Comments Sought on Proposed Indian Oil Valuation Amendments

Notice: Office of Natural Resources Revenue Releases
Proposed Indian Oil Valuation Amendments

On June 19, 2014, the Department of the Interior (DOI) through the Office of Natural Resources Revenue (ONRR) announced a proposed rulemaking for oil royalty calculations on Indian Tribal and Allotted leases. See Indian Oil Valuation Amendments (Proposed Rule), 70 Fed. Reg. 35102, available at http://www.onrr.gov.  Comments pertaining to the proposed rule must be submitted to ONRR on or before August 18, 2014.  The proposed rule was created after the Indian Oil Valuation Negotiated Rulemaking Committee met several times through 2012 and 2013 to discuss revision to the valuation of oil produced on Indian Tribal and Allotted leases.  This committee consisted of representatives from various Tribes, individual Indian mineral owner associations, industry, trade associations, ONRR and the Bureau of Indian Affairs (BIA).

The Express Purpose of the Proposed Rule is Effectuate a 3.82 – 3.93% Increase in Royalty Revenues:

Despite industry involvement in the Indian Oil Valuation Negotiated Rulemaking Committee, the proposed rule is specifically designed to effectuate an increase in royalty revenues.  ONRR states that the rule "would result in an estimated annual increase in royalty collections between $19.4 million and $20.6 million to be disbursed to Indian lessors."   70 Fed. Reg. at 35108.  ONRR explains that this increase would represent "a minimal increase between 3.82 percent and 3.93 percent of the total Indian oil royalties ONRR collected in 2012."  Id.  

The Current Rule:

The current oil royalty regulations for Indian Tribal and Allotted leases have been in place since 1988, and are compiled at 30 C.F.R. part 1206, subpart B.  ONRR suggests in the proposed rule that changes are needed in the current oil royalty calculations to adjust to changes in the oil market since 1988.  In particular, ONRR, stating it is acting in its capacity as trustee for the Tribes and allottees, desires to create a new oil valuation method which obtains increased royalty revenues by ostensibly better addressing the major portion provision included in paragraph 3(c) of most Indian oil and gas lease agreements.  The major portion provision requires royalties to be valued on the highest price paid for a major portion of production from the field or area.

Increased Royalty Revenues Will Be Obtained Through Revisions to Major Portion Prices: 

To effectuate ONRR's desired royalty revenue increase, ONRR proposes significant changes to the current major portion pricing rules for oil royalties on Indian Tribal and Allotted leases. In lieu of the current major pricing provisions, ONRR instead proposes the creation of a new index pricing mechanism, which would be based on futures prices published in the New York Mercantile Exchange (NYMEX).  This new index pricing mechanism would be entitled the Index-Based Major Portion value (IBMP).  The IBMP will be calculated using a monthly average of prices published in the NYMEX (excluding weekends and holidays), and adjusted by a Location and Crude Type Differential (LCTD) to account for differentials caused by differences in lease location and type or quality of oil produced. 

How ONRR Proposes to Account for Differentials in Oil Valuations by Location and Type of Crude: 

According to ONRR, the LCTD "would assure that the calculated major portion price represents, on average, the equivalent of a 75% major portion price calculated by arraying all of the prices reported in a designated area from the highest to the lowest price and starting from the top of the array to determine that price associated with the 25th percentile by volume plus one barrel of oil."  70 Fed. Reg. at 35103.  ONRR will initially establish the LCTD value for a set of designated areas based on the previous year's average annual difference between the NYMEX and the Major Portion Price paid by lessees within the area.  The Major Portion Price in the LCTD calculation would then be determined by "arraying all of the prices reported in a designated area from the highest to the lowest price and starting from the top of the array to determine that price associated with the 25th percentile by volume plus one barrel."  Id.  A different Major Portion Price will be calculated for each type of crude sold within the designated area "using all calculated values (arm's-length and non-arm's length) payors report on Form ONRR-2014."  Id. at 35104. 

"Each sales month, ONRR would monitor each of the designated areas' reported sales volumes to identify when oil sales volumes reported as a lessee's gross proceeds are either more than 28 percent or less than 22 percent, of the total volumes sold in that designated area for the specified crude oil type[.]"  Id. at 35103.  "In months where the volumes in a designated area for a particular crude oil type fall outside 22 to 28 percent of the total volumes sold, ONRR would adjust the current month's LCTD up or down by 10 percent.  ONRR would then use the adjusted LCTD, along with the NYMEX Calendar Month Average, to calculate the next month's IBMP value."  Id.  Similar to index prices for royalties from gas production on Indian Tribal and Allotted leases, ONRR would publish monthly IBMP values on its website at http:www.onrr.gov.

Questions and Concerns for Industry When Reviewing the Proposal:

A clear benefit of the proposed rule is that monthly IBMP values would be published by ONRR, simplifying the royalty accounting process.  However, lessees should review the proposal to ensure that the use of an IBMP and LCTD are not being arbitrarily applied to their leases, and fairly capture the value of oil actually being produced.  This will include looking at whether NYMEX futures prices should be used as a basis for oil valuation, and determining whether the LCTD accurately accounts for location and oil quality differentials. 

 Lessees should also question ONRR's new understanding of "major portion" being asserted under the proposed rule.  Under the existing regulations, "[t]he major portion" has been defined as the "price at which 50 percent by volume plus on barrel of oil (starting from the bottom) is sold."  30 C.F.R. § 1206.54.  The proposed rule redefines "major portion" as 75 percent – a significant increase.  This is being achieved through the use of the LCTD, which is designed to "assure that the calculated major portion price represents, on average, the equivalent of a 75% major portion price."  70 Fed. Reg. at 35103.  This change would mirror the January 1, 2000 valuation changes to gas valuation, which define "major portion" as 75%.

 Finally, lessees should question whether or not it is proper for ONRR to attempt to change the rule specifically to effectuate a 3.82 percent and 3.93 percent increase in royalty revenues, when royalty rates have already been expressly agreed to in the existing lease agreements.

Other Changes in the Rule Would Relate to Transportation Allowances:

In addition to significantly changing major portion pricing on Indian Tribal and Allotted leases, ONRR seeks comments on the following:

 Removal of the requirement to file Form ONRR-4110 for Transportation Allowances

ONRR proposes that the filing requirement of From ONRR-4110 be removed from the regulations and instead, lessees would be required to file their actual transportation agreements with the agency, similar to the requirements under the current Indian Gas Valuation Rule at § 1206.178(a)(1)(i).

 The elimination of reporting of transportation factors 

Section 1206.57(a)(5) currently allows lessees to reduce their gross proceeds by a transportation factor according to the terms of an arm's length transportation agreement.  Under the rules, lessees are only required to report gross proceeds net of the transportation factor on Form ONRR-2014, and thus do not actually report the transportation factor itself.  ONRR would like to eliminate the use of transportation factors under the current rules, and require payors to report their transportation allowances.

 The removal of exceptions to the 50% limitation on transportation allowances 

Currently, § 1206.56(b)(1) states that, subject to certain exceptions, transportation allowances for each sales type code cannot exceed 50% of the value of the oil at the point of sale.  ONRR proposes to more generally provide that cost allowances cannot exceed 50% of the value of the oil.

Comments regarding any of the above can be submitted to ONRR on or before August 18, 2014.  Please see the Proposed Rule or contact Jennifer Bradfute at jennifer.bradfute@modrall.com for more detail.