking. The language of the Report is quoted below:

"The managers are aware that the MMS has received numerous expressions of concern about the proposed new regulations on oil valuation including concerns about the proposed changes in the long standing practice of valuation of hydrocarbon production at the lease where it is brought to the surface; the impact of transportation, administrative costs and other risks if valuation of hydrocarbon production is conducted away from the lease site; and the application of any new regulations retroactively. The managers expect the MMS to continue to consult with industry and the States and to report back to the Committees prior to finalizing this regulation. The managers also intend to explore the possibility of an independent evaluation by the General Accounting Office on this issue and on the issue of royalty in kind." (page 70.)

In House Report 105-504, concerning supplemental appropriations for Fiscal Year 1998, additional information was requested on the rulemaking process in light of the moratorium placed on issuing final regulations:

"The managers have included language placing a moratorium on the issuance of final regulations by the Minerals Management Service on the valuation of crude oil for royalty purposes. This moratorium will remain in effect until October 1, 1998. The managers expect the Service to report to the House and Senate Committees on Appropriations as soon as possible on the proposed regulations, including a description of the comments the Service has received and how those comments have been addressed." (page 70.)

Since December 1995, the MMS has requested public comment on valuing oil produced from Federal leases in five separate Federal Register notices and has held 14 public meetings or workshops in five States and the District of Columbia to get feedback on this issue. In addition, MMS has hired five consultants and talked to numerous other experts in the industry to obtain advice on this matter and has worked closely with the States of Louisiana, Wyoming, New Mexico, Colorado, California, and Montana. The MMS has also briefed Committee staff on this rulemaking numerous times over the past two years. The intent of this rulemaking effort is to reduce reliance on posted prices for royalty valuation, reflect true market value, provide certainty to all involved, and provide maximum flexibility to adapt to changing market conditions.

The current MMS oil valuation rules issued in 1988 rely fairly heavily on posted prices as the royalty valuation basis, especially in non-arm's-length situations. Posted prices are published offers, but not obligations, to purchase crude oil. Over time the validity of posted prices as an indicator of oil market value has come into question. MMS believes that postings substantially understate market value, based on:

The current oil valuation regulations need modification to address the changes in the crude oil market since their publication in 1988, including the following:

A revised rulemaking would clarify the value of crude oil in these non-arm's-length situations. It will base these royalties on a price that is known to all market participants. Such a revision would provide certainty to payors so that they will be able to pay royalties right the first time; alleviate future litigation on crude valuation; simplify reporting requirements; and reduce resources spent auditing.

In December 1995, MMS began the process of revising the 1988 Federal oil valuation regulations by publishing an Advanced Notice of Proposed Rulemaking in the Federal Register. The notice asked whether MMS's regulations needed to move away from reliance on posted prices. It also requested ideas on alternative valuation methods. Finally, the notice asked for comments on how the rulemaking process should be conducted such as a negotiated rulemaking.

In general, States commented that postings no longer reflect market value and that some form of index pricing would be appropriate. State commenters also recommended that MMS move quickly to publish an interim final rule based on index pricing.

Industry generally supported retention of posted prices for valuing oil not sold arm's length, and declined to participate in a negotiated rulemaking process because of their involvement in ongoing litigation over similar issues. Given that this litigation could take years to resolve, MMS decided to proceed with the rulemaking process.

The MMS then formed a team to develop the concepts for the revised rule. The team included various MMS representatives and individual members representing the States, Indian interests, and the Western States Land Commissioners. MMS invited industry to participate by contacting industry trade associations and individual companies, but these groups declined to participate.

The team consulted with a number of crude oil marketing experts to get a better understanding of crude oil markets and marketing. These experts included crude oil brokers, refiners, commercial price reporting services, companies that market oil directly, producer marketers, and private consultants knowledgeable in crude oil marketing.

Studies by the team and the experts it consulted concluded that the 1988 oil valuation regulations needed to be revised, largely because of their dependence on posted prices as value indicators. They found that postings are no longer generally accepted as market value by industry, as evidenced by the large number of premiums over posted prices found in arm's-length-sales contracts. (Audits have revealed that premiums typically ranging from $0.25 per barrel to $2.00 per barrel above posted prices.) These studies also indicated that integrated oil companies rarely sell crude oil at the lease. Instead, they rely on various exchange arrangements, which do not always reference a price, to transfer oil to refineries. Even where exchange agreements reference a price, the team found that the transaction's purpose is to exchange oil for oil rather than money for oil; therefore, the price stated is not necessarily reflective of actual market value.

The MMS received advice from its consultants and various price reporting services that index prices, with adjustments for location and quality, are the best measures of value for Federal oil not sold in true arm's-length transactions. These experts agreed that the use of index pricing has several advantages over the current regulations for valuing such oil:

The result will be assurance to the public that it is receiving the market price for Federal oil not sold under arm's-length conditions.

Based on the findings of MMS' oil valuation studies, on January 24, 1997, MMS published a proposed rule for prospectively valuing crude oil production from Federal leases.

In summary, the rule proposed that value would be based on the gross proceeds received under the lessee's arm's-length contract with three new exceptions not contained in the current regulations:

For non-arm's-length sales, including the three conditions above, the rule proposed that value would generally be based on index pricing (Alaska North Slope (ANS) spot prices for California and Alaska and NYMEX prices for other areas of the country), adjusted for location, quality, and transportation. If the lessee sold oil to its affiliate and the affiliate resold the oil at arm's-length, the lessee would have the option to use the affiliate's arm's-length resale price or index for value. If that affiliate refined the oil instead of reselling it, value would be based on index. The rule introduced a new reporting form that MMS would use to help the lessee compute its location/quality adjustment.

MMS held public meetings in Denver, CO and Houston, TX in April 1997 to obtain public input on the proposed rule. There was a large turnout for these meetings -- 70 people attended in Denver, of whom 19 spoke; and 108 attended in Houston, of whom 20 spoke. Both of these meetings lasted at least four hours.

At industry's request, MMS twice extended the comment period for the January 1997 proposed rule to provide ample opportunity to prepare and submit comments. During the comment period, MMS received many comments from industry that the proposed rule was too restrictive in categorizing arm's-length sales and would require some legitimate arm's-length sales to be valued as if not at arm's length, thereby forcing these payors to pay on index prices.

In an effort to be responsive to these comments, MMS published a Supplementary Proposed Rule on July 3, 1997, that removed many of these restrictions. The changes made were:

The MMS received over 2,600 pages of comments on the proposed and supplementary proposed rules. Both industry and the States had many comments about ways the rule could be improved. While industry was opposed to much of the rule, the independents commented that those with affiliates preferred using their arm's-length gross proceeds over an index-based method. The States generally supported index pricing but differed on the specifics of calculating differentials.

Based on the diverse comments received on these proposed rules, MMS reopened the public comment period on September 22, 1997, to get comments on a number of alternative valuation procedures suggested by previous commenters.

Alternative 1 - Lessees should be allowed to value oil not sold at arm's length based on prices they receive for outright sales of crude in the particular region or area under a bidding or tendering program.

Alternative 2 - Lessees should be permitted to use the first applicable of a new set of benchmarks, but without reference to posted prices.

Alternative 3 - MMS should establish value for geographic locations based on data it collects from individual payors.

Alternative 4 - Use flat-rate differentials (cents per barrel or cents per mile transported) to adjust the index price.

In September and October 1997, MMS held seven public workshops and meetings to discuss these and other valuation alternatives with the States and industry. At the workshops, participants representing the States and industry were given the opportunity to present viewpoints and technical information regarding valuation and oil marketing practices. The workshops and meetings were open for public attendance and were held in Denver, CO; two in Houston, TX; Bakersfield, CA; Casper, WY; Roswell, NM; and Washington, D.C. Additionally, MMS received various written comments on the alternatives. There was less attendance at these sessions than at those in the Spring of 1997. For both the Denver and Houston workshops, there were 20 participants and between 15 to 25 audience members. At the next five public workshops, attendance ranged from 44 in Houston to 25 in Washington to 12 in Roswell and Casper to nine in Bakersfield. Meeting times were also shorter, averaging about two hours. However, the workshops proved extremely useful in clarifying the alternatives and providing feedback on the merits and viability of the various proposals. MMS used a number of suggestions from these workshops and in written comments to refine the proposed rule.

After considering all comments received in response to the proposed and supplementary proposed rules, the public workshops, and the request for comments on alternative methods, MMS published a second supplementary proposed rulemaking in the Federal Register on February 6, 1998. The most important changes in the February 1998 proposal as compared to the earlier versions were:

The value of oil not sold at arm's length would be determined in the three different market areas as summarized below:

California/Alaska	Rocky Mtn. Region	Gulf of Mexico
Alaska North Slope (ANS) Spot prices	Series of benchmarks 1. Tendering 2. Sales and purchases from the field or area 3. NYMEX 4. MMS-approved method	Spot prices

In developing a framework for this rule, MMS adopted the straightforward approach of basing royalty value on the gross proceeds received when oil is sold under an arm's-length contract and on index pricing or other benchmarks when oil is not sold under an arm's-length contract. As explained above, MMS also attempted to address many of industry's major concerns and suggestions where practicable. The MMS did not attempt to address all of the individual comments received until publication of a final rule. While industry remained generally opposed to index pricing as a valuation basis, MMS believed that, because of its widespread use in the industry, it was still the most valid indicator of market value in most non-arm's-length situations.

Industry also continued to object to MMS' position that the lessee must market the production for the mutual benefit of the lessee and lessor at no cost to the lessor. However, based on decades of support in law on this issue, MMS has had no compelling reason to abandon its position.

The MMS was told by its consultants, commenters, and workshop participants that the Rocky Mountain Region exhibits particular oil marketing characteristics that would justify different royalty valuation standards. Production is controlled by relatively few companies in the Rocky Mountain Region. The number of buyers is also more limited than in the Texas, Gulf Coast, or Mid-continent areas and there are limited third party shippers and less competition for transportation services in this area. Finally, there is less spot market activity and trading in this area as a result of this control over production and refining, and because crude oil production is smaller and more diffuse than in the Gulf Coast and Permian Basin areas. Based on feedback from the workshops and the written comments submitted on the 5 alternatives, MMS proposed a series of four benchmarks for the Rocky Mountain Region.

The logic of the Rocky Mountain benchmarks ordering was to start with sales from the lease (tendering). Then, if a producer does not have a tendering program, it would move to sales and purchases in the field or area. Then, if that benchmark is not applicable, it would further expand the area of consideration to NYMEX at Cushing, OK. MMS proposed tendering as the first benchmark in an effort to be responsive to the comments received from industry and the States. With the exception of California, there was general consensus among the States and industry supporting the concept of tendering for use in the Rocky Mountain area.

No change from previous proposed rules - value would be based on ANS spot prices.

With the exception of the Rocky Mountain Region, spot and spot-related prices drive the manner in which crude oil is bought and traded. Spot prices play a significant role in crude oil marketing in terms of the basis upon which deals are negotiated and priced and are readily available to lessees via price reporting services. We believe that spot prices are the best indicator of value for production from leases not located in California, Alaska, or the Rocky Mountain Region; therefore, it is not necessary to consider other less accurate means of valuing production not sold arm's-length from this area.

In February and March 1998, MMS held five public meetings across the country to get public comment on the February 6, 1998, proposal in Houston, TX; Washington, D.C.; Lakewood, CO; Bakersfield, CA; and Casper, WY. The MMS was disappointed that, with the exception of the Houston public meeting, participation had diminished sharply at these sessions compared to earlier ones, and they were much shorter. In Houston, 30 people attended, of whom only four offered comments for the record. Sixteen people raised questions about how the proposal works. In Denver, only 12 people attended, only three had questions, there were no formal presentations, and the meeting lasted just 30 minutes. The Washington, D.C., public meeting had 12 attendees with four speakers; Bakersfield had 10 attendees and three speakers; and Casper had 6 attendees with only one company offering any comments for the record.

After an extension at industry's request, the comment period on the latest proposal ended April 7, 1998. The MMS received about 600 pages of comments from a wide range of industry trade associations and individual companies and from five commenters representing three different States.

In its comments on the proposal, the commenter from the State of New Mexico Taxation and Revenue Department stated, "First and foremost, the Minerals Management Service should be commended for the effort they have made in developing oil valuation regulations that are fair to all interested parties. They should also be commended for recognizing an issue and following through with it to resolution. . ."

One major integrated company commented that MMS had made great strides in this Notice in proposing a reasonable valuation method. Other major integrated companies and industry trade associations continued to object to MMS's latest proposal, again raising the issues of duty to market, value away from the lease, and the administrative costs of Form MMS-4415. In addition, MMS received new comments from industry on the latest proposal. For example, some industry commenters stated that they strongly opposed the tracing of multiple exchanges to the ultimate arm's-length resale point, while others objected to the proposal to use different valuation methods for three areas of the country.

However, these new comments are not consistent with earlier comments by the industry provided in writing and orally at the workshops. For example, the Independent Petroleum Association of American (IPAA) stated in its October 31, 1997, comments that those members with affiliates believe that MMS should look to their arm's-length activity and not subject them to arbitrary valuation schemes like NYMEX.

Regarding MMS establishing separate valuation methods by marketing area, industry was in general agreement during the workshops that areas such as the Rocky Mountains and Outer Continental Shelf (OCS) exhibited unique marketing characteristics that warranted different valuation treatment. In its November 4, 1997, comments, the American Petroleum Institute stated:

The MMS is continuing to review the comments received on the latest proposal and is developing a final rule that responds in detail to all of the comments received to date. In a recent close-out meeting, the General Accounting Office found that MMS has been responsive to industry concerns expressed in public comments on the crude oil regulation.

Throughout this two and one-half year rulemaking initiative, MMS believes it has made every effort to consult with all affected constituents. In moving to the final phase of the rulemaking, MMS remains committed to its initial objective to assure that the American public receives market value for its mineral resources.