SPEAKERS CONTENTS INSERTS
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49–151 CC
1998
HEARINGS ON H.R. 3334, THE ROYALTY ENHANCEMENT ACT OF 1998
HEARINGS
before the
SUBCOMMITTEE ON ENERGY
AND MINERAL RESOURCES
of the
COMMITTEE ON RESOURCES
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
SECOND SESSION
MARCH 19 AND MAY 21, 1998, WASHINGTON, DC
Serial No. 105–92
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Printed for the use of the Committee on Resources
HEARINGS ON H.R. 3334, THE ROYALTY ENHANCEMENT ACT OF 1998
HEARINGS
before the
SUBCOMMITTEE ON ENERGY
AND MINERAL RESOURCES
of the
COMMITTEE ON RESOURCES
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
SECOND SESSION
MARCH 19 AND MAY 21, 1998, WASHINGTON, DC
Serial No. 105–92
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Printed for the use of the Committee on Resources
HEARINGS ON H.R. 3334, THE ROYALTY ENHANCEMENT ACT OF 1998
COMMITTEE ON RESOURCES
DON YOUNG, Alaska, Chairman
W.J. (BILLY) TAUZIN, Louisiana
JAMES V. HANSEN, Utah
JIM SAXTON, New Jersey
ELTON GALLEGLY, California
JOHN J. DUNCAN, Jr., Tennessee
JOEL HEFLEY, Colorado
JOHN T. DOOLITTLE, California
WAYNE T. GILCHREST, Maryland
KEN CALVERT, California
RICHARD W. POMBO, California
BARBARA CUBIN, Wyoming
HELEN CHENOWETH, Idaho
LINDA SMITH, Washington
GEORGE P. RADANOVICH, California
WALTER B. JONES, Jr., North Carolina
WILLIAM M. (MAC) THORNBERRY, Texas
JOHN SHADEGG, Arizona
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JOHN E. ENSIGN, Nevada
ROBERT F. SMITH, Oregon
CHRIS CANNON, Utah
KEVIN BRADY, Texas
JOHN PETERSON, Pennsylvania
RICK HILL, Montana
BOB SCHAFFER, Colorado
JIM GIBBONS, Nevada
MICHAEL D. CRAPO, Idaho
GEORGE MILLER, California
EDWARD J. MARKEY, Massachusetts
NICK J. RAHALL II, West Virginia
BRUCE F. VENTO, Minnesota
DALE E. KILDEE, Michigan
PETER A. DeFAZIO, Oregon
ENI F.H. FALEOMAVAEGA, American Samoa
NEIL ABERCROMBIE, Hawaii
SOLOMON P. ORTIZ, Texas
OWEN B. PICKETT, Virginia
FRANK PALLONE, Jr., New Jersey
CALVIN M. DOOLEY, California
CARLOS A. ROMERO-BARCELÓ, Puerto Rico
MAURICE D. HINCHEY, New York
ROBERT A. UNDERWOOD, Guam
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SAM FARR, California
PATRICK J. KENNEDY, Rhode Island
ADAM SMITH, Washington
WILLIAM D. DELAHUNT, Massachusetts
CHRIS JOHN, Louisiana
DONNA CHRISTIAN-GREEN, Virgin Islands
RON KIND, Wisconsin
LLOYD DOGGETT, Texas
LLOYD A. JONES, Chief of Staff
ELIZABETH MEGGINSON, Chief Counsel
CHRISTINE KENNEDY, Chief Clerk/Administrator
JOHN LAWRENCE, Democratic Staff Director
Subcommittee on Energy and Mineral Resources
BARBARA CUBIN, Wyoming, CHAIRMAN
W.J. (BILLY) TAUZIN, Louisiana
JOHN L. DUNCAN, Jr., Tennessee
KEN CALVERT, California
WILLIAM M. (MAC) THORNBERRY, Texas
CHRIS CANNON, Utah
KEVIN BRADY, Texas
JIM GIBBONS, Nevada
CARLOS ROMERO-BARCELÓ, Puerto Rico
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NICK J. RAHALL II, West Virginia
SOLOMON P. ORTIZ, Texas
CALVIN M. DOOLEY, California
CHRIS JOHN, Louisiana
DONNA CHRISTIAN-GREEN, Virgin Islands
——— ———
BILL CONDIT, Professional Staff
MIKE HENRY, Professional Staff
DEBORAH LANZONE, Professional Staff
C O N T E N T S
Hearing held March 19, 1998
Statements of Members:
Brady, Hon. Kevin, a Representative in Congress from the State of Texas
Cubin, Hon. Barbara, a Representative in Congress from the State of Wyoming
Dooley, Hon. Calvin, a Representative in Congress from the State of California
John, Hon. Chris, a Representative in Congress from the State of Louisiana
Romero-Barceló, Hon. Carlos A., a Representative in Congress from Puerto Rico
Prepared statement of
Tauzin, Hon. W.J. (Billy), a Representative in Congress from the State of Louisiana
Additional material submitted by
Thornberry, Hon. William M. (Mac), a Representative in Congress from the State of Texas
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Additional material submitted for the record
Statements of witnesses:
Geringer, Hon. Jim, Governor of Wyoming
Prepared statement of
Hawk, Philip J., President & CEO of EOTT Energy Corp.
Prepared statement of
Leggette, Poe, Esq., Jackson & Kelly; representing the Independent Petroleum Association of America and the Domestic Petroleum Council
Prepared statement of
Quarterman, Cynthia, Director, Minerals Management Service, U.S. Department of the Interior, Washington, DC
Prepared statement of
Schaefer, Hugh V., Director, Welborn, Sullivan, Meck & Tooley, Denver, Colorado; Chair, Royalties Committee, Independent Petroleum Association of Mountain States
Prepared statement of
Additional material supplied:
American Petroleum Institute, Mid-Continent Oil and Gas Association, The National Ocean Industries Association and The Rocky Mountain Oil and Gas Association, prepared statement of
Memorandum to Members and Staff of Subcommittee
MMS Second Supplementary Proposed Rule, Feb. 6, 1998
Royalty Enhancement Act of 1998, H.R. 3334, Section-by-Section Analysis
Text of H.R. 3334
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Hearing held May 21, 1998
Statements of Members:
Cubin, Hon. Barbara, a Representative in Congress from the State of Wyoming
Thornberry, Hon. William M. ''Mac,'' a Representative in Congress from the State of Texas, prepared statement of
Statements of witnesses:
DeGennaro, Ralph, Executive Director, Taxpayers for Common Sense
Prepared statement of
Hagemeyer, Fred, Coordinating Manager, Marathon Oil Company
Prepared statement of
Kalt, Joseph P., Ford Foundation Professor of International Political Economy, John F. Kennedy School of Government, Harvard University
Prepared statement of
Leggette, Poe, Esq., Jackson and Kelly
Prepared statement of
McCabe, James, Deputy City Attorney, City of Long Beach, California accompanied by M. Brian McMahon, McMahon and Speigel
Prepared statement of
Neufeld, Bob, Vice President, Environmental and Government Relations, Wyoming Refining Company
Prepared statement of
Quarterman, Cynthia, Director, Minerals Management Service
Prepared statement of
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Additional material submitted by
Smith, Lin, Managing Director, Barents Group
Prepared statement of
True, Diemer, Partner, The True Company
Prepared statement of
Vicenti, Rodger, Acting President, Jicarilla Apache Tribe
Prepared statement of
Wallop, Malcolm, a former United States Senator from the State of Wyoming, and Chairman, Frontiers of Freedom Institute
Prepared statement of
Additional material supplied:
Mauro, Garry, Commissionar, Texas General Land Office, additional material submitted by
Powell, Ray, M.S., D.V.M., Commissioner of Public Lands, New Mexico, prepared statement of
Additional material submitted by
Reid, Spencer L., Texas General Land Office, additional material submitted by
Shively, John T., Commissioner, State of Alaska, Memorandum submitted by
HEARING ON H.R. 3334, THE ROYALTY ENHANCEMENT ACT OF 1998
THURSDAY, MARCH 19, 1998
House of Representatives, Subcommittee on Energy & Mineral Resources, Committee on Resources, Washington, DC.
The Subcommittee met, pursuant to notice, at 2 p.m., in room 1334, Longworth House Office Building, Hon. Barbara Cubin (chairman of the Subcommittee) presiding.
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Members present: Representatives Cubin, Tauzin, Thornberry, Brady, Romero-Barceló, Dooley, and John.
STATEMENT OF HON. BARBARA CUBIN, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF WYOMING
Mrs. CUBIN. The Subcommittee on Energy and Mineral Resources will come to order.
The Subcommittee is meeting today to hear testimony on H.R. 3334 to provide certainty for, reduce administrative and compliance burdens associated with, and streamline and improve the collection of royalties from Federal and outer continental shelf oil and gas leases, and for other purposes.
The Subcommittee meets today to hear testimony on H.R. 3334, a bill—oh, excuse me, H.R. 3334, the Royalty Enhancement Act of 1998 is sufficiently complex that I believe two days of testimony will be necessary to fully consider the bill.
At this time, I have scheduled a second hearing date for Tuesday, March 31, to focus on issues not covered today. Also, some of the witnesses that were scheduled to testify here today were unable to, due to snow at the Denver airport were unable to be here, so it is all the more important that we have the hearing on the 31st.
[The text of the bill may be found at end of hearing.]
Mrs. CUBIN. Obviously, significant changes in the manner in which some $4 billion of oil and gas royalties are collected each year must be scrutinized very, very carefully. I fully recognize this, but I am not willing to sit back and do nothing while states such as mine are asked to bear a portion of the Federal Government's cost to administer the Federal Leasing Act.
Our states are given little to say—little or nothing to say actually—in the management of what is clearly a broken system for the valuation of crude oil and natural gas. I know what a difficult issue this is because when I served in the Wyoming state legislature I was on the committee where we recodified all of the state statutes on mineral valuation, taxation and point of taxation.
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It is very complicated, but there is no doubt in my mind that this system that MMS is using is fatally broken. I do not say that lightly as I understand the magnitude of the dollars in dispute in various venues around the country, especially with respect to crude oil.
I would note emphatically at the outset that this bill in no way—in no way—forecloses the opportunity for private royalty owners, states or the Federal Government to litigate questions of alleged undervaluation and payment of royalties owed.
What Mr. Thornberry has done by introducing H.R. 3334 is to move us down the road toward designing a system which may dramatically reduce the costs of collecting royalties. At the same time, this bill provides an opportunity for adding value to the public's royalty oil and gas by aggregating volumes and aggressively marketing the product downstream from the traditional valuation point which, as we know, is the wellhead or the lease boundary.
I commend my colleague for the thought that his staff working with the Subcommittee staff have put into drafting this bill in an effort to have a fair and equitable bill ocean everyone.
Did we take advice from the oil and gas industry in the preparation of this bill? Absolutely. Yes, we did. However, you will find that prior to introduction the bill was scrutinized for potential scoring impacts and modified, where in our view a departure from current practice would have negative consequences for revenues to the states and to the Federal Treasury.
Let me reiterate this bill is an attempt to fix a broken royalty-in-value system which requires extraordinarily expensive audit and litigation costs upon the government and on industry alike. Costs which range in tens of millions of dollars annually. Costs which are factored into the net receipts sharing formula whereby MMS will reduce payments to Wyoming by over $7 million in one fiscal year alone.
The Governor told me yesterday that the state legislature, which just adjourned in Wyoming because there was a $14 million shortfall, almost had to stay in session another week. Well, saving this $7 million a year would have taken care of that and could have avoided the problem altogether.
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Costs which are factored into the net receipt sharing formula whereby MMS will reduce payments to Wyoming by $7 million a year just simply is not acceptable. I do not need to remind my colleagues about the testimony that we heard from Ms. Maloney of New York City at our oversight hearing last July where she spoke of lost revenues for California school children from alleged underpayment of royalties.
Well, guess what? Wyoming school kids are being denied $7 million under current law, and there are a whole lot fewer of them to absorb that loss than there are kids in California. In fact, no state receives a larger percentage of its annual budget from Federal mineral receipts than does Wyoming. Therefore, no state has more to win or to lose than Wyoming does.
Therefore, I am very confident that Governor Geringer, who is with us today, would not risk revenues due to the state just to make a few oil producers happy. I know him. I know he would not do that, nor would I. He and I both will demand accountability of the industry and the MMS to be sure revenues are maximized.
I will say now that I have no intention of moving any bill which does not score positively under the rules of the CBO, and those rules do not give credit for what should be a greatly diminished Federal budget for audit and enforcement of an R-I-K program, I might add. This R-I-K program will replace several thousand payors on the MMS computer system with, perhaps, a mere couple of dozen qualified marketing agents.
Furthermore, we have asked for the Interior Department's input from back in March 1996, when Mr. Thornberry first sought to have Texas take its Section 8(g) OCS royalty share in-kind. But, the administration has been unwilling to even contemplate statutory changes, let alone recommend language saying again and again that the secretary has all the authority that he needs. So here we are again in an adversarial position on this issue. It is an issue that begs for mutual understanding, cooperation in a relationship between the states and the Federal Government to get it right for the benefit of the American people.
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I am the eternal optimist, so I am willing to ask one more time—or maybe two or ten more times, whatever it takes—for the administration's cooperation and commitment to work with this Subcommittee and with the states to fashion a workable system. I will not take personally any criticism of our efforts to date and I believe my colleagues from Texas will not either, but neither will I settle for continued foot dragging by the MMS on the premise that ongoing valuation lawsuits somehow compel Congress not to act prospectively.
The chair now recognizes the Ranking Member, Mr. Romero-Barceló.
STATEMENT OF HON. CARLOS A. ROMERO-BARCELÓ, A DELEGATE IN CONGRESS FROM PUERTO RICO
Mr. ROMERO-BARCELÓ. Thank you, Madam Chair.
We are pleased to welcome the distinguished guests before the Subcommittee today. The Minority has not expressed a position on our colleague, Representative Mark Thornberry's legislation, H.R. 3334, but we would like at the outset to commend him for tackling the thorny issue of Federal royalty management.
It is a very dry and technical area and he needs to be congratulated for making this effort. It is much more difficult to be creative than to be critical. Instead of simply attacking the Federal royalty program, Mr. Thornberry has devised some comprehensive and innovative alternatives. We owe him a serious and careful analysis of the bill. So we will not offer a position at this time.
Instead, we will strive to keep an open mind while listening to our witnesses discuss the strengths and the weaknesses of the Thornberry legislation. However, I am compelled to note that the administration is strongly opposed to this bill, and would go as far as to recommend a veto if it were presented to the President. Since Mr. Thornberry has assured us that this bill is simply a starting point, we look forward to working with him to craft a bill that is acceptable to our employers, the American people.
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Such a bill will protect the rights and interests of the United States, and will fulfill the guiding principle of any royalty program to assure the receipt of the full amount due. Such a bill will balance the rights of the United States and its lessors. Such a bill will not relieve lessees of duties only to unfairly place new obligations on the United States. Finally, such a bill will be, at least, revenue neutral.
We do have many questions. Preliminary estimates indicate that the bill, as currently drafted, would cost the government hundreds of millions of dollars each year. If this is correct, then the bill must be revised so that we will not lose the revenues. The Federal oil and gas leasing program is now raising more than $6 billion a year. Clearly, we cannot jeopardize those funds.
In that vein, I have asked the Congressional Budget Office to prepare a preliminary estimate on costs and benefits of H.R. 3334 as introduced, so that we may have the benefit of their expertise as we in the Subcommittee move forward marking up the bill. With your concurrence, Madam Chair, I would like to submit my letter for the record.
I must comment that I appreciate the fact that Madam Chair has already indicated that it will take CBO's estimates into consideration, which is something that we must do. That concludes my opening statement, so we look forward to this afternoon's hearings.
Thank you, Madam Chair.
Mrs. CUBIN. Mr. Thornberry, do you have an opening statement? I bet you do.
[The prepared statement of Mr. Romero-Barceló follows:]
STATEMENT OF HON. CARLOS ROMERO-BARCELÓ, A DELEGATE IN CONGRESS FROM THE STATE OF PUERTO RICO
Madame Chair, we are pleased to join you in welcoming our distinguished guests before the Subcommittee today.
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The Minority has not expressed a position on our colleague, Rep. Mac Thornberry's legislation, H.R. 3334. But we would like, at the outset, to commend him for tackling the thorny issue of Federal royalty management. It is a very dry and technical area, and he is to be congratulated for making this effort. It is much more difficult to be creative than to be critical. Instead of simply attacking the Federal royalty program, Mr. Thornberry has devised a comprehensive and innovative alternative. We owe him a serious and careful analysis of the bill. So, we will not offer a position at this time.
Instead, we will strive to keep an open mind, while listening to our witnesses discuss the strengths and weaknesses of the Thornberry legislation. However, I am compelled to note that the Administration is strongly opposed to the bill, and would go so far as to recommend a veto if it were presented to the President. Since Mr. Thornberry has assured us that his bill is simply a ''starting point''—we look forward to working with him to craft a bill that is acceptable to our employers—the American people.
Such a bill will protect the rights and interests of the United States, and will fulfill the guiding principle of any royalty program—to assure the receipt of the full amount due. Such a bill will balance the rights of the United States and its lessors. Such a bill will not relieve lessees of duties only to unfairly place new obligations on the United States. And finally, such a bill will be, at least, revenue neutral.
We do have many questions. Preliminary estimates indicate the bill, as currently drafted, would cost the government hundreds of millions of dollars each year. If this is correct, then the bill must be revised so that we will not lose revenues. The Federal oil and gas leasing program is now raising more than $6 billion a year. Clearly, we cannot jeopardize those funds.
In that vein, I have asked the Congressional Budget Office to prepare a preliminary estimate on the costs and benefits of H.R. 3334 as introduced, so that we may have the benefit of their expertise as we in the Subcommittee move toward marking-up the bill. With your concurrence, I would like to submit my letter to the record.
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That concludes my opening statement, we look forward to this afternoon's hearing.
The Hon. JUNE E. O'NEIL,
Director, Congressional Budget Office,
Ford House Office Building
Inside Mail
DEAR DIRECTOR O'NEIL:
The Subcommittee on Energy and Mineral Resources is holding hearings this month on H.R. 3334, a bill to change the current Federal oil and gas royalty system from a percentage of production as a cash payment to a ''
''royalty-in-kind'' payment. Under this scenario, the Federal Government would be required to take all oil and gas royalties as product and have a marketing agent, in turn, sell the oil or gas on behalf of the government.
While we are some time away from requiring an actual score on this proposal by CBO, it would be helpful to receive a preliminary analysis of the legislation from you.
The hearings are scheduled for March 19 and March 31, 1998. Your input prior to the second hearing would be most appreciated. A copy of the bill is enclosed for your convenience.
Should you have questions regarding this request you may call me directly, or your staff may contact Deborah Lanzone, Resources Committee at 6-2311.
Sincerely,
| Carlos Romero-Barceló, |
| Senior Democrat |
| Subcommittee on Energy and Minerals |
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STATEMENT OF HON. WILLIAM M. (MAC) THORNBERRY, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS
Mr. THORNBERRY. Thank you, Madam Chairman.
I will not take much time. I just want to express my appreciation to you and to the Ranking Member and to all my colleagues on the Subcommittee for their willingness to consider a little different approach to this, and their open mindedness to consider if there couldn't be a better way to do this thing.
I kind of look upon this issue like the tax code mess. It is so big and complicated nobody has confidence in it. Nobody thinks that there is a way to write enough tax code regulations to get proper enforcement. There has got to be a way to cut through that, to have a simpler fairer system that benefits everybody. That was certainly my goal.
When we started talking about this two years ago, I was assured that there was no way that the industry could even come together because you had big majors, you had independents, you had oil, you had gas, you had onshore, you had offshore, and that there was no way that you could have a plan or a proposal that would work for all of those different situations.
I think we have got one that might just do it, but I am certainly open and willing to constructive criticism. I don't have much sympathy for the people who sit out there and put out press releases and throw rocks, but for constructive criticism and improvements I certainly want to hear it from any quarter. So I look forward to working with my colleagues and listening our witnesses to try to do the best for the taxpayers all the way around.
Thank you.
Mrs. CUBIN. Mr. Dooley, would you like to have an opening statement?
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STATEMENT OF HON. CALVIN DOOLEY, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF CALIFORNIA
Mr. DOOLEY. Thank you, Ms. Cubin. I appreciate the Committee allowing me to make an opening statement. I am, unfortunately, going to have to leave to a conference committee very shortly.
I just wanted to say that, you know, I applaud the actions of Mr. Thornberry and the actions of the Committee in giving due consideration to the royalty-in-kind proposal. I want to make it very clear that I am a very strong proponent of the concept which is embraced by royalty-in-kind.
I am so because I think it embraces some principles which we all should be able to support. I mean, we spend a lot of time talking about how do we reinvent government over the last few years and how can we make government to be more responsive to the needs of different constituencies and making sure that the government is getting the greatest return to taxpayers for the investment of the taxpayers' dollars.
I think the royalty-in-kind proposal really can move us down that path because it, in fact, will put, I think, in place the appropriate incentives for people who might be marketing oil that would be given to the government as royalty to maximize the return on that. We will be ensured that they will have a vested interest in getting the greatest return to taxpayers because they are going to have a financial incentive to get the greatest return for themselves.
Right now, I would have to say that our royalty proposal or program doesn't necessarily provide for that incentive. I think that is probably the best protection that the taxpayers of this country could hope for when you put that financial incentive into place.
What I think also is very important and it really gets to the issue that Mr. Thornberry talked about, whether you are a large producer or a smaller producer, is how do you ensure that you have equity. I think that this proposal can also ensure that we are providing equity to producers, to making sure that they are paying a fair rate, a fair royalty for the oil that they are producing. It is also ensuring, I think, we provide equity for the taxpayers, too, because they have certainly a vested interest in getting a return on what is a taxpayer asset. I think this royalty-in-kind proposal moves us in that direction.
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I appreciate the fact that we are having this hearing today, because I think Mr. Thornberry acknowledged that maybe this legislation is not perfect yet. But, hopefully, at the end of the day we will hear from some well-informed people that have some expertise and experience and what are the modifications that we can make that we can, in fact, make those proposals something that the administration and all of us can be very proud of.
So thank you.
Mrs. CUBIN. Yes. Mr. Brady, did you have an opening statement?
STATEMENT OF HON. KEVIN BRADY, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS
Mr. BRADY. Yes. Madam Chairman, I had not intended to speak at this point. But my understanding is that earlier today it was reported that the State of Texas General Land Office is opposed to this bill. Let me tell you as of an hour ago they do not believe that is the case. They are not opposed to H.R. 3334. It would be illegal for the agency to oppose legislation. They have some constructive comments that they are getting to us and working with us on, which I appreciate.
Let me clarify again Texas and the General Land Office is not opposed. Let me clarify, too, any perception about the profits of the Texas program quoting directly from Spencer Reed of the Texas General Land Office. The Texas Program is definitely revenue positive. Parts of the program which sell on the spot market are understandably revenue neutral at times, but the self-consumption is highly profitable.
Being a former state legislator a year removed, I can tell you that the biggest part of our public school fund is derived from oil and gas revenues. We would not trust that important fund to a program that doesn't consistently produce for us. I am not going to speak for the General Land Office. They will be here on March 31 for the hearing, Madam Chairman, and I am looking forward to their comments.
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Thank you.
Mrs. CUBIN. Thank you, Mr. Brady.
Mr. John has been speechless since he found out his wife was going to have triplets.
[Laughter.]
Mrs. CUBIN. So I don't know if he has an opening statement, but he is certainly welcome to make one if he does.
STATEMENT OF HON. CHRIS JOHN, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF LOUISIANA
Mr. JOHN. Thank you, Madam Chairman.
If I start to repeat myself, on the third time please just stop me.
[Laughter.]
Mr. JOHN. I, too, want to thank my colleague from Texas for tackling such a very complex issue. It is an issue, I think, worthy of lots of debate including this forum here today. I also agree with a lot of the aforementioned comments with my colleague from California and my friend from Puerto Rico.
I have been in constant contact with the state of Louisiana, the secretary of natural resources, trying to understand how this would impact Louisiana, and we are working through that. But I just look very much forward to this debate because the merits of this I am in full support of. It is trying to get through the devils of the details, and that is what we are here for. I thank Mac for trying to get us to that point.
Thanks.
Mrs. CUBIN. Mr. Tauzin, do you have opening comments?
STATEMENT OF HON. W.J. (BILLY) TAUZIN, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF LOUISIANA
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Mr. TAUZIN. Well, I certainly want to take a minute again to congratulate my colleague on what a tremendous triple blessing he and Payton are going to experience very shortly. We just got a new puppy, and there is nothing like that.
[Laughter.]
Mr. TAUZIN. You are going to have to work hard, I promise you, Chris. I did want to comment briefly, Madam Chairman, with reference to this issue because it is one in which it appears to me the government wants to have its cake and eat it too.
The government wants to be able to allege that in the marketplace, that in the real marketplace, that companies who produce oil and gas and other hydrocarbons for their purposes and government purposes on government lands or not accounting properly, and they are challenging in court on that basis, for the fact that they are making more money in the marketplace when they sell those products than they are accounting for to the government in royalty. At the same time, they want to argue this issue that they are going to lose money if they have to take the product in kind and go into that same marketplace and sell it.
It seems to me those two arguments are quite contradictory. If the industry is, in fact, benefiting from selling product in the marketplace, then the government should enjoy that same possibility by taking the product in kind and taking it to that same marketplace, if it disputes the value of the royalties collected.
It seems to me that what we begin today is a very worthwhile discussion of which one of those arguments really holds true in the real world. The bottom line is that government can today, as I understand it, take its product in kind if it wants to. If it really believes that companies can do better in the marketplace, then they should be able to do better as well.
It occurs to me as we debate this we ought to ask those who testify to give us some insight as to what happens from the point of production to the point of sale and what it is about this process that the government feels like companies are benefiting in ways that they could not benefit were they to, in fact, take the royalty in kind and go into that same marketplace and sell their product. I should think that we are going to learn a lot, Madam Chairman, in asking witnesses those kinds of questions, and I look forward to doing so.
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My friend Mr. John, I have done some checking with the authorities in Louisiana as well, and they seem to be sort of waiting before taking any firm position on the issue. They are sort of neutral on it because the state has to collect royalties too. I think they have an interest in knowing a little more about the issue before they come down solidly on one side or the other, and I don't blame them.
That is sort of the position, I think, we ought to be in. We ought to ask the hard questions at this hearing and really learn how this marketplace works, and see whether or not the government is really asking to have its cake and eat it or whether or not the government can and should do better by taking its product in kind and going out in the marketplace and selling it, so that we don't have all of these lawsuits about what is the way to calculate the value because in that world the government gets its value straight out. It goes into that marketplace it claims the company is benefiting so royally from and makes its profit directly in the sale of its product through its own marketing capacity. So this will be an interesting discussion, Madam Chairman. I appreciate the fact that you called this hearing and look forward to it.
Mrs. CUBIN. Thank you, Mr. Tauzin.
Now I would like the first panel to come forward. The Honorable Jim Geringer, Governor of my state and his state—480,000 of us. I want to welcome the Governor. We served in the Wyoming Legislature together in the state house and in the state senate, and now he is the king. But today I am the boss.
[Laughter.]
Mrs. CUBIN. Welcome, Governor Geringer. Cynthia Quarterman, director of the Minerals Management Service of the U.S. Department of Interior, if you please could come forward.
Could I ask you to rise for swearing in. Raise your right hand. We do this for everyone.
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[Witnesses sworn.]
Mrs. CUBIN. Governor Geringer, I would like to call on you first for your testimony.
STATEMENT OF HON. JIM GERINGER, GOVERNOR OF WYOMING
Mr. GERINGER. Thank you, Madam Chairman.
I will at least try to encourage the movement of this at a fairly and significant pace because I am due out of National Airport in just a little over an hour so I might be departing early. If I am not able to answer all of the questions that the Committee might wish to raise, I will see to it that there are answers that are brought back to you.
You know, the issue has been framed fairly well around the table already, Madam Chairman, as to what we are hoping to do through this. If we could find a better way to administer programs through government or through the states or through some other process, then we ought to all look at that, and that is the intent of speaking in favor of H.R. 3334 today.
There are many indications that perhaps this may not be the perfect bill. There seldom has been a bill written perfectly or we wouldn't be back every time year after year to bicker about it. But the concepts that have been illustrated so far, for instance, Wyoming receives about $200 million a year in royalty payments. The Federal Government receives at least that much, and that is part of the contention that we have. I say ''at least,'' because there is more than that accrues to their pocketbook through a process called ''administrative costs.''
To my knowledge, no state nor the Federal Government have has ever taken a company to court for selling something too high. There is always a contention that it has been sold too low or valued too low, and that deliberation goes on and on. It is a very expensive litigation process and appeals process.
I am very pleased that Representative Thornberry has taken it upon himself and co-sponsored with yourself and Representative Brady this particular legislation to move an issue along. It certainly needs remedying.
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In Wyoming, we take the royalty payments and share them 50 percent with the schools and the other half goes to various local governments. So this is something that is definitely the underpinnings of the most fundamental part of our society.
H.R. 3334 would simplify the royalty collection process, decrease administrative cost for both the MMS and industry, thereby increasing the net payment to the state to provide certainty and royalty valuation, and decreases the cost of audits and the subsequent appeals and still achieves a fair and equitable market value for the product.
We have been frustrated for some time that we do not have a simple and fair method to value oil and gas for royalty payments. Some producers and leaseholders work very hard to be objective and above board in the valuation of the product at the lease, others are not as forthcoming, and instead they devise all sorts of third party marketing transactions and camouflage the real market that is out there. It is difficult to tell who is right and who is wrong, and rather than assigning blame why don't we just take a simpler approach. That is what this bill endeavors to do.
We are frustrated also with the charges that are being made from the Federal Government to the states to administer the current system. Wyoming receives its 50 percent share of Federal mineral royalties on a net receipts sharing basis, which means that we suffer a deduction of 25 percent of the cost of administration.
It has not always been that way. It has only been lately that the MMS has assigned that cost to the states because their own costs have increased significantly. We do not like the high cost of Federal administration, and so I propose to Assistant Secretary Armstrong that Wyoming be allowed to take its royalty share in kind rather than in cash and avoid having to pay at least the $7 million per year that we lose from the Federal collection and administration.
Now, if the Federal Government could receive the same or greater income from Federal in-kind royalties as it would receive from traditional royalty payments, it seems like a slam-dunk that we should go forward with this. That is our goal in supporting this particular bill.
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There have been several studies from the General Accounting Office, from the Department of Interior IG's Office within the state of Wyoming to determine the true costs of administration. Wyoming contends that we can accomplish the administration of the royalty program for one-seventh of the cost, that when we have attempted to have detailed disclosure of the cost breakdowns from the MMS we do not get those in a way that we can do a one-on-one comparison.
The GAO stated that we could not compare both programs because their tasks were so completely different. We disagreed with the GAO's conclusion. The task of monitoring leases, production, valuation, and collection of royalties are no different on a state lease or a Federal lease, and we do both.
The state of Wyoming still does the auditing for many of the leases that the Federal Government has undertaken. There will be a written designated agent for the last—I believe it came in in 1983, so about 15 years. In fact, we have saved the Federal Government through our collections and auditing $50 million just in the last 11 years alone, so we already know how to do it.
They have acknowledged that by renewing the contract with the state every year. States know how to do it, and they do do it very well. For whatever was said at the press conference this morning, I think the facts speak for themselves that the states are significantly capable of handling this. One of the proposals for the marketing of the in-kind oil or marketing of anything or to calculate valuation would be based on NYMEX pricing.
As I looked at the oil price this morning as it was posted for Wyoming production, some of the postings are based on a NYMEX price, but most of the Wyoming posted is based on what is called the West Texas intermediate. The Wyoming valuation has dropped significantly. There is another reason, Madam Chairman, for why we in Wyoming are proposing the opportunity to take royalty in kind.
If the state of Wyoming is able to contract with a qualified marketing agent and aggregate all of its production or at least a significant portion of whatever is economically feasible, we could aggregate it because it is going through a third party. It would be truly at arm's length.
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We would encourage a lot of our independent producers in Wyoming who are currently suffering mightily at the drop in oil prices—they are about to shut in their wells—rather than shut in all of these marginal wells, which nationally could amount to 20 percent of the entire production of consumption of the United States' petroleum, if those wells were shut in, they likely would not be brought back in.
That has a significant impact on our national security and our future as far as the control of the costs, or at least the opportunity to have an influence on the cost of that production. If we can keep our small independent operators going through an aggregation process where they can bid in and ask the same agent to aggregate their product and thereby increasing the total volume, the benefits accrue all across the board. We all benefit. So, it is a true partnership that could evolve out of the system. I see so much potential there that it certainly ought to be evaluated, and so I speak in favor of that.
The state should be able to continue to retain its 50 percent, but it should be on a gross proceeds basis rather than net proceeds. We should not have to argue over whose valuation or whose administrative costs are deducted. Let the state have the sole option whether or not it wants to take on the program. The state should be able the use a qualified marketing agent. The state should enjoy all of the benefits of the Federal Government.
The bill, Madam Chairman, does state that on page 10 under Section (b)(1): ''The state shall enjoy all the rights and assume all of the obligations that the United States would otherwise have under this Act.'' That is all that we are asking. It is a pretty easy concept. If the states are willing to take it on and want to do it, let them do it.
The MMS has proposed pilot programs and have proposed one in Wyoming which we have supported, at least in concept. The actual process and procedure we are not in full agreement on, but we ought to acknowledge that there are ways that we could do it to demonstrate whether or not such a program would work.
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I believe that the best chance for success is to let the real experts market the oil and gas in order to get the best price. MMS believes that they should be allowed to do the marketing and I question whether they have the expertise to do that marketing.
I appreciate Cynthia Quarterman's and MMS's intent work with our state in developing a pilot project, but I do point out that there is a big difference between being a joint partner where we jointly develop the process, the procedure, the standards and just being full what it will be, kind of like a take-it-or-leave-it partnership. I like one where we truly benefit from each other's expertise and capability.
In summation, Madam Chairman, as you move the legislation, I urge that you ensure the legislation at least maintains the opportunity for royalty in kind to be allowed by the Federal Government, that the states be able to opt in at their sole discretion, that the Federal Government do contract with a qualified marketing agent so we know we have a true market-oriented transaction, that the option for the states to elect a contract with a qualified marketing agent on behalf of themselves should be maintained.
The intent to keep audit requirements simple and nonduplicative and the goal overall to reduce government costs and increase return to the Federal and state treasuries, that really is our goal. If there were a simpler way to do this, we would be advocating that. Absent any other way to establish valuation for the product that is being considered, I urge you to consider a way to give us that opportunity so that we can determine whether or not we can enjoy greater income for the benefit of both the Federal Government and the state government and certainly for the children who benefit from that allocation to education.
Thank you, Madam Chairman. Oh, Madam Chairman, for the record if there might be any question as to what the Wyoming proposal is on the pilot project, I would like to submit for the record an exhibit that shows as of March 25, 1997, what we have transmitted as the Wyoming proposal to take state share of Federal royalties-in-kind oil. If that could be entered along with my comments, I would appreciate it.
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Mrs. CUBIN. Without objection. Thank you, Governor.
Ms. Quarterman?
[The prepared statement of Mr. Geringer may be found at end of hearing.]
STATEMENT OF CYNTHIA QUARTERMAN, DIRECTOR, MINERALS MANAGEMENT SERVICE, U.S. DEPARTMENT OF THE INTERIOR, WASHINGTON, DC
Ms. QUARTERMAN. Good afternoon. Madam Chairwoman and members of the Subcommittee, I appreciate the opportunity to appear today to present testimony on H.R. 3334 and on our implementation of programs to take oil and gas royalties in kind. I will briefly address the RIK legislation before providing a progress report on our three pilot projects.
At the outset, I would like to make our position on RIK legislation clear. We do not believe that legislation is needed to exercise our contractual rights to take royalties in kind. The Mineral Leasing Act, the Outer Continental Shelf Lands Act and the lease agreement with the producers all grant us the option to take our royalties in kind. The Department, therefore, strongly opposes any legislation mandating the United States to take mineral royalties in kind.
I would like to also clarify our position on RIK implementation. As I testified last year before the Subcommittee, we are genuinely excited by the potential of RIK programs to streamline and improve aspects of our Royalty Management program. Accordingly, we are aggressively working on an ambitious schedule to implement our three RIK pilots.
There is no inconsistency in these two positions. We strongly believe that the realistic test of RIK under actual conditions are needed prior to any legislative decisions on broader implementation. RIK is unproven for the royalty collection in the United States. As stewards of public assets, we must have assurance that the revenue and administrative effects of RIK are at least revenue neutral before moving to implementation.
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I hasten to remind this Subcommittee that the one instance we have of testing, taking royalties in kind resulted in a loss of revenue. A legislatively mandated RIK program would eliminate the value of being able to choose which collection method in-kind or in-value works best in each location.
I will limit my discussion of this bill to just a few general reactions. As a whole, this bill would force the United States to relinquish many of its long-established legal rights as lessor while relieving lessees of many of their equally long-established obligations. The collective result of the bill is to drastically reduce the options and legal rights of the Federal Government. We all must seriously ask ourselves how it is to the advantage of the citizens of the United States to give up these rights, and as a result a substantial part of the value received for our nation's nonrenewable resources.
There are many specific components of this legislation that would act to decrease the value of Federal mineral royalties. While we haven't fully analyzed this bill, we believe the details of the bill will have substantial revenue and legal impacts. The more damaging aspects of this bill to the public interest are, first, the Federal lessor would assume cost of marketing oil and gas in a royalty-in-kind program where production is sold downstream of the lease.
Under in value royalty collections currently in effect, the Federal Government has not participated in such costs. So unless we can somehow make the production more valuable than it is now, royalty revenues to the Federal Treasury will logically and unambiguously decline under RIK.
Second, we have identified several unfavorable conditions under which RIK programs would reduce revenues. These conditions include taking diminimus volumes in remote areas, taking production at less than marketable condition and paying above market rates for transportation. This bill mandates RIK under all of these unfavorable conditions, we believe, ensuring a revenue loss.
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The bill would statutorily adopt many of the positions taken by the oil and gas industry in historic disputes with the Department on valuation gathering, field processing and transportation. Disputes, I might add, that have been consistently won by the Department. This would be an unjustified economic gift to the lessee. We must be careful not to effect legislation or rulemakings, for that matter, that serve only the special interests of either lessee or lessor.
We at MMS regard our program initiatives in valuation and in-kind royalties as completely independent efforts. However, it has become increasingly apparent that some view these efforts as directly related. Specifically, we are told that RIK is needed because MMS is increasingly establishing royalty value at downstream locations and abandoning gross proceeds as a valuation basis.
That is simply not the case. We have taken very seriously the concerns raised on these aspects of our rulemaking. In our recently published crude oil valuation proposal, we have presented five valuation principles we use as our basis including that royalty obligations for arm's length contracts should be based on gross proceeds received under such contracts.
For the record, I just want to clarify the lease requirement that a lessee has a duty to market at no cost the lessor since it has been so often misunderstood. It does not mean that we will second guess a lessee's decision not to market downstream. MMS does not participate in the marketing decisions of the lessees. It does not tell the lessee how to market. Accordingly, it does not participate in its cost.
Now as for our RIK pilot projects, last summer we decided to implement RIK pilot projects in Wyoming, offshore Texas and the Gulf of Mexico. I am pleased to report that we are currently making great progress in implementing those recommendations.
We are on course to begin the Wyoming crude oil pilot this October. From the outset we have been developing the pilot in a close and cooperative partnership with the state of Wyoming. I understand that the state will decide after an early April briefing whether to include state volumes in the project as well. Governor Geringer and I will receive the same decision briefing from the RIK implementation team.
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Governor Geringer, I want to assure you that we will not implement a project, a pilot project, in your state without your support.
Mr. GERINGER. Good.
Ms. QUARTERMAN. Regarding the Texas pilot, we are working with the state concerning implementation of RIK for natural gas from offshore 8(g) leases in the Gulf of Mexico. We also expect that pilot to begin this October.
Lastly, we are quite excited about the prospects of our outer continental shelf in-kind project in which we will take a substantial portion of royalty gas from the Gulf of Mexico and use marketing agents for its management and disposition. The size and complexity of this project dictate that we take another year before we can begin with confidence. The startup date is said to be October 1999.
These projects form a logical, deliberate process that tests RIK across a broad array of Federal lease and production situations. Our hope is that these tests will allow us to implement the already-existing RIK option in the best manner and under the right circumstances. This spells success not only for royalty management, but for the taxpayer as well. In contrast, we strongly believe that implementation of this bill without first discovering its real impacts and actual programs is unwise.
In closing, our message today is that this bill represents a dramatic transfer of cost and obligations from the oil and gas industry to the Federal Government. Our preliminary analysis suggests that the revenue lost would be significant and could be as much as half a billion dollars.
Because of the effect of this bill on the taxpayer and the budget, the Department will recommend that the president veto H.R. 3334 or any bill that requires mandatory RIK.
Thank you, Madam Chairman and members of the Subcommittee. I would be happy to address any of your questions.
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[The prepared statement of Ms. Quarterman may be found at end of hearing.]
Mrs. CUBIN. Thank you, Ms. Quarterman.
I think I will start my questioning with the Governor. We will have two rounds of questioning, so I will just focus on the Governor for right now.
As Chairman of the Interstate Oil and Gas Commission, a compact commission in Wyoming, I understand that you and your staff have taken a look at both the pros and the cons in our RIK program. Can you tell me what the commission has concluded? Have they endorsed a concept for a Federal mandate for royalties in kind?
Mr. GERINGER. Yes. Madam Chairman, the Interstate Oil and Gas Compact Commission represents 36 states either as direct members or as affiliates. We have worked cooperatively since 1935 to address energy conservation and regulation of the industry. That association is very familiar with the cost as well as the process that is involved with oil production and certainly conservation, because we consider our primary role to be one of conserving the resource and not letting it get out of hand.
The commission unanimously approved a resolution in the December meeting to support the development of a comprehensive and flexible royalty-in-kind program for both oil and gas. The resolution also supports allowing a producing state at its sole option to assume those marketing and administrative functions designated to the Federal Government, which this legislation would allow.
The association does not just blindly pass resolutions. It is a tough nut to crack to get a resolution through that organization, but they have indicated their willingness to support this and the 36 members and affiliates spoke in favor of that.
Mrs. CUBIN. In your testimony, you make reference to a study that the state of Wyoming did on the administrative process associated with the collection and distribution of mineral royalties. Can you elaborate a little bit for me on that study and tell the Subcommittee what cost savings your study predicted if a state like Wyoming were to manage its own royalty program?
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Mr. GERINGER. Well, Madam Chairman, it has been a bit of a difficult process because we have never been able to obtain a full accounting for how the Federal deductions come about. We did complete a study of our own as to what we thought the projected cost of administration of a state-operated program would be, so we know what our costs are. They come out to be about one-seventh of what we are being charged by the Federal Government. There must be something that could be learned from a full disclosure as to what the costs are and why the deductions are as high as they are.
In October 1997, the Department of Interior IG's Office issued a report of the MMS Service, the BLM and the USDA Forest Service. They analyzed the expenses that were charged against Federal royalties in the context of net receipts for three fiscal years, 1994 through 1996.
The conclusion of that report was that the states had been overcharged. So there is an IG's report that at least says overcharging does occur. We think that there could be considerably more at stake than what the IG's report turned up, and we have asked the secretary of interior to refund those overcharges to Wyoming. I believe New Mexico has also asked the same thing.
Mrs. CUBIN. Since you do not have any information to the contrary, is it correct for me to say that you assume that the cost savings that the state could make would be comparable in a royalty-in-kind program?
Mr. GERINGER. That is certainly our goal, Madam Chairman. I think any reasonable person would say that based on the indications that we have through our own analysis, through the IG's report and just for the sheer frustration of not being able to consistently come up with an answer to what the value is at the lease—nobody markets at the lease, yet we have to calculate a value at the lease—I guess, as I said earlier, the logic seems to be overwhelmingly in favor of some sort of an RIK program, which if an individual state wants to take it on, it is a reduced cost to MMS. The opportunity to enhance royalties for both the state and the Federal Government is there. I mean, that is a no lose situation.
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Mrs. CUBIN. Ms. Quarterman, can you tell me why the states have not been able to get the information, the statistics, that they need to know exactly what the costs are that MMS spends on collection?
Ms. QUARTERMAN. We have provided the states with detailed accountings of all of our costs.
Mrs. CUBIN. Then why doesn't the Governor understand it?
Ms. QUARTERMAN. I can't answer that one.
Mrs. CUBIN. Do you agree with that, Governor?
Mr. GERINGER. Madam Chairman, if we could have a side-by-side comparison of why the costs are allocated as high as they are and so much higher than what the equivalent costs would be on a state lease, if you take single lease in a unitized field or something that is comparable close by, you ought to be able to have a side-by-side comparison. When Wyoming runs its cost out and it comes up that much higher, why are they that much higher?
Mrs. CUBIN. Could I ask you both here today to make a date to sit down at the table and compare those figures and work that out? I think that is something that is very important for the Committee to know before we would move forward. Would you both commit to doing that?
Mr. GERINGER. I certainly would, Madam Chairman.
Ms. QUARTERMAN. Our figures are open for anyone to look at our costs, absolutely.
Mrs. CUBIN. No, no, no. Would you sit down at the table and go side by side with the Governor and his staff, your staff and make a comparison?
Ms. QUARTERMAN. Oh, certainly.
Mrs. CUBIN. OK. Now it is a date, don't forget. I see that my time is up.
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Mr. Romero-Barceló?
Mr. ROMERO-BARCELÓ. Thank you, Madam Chair.
First of all, I want to welcome the Governor here to the hearing and ask a couple of questions.
Mr. GERINGER. Thank you.
Mr. ROMERO-BARCELÓ. Governor, according to the President's basic budget documents, approximately $7 million that would otherwise go to Wyoming is used to offset the Federal Government cost in order to run the Federal longshore oil and gas leasing from which Wyoming is entitled to an equal share of the gross receipts.
We understand that the state of Wyoming has strong objections to the net receipt sharing program in which the states pay a portion of the Federal Government's cost to administer the onshore oil and gas leasing program. Under H.R. 3334, Wyoming would no longer share in the Federal Government's cost to run the onshore program.
Have you considered the possibility that states could lose even more than they are now paying under the net receipts sharing because the gross revenues would be reduced by paying for things that the Federal Government does not now pay under the current law like marketing, transportation, processing, and aggregating?
Mr. GERINGER. Madam Chairman, if the state of Wyoming had the opportunity to take its product in kind, there would be very little to account for at the Federal level with the 1,800 employees that are currently at MMS. Perhaps in a rather crude analogy or comparison, the Province of Alberta in Canada has 67 employees to administer an in-kind program where they have contracted with a third party to market almost an equivalent amount of product. Sixty-seven employees in Alberta compared to 1,800 employees in MMS, there is probably something in between that could be counted as savings to both parties.
Mrs. CUBIN. Excuse me for interrupting, Mr. Romero-Barceló. The Governor has a plane to catch at 3:30, and so I thought I would ask the panel if they would object to submitting written questions to him if they have any further questions. Would that be all right with the panel and with the Governor?
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Mr. GERINGER. If there is any burning issue that needs to be answered right away, Madam Chairman, I would sure stick around for one or two questions; but, yes, I do appreciate your indulgence in trying to burn a little jet fuel here.
Mrs. CUBIN. Are there any burning questions from the panel?
[No response.]
Mrs. CUBIN. Thank you. Thank you very much for your testimony, Governor Geringer.
Mr. GERINGER. Thank you, Madam Chairman.
Mr. ROMERO-BARCELO. Madam Chair, I have 10 questions that I want to submit in writing.
Mrs. CUBIN. Absolutely. The record will certainly be kept open to get those.
Mr. GERINGER. Madam Chairman, we do want to indicate our willingness to work with MMS, with Ms. Quarterman and with this Committee at whatever markup is done on the bill because I think we can mutually benefit from how we come out of this. This is not a choice of whether the states versus the Federal Government can do a job better. It is an indication of what we might do together that has a mutual benefit for us both. It is not an either/or, but it is how we might mutually benefit from whatever comes out of this legislation. So thank you for the opportunity.
Mrs. CUBIN. Godspeed, Governor.
Mr. Barceló, would you like to—we will add some minutes on to your time since I interrupted you.
Mr. ROMERO-BARCELÓ. No, that is all right. I can submit my questions to Ms. Quarterman also in writing.
Mrs. CUBIN. Well, we are going to have two rounds of questioning, so if you want to start with questioning Ms. Quarterman, that is fine.
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Mr. ROMERO-BARCELÓ. I have got 13 questions here. I think I would just as soon submit them in writing, so we can save some time. We have quite a few members and other panels.
Mrs. CUBIN. OK. Good.
Mr. Tauzin?
Thank you, sir.
Mr. TAUZIN. No questions, Madam Chairman.
Mrs. CUBIN. Mr. Thornberry?
Mr. THORNBERRY. Thank you, Madam Chairman.
Ms. Quarterman, I appreciate you being here. I tell you the truth after you called last night I was a little disappointed in the tone of your remarks of your testimony. I certainly never expected the administration to support a mandatory in-kind bill.
You make it clear on the first page of your testimony, that the issues about whether you have authority to do it or not indicates that you would not accept it. I understand that a mandatory royalty-in-kind bill reduces the size and power and control of MMS. I never had any question about whether that would be something that you or your Agency could support.
I had hoped all through this process that there could be a more constructive dialog about how if there were going to be an RIK program, how it could be done in a way that makes sense for everybody. I have got to tell you I am particularly concerned about some aspects of your testimony that do not appear to have anything to do with the bill that we introduced. There are several instances.
On page 6 of your testimony, you talk about that the bill would mandate RIK programs in areas where unfavorable conditions—and one of the conditions you referred to was taking production at less than marketable condition. That does not apply to our bill. You mentioned that H.R. 3334 would require MMS to pay above market rates for transportation. We changed that. We took from your geothermal regulations the method of computing the transportation costs, so that does not apply.
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On page three of your testimony, you have a number of things listed there that were in the industry draft but were not in my bill as introduced.
The fourth thing you have on page three says that the bill's criteria—that they could sell to themselves, that the companies could sell to themselves, or affiliates are so broad and enforceable that it would be a problem. We let the secretary set up the rules on how that can be done.
I am a little perplexed, I guess, as to whether in your testimony your staff was working off of the industry draft or the bill that was actually introduced. The difficulty is that also makes it somewhat difficult to have a real dialog and constructive comments about how to do this thing in the best interest of the taxpayers and everybody who is involved with it.
Let me get to one issue at least beginning, and that is, this question of whether or not MMS can take royalty-in-kind now under existing authorities. I have got before me ''Minerals Management Service Royalty Gas Marketing Pilot Final Report,'' September 1996, which indicates on page 27 that ''The OCSLA fair market value provisions preclude us from proceeding with a new pilot or program without a change for gas royalties in kind.'' Then I have also got from your September 2, 1997, press release a statement that ''Most Federal mineral leases contain a provision that permits the government to receive its royalty share in kind.''
Now, have your lawyers sorted out whether or not MMS with no existing authorities can require royalty in kind mandatory across the board for all leases?
Ms. QUARTERMAN. Well, first, Mr. Thornberry, I want to assure you that my staff did have a copy of H.R. 3334 before them, and I did note that there were changes between the two bills, the industry version and your version. Attempts may have been made by your staff to correct some of the things that are listed in my testimony; however, they are not corrected in that bill.
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With respect to the statements made both in the report and the press release, lawyers were neither on the team that put together that report or involved in the writing of that press release. It is my understanding that we have legal authority to proceed.
Mr. THORNBERRY. That would be discretionary to you on whether to do it and how to do it currently. These two things are wrong. In your view, you have the discretion on when and how and in what circumstances to take royalty-in-kind?
Ms. QUARTERMAN. It is my understanding the law does give us that discretion.
Mr. THORNBERRY. OK. Madam Chairman, I will reserve until the next line of questions.
Mrs. CUBIN. Mr. John?
Mr. JOHN. Ms. Quarterman, in your testimony you had talked a lot about—well, a little bit about the pilot programs. I saw an optimistic look on your face and in the inflection in your voice. Can you share with us what you see the problems that you are going to encounter that we might be able to learn and incorporate in the piece of legislation that we are proposing or looking at, at this point in time? Because you are in what? Two of 3 years in the Wyoming pilot and progressing in each of the other states?
Ms. QUARTERMAN. Yes.
Mr. JOHN. Give us where you see where we can maybe look at some of the problems?
Ms. QUARTERMAN. We have taken royalty-in-kind. In 1995, the Federal Government took about 6 percent of its gas offshore in kind, and there was an extensive study done—maybe the one that Mr. Thornberry is referring to—that listed some of the problems that we had in that study where we lost 6 percent of our revenues.
Mr. JOHN. Why? Give reasons.
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Ms. QUARTERMAN. There were a number of reasons. I can give you a handful of them, but probably not all of them. I haven't read it recently. One of the things that we thought was problematic was that we took our gas in kind at the beginning of the year. We thought that it would make more sense to do it at the beginning of the heating season.
Secondarily, the way we handled the pilot, we turned it over directly. We, essentially, sold it to a marketer to sell later on in which case we really do not have the opportunity to carry the gas to a further point downstream. We see that as a problem.
Another problem was that we did this very, very quickly. We did have a great deal of involvement by gas marketers, the Gas Supply Association, oil and gas industry associations because we did not really know what we were doing and we wanted to make sure that what we wrote in a contract with a marketer was something that was akin to what an oil and gas company would write in a contract with a marketer. We did not want to put in any hidden ugly things that would cause us to reduce value. Those are some of the things.
Some of the others, transportation cost was another. What we found was that our marketer bid on certain production of gas. When it came time to accept the gas and move it to the marketplace, he had not taken into account the fact that there are many nonjurisdictional pipelines along the way and he would have to negotiate with each individual owner of those pipelines a nonpublic rate along the way, so he had not included those costs. We had a couple marketers drop out after they had submitted bids because they had overbid the situation. Since it was a pilot, we thought it was appropriate to do that.
Mr. JOHN. There are some critics and research on this issue that say some of the problems you have encountered with some of these pilot programs are obviously in the marketing area, and you have touched on that. Are those problems a result of your office trying to be the marketers in those situations?
Ms. QUARTERMAN. We have never tried to be the marketer. We certainly do not have the expertise to do that.
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Mr. JOHN. OK.
Ms. QUARTERMAN. Some might think that is an interesting idea maybe to start a quasi-government corporation that markets oil and gas.
Mr. JOHN. No. That is not what I am suggesting here.
Ms. QUARTERMAN. It is not what we are suggesting either, but it is an idea.
Mr. JOHN. Thank you.
Mrs. CUBIN. Mr. Brady?
Mr. BRADY. Thank you, Madam Chairman.
In your testimony, you identified a figure of a half a billion dollars as the cost to American taxpayers for this bill. I know you are a very knowledgeable executive, so I know I can ask you these questions with confidence.
Those figures, do they include taking advantage of the best practices of current marketing, that is, using qualified marketing agents versus unqualified marketing agents who are in a learning curve?
Ms. QUARTERMAN. Yes. This assumes that the government would hire the best marketers available. I mean, we are talking about an extremely large amount of oil and gas production. I do not think we should settle for anything less than the best in those circumstances.
Mr. BRADY. I am reading the testimony from Governor Geringer and I understand that to date you are not planning to use a qualified marketing agent in that state; is that correct?
Ms. QUARTERMAN. In the Wyoming pilot, we had two options available to us: one was to do a competitive bid, and the second was to do a qualified marketing agent. The team working on that which did include Wyoming representatives thought it was a good idea to try to look at both of those methodologies. I have since learned that the Governor's office does not support the competitive bidding portion of that; and if that is the case, we will drop it out of our pilot.
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Mr. BRADY. The only reason I ask is that obviously the private sector has found that having qualified real experts, as the Governor identified them, marketing is the key to enhancing the value. If past practice from the Agency has been to not use them, it is easily assumable that the estimates used today would be assuming you are not using the best in the field in the future.
Ms. QUARTERMAN. In our pilot where we actually did take gas in kind in 1995, I think you would find that we used the best marketing available.
Mr. BRADY. Within the existing one? Just so I understand, there is one in effect?
Ms. QUARTERMAN. Actually, we haven't started taking any oil in that pilot at this point.
Mr. BRADY. May I ask, have you talked to any qualified marketers in that pilot program?
Ms. QUARTERMAN. Not to my knowledge.
Mr. BRADY. Does the $500 million figure include the reduction in any regulatory auditing or litigation costs as a result of being part of the market versus chasing it?
Ms. QUARTERMAN. I said close to half a billion dollars. That figure includes a deduction of about $6 million, which is MMS's share of net receipt sharing costs that are currently paid by all the states combined as a deduction in terms of increases for administrative costs. I think the chairwoman alluded to earlier those sorts of things are not typically scorable administrative savings.
Mr. BRADY. For the most part, it does not include that reduction?
Ms. QUARTERMAN. I can give you a broad estimate of that. Our current royalty management program costs approximately $60 million. Our best guess at this time is that if this bill were to pass, and I think that it requires a year's time before it is actually implemented, given the Royalty Simplification and Fairness Act that passed a couple of years ago we would probably need to have all of our auditors on board for 7 years beyond the date anything was put in place in order to take care of the statute of limitations period that is currently pending.
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Other than oil and gas production, we do collect royalties on behalf of about 20 tribes and 20,000 allottees that would also have to continue to go on. We collect geothermal, coal, solid minerals, any number of things. Our best guess would be, assuming that everything disappeared in 7 years of those things that are currently associated with oil and gas, about a $32 million reduction.
Mr. BRADY. Does the figure include the acceleration of royalty receipts now lost to the time-consuming delays in litigation and dispute?
Ms. QUARTERMAN. Currently, if a delay occurs because of litigation, the company is required to pay, assuming that we win, if there is a delay they pay interest on that so there is no time value of money loss involved.
Mr. BRADY. You do not collect during that period?
Ms. QUARTERMAN. We do not collect during that period for any moneys that are carried over, correct.
Mr. BRADY. Is it safe to say that is not included in the figure?
Ms. QUARTERMAN. That would not be included in the figure. It would be very small.
Mr. BRADY. A couple of quick questions. I assume you included the risk costs in the analysis. Can you tell us what figure you assigned to the enhanced value of the oil and gas?
Ms. QUARTERMAN. First, I should say that the number that I mentioned is a beginning number in that it only is really associated with the items that I mentioned in my testimony. There are a number of other items that we have not at this point tried to define the value. One included is the cost of risk. I am not sure how we would value such a risk.
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Mr. BRADY. I do not mean to interrupt, but I assume you got $500 million by figuring in certain costs and certain risks and certain expenses associated with it. My question is, What figure did you use as a result of what the real goal of RIK is, which is the enhanced value of the product? I know you want to balance out. You do not want to count just one and ignore the other.
Ms. QUARTERMAN. OK. There is no risk cost yet in that number, so the number would potentially increase in terms of potential loss. As to potential uplift, I do not believe there is any uplift that we can measure at this time. The Federal Government currently has the authority to take its oil and gas in kind at its option, which means that forcing it to do something that it already can do does not include any uplift. If we were to do an estimate, we would have to go back to the natural gas pilot in which we lost money, and that would be a further negative.
Mr. BRADY. You would ignore the reams of real life data occurring in the private market today and would go back to a fairly flawed pilot program in order to ascertain the numbers?
Ms. QUARTERMAN. I am not aware of the data that you are referring to.
Mr. BRADY. Thank you, Madam Chairman.
Mrs. CUBIN. Mr. Tauzin?
Mr. TAUZIN. Madam Chairman.
Ms. Quarterman, I am trying to follow your statement. When you say the results of your pilots would allow you to select the areas where an RIK can produce additional net revenues, and to avoid those areas they will lose revenue. You say that is not an inconsistent—there is no inconsistency in these two positions. Let me see if I can interpret that and you can help me with it.
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What I read is that you are saying where you, as the government, can take royalty in kind and the transportation and marketing costs are low enough risk for you to go out and market it and make more money doing so that you want the right to do that. On the other hand, when the transportation and marketing costs may be too high, you want the right to put that cost on the oil company and to take the value added without taking the risk. Is that a fair assessment of your position?
Ms. QUARTERMAN. Well, I would say a couple of things. You know, in my role as director of the MMS I have not only the Royalty Management program, but also the Offshore Minerals Management Program off of the Coast of Louisiana. As part of the broader picture of things, one of the things I have to balance is not only receiving fair—not maximum, but fair market value on behalf of the taxpayers—but also to lease areas that we think are appropriate for leasing.
Mr. TAUZIN. Ms. Quarterman, I am going to be limited in time. I understand you have got a lot of roles to perform, but I would just like an answer to the question. Am I correct in assessing your statement that you are saying that the government should have the right in cases where transportation and marketing costs may be high to take the value added in terms of royalty calculation without having to pay the cost of transportation and marketing, to put the risk on the oil company? Is that what you are telling us in your statement?
Ms. QUARTERMAN. Sir, what I am telling you is that the government has that right.
Mr. TAUZIN. You are saying that the government has the right under current law——
Ms. QUARTERMAN. Yes.
Mr. TAUZIN. [continuing] to literally tell an oil company that, ''You have to pay all the cost of marketing and transportation and the government will then get the added value at your expense at no risk to the government. But if we want to, we can go in the market where the conditions are more favorable and take that added value at our own expense in transportation and marketing''? In short, you are saying that the government has the right to interpret the contracts you have with oil companies in a way that is most always beneficial to the government; is that correct?
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Ms. QUARTERMAN. We do allow for transportation costs. I just did not want that to get lost there. The government does, both in the OCS Lands Act and the contract with the companies, have the right at its option to take royalty in kind or in value.
Mr. TAUZIN. I understand you have that right. I am saying that you are telling us, as I understand it, that the current law allows you to interpret the contract with the oil company that is drilling on Federal lands and interpret it in such a way as to always interpret it in favor of the government and at the expense of the company?
Here is my problem. My problem is not just with the enormous cost of all of this auditing and the lawsuits that are flowing out of it and the disputes over whether or not marketing costs should be allocated or not allocated in the discussion of royalty payment, the problem I have is that there are three possibilities here.
One is that Congress passes a law clearly defining the rights of the government and the rights of the citizen who is leasing government property for the production of minerals; or the contract specifies those terms is the second option and specifies them very clearly, who is responsible for the cost of transportation and marketing; or the third option is for the bureaucracy of our government to interpret a contract at will, at its discretion, to always take the benefit for the government out of that contract.
It seems to me that that is the least favorable option for us in fairness to the citizens who participate with the government in the production of its minerals, that the best situation is either one or the other two. Either the contracts ought to very clearly say what the right of the government is and what the right of the oil company is in regards to how costs are allocated, or the Congress ought to say it.
What we are being asked to do is to continue a status quo where the government is constantly trying in intricate, complicated rulemaking to determine value as against cost in contracts that are not apparently very clear, that are blind in a lot of these areas, where the government will always try to interpret it to the benefit of the government, and where we end up with diagrams of government rulemaking that look like Dungeons and Dragons to me, if this is an accurate interpretation of what the rule actually requires.
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When we have a choice of doing one or two things, passing a bill that clearly defines the right of government and the oil companies so that there are no more disputes and no more audits necessary, or requiring the government to specify its rights clearly in a contract.
Madam Chairman, I will wrap up. I know my time is up. I simply want to say this. It seems to me untenable for us to continue a process where the government has to keep going to court arguing that costs should be allocated one way or another in the process of fixing values or that values ought to be assessed at some gathering point, at some wellhead, or at some downstream point, at the refinery, or perhaps all the way to the gas station when either the contracts ought to make that clear or we ought to make it clear in the law.
One of the very easy ways to make it clear in the law, to get rid of all of this auditing and all of these lawsuits and all of this conflict between what should be partners, government and citizens in partnership to develop minerals for our country on Federal lands, when the very simple thing to do is to say to the government, ''Take your share of it, hire a marketer and market it yourself and get your value.'' Then, nobody has a complaint anymore about what the value is.
To let the government have the best of all worlds, to take the higher value when it suits you and then force the oil company to eat all the costs when you think that helps your situation is to me an untenable situation that leaves for the bureaucracy the interpretation of what ought to be the law between the parties as defined by the contract or by the law.
Thank you, Madam Chairman. I have gone over.
Mrs. CUBIN. That is fine.
Dr. Quarterman, I want to start out by saying that I have always been very impressed and appreciate your professionalism and your knowledge of the issues and your willingness to work with the Committee to cooperate on information.
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I do want to followup on some of Mr. Thornberry's comments however. I was just kind of amazed because when he started talking about the fact—or the opinion, I guess, that the testimony you have submitted seems more related to the industry draft rather than the bill that is before us, that was exactly what I thought.
As I read through your testimony once and then I read through it again, and it was so nonspecific and it was so vague that to try to gain any kind of way that we could come together to solve problems that are perceived is really impossible. For that reason, I am going to have to ask you to come back on the 31st for the hearing on the 31st.
I realize you probably did not write that, those remarks yourself, but really in my opinion they really are inadequate. For example, you said, ''Well, yes, we did,'' your comment was, ''Oh, yes, we did use the right bill,'' but there was not anything discussed or explained about transportation, gathering costs and return on investments in pipelines.
On the top of page three, you mentioned paying above-market prices for transportation. But as we will discuss at the second hearing as well, definitions of gathering transportation and return on capital investment was significantly modified from the industry's draft, I should say. We view this bill as a return to current practice. It also allows the secretary plenty of discretion on how to disallow deductions on a lease-by-lease basis.
I am disappointed. Since we did not get this, your testimony, until 5:30 last night we did not have the opportunity to get in touch with you and ask for more specifics, things that were more directly related to the bill.
I know that we are likely to disagree here today on the central question of the so-called duty-to-market issue, but we will hear the witnesses to follow you today are quite sure that such a duty is not historical practice as your testimony suggests. They and many others believe that MMS is now seeking to move the valuation point downstream to ensure that the government will receive, as Mr. Tauzin referred, additional revenues without accepting any risks. Could you respond to that for me?
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Ms. QUARTERMAN. I am sorry, what is the question again?
Mrs. CUBIN. Well, there will be witnesses that will be following you that are going to say that there is not a historical practice of duty to market, and that MMS is now seeking to move the valuation downstream to capture added value without accepting any of the risks or associated costs. I would just like your response to that.
Ms. QUARTERMAN. It is my understanding that historically there has always been a duty to market that the government has not born, that lessees have born and that the law is pretty clear on this issue, that there really is not much to argue about. There have been cases related to it, and the government has consistently won them. I am not sure what else there is to say on that one. I am not going to say that I have done any great legal research on this either, because I have not.
Mrs. CUBIN. You said, this is a quote, ''Our preliminary analysis suggests that the revenue loss would be significant and on the order of hundreds of millions at a minimum.'' Again, incomplete information. Over what period of time?
Ms. QUARTERMAN. Per year. If I could, on your earlier statement. I would be happy to come back before the Committee on the 31st or any other time you deem appropriate. One of the things I did mention to Representative Thornberry last night is that we have not had the opportunity to do a detailed analysis of the bill line by line, which is something we want very much to do and are in the process of doing and will have done by the 31st. It was also my understanding that that hearing would deal with transportation issues, technical transportation issues, and those sorts of things. I will be happy to come back. I do not know if I am the best person to talk about that level of detail, but I will try.
Mrs. CUBIN. I can relate to that. Bring your experts along with you. This is the last thing because I am over my time and Mac is giving me the evil eye. It distresses me that the alleged failure to make money in the 1995 gas pilot project in the Gulf keeps cropping up as it has here today.
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You would acknowledge that there are lots of mistakes made in designing that pilot, but I see one big problem, which is that the government took the gas at the lease and then immediately sold it. It did not flip the gas, and therefore did not get the value added from downstream marketing efforts. That is what this so-called uplift which we want to earn for the states and Federal Government is, just for what it is worth.
Mr. John, do you have a second round of questioning?
Mr. JOHN. No, Madam Chairman.
Mrs. CUBIN. Mr. Thornberry?
Mr. THORNBERRY. Thank you, Madam Chairman.
I guess I would like to use my time just to get as much factual information as you have available to you on what basis you made the statement that the potential to lose money in the order of hundreds of millions of dollars. No. 1 is, What baseline did you use, did you operate from? Is it the existing rules? Is it your new proposed rule? Where did you start from?
Mrs. CUBIN. The existing rules.
Mr. THORNBERRY. What is the biggest factor that you included in your estimate that you believe would lose money under an RIK proposal? What loses the most money and what you have looked at so far?
Ms. QUARTERMAN. Transportation costs, I believe.
Mr. THORNBERRY. OK.
Ms. QUARTERMAN. I would have to verify that.
Mr. THORNBERRY. Do you have a figure there handy?
Ms. QUARTERMAN. It is the changes to the transportation provisions between $97.5 million to $246 million.
Mr. THORNBERRY. OK. From $97 million to $246 million is the range?
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Ms. QUARTERMAN. Is the range, yes.
Mr. THORNBERRY. OK. Just briefly, you are talking about an increased cost to the government for transportation costs that the qualified marketing agent would have to assume, or are you talking about a reduction in cost that the government now gets reimbursed by the oil company?
Ms. QUARTERMAN. A reduction in cost over the current rules.
Mr. THORNBERRY. Which the government currently is paid in some fashion?
Ms. QUARTERMAN. In some fashion, yes.
Mr. THORNBERRY. By the oil company. That range is $97 million to $246 million. What is the next item?
Ms. QUARTERMAN. Again, these numbers are very preliminary.
Mr. THORNBERRY. But if you use them, I want to know how you got there.
Ms. QUARTERMAN. Between $61 million to $158 million on processing changes.
Mr. THORNBERRY. This starts to get into at what stage in the marketing chain you sell the product? The change from the current practice, your estimate is that it would be that much of a change?
Ms. QUARTERMAN. Yes.
Mr. THORNBERRY. OK. What is the next item?
Ms. QUARTERMAN. Oh, between $17 million and $46 million on the change to the marketing requirements.
Mr. THORNBERRY. OK. Explain to me the difference in how you calculate the change in processing and the change in marketing?
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Ms. QUARTERMAN. Processing is something that lessees currently have to do to put the product into marketable condition. ''Marketing'' means taking the product to market whatever costs may be associated with aggregating production, that kind of thing.
Mr. THORNBERRY. OK. All right, what is the next item?
Ms. QUARTERMAN. That adds up everything that we have gotten to thus far. There are other things that we do not have a value on at this point.
Mr. THORNBERRY. My understanding from your answer to Mr. Brady's question was that you have no increase in value because of any uplift?
Ms. QUARTERMAN. That is correct.
Mr. THORNBERRY. My understanding is also you have no value in there as a result of reduced administrative costs, litigation costs, and so forth?
Ms. QUARTERMAN. That is correct.
Mr. THORNBERRY. Now, I noticed in your testimony you made some comments about how the cost of marketing would be shifted from the lessee to the Federal Government under an RIK program. Does that argument play into these cost figures that you have given me?
Ms. QUARTERMAN. The item that I listed that said marketing, that is the element.
Mr. THORNBERRY. That is where that fits in?
Ms. QUARTERMAN. That is where it fits in.
Mr. THORNBERRY. OK. When making an assumption like that, what is your assumption on how a qualified marketing agent will be paid or reimbursed for his services? How do you figure that it will happen to get this estimate?
Ms. QUARTERMAN. I do not have the details of that. I would be happy to provide that to you when we get closer to a final number.
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Mr. THORNBERRY. Well, let me just offer this. Did you consider the possibility that some qualified marketing agents may be willing to market the Federal Government's share of oil for nothing so that they can aggregate a larger volume of crude, and therefore have a more valuable product to sell?
Ms. QUARTERMAN. I have heard some put forward that viewpoint. In my experience, people are rarely willing to do something for nothing.
Mr. THORNBERRY. Even if it is of value to them?
Ms. QUARTERMAN. It is a value that is usually taken out of the other person's hide, I would suggest.
Mr. THORNBERRY. The bottom line is we do not know from your estimates how you assumed the marketing costs would be, although you do have a number, a gross number, but we do not know how that has arrived at?
Ms. QUARTERMAN. I cannot tell you now what that number is or what went into that calculation, no, that is correct.
Mr. THORNBERRY. OK. Thank you, Madam Chairman.
Mrs. CUBIN. Mr. Brady?
Mr. BRADY. Madam Chairman, staying on that sheet, if we could, you have identified a number of expenses and costs and reductions. Shifting to the other side of that, can you read me the items and dollar figures for enhanced value and increased revenue under RIK?
Ms. QUARTERMAN. Zero at this point. As I explained earlier, we have the authority to do it at this point in time. I cannot imagine a scenario under which there would be an uplift, given the fact that we have no experience to know that.
Mr. BRADY. Now, in earlier testimony before the Committee, you talked about the potential of RIK and today you talked about the potential of RIK to increase revenues under the right conditions. Is it safe to say that you included no enhanced value? You didn't include the savings of self-consumption by Federal agencies either, which has been very successful in Texas where basically Federal facilities or Federal agencies use the oil and gas in kind to reduce their own costs? Was that on the balance sheet at all?
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Ms. QUARTERMAN. Well, I think the operative word in my testimony has been ''potential,'' we have not in fact seen it. We have in the past spoken with both the Defense Fuel Supply Corporation and the GSA which are responsible for supplying gas primarily to a large segment of the Federal Government to the Defense Department. I spoke with them about the opportunity of taking gas in kind. They really had no interest in taking our gas because they got a better deal elsewhere.
Mr. BRADY. I will finish with this, Madam Chairman.
Just so I understand, is it safe to say you have a completely negative analysis of this impact with absolutely no positive impacts? Ignoring what is occurring in the marketplace, ignoring your earlier testimony about potential, ignoring what states and other entities have received in enhanced value, is it safe to say your analysis while preliminary is completely negative?
Ms. QUARTERMAN. Is it safe to say that, yes.
Mr. BRADY. I do respect your knowledge and your homework. If you could, send us those figures.
Before the next hearing, Madam Chairman, if we could get those in advance so we have an opportunity to review them ourselves that would be a great help. Obviously, we are all trying to get to a point where we increase revenues for taxpayers, and so those numbers are important.
Ms. QUARTERMAN. I would be pleased to provide them.
Mr. BRADY. Thank you. I appreciate that.
Thank you, Madam Chairman.
Mrs. CUBIN. Mr. Tauzin?
Mr. TAUZIN. Well, I would like to make maybe a different point, though, and that is: it is one thing to say the government will not get some money, but it is another thing to say whether or not the government is entitled to that money. If the government does not get some money it is not entitled to, I do not have a problem with that. It is a little bit like, you know, if we had a piece of land we wanted to build a building on and we told the contractor you go build a building and you be responsible for the cost, we will just enjoy the building.
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I do not think the taxpayers of America would appreciate the government treating the contractor that way. What I am saying is you can do an evaluation that says the government may not come out as well if it has to bear some of the cost of marketing and transportation, if it wants the benefits of a higher price at some other point than the point of delivery of the product, but it is another thing to say that the government was entitled to that money without an express agreement by the parties or some law saying that that was going to be the law between the two parties when the lessor and the lessee agreed.
You know, that is my problem, Ms. Quarterman. It is not just a question of what the dollars are, it is a question of what the equities are here, No. 1. No. 2, isn't there a simpler way of doing this than this extraordinarily complex rule for setting values that takes us to court all the time? It is looking more like the IRS. That is my problem. I mean, maybe worse.
If you end up having to have an oil evaluation rule that is so complex because it has to take into account every kind of different scenario in the world—commingling, transportation, aggregation, exchange, and whether or not a company is dealing with an affiliate or a nonaffiliate with its transaction or not—when you start having to deal with so many different scenarios to try to figure out a rule to assess their value, the cost of doing that in regulations, the cost of doing that in disputes or the courts, the cost of deciding in the end what the value is adds up considerably.
I saw you asked for additional moneys for your Department. I would hope the extra $5 million is not just to enforce this rule, but I would think it is probably related. I mean, this is getting pretty complex. It just seems to me that maybe the RIKs are ways in which we can solve this in a more simple, more satisfying way for both the parties if we define who is responsible for cost somewhere along the line. It seems to me that, you know, some definition of what the lessee is responsible for and then where the lessor picks up the product and is responsible from then on is a fair way of doing that.
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In regards to the RIK you have done, the pilots you have done, did you seek the counsel and the advice and the cooperation of the companies in designing these pilots, or did your Agency do them on your own?
Ms. QUARTERMAN. Absolutely, we worked hand in hand with the oil and gas industry in developing these pilots.
Mr. TAUZIN. They were contributors to the design of these pilots? Because I am told otherwise, that they did not have as big a hand as perhaps they might have wanted to have in making sure the pilots were good examples of what might occur. Are you telling me you think they did?
Ms. QUARTERMAN. Oh, absolutely.
Mr. TAUZIN. The pilots that you are running indicate to you that at least on some occasions the government can make money when it takes royalty-in-kind; right?
Ms. QUARTERMAN. Not at this point we have not had that indication. We are extremely hopeful. I would like to think there is an opportunity for RIK, and that is precisely why the government is running these pilots.
Mr. TAUZIN. In fact, I have seen some of your quotes indicating that, in fact, you not only have a lot of hope, that you think it is very logical that the government will do well at least in certain cases where RIKs can work for the benefit of the government; right?
Ms. QUARTERMAN. Yes, there are certain cases that are appealing at least on the face.
Mr. TAUZIN. You are not ready to say that your pilot programs have disproved that yet?
Ms. QUARTERMAN. Our pilot programs haven't started other than the one that we had in 1995 in the Gulf.
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Mr. TAUZIN. You are literally making your projections of losses without the benefit of the knowledge you might gain from these pilot programs?
Ms. QUARTERMAN. We are making our losses based on the legislation versus current situation. As I said, we have nothing other than the 1995 pilot where we lost money to determine whether or not we would make money here or not.
Mr. TAUZIN. There are theoretical losses based upon the notion that if the government had to always take its product in kind from the gathering point and then be responsible for transportation and marketing costs in the process that it would lose money.
My only conclusion, then, you must be saying what I initially thought you said in your report, that you thought it was OK for the government to allow the lessee to bear all of those costs and bear risks and have the government take the benefit of the extra value downstream; is that correct?
Ms. QUARTERMAN. They are not theoretical losses. You know, I want to be clear. We do not think that in taking royalty in kind or in value there is any detriment to the oil and gas industry. They are required by law to allow us to take it either in value or in kind. If we take our oil in value, they must provide us with fair market value unless this Congress decides to change that.
Mr. TAUZIN. Yes, but it is not that simple. The question is when do you value it? Where do you value it? If you insist that you value it at some point downstream after the company has absorbed a lot of cost and risk in marketing as opposed to valuing it at the point when it is deliverable to the government as an in-kind situation, that is a big difference, is it not? Isn't that the difference in your numbers?
Ms. QUARTERMAN. That is not what is in my valuation rulemaking.
Mr. TAUZIN. Isn't that in your numbers of losses?
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Ms. QUARTERMAN. I am sorry?
Mr. TAUZIN. Isn't that difference really where you get your numbers of losses?
Ms. QUARTERMAN. The difference in losses is between the current regulation, the current way things are operating, and the way things would change under RIK because there would be changes in the way we look at transportation, the way we look at processing and other kinds of things.
Mr. TAUZIN. Well, you look at who bears the cost of it is what you are saying?
Ms. QUARTERMAN. Precisely.
Mr. TAUZIN. Thank you.
Mrs. CUBIN. Thank you.
We certainly thank you for your time and your testimony here today. I just want to request one last thing. First of all, I want you to know I think geothermal energy certainly is an absolutely essential part of the nation's overall energy supply. I also realize that far, far less money is at stake in geothermal than in the RIK program that we are talking about.
When we come back on the 31st, I would appreciate it if you would please be prepared to fully discuss why H.R. 3334 provision regarding return investment on transportation, say, like, a pipeline in the Gulf of Mexico isn't fair? We modeled that provision exactly upon the geothermal or what the geothermal gets, which is two times the Standard and Poor BBB return on investments. I would appreciate an explanation of why that is not fair when you come back on the 31st.
Ms. QUARTERMAN. I will be happy to do that. I should say geothermal and the oil and gas industry are different. We do have different standards for valuing transportation costs in the oil and gas industry. We would be happy to provide those figures, so you have an apples to apples comparison.
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Mrs. CUBIN. I certainly realize that it is different. I do not exactly understand why transportation would be different, but we will make that clear on the 31st. Thank you very much for your testimony. Maybe I can be more specific in the information we would like you to provide on the 31st.
Thank you very much.
Now I would like to call the second panel: Mr. Hugh Schaefer, the director of Welborn, Sullivan, Meck and others, the Independent Petroleum Association of the Mountain States; Mr. Poe Leggette of Jackson & Kelly representing the Independent Petroleum Association of America and the Domestic Petroleum Council.
Mr. Hawk, since the witness that was to be on your panel was not able to get here due to weather, I would ask you to join this panel as well. Mr. Phil Hawk, President and CEO of EOTT Corporation.
If you would, stand so that I can swear you in.
[Witnesses sworn.]
Mrs. CUBIN. Thank you.
Let me remind the witnesses that under our rules your testimony, your oral statements should be limited to 10 minutes, but your entire written statement will be included in the record. We will start the testimony with Mr. Schaefer.
STATEMENT OF HUGH V. SCHAEFER, DIRECTOR, WELBORN, SULLIVAN, MECK & TOOLEY, DENVER, COLORADO; CHAIR, ROYALTIES COMMITTEE, INDEPENDENT PETROLEUM ASSOCIATION OF MOUNTAIN STATES
Mr. SCHAEFER. Thank you, Madam Chairman.
My name is Hugh Schaefer. I am chair of the Royalties Committee of the Independent Petroleum Association of Mountain States, which I will refer to simply as ''IPAMS'' throughout the rest of my presentation. IPAMS is a nonprofit, nonpartisan association representing over 700 independent oil and gas producers, service/supply companies, and industry consultants in the Rocky Mountain region.
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IPAMS appreciates the opportunity to appear before you today and present this statement. We believe that there is a distinct need for relief from the current royalty in-value system. There are significant advantages to be gained by requiring the Federal Government to take its oil and gas royalties in kind rather than in value and avoid the wasteful, time-consuming, and complex process that is involved with the determination, payment and auditing of Federal royalty payments.
Until the recent enactment of the Federal Oil and Gas Royalty Simplification and Fairness Act, most audits were not commenced until an average of 4 to 5 years after the royalty payments in question had been made. Thereafter, a lengthy administrative appeal process delayed the final resolution of MMS royalty claims, assuming that the lessee disputed the audit claims and sought administrative relief. This 3 to 4 years was just what it took to get the case through the Department of the Interior.
IPAMS believes that a royalty-in-kind program will eliminated a substantial portion of this time-consuming delay in the resolution of audit disputes. Although the Fairness Act has speeded up the audit process with a 33-month rule, nonetheless the Federal Government still has 7 years in which they can file a royalty claim for underpayment of royalties or be time barred by the statute.
Now, under the current royalty-in-value system, a lessee who appeals a royalty payment has an election either to pay the disputed royalties under protest and subject to appeal or post a surety bond or irrevocable letter of credit. If the lessee elects the later, then any Federal royalty revenues are going to be postponed until the appeal process is exhausted. If the lessee elects to go to court and post another bond, then again Federal royalty revenues are being denied.
Now, I realize that the bonding process requires that there be a bond to cover both principal and interest for one year in advance, but this is a rolling type of bond where each year the accrued interest is rolled up and put into the principal.
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We believe that if the royalty-in-value program remains in place the audit process will become even more exacerbated and difficult to administer, because new and proposed royalty valuation regulations have become more and more complicated and difficult to administer for the small independent oil and gas producer.
They will create more cost and effort to apply these new regulations properly, effectively and efficiently. They will also require the employment of qualified personnel or consultants to do this work for Federal lessees. This additional cost becomes particularly onerous when industry goes through periods of price volatility such as we are experiencing now.
I do not have to tell you, Madam Chairman, that we all know what the price of crude oil, Wyoming sour and Wyoming asphalt is today. It is somewhere between $7 and $8 a barrel. As you mentioned earlier in your opening comments, I can testify my clients are shutting in their fields because this is not an economic return for them.
As you are all aware, the MMS gas transportation allowance regulations have recently been challenged in Federal court. That challenge has been mounted for the very reason of which I have just spoken. It is a complex regulation. It is difficult to administer. As we get new regulations on oil and also on gas valuation, I believe that it is a distinct possibility that these, too, may end up in litigation. Now that is not intended as a threat, but it is just my educated guess.
I want to talk a little bit about these proposals because the whole thrust of my presentation today is that I honestly believe that there is even now in the current regulatory system a shift away from traditional methods of valuing oil and gas under Federal leases.
In my remarks, I pointed out that, for example, the Mineral Leasing Act has always been that the value of production in wells are at the well, in the field or area. Then the approach that is being taken now, even though the regulations are just merely proposed or haven't even been proposed, is that we are already beginning to see ''a netback'' approach, that is: to go to a downstream market and net back from the sales point or the delivery point back to the wellhead.
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In the cases that I have observed, and I should say I have presently on appeal to the director or the Interior Board of Land Appeals, not all of these prices have even been adjusted properly to reflect the transportation differential. This is very interesting because back in 1988, now we are looking at these regulations, we went through all of this before.
I would suggest that, with all due respect to the Committee, if you have time, to go back and look at the 1988 regulations. You are going to see that all of this got ironed out before, the affiliate issue, and now we are coming back all over again. As Yogi Berra said, it is ''Deja vu all over again.'' We are going to go through this again.
The other thing I want to mention is that recently the industry and MMS and the states have been working on developing a gas valuation regulation. We have gone through iteration after iteration for 3 to 4 years, and we still do not have a gas valuation regulation. I expect that we will have one, but I also expect it is not going to be very well received by the industry and possibly even the states. As I mentioned earlier, it could very possibly lead to litigation.
Now at this juncture I want to describe a couple of cases which point up the flaws in the current audit process. I have several of them enumerated in my comments, and I recommend them to you for your reading. The first example involves a small, independent affiliate who does, in fact, have a marketing affiliate.
Let me just digress for a moment to say that the marketing affiliate has risen to the fore because of the way in which natural gas is being marketed today. We no longer sell gas at the wellhead to an interstate pipeline company. The FERC through its Order 636 reorganized and unbundled the whole pipeline marketing system so that now it is incumbent upon a producer to go to an end-use customer and find a market for that gas.
Most independent oil and gas producers were not equipped to do that because that was something they left to the pipeline. Now they have to turn and use these marketing affiliates. It makes a lot of business sense that if you can afford to have your own marketing affiliate do this work you are going to save money because it is going to cost you more money to hire somebody who is independent. That only makes sense.
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Now, in this case my client sold gas to its marketing affiliate, and we were unclear under the regulations as to how that gas should be valued when we sold it to our marketing affiliate. Now, let me say this is a marketing affiliate that buys and sells not only its own affiliates' gas but gas of third parties, so it is not what I would call an ''MMS marketing affiliate.'' Under MMS regulations, an ''MMS marketing affiliate'' is one that deals exclusively with gas or oil that is produced by its own affiliate.
The request was denied. Well, let me back up. My affiliate—or my client, excuse me, wanted to use as a value basis prices, index prices, on gas transmission lines in the field or area. That was declined. We received an order to comply with the existing regulations. We proceeded to file the new reports and pay the additional royalties in.
A few years after that, we were audited. The auditors came in and disregarded and rejected the valuation methodology and force ordered my client to pay on the basis of prices that were being received in the end user market and netting back to the wellhead. In fact, this is unclear, but I am told by my client that the auditors did not even know about the valuation order until they showed up at the doorstep and they asked, ''What are you doing here? We have already paid these royalties.''
In another case—this is truly a tragic story—my client received an order to pay, appealed the order to the Director of the MMS, the order was upheld, appealed to the IBLA. Unfortunately, the proofs of service, the certified mail receipts which under IBLA regulations must be filed to show that the appeal was timely filed, were lost.
The lessee sued the law firm that filed the ''Notice of Appeal'' and won a judgment for malpractice. The point being that the auditors confused gas volumes that would be excluded because the gas was being put to a beneficial use and with a cost that a lessee is not allowed to deduct for gathering, dehydrating, cleaning the gas and everything like that. That cost that law firm $250,000, because that is the amount of the additional assessment. I see I am out of time. My comments have a lot more in it, and I will be happy to answer any questions.
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[The prepared statement of Mr. Schaefer may be found at end of hearing.]
Mrs. CUBIN. Thank you Mr. Schaefer. Your entire comments will be part of the record.
Mr. Leggette?
Mr. LEGGETTE. Leggette.
Mrs. CUBIN. I knew that.
STATEMENT OF POE LEGGETTE, ESQ., JACKSON & KELLY; REPRESENTING THE INDEPENDENT PETROLEUM ASSOCIATION OF AMERICA AND THE DOMESTIC PETROLEUM COUNCIL
Mr. LEGGETTE. Madam Chairman, it is my pleasure to be here to conduct a very brief but magical history tour of Federal royalty law relevant to the bill before you today.
In 1929, the Federal onshore leasing program was only 9 years old, but already the Department of the Interior suspected that oil produced in the Kettleman Hills in California was being valued for royalty purposes at less than its fair market value, so the Department took its royalty share in kind. Instead of receiving $1.65 per barrel in value, Interior received $2.25; and $2.54 cents per barrel for the barrels that it sold.
Then the Department changed its tactics. It ordered the Federal lessees in the field to pay royalty in value, and to do so using the highest posted price anywhere in California for oil of like gravity. The secretary believed he had the implied power under the lease and under his regulations to set the value of oil for royalty purposes. He sued the lessees to prove his point, and he lost.
In United States v. General Petroleum Corporation, the trial court held that when leasing the Department's role is like that of a private landowner. For the secretary to have the power unilaterally to set the value of oil, that power must be expressly stated in the lease or regulations. The Department appealed this point, and again it lost. The Ninth Circuit Court of Appeals ruled in 1950 that unless the power is expressed the secretary does not have it.
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Independents have reviewed the numerous Federal lease forms going back to 1920 when the Mineral Leasing Act was enacted and the regulations going back to that date. There is no express power in the lease or rules allowing the secretary to require lessees to market oil or gas at no cost to the lessor.
I believe that Ms. Quarterman, in talking about court cases that she said were to the contrary, must have been referring to a separate duty, the duty to place oil and gas in marketable condition at the lease—a duty that this bill does not change.
The case I just discussed, by the way, is the only court case that the Department of the Interior has pointed to in support of its claim that there is an implied duty to market beyond the lease at no cost to the lessor. Obviously, we think the Department's position is not well founded.
Well, my history tour is over, but the question remains the same today. Royalty in kind or royalty in value? Once again, the Department's preference is for royalty in value. It has proposed to overhaul its current rules for oil. It says that this change will bring certainty and simplicity. I now invite the Committee's attention to the charts to my right.
This is an illustration of the decision tree that one would have to go through to apply the current proposal. I am not going to bore the Committee with a detailed description of this. What I would like to point out is that every blue or yellow box is a decision point. The ovals that look like gears in a Charlie Chaplin movie, at least that is what I wanted to say until I heard you refer to it as ''Dungeons and Dragons'' and I think that is much better, but that is the point where MMS has to make a determination.
What is really important to understand here is that all of the yellow boxes are subjective decision points. These are the ones where neither the lessee nor the lessor have certainty. There are more yellow than blue boxes. For MMS to assert that this proposal is simple and certain is simply and certainly inaccurate.
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I must also respectfully disagree with Ms. Quarterman on another point that she stated, and that is this. The proposed rule is expressly drafted to allow MMS to use this new duty to market to second-guess an independent producer's decision to sell its oil at arm's length at the lease. The Kettleman Hills case was litigated for over 11 years. You can imagine what fun lawyers are going to have with this proposed rule. There is a better way.
Diemer True, president if IPAA's Land and Royalty Committee was prepared to outline it for this Committee; however, he cannot join us today because of a heavy snowstorm in Wyoming. He sends his apologies. He will testify on March 31. On behalf of independents, we submit his statement for the record today. With your leave, Madam Chairman, independents would like me briefly to touch on the highlights of his testimony.
Mrs. CUBIN. Can I interrupt you just for a second, so that I do not forget to do this later. Since I have sworn in the witnesses, I would prefer that you not submit his testimony for the record today. He will be here on the 31st to do that himself.
Mr. LEGGETTE. My offer is withdrawn.
Mrs. CUBIN. Please do go ahead and summarize the testimony as you started to do.
Mr. LEGGETTE. Thank you. Independents support H.R. 3334, the Royalty Enhancement Act. Independent producers agree that a mandatory royalty-in-kind program will once and for all eliminate the disputes and uncertainty inherent in any royalty-in-value program.
This bill could not have been introduced at a better time. World oil prices have sunk to levels not seen since 1986. If America is to maintain a viable domestic oil and gas program, we need Federal programs and policies that encourage industry to grow. The lower prices drop, the harsher the impact of the costs of royalty compliance are on independents. This bill would allow us to redirect money from royalty compliance to investments in exploration and production. The bill will be revenue-neutral at worst. I think you all have guaranteed that.
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From the general design of the bill, I believe it will be revenue positive. You have already heard our friends in the Department say the opposite. I know that. But their view is based primarily on the assumption that they are going to succeed in creating this new duty to market at no cost to the lessor. We invite them to bring their budget scorecard to the table and to work with us to create a winning solution for the country.
Please consider all of the cost savings this bill can bring. The government's cost of administering the royalty value program would largely be eliminated. Using private marketing expertise to market Federal royalty oil, the government can maximize its revenue without creating a new Federal marketing bureaucracy to replace the current royalty value bureaucracy.
Independents are ready to work with the Committee, with the administration and interested skeptics to refine the bill, to minimize the government's costs without unfairly assigning them to producers. Independents urge Congress to proceed with the passage of the Royalty Enhancement Act, and we ask proponents of the status quo to work with us in developing a successful program.
In closing, I would like to offer the Committee a personal perspective that it will not receive from any other witness. I am the only witness today who has served in the front lines of the Federal royalty wars on both sides, 11 years with the government and 8 years in private practice. I know how both sides see the issue and I know how both sides feel, and it worries me.
Never has the level of distrust between the Federal lessor and its lessees been greater. The emblem of the government's distrust of lessees is its decision to use the bludgeon of the False Claims Act in an effort to impose on lessees retroactive changes in royalty policies. The emblem of the lessees' distrust of the government is their enthusiasm for this bill—an enthusiasm that, in my view, would have been unthinkable just a few years ago.
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Distrust has its costs. In making a business decision, a smart business person like Mr. Hawk has to consider many tangible things, but also the intangible factor of how reliable he feels the party on the other end of the contract will be. Right now, lessees do not believe their lessor is reliable. That means that money that would be invested in marginal Federal oil and gas prospects will instead be invested elsewhere, and that means less revenue to the state and Federal Governments.
I was disappointed to learn that the Department has argued that independents support the Royalty Enhancement Act as a diversionary tactic. That is very wrong. The Act is not a means of diversion; it is a means of salvation for the Federal leasing program, for it will eliminate the single greatest cause of distrust between lessee and lessor. Independents urge its passage.
Thank you.
[The prepared statement of Mr. Leggette may be found at end of hearing.]
Mrs. CUBIN. Thank you, Mr. Leggette.
Mr. Hawk?
STATEMENT OF PHILIP J. HAWK, PRESIDENT & CEO OF EOTT ENERGY CORP.
Mr. HAWK. Madam Chair, good afternoon.
My name is Phil Hawk, and I am the president and chief executive officer of EOTT Energy. As a context for my remarks today, I would like to briefly describe our business. EOTT Energy is one of the largest independent gatherers and marketers of crude oil in North America. We are the guys you have been talking about that seek to get that uplift from the wellhead to the ultimate users of crude oil refiners.
We purchase over 300,000 barrels a day at the lease. By the word ''independent,'' I mean we do not have any economic interest or ownership in any of the producers or their production or in the refineries that we ultimately sell to. We make a profit by providing the services necessary to officially and effectively move crude oil from a site of production to its ultimate user.
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Our services include a broad range of logistical, administrative and marketing activities. For example, we own and operate over 2,200 miles of pipeline, 6 million barrels of storage and operate over 275 tank trucks. We maintain extensive division order and royalty records and make disbursement of production proceeds on behalf of producers to over 150,000 interest owners. In total, we have over $150 million in assets as well as over 900 people providing these services.
As a return on this substantial investment in assets and resources, we strive to earn a small margin which we hope is commensurate with our value provided. On average over time, we strive to earn approximately 15 cents per barrel. However, as it is for all competitive industries like ours, there is no guarantee of profit. Due to the difficult market conditions and intense competition in 1997, our company failed to make any profit at all. Contrary to the inferences of some, competition to purchase crude oil at the lease is broad based and intense.
Now, from this perspective as a major purchaser, gatherer and marketer of crude oil, we strongly support the Royalty Enhancement Act of 1998 and the RIK program and associated QMA program. We do so for three primary reasons. First, RIK is the best way to achieve market value for the government's production.
The market value of a specific barrel of oil is affected by a large number of factors: quality or refining value, the transportation or logistics expense necessary to move that to market, the relative access to various markets, different refineries that may value that barrel differently, the shortages or surpluses of that particular type of crude oil or its alternatives that may exist in a particular market at a particular point in time, the length of purchase or sales commitments by either the producer on the purchase side or the sales side and the refiner on the purchase side, and also the ability to leverage intermediary activities of a company such as EOTT which could provide additional aggregation opportunities or cost sharing that not otherwise would be available to an individual producer.
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To show how these various factors come into play in the market, I wanted to share with you in my testimony the actual prices, market prices, paid for seven apparently similar leases at the same point in time in the state of Wyoming. These leases were all purchased from unaffiliated third parties and we won the right to purchase that on a competitive bid basis, so these are in my view market prices.
Due to all of the factors I mentioned above, the price ranges for these—this is for the month of December—range from a low of $10.78 to a high of $12.31, or a differential of approximately $1.50 per barrel. Let me assure you that the low prices listed here do not represent windfalls to EOTT, but rather they reflect the numerous and complex considerations that go into the determination of market value.
I contend that there is no formula that could accurately calculate or estimate these real differences in value. Consequently, the only approach to determine and ultimately receive market value is to sell the oil on an open and competitive basis. That is the essence of what the RIK program along with the use of qualified marketing agents allows and provides to the government. Any other approach, in our view, will create doubt as to whether or not the government is receiving full value. There are several other benefits as well that several of the other people have testified to.
The RIK program creates certainty and lowers administrative costs. The prospects of audits and second-guessing after the fact is time consuming and expensive at its best, but I would suggest that the uncertainty associated with the potential audits and possible retroactive price adjustments in the final analysis reduces the attractiveness of MMS leases and reduces the ultimate proceeds that return to the government. From a government perspective, the need for audits would be greatly reduced and therefore the administration of this program should be greatly simpler than current approaches.
Finally, the RIK program enables the government to market crude oil at its most attractive sales point. It has the option to sell crude oil at the lease or anywhere downstream where it is most attractive.
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Now, I will tell you as a service provider in this industry, in an industry that I believe is pretty competitive, that we believe that aggregators like EOTT generally move crude oil downstream more efficiently and effectively than individual producers. I think the evidence of that is that we are a significant purchaser of that crude when, again, private producers have that option and right today to move it to market themselves.
Nevertheless, the RIK program does not arbitrarily determine that the point of sale must be the production point. It gives the latitude to the government to sell it at the most attractive point of sale, whether that be at the point of production or at any point downstream.
In summary, we strongly support the RIK program because it provides the best and most direct opportunity to ensure that the government receives fair value; it greatly simplifies and adds certainty to the royalty valuation issues that have hampered this industry and should greatly simplify the administrative costs in managing it; and by virtue of the flexibility it provides, it gives the opportunity to the government to sell its crude oil at the optimum location, wherever that might be.
We might also point out that to be effective the RIK program needs to be broadly implemented and maintained over time. This is not a spot program that can be chosen or not chosen on a month-to-month or year-to-year basis, but needs to be the basic marketing approach for the government's royalty barrels.
Finally, the proposed program will enable the government to utilize the substantial marketing expertise that already exists in the industry via the QMA approach to realize the full value for its crude oil.
Thank you very much.
[The prepared statement of Mr. Hawk may be found at end of hearing.]
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Mrs. CUBIN. Thank you very much for your testimony. I have two very simple, straightforward questions. I think I will ask the first one of Mr. Leggette. Why mandatory RIK?
Mr. LEGGETTE. Right now, there are at least two significant impediments under existing law to the Department's achieving the kinds of benefits that it could under this bill. One is that the government does not have a universal right to require that its royalty be paid in kind. There are so-called Section 6 leases off the Coast of Texas and Louisiana where that option is with the lessee. Elsewhere the government does have the right, but there is a significant additional obstacle.
It is reasonably clear that under the OCS Lands Act the price at which the government would have to sell the oil would be a price determined by an averaging of prices received at the lease in the field. By definition, that precludes any possibility of getting the uplift from moving oil or gas downstream to hubs or marketing centers. Offhand, I am not sure if there is a similar impediment with onshore leasing, but there probably is at least some doubt about where the government could sell the oil that it took in kind. In the illustration I gave in my testimony, the royalty in kind was sold at the lease.
Mrs. CUBIN. Thank you. I just wanted to say that I did not think the chart looked like Dungeons and Dragons. It looked more like the 1994 or 1995 Clinton nationalized health care plan is what it looked like to me.
[Laughter.]
Mrs. CUBIN. My second question—and this is of you, Mr. Schaefer—why in Director Quarterman's testimony she said that it was not realistic or would not be cost-effective to have royalty in kind on marginal wells. Why should the United States have to take its royalty in kind from marginal wells?
Mr. SCHAEFER. Well, I believe that there is an advantage to be gained by taking them from marginal wells because the government can aggregate all the oil from the marginal wells and put them into one pool or pocket and actually optimize the return by pooling and putting it in, whereas for the individual who is operating a marginal well that is not as attractive on the market, those volumes. If they can be aggregated somewhere, it is going to be more attractive and should bring a higher price.
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Mrs. CUBIN. That is exactly what I thought, but it seemed like such a simple concept I thought, ''Well, I must be mistaken here.'' It seems to me that royalty in value would exponentially be less cost effective for those marginal wells than royalty in kind would be.
Mr. SCHAEFER. Well, I think it would be less cost effective to the government and to the lessee because whether it is a marginal well or a nonmarginal well, you still file the same reports and you go through the same paperwork and you may be faced with the same kind of audit problems that you would with a highly prolific well.
Mrs. CUBIN. Right.
Mr. SCHAEFER. There is no difference there.
Mrs. CUBIN. Thank you very much.
Mr. Thornberry?
Mr. THORNBERRY. Thank you, Madam Chairman.
That was exactly one of the lines of questioning that I wanted to ask of these witnesses. It seems to me to be a key objection to MMS that if you make it mandatory it applies to marginal wells out in the middle of nowhere and there is no way you can do that to make money. I think you have answered that very well.
Do either of the other of you have a comment on that point about marginal wells, whether it would be profitable, whether it could be profitable to take that royalty in kind rather than in value?
Mr. LEGGETTE. I am not an economist, but I play one on TV. I will just add briefly that I agree with Mr. Schaefer's point, because what makes marginal properties so unattractive for a buyer buying ad hoc is the transactional costs of going out and picking up a lot of individual packets of oil. But if the government can get a market person in there to aggregate that oil, which is exactly the function Mr. Hawk's company plays, that is where they make the money.
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Mr. THORNBERRY. Indeed, not only is it possible RIK would not reduce the money coming into the Federal Government, it could actually be substantially more than in value because you do have the ability to aggregate even the production for marginal wells. It is worth more that way rather than a few barrels at a time.
Mr. LEGGETTE. The proof is the success of Mr. Hawk's company.
Mr. THORNBERRY. Mr. Hawk, let me ask you—I hope you were here for a little bit of the discussion I had on what methods a QMA may want to use to bid to be able to sell oil or gas. Can you describe for me some possibilities at least that you might envision how this might work? Is it completely beyond the realm of the possible, for example, that somebody might bid to market the Federal share just to have that bigger volume and to have a more valuable asset to sell?
Mr. HAWK. I think just stated simply as you described it, I am not sure I can answer the question. I do not know because, obviously, there would need to be an uplift opportunity available to the QMA in your scenario. I think there are many ways the marketing industry can participate and assist the government.
I would encourage the Department of Interior in setting up the rules or exploring this to challenge the industry to propose those, and as part of their proposals come forward competitively with the various approaches that would work. They could include a small marketing fee, in terms of just administratively handling, acting as an agent on behalf of the government; they could be incentive-based fees based on the achievement of results on an absolute basis or relative to relative indexes that would be mutually agreeable to the government and the marketing agent. There could be just a whole range of factors.
I would say this that one of the things as we contemplate the possibility of being a QMA, if this should come to pass—and we are, by the way, participating, at least offering counsel and guidance to the MMS in their Wyoming pilot in terms of as they work that through—is that what we want to avoid is a situation where we inadvertently shift this tremendous audit burden which is now on the producer that all we do is shift it one step downstream and through complex relationships create a huge audit requirement just one step removed.
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I think the arrangement needs to be simple and straightforward where it is very clear to all parties—obviously there needs to be audits on volumes and things of that sort, but it needs to be simple and straightforward where there is not a need for any extensive audits of any of the parties on this.
Mr. THORNBERRY. OK. Can you briefly—these are some fundamental terms in this discussion and I am not sure that they have been explained adequately—could you briefly describe ''uplift'' and ''aggregation,'' and how it is that the Federal Government could actually receive more money for the same quantity of oil because of these factors?
Mr. HAWK. The term ''uplift'' refers to the difference in the sales price at the wellhead and downstream locations. The highest point of uplift would probably be a sale of WTI on the New York Mercantile Exchange. The differential can be several dollars in some cases, particularly with sour grades or different qualities. More than $5 in some instances with the sour grades that you were mentioning.
The uplift, so that is the differential. The premise is, ''Well, gee, wouldn't it be better to sell it for a NYMEX price than the price I am receiving at the wellhead.'' This is most certainly true if you do not need to spend the resources, take the risk and absorb the cost associated with moving it from that point to that higher sales point.
Mr. THORNBERRY. No, that is helpful.
Mr. HAWK. What ''uplift'' means is basically the moving of the product downstream to sell it at a higher value location.
Mr. THORNBERRY. In summary, what we are talking about is having somebody in the business try to sort through cost and benefits and figure out where along that continuum is the best place to sell it.
Mr. HAWK. ''Aggregation'' is the bringing together of smaller pockets of MMS oil into a bigger pool. As a company, our industry is an aggregator. The reason that is valuable is there are significant fixed costs in this business. As we can spread that over higher and higher volumes, the unit cost of managing or administering the various aspects of our services decline. The basic benefit of aggregation is to spread fixed cost over more barrels.
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Mr. THORNBERRY. Thank you.
Mrs. CUBIN. Mr. Tauzin?
Mr. TAUZIN. Mr. Leggette, in your magical history tour you took us, I think, to the 1950 decision, Continental Oil v. United States or the United States v. Continental Oil? Is that the one?
Mr. LEGGETTE. Yes.
Mr. TAUZIN. I am reading from it, and what I read in it is literally a conclusion by the Ninth Circuit, and I quote:
''The contract provision authorizing one party to the contract to fix the obligation of the other party by unilateral action is so foreign to ordinary contracts and so drastic in operation we think it should not be implied in the manner for which the government is here contending. We think that such a right cannot have been within the contemplation of the parties in the absence of expressed reservation to that effect.''
That goes back to an old Latin judicial rule, ''Expressio unius est exclusio alterius,'' which I think means, you know, unless you have an express provision you cannot apply it in a contract. What I read from this decision is quite contrary to what I heard from Ms. Quarterman. What I read is that government cannot fix a value of royalty payment on a downstream location and assess the cost of transportation and marketing to the lessee, in effect. In other words, interpreting the contract in order to have the best of both worlds, as I was trying to illustrate when Ms. Quarterman was in her statement, which is what she wanted to do.
Am I correct that this court decision flies in the face of that government position that it has the right to interpret the contracts so as to impose the cost of transportation and marketing on the lessee and then take the added value at some point downstream without having had to share in the risk? Is that what this court says?
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Mr. LEGGETTE. That is correct. The court is saying that unless the lessee has expressly agreed to give the secretary that power, he lacks the power through implication to make the rules up as he goes.
Mr. TAUZIN. In short, if the contract does not clearly provide that interpretation to the secretary, the Department cannot interpret it that way? To do so would be to allow the bureaucracy to constantly reinterpret contracts to the best advantage of only one of the parties without the express consent of both parties in the contract to that arrangement?
Therefore, does it not follow, then, that we need to do one of two things, either we have to have contracts that expressly define the sharing of that cost and the accounting procedure accordingly, or we in Congress have to pass a law that clearly defines the rights of the government in terms of its oil and gas royalties as an RIK program bill would do?
The worst alternative is to leave it to bureaucrats to write a complex system by which they can constantly and subjectively make determinations of value that were never expressly accorded to the Department as a party to the contract. The Ninth Circuit is saying not only is that bad policy, that is illegal.
Mr. LEGGETTE. That is correct. I agree with you fully. Door No. 3 is a snake pit.
Mr. TAUZIN. Yes, that is right. The Dungeons and Dragons analogy is accurate. I mean, I see lots of snake pits. I mean, I have tried to follow this, the copy of the chart I was looking at. It literally, again, leaves the Department time after time in every one of these yellow locations the ability to turn into a dragon and make its own decision about what the contract means. I do not think that is in the interest of good Federal policy to encourage companies to come in and bid on leases and produce minerals here in America.
After all, I mean, I know a little bit about this business. I was in the state government and chaired the Natural Resource Committee in Louisiana that oversaw oil and gas activities in our own state as well as a whole wide range of other issues. I know for a fact that all of the companies who operated in our state and in our OCS they had some choices to make. They could either produce there or they can go elsewhere in the world and put their dollars into exploration and development and production.
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If our government continues to play this game of reinterpreting contracts to best suit the interest of collecting more money from the lessee whether or not the contract gave them that authority, I suspect we are going to continue to drive companies to go produce somewhere else and import it into this country rather than producing it in our own land and providing it for us in this country.
It seems to me that if I read this court decision correctly, Ms. Quarterman's contention that the government has the right to literally take all of the value at no risk and force the lessee to take all the risk in any circumstance where the government chooses to do so is not only contrary to this legal precedent, but I think contrary to good national policy if we are going to have a good partnership relationship between those who come in and bid these leases—we had another great successful lease in Louisiana just yesterday—if we are going to continue to have successful lease auctions and successful exploration and development programs in our own country. I want to again commend the author for this attempt to put some sanity in this process.
I am on the road with Dick Armey in a wonderful tour we call Scrap the Code tour. The reason I have joined that tour and given so much of my time and attention to this national debate is that we now have a 5.5-million-word tax code that is so complex the government does not know what it means anymore. It gave out 8.5 million wrong answers to taxpayers one year alone and then fines and goes after taxpayers who have relied upon that misinformation. I see it happening all over again here.
I see it, Mr. Schaefer, in the descriptions of the cases you have given us where relying upon information you thought was right you end up years later being brought into court and like some criminal hauled before the Bar to answer for some new evaluation technique invented by another department using their own judgment about what a contract means.
I think the Ninth Circuit Court said it best. The government has no right to interpret unilaterally at the expense of the other party. We are going to have very many changes in the way in which we contract these things, or we have to write some new law. We cannot, in my opinion, leave the Department the power to continue to create messes like this for us.
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Thank you very much.
Mrs. CUBIN. I thank the panel for their testimony and the committee for the witnesses.
Are there any further questions?
Mr. Thornberry, did you have any?
Mr. THORNBERRY. Madam Chairman, I would just ask permission to have a couple of documents included in the record at this point, one from the Domestic Petroleum Council and another from API, Mid-Continent, the National Ocean Industries Association, and Rocky Mountain Oil and Gas Association.
[The information of Mr. Thornberry may be found at end of hearing.]
Mrs. CUBIN. Without objection. The hearing record will be held open until the next hearing, which will be on the 31st, and then after that it will be held open for two weeks so anyone who wants to supplement their testimony or whatever, ask questions is welcome to do that.
Thank you very much. The Subcommittee stands adjourned.
[Whereupon, at 4:30 p.m., the Subcommittee was adjourned.]
[Additional material submitted for the record follows.]
STATEMENT OF HON. JIM GERINGER, GOVERNOR, STATE OF WYOMING
Madam Chairman, members of the Subcommittee, thank you for your invitation to address H.R. 3334, the Royalty Enhancement Act of 1998, sponsored by Representative Thornberry and cosponsored by yourself and Representative Brady. I commend you for your efforts to work with individuals, associations and state governments concerned with this issue. We need alternatives to the present Federal oil and gas royalty program.
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I am here today in my primary role as Governor of Wyoming, but I also speak as Chairman of the Interstate Oil and Gas Compact Commission and as Vice-Chairman of the Western Governors' Association.
Madam Chairman, I speak in favor of H.R. 3334. The legislation would allow Federal royalty oil and gas to be taken in-kind by the United States rather than in cash, and allow states at their discretion, to do the same for their legal share.
H.R. 3334 would:
• simplify the royalty collection process
• decrease administrative costs for both the Minerals Management Service and industry, thereby increasing the net payment to the state
• provide certainty in royalty valuation
• decrease the costs of audits and subsequent appeals, and
• achieve a fair and equitable market value for the products.
Wyoming has long been frustrated with the lack of a simple and fair method to value oil and gas for royalty payments. Some producers and lease holders work hard to be objective and above-board to value the product. Others are not as forthcoming, and instead devise all sorts of marketing transactions to camouflage the real market.
Wyoming's interest in a royalty in-kind program for Federal oil and gas royalties is based on experience and frustration with the current Federal royalty program. Under the current system the states receive their 50 percent of Federal mineral royalties on a ''net receipts sharing'' basis, which means that the states suffer a deduction of up to 25 percent of the costs of administration of the minerals program.
We don't like the high cost of Federal administration. In the fall of 1996, I proposed to Assistant Secretary of the Interior, Bob Armstrong, that Wyoming be allowed to take its royalty share in-kind rather than pay the multimillion dollar cost of Federal collection and administration. We are convinced that Federal charges are as much as seven times higher than what the states would spend for exactly the same program under state administration.
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The Federal Government could receive the same or greater income from Federal in kind royalties as it would receive from traditional royalty payments. That would in turn, benefit the states. A royalty in-kind program could easily have lower administrative costs than the current royalty valuation program. States would then benefit because the Mineral Management Service royalty management costs are currently deducted from total royalty collections before the states ever receive their share.
Wyoming has never been able to obtain a full accounting for the Federal deductions. In 1993 the State completed a study of the projected cost of administration of a state operated royalty administration program. The conclusion of that study demonstrated that a state program meeting all basic Federal requirements could be operated at a significant cost savings to both state and Federal royalty owners. However, lack of detailed disclosure of cost breakdowns for the Federal MMS program would not allow a direct comparison.
The General Accounting Office, in 1996, conducted a study attempting to compare the costs of collecting Federal mineral royalties by MMS and the cost of collecting state royalties by various state offices. The conclusion of the GAO study was that it was impossible to compare both programs because their tasks were so different. We disagree with that conclusion. The tasks of monitoring leases, production, valuation and collection of royalties are no different whether on a state lease or a Federal lease. The difference this study did not seem to want to address, is the overly large bureaucracy inherent in the Federal systems to monitor, value and collect the royalties.
More recently, in October 1997, the Department of Interior's Inspector General's office issued an audit report of the Minerals Management Service, Bureau of Land Management and USDA Forest Service. It analyzed the expenses charged against Federal royalties in the context of net receipts sharing for fiscal years 1994 through 1996. The conclusion of that report was that the states have been overcharged. New Mexico and Wyoming have since asked the Secretary of the Interior to refund the overcharges.
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I understand that the members of the Subcommittee are familiar with the current effort by MMS to develop new methodologies for valuation of royalty oil. Wyoming has given only qualified support for this effort as recognition of the difficulties in valuation caused by non-arms-length transactions between affiliates. We remain concerned that the proposed method of valuation based NYMEX pricing does not sufficiently relate to the realities of the regionalized Wyoming marketplace. MMS might be able to justify the NYMEX approach since regional differences tend to come out neutral overall for the Federal share. Not so for regional markets including Wyoming. MMS did attempt to incorporate our comments in the proposed rule to recognize a Rocky Mountain Region market. We don't care for NYMEX pricing as it is a futures market. The Wyoming proposal would create at least two other benchmarks for any non-arms-length transaction before resorting to NYMEX. The tendering benchmark, at 33 1/3 percent of Federal and non-Federal leases in the area, will be difficult meet. We thought that a 15 to 20 percent benchmark would have been more realistic. The second benchmark would be established by comparable sales in arms-length transactions. Again, here, the benchmark is too high to be of much use. The rule will require that 50 percent of sales be arms-length in order to be used as benchmarks. The state believes that 20 to 25 percent would have been a sufficient statistical percentage to establish the value of oil in a particular area. We are not confident that a single national valuation approach can be devised which could apply to regional markets. Wyoming's interest in a royalty in-kind approach precedes this MMS valuation initiative, and we believe that the difficulties under the MMS approach will provide even more impetus to go to a royalty in-kind process.
While each of these experiences has caused Wyoming to call for a re-engineering of the Federal royalty program, we are equally motivated by the opportunities for revenue enhancement under royalty in-kind. We expect major cost reductions under a program that would no longer need a system for collection, analysis and auditing of pricing data. More importantly, we believe that the marketplace holds significant promise for increased state revenues.
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The State of Wyoming is prepared to assume the responsibility for our share of Federal royalty oil and gas. The 1997 Wyoming Legislature authorized the state to take its share of Federal mineral royalties in-kind under Wyoming Statutes 9-4-601(g). The production would be taken in the same percentage of volume as the gross percentage of royalty proceeds.
I further note the strong support of many states other than Wyoming. The Interstate Oil and Gas Compact Commission, representing America's oil and gas producing states, has monitored important developments in energy regulation for over sixty years. The 36 member states have worked cooperatively since 1935 to address energy conservation and borrow from each others' experiences to come up with solutions to our common problems. During the 1997 Annual Meeting, the members of the IOGCC unanimously approved a resolution to support the development of a comprehensive and flexible Federal royalty in kind program for oil and gas. The resolution also supports allowing a producing state, at its sole option, to assume those marketing and administrative functions designated to the designated to the Federal Government which your legislation would also allow.
Proper design and implementation is critical to the success of a Federal royalty in-kind program. The program must reflect the concerns and ideas of the states, producers, marketers and the MMS. Your legislation would allow that. As you move the legislation, I urge you to ensure that the legislation maintains:
• the requirement that royalty in-kind will be allowed by the Federal Government
• the requirement that the Federal Government contract with a qualified marketing agent
• the option for states to elect to contract with the qualified marketing agent on behalf of themselves or the Federal Government
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• the intent to keep audit requirements simple and non-duplicative, and
• the goal to reduce government costs and increase returns to the Federal and state treasuries.
I ask that as the process progresses, you allow us to continue to work with you in refining the bill's language. The bill draft was not available to us until lately, Madam Chairman, which as you know is a very hectic time with the State Legislature in session. We will continue to analyze H.R. 3334 and will alert you to any concerns we might have.
Again, I thank you for your courtesies and the invitation to testify. I would answer any questions you might have.
INSERT OFFSET FOLIOS 57 TO 60 HERE
STATEMENT OF CYNTHIA L. QUARTERMAN, DIRECTOR, MINERALS MANAGEMENT SERVICE, U.S. DEPARTMENT OF THE INTERIOR
Madam Chairman and Members of the Subcommittee, I appreciate the opportunity to appear today to present testimony on H.R. 3334, and on the Minerals Management Service's (MMS) implementation of programs to take oil and gas royalties ''in kind.'' In testimony submitted for the July 31, 1997 and September 18, 1997 hearings on royalty in kind (RIK) before the Subcommittee, we provided background information, described the results of our 1997 Royalty in Kind Feasibility Study, and summarized our plans to implement three RIK pilot projects. My testimony today will briefly address RIK legislative initiatives before providing a progress report on our three pilot projects.
RIK Legislation. At the outset, I would like to make the Department's position on RIK legislation perfectly clear. Legislation is not needed to exercise our lease contract rights to take royalties in kind. The Mineral Leasing Act, the OCS Lands Act and the lease agreements with the producers all grant the Federal Government the option to take our royalties in kind. The Department, therefore, strongly opposes any legislation mandating the United States to take its mineral royalties in kind and would recommend that H.R. 3334 be vetoed if it were presented to the President.
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I would also like to clarify our position on RIK implementation. As I testified last year before this Subcommittee, we are excited by the potential of RIK programs to streamline and improve aspects of our royalty collection and verification processes. RIK programs might increase revenues to the Federal Government, but only if implemented under favorable conditions. Accordingly, we are aggressively working on an ambitious schedule to implement three major RIK pilot projects. The results of these pilots will allow us to select areas where RIK can provide additional net revenues, and avoid those areas that will lose revenues.
There is no inconsistency in these positions. We strongly believe that both the Federal Government and industry need to conduct realistic tests of the RIK concept under actual conditions prior to any administrative or legislative decisions on broader implementation. RIK is unproven and risky for royalty collection in the U.S. As stewards of public assets, we must have assurance that the revenue and administrative effects of RIK are decidedly positive before moving to implementation. Anything less is a gambler's folly with the taxpayers money. We must identify and test those factors that would lead to RIK program success and then structure any broad programs around those factors. A legislatively-mandated RIK program would unnecessarily limit the flexibility of lessees and the lessor in the optimal design and implementation of RIK and destroy the value of being able to choose which collection method, ''in-kind'' or ''in-value,'' works best in each location.
H.R. 3334. I will limit my discussion of the bill that is the subject of this hearing to only a few general reactions because we have not prepared a detailed analysis. First, we are frankly disappointed that this bill is weighted heavily in favor of the oil and gas industry. Simply put, the bill would force the United States to relinquish many of its long established legal rights as lessor while relieving lessees of many of their equally long established legal obligations. The collective result of the bill is to drastically reduce the options and legal rights of the Federal mineral lessor. We must seriously ask ourselves how it is to the advantage of the citizens of the United States to give up these rights, and as a result, give up a substantial part of the value they receive for the production of their non-renewable resources.
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There are many specific components of this bill that would act to decrease the value of Federal mineral royalties. Although these details would have substantial revenue and legal implications, they are too numerous to discuss adequately in this testimony. We will provide a list and description of effects of these items under separate cover. For today's purposes, the most important point we wish to make is that, notwithstanding the details of the bill, there are several overarching reasons why this legislation is misguided and detrimental to the public.
• First, the Federal lessor would assume costs of marketing oil and gas in an RIK program where production under U.S. title is sold downstream of the lease. Under the historical ''in value'' royalty scheme currently in effect, the Federal Government has not shared such costs. Thus, royalty revenues to the Federal Treasury will logically and unambiguously decline under RIK.
A major purpose of our RlK pilot programs is to identify and test the circumstances under which Federal in kind production could be made more valuable in the marketplace. Our 1995 Gas Marketing Pilot demonstrated the potential for RIK to lose money. Our 1997 Feasibility Study suggested that revenue ''uplift'' is most likely for Gulf of Mexico gas, and unlikely for oil. No one, however, knows and actual tests are necessary for both oil and gas, to better understand the real potential for enhanced value.
• Second, our 1997 RIK Feasibility Study and subsequent analyses have identified several unfavorable conditions under which RIK programs would reduce revenues. These conditions include taking de minimis volumes in remote areas, taking production at less than marketable condition, and paying above market rates for transportation. H.R. 3334 would mandate RIK programs in areas where these unfavorable conditions exist, ensuring a loss of revenue from these areas.
Our RIK pilot programs will be structured to isolate and test the effects of various factors affecting RIK program success, thus reducing the exposure of Federal revenues to loss and providing the information needed to intelligently choose where to implement RIK.
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• Third, the Bill would statutorily adopt many of the positions taken by the oil and gas industry in historic valuation disputes with the Department—disputes, I might add, that have been consistently won by the Department. This would be an unjustified major economic gift to the lessee. Specifically, the Bill would require the United States to begin paying for: (1) gathering of production before it reaches the royalty meter; (2) movement of unseparated, bulk production; (3) field treatment of production; and (4) would absolve the lessee from the duty to market. Further, the bill's prescribed methods for setting rates for upstream transportation would significantly increase these rates, which the Federal Government would be forced to pay.
• Fourth, the bill's criteria under which government marketing agents could sell to themselves or affiliates are so broad and unenforceable that they would assure continuation of disputes between marketers and the U.S. over sales prices and substantial administrative costs for both the government and marketers.
• Finally, we believe the bill is riddled with other provisions that make it unacceptable.
We must be careful not to enact legislation that serve only the special interests of either lessee or lessor. For the reasons I have described, we can only conclude that this legislative initiative is primarily designed to enhance the interests of oil and gas producers, at the expense of the American taxpayer.
Model RIK Programs. In its support of mandatory RIK, the oil and gas industry has pointed to the RIK programs of Texas and Alberta as models of successful RIK program. Yet, many of the major elements of these programs are not included in this legislation. It is these key ''missing'' elements that are, in fact, directly responsible for the success of the Texas and Alberta programs. Specifically:
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f Alberta: According to Alberta officials, the Province's agent has the authority to take imbalance shortages at times of high prices. Further, lessees are required to deliver Crown production to pipeline interconnects, at significant distances from the lease, at non-discriminatory rates. The marketing agents' 5 cents per barrel marketing fee is modest because much of the work to aggregate Crown production is performed by the lessee. Domestic producers have told us that U.S. marketing fees could be at least 15 cents per barrel. Without these and other advantages, Alberta's marginal 5 cents per barrel revenue gain from RIK would quickly become a big loss.
f Texas: We understand that the State's oil RIK program has in recent years gone from decidedly revenue positive to essentially revenue neutral, as producers began paying royalties for non-RIK State production at market value. In addition, the State's oil RIK program is not mandatory, and it does not include production from wells that produce less than 10 barrels per day or from any particular lease that the state chooses to exclude from the program. The inclusion of such tiny volumes would likely cause the State program to lose revenue.
With respect to Texas' RIK program for natural gas, the State directs the producer to deliver royalty volumes to convenient sales points, free of any charges. Further, State law requires pipelines in the State to transport Texas royalty volumes if nominated, at non-discriminatory rates. These are big advantages that essentially assure success. If we truly want a successful RIK program for the U.S., why don't we see these key elements in this legislation?
Relationship to Valuation Regulations. We at MMS regard our program initiatives in valuation regulations and in-kind royalties as completely independent efforts. However, it has become apparent that the oil and gas industry views these efforts as directly related. Specifically, we are told by industry representatives that mandatory, across-the-board RIK is needed because MMS valuation policies and regulations are abandoning gross proceeds as a valuation basis. To such assertions, I respond as follows:
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• Our recently-published supplemental proposed rule for crude oil valuation contains five valuation principles, including that royalty obligations for arm's length contracts should be based on gross proceeds received under such contracts.
• Under our supplemental proposed rule, some 68 percent of Rocky Mountain crude oil production would be valued for royalty purposes based on gross proceeds received under arm's-length sales.
• In a close-out audit meeting, the General Accounting Office recently told us that it found MMS has been responsive to industry concerns expressed in public notice and comment on the crude oil rule, and that it did not advise statutorily-mandatory RIK programs.
• For the record, I wish to clarify the lease requirement that a lessee has the duty to market at no cost to the lessor, since it has so often been misrepresented. It does not mean that we will second guess a lessee's decision not to market at downstream locations. MMS has never done such second guessing and has no plans to do so in the future. MMS does not participate in the marketing decisions of the lessee, does not tell the lessee how to market its product, and accordingly does not participate in its cost.
Royalty in Kind Pilot Projects. As you are aware, last summer, our senior management team at MMS accepted the recommendations of the 1997 RIK Feasibility Study, namely to implement RIK pilot projects in Wyoming (crude oil in-kind), offshore Texas in 8(9) waters (natural gas in-kind), and the Gulf of Mexico (natural gas in-kind). I am pleased to report to you that we are currently making great progress in implementing these recommendations. We have formed an RIK team of some 16 staff dedicated to successfully implementing these projects.
f Wyoming Crude Oil Pilot: We are on course to begin this 2- to 3- year pilot program in October of this year. The objective of the Wyoming Pilot is to test the administrative and economic feasibility of a variety of methods and conditions of RIK programs for onshore crude oil—in a manner that at least preserves revenue neutrality. From the outset, we have been developing the pilot in close partnership with the State of Wyoming.
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We will test the effects of such factors as sales methods, production volumes and qualities, transportation methods, and lease location. We recently held a well attended public meeting in Casper where the RIK team obtained useful input on these and other factors, primarily from the industry and State governments. The pilot is currently on track for its October 1, 1998 start date.
We have been enjoying a close and cooperative working relationship with personnel from the State of Wyoming. I understand that the State is considering whether to commit State lease royalty volumes to the joint RIK Pilot. We understand it will decide after an early April briefing on the detailed final structure of the Pilot. Governor Geringer and I will receive the same decision briefing from the RIK implementation team. Our interests in the pilot are the same—to produce the best possible test of the RIK concept and the knowledge confidently use it to assure full and fair market value for our resources.
f Texas 8(9) Pilot Project. We are working with the State of Texas concerning implementation of a natural gas Pilot project for offshore 8(9) leases in the Gulf of Mexico. As you know, the State has an existing successful RIK program from State leases. While Texas enjoys significant advantages in its RIK program, that we will not have, the General Land Office has considerable experience and expertise that will help us design the best possible pilot. We are exploring the potential for a joint program that could potentially supply the State, other end users in Texas, and Federal facilities. By supplying the needs of Federal Facilities with RIK gas, we might not only increase royalty revenue but also reduce energy costs for the Federal Government. We also expect this pilot to begin October 1, 1998.
f Outer Continental Shelf RIK Project. This project is a logical follow-on to our 1995 gas RIK pilot, and will involve substantial volumes of OCS natural gas handled by one or several marketing agents. Similar to the Wyoming Pilot, the OCS project will test a variety of factors, including the method of marketing.
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The size and complexity of this project dictate that it will take another year before we can begin with confidence. The start-up date is anticipated to be October, 1999. Currently, we are assessing lease data, pipeline infrastructures, procurement options, and marketing strategies. The project structure will be presented in the Fall of this year. We anticipate convening a series of public meetings to collect comments, have open discussions about our planning, and further refine our pilot. We invite the industry and all interested entities to work with us.
I wish to emphasize that the pilot projects described above form a logical, deliberate process designed to test the feasibility of RIK programs across a broad swath of Federal lease and production situations. We strongly believe that implementation of RIK across-the-board, without discovering its real impacts in actual programs, is unwise and risky. The royalty revenues from Federal leases are too important to the American taxpayer and mineral producing States to risk blindly jumping into mandatory RIK before we know how and if it will work.
Some have speculated that we oppose legislation mandating RIK because of a fear of losing jobs. We highly value the contributions of our employees, and will continue to do so under any type of royalty scheme that may evolve from the current one. We at MMS believe that we have a very effective royalty management program, which last year cost taxpayers only a penny for each dollar collected. Nevertheless, we are always striving to improve our royalty management systems to increase efficiency and effectiveness. Our current reengineering effort in the royalty management program promises to provide efficiencies to increase our productivity for the taxpayer. Even with mandatory RIK many of our functions and costs would remain. Our opposition to this legislation begins and ends with the fundamental principle of ensuring that the public receives fair market value for its assets.
In closing, let me state that we are enthusiastic about the prospects of implementing successful RIK programs for Federal mineral leases. Such programs may provide an innovative way to streamline the royalty management process. Effective implementation of the already existing RIK option, developed through the practical and prudent investigation of our pilot programs, spells success not only for royalty management but for the taxpayer as well.
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We will need some time to fully assess the revenue implications of this bill. However, it clearly represents a dramatic transfer of costs and obligations from the oil and gas industry to the American taxpayer. Our preliminary analysis suggests that the revenue loss would be significant and on the order of hundreds of millions of dollars at a minimum. I believe we must seriously ask ourselves how the American taxpayer would benefit from H.R. 3334. Because of the disastrous effect this bill would have on the taxpayer and the budget, the Department is prepared to recommend a veto.
Thank you Madam Chairman and Members of the Subcommittee, this concludes my prepared remarks. I would be pleased to answer any questions you may have.
STATEMENT OF HUGH V. SCHAEFER, DIRECTOR, WELBORN SULLIVAN MECK & TOOLEY, P.C., ATTORNEYS AT LAW, DENVER, COLORADO
Ladies and Gentlemen:
My name is Hugh Schaefer. I am chair of the Royalties Committee of the Independent Petroleum Association of Mountain States (''IPAMS''). IPAMS is a non-profit, non-partisan association representing over 700 independent oil and gas producers, service/supply companies and industry consultants in the Rocky Mountain region. IPAMS appreciates the opportunity to appear before you today and present this statement.
My statement today will present the views of the Independent Petroleum Association of Mountain States (IPAMS) with respect to H.R. 3334, the Royalty Enhancement Act of 1988. IPAMS and its members believe there is a distinct need for relief from the current royalty in value system. IPAMS believes there are significant advantages to be gained by requiring the Federal Government to take its oil and gas royalties in kind rather than in value and avoid the wasteful, time consuming and complex processes involved with the determination, payment, and auditing of Federal royalty payments. My comments will focus on why this change is imperative. My written testimony will provide details of personal experiences I have had with the present in-value system, particularly in the audit and settlement of Federal royalty claims against lessees on Federal lands.
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Until the recent enactment of the Federal Oil & Gas Royalty Simplification and Fairness Act Public Law 104–185 (1996), most audits were not commenced until an average of four to five years after the royalty payments in question had been made. Thereafter, a lengthy administrative appeal process delayed the final resolution of MMS royalty claims for at least another three to four years within the Department of the Interior. IPAMS believes that a royalty-in-kind program will eliminate a substantial portion of this time consuming delay in the resolution of audit disputes. Although the Federal Oil & Gas Royalty Simplification and Fairness Act will now speed up the process somewhat by requiring audits to be commenced within three years from the date of payment, however, any MMS formal claim for additional royalties is not barred until seven years from the date a royalty payment was made. IPAMS submits that a royalty-in-kind program should result in faster receipt of royalty revenues.
Under the current royalty-in-value system, a lessee who appeals a royalty payment order has an election either to pay the disputed royalties under protest and subject to appeal or post a surety bond or irrevocable letter of credit. If the lessee elects the latter, then any Federal royalty revenues to which the United States may be ultimately entitled is postponed until the administrative appeal process has been concluded unless the lessee and the MMS settle the case in the meantime. IPAMS submits that with a royalty in kind program, the Federal Government will receive its revenues much faster and avoid the time consuming and costly process of disputed audits and contested royalty payment orders. It is my understanding that the cost of the audit and review process is nearly $60 million per year.
IPAMS believes that if the royalty-in-value program remains in place, the audit process will become even more exacerbated and difficult to administer because new and proposed royalty valuation regulations have become more and more complicated and difficult to administer for the small independent oil and gas producer. They will create more cost and effort to apply these new regulations properly, effectively and efficiently. They will necessitate the hiring of qualified personnel or consultants to do this work for Federal lessees. This additional cost becomes particularly onerous when the industry is going through periods of price volatility in oil and gas markets such as are being experienced now. For example, crude oil produced in the Rocky Mountains is approaching historical low prices again forcing some operators to shut in fields because the cost of production exceeds the price being received for crude oil. Gas prices often experience similar volatility.
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As you are no doubt aware, the recently adopted MMS Gas Transportation Allowance Regulations have been challenged in a Federal court in Washington DC. That challenge has been mounted for the very reason which I have just spoken: the regulations are complex, difficult to administer, and vague and uncertain in many other respects. That suit has been brought by the Independent Petroleum Association of America, a sister organization of IPAMS.
New oil valuation regulations have been proposed and new gas valuation regulations will be proposed by the MMS in the near future which we understand are similarly complex. It is not beyond reason to expect that these regulations may also be challenged in the courts for many of the same reasons that the transportation allowance regulations have been challenged. This opinion is not intended to be a threat of litigation but only an educated guess.
The new MMS approach in these regulations flies in the face of two fundamental principles of royalty valuation at the Federal level. First, since the enactment of the Mineral Leasing Act of 1920 over nearly 78 years ago, royalty valuation on Federal (as well as private) leases have been guided by the principle that gross proceeds received under arms-length contracts in the field or area of production determine market value and consequently set the value for royalty payments. The 1988 MMS Royalty Valuations Regulations continue to observe that principle by recognizing that interaction of market forces in a free and open market in the general area of production is the best determination of value 53 F.R. 1182, 1187 (Jan. 15, 1988).
Second, ''a netback'' method to determine royalty is proper only where other methods cannot be used to calculate a wellhead or a leasehold value because of the lack of comparable values in the field or area of production. The auditors' approach that I have described is a netback method that improperly ignores the availability of other, more reliable, valuation methods. Moreover, the auditors' approach goes far beyond even the acceptable reach of netback calculations. In fact, when the Department adopted the 1988 Royalty Valuation Regulations it admitted the netback approach was the least desirable method of valuation 52 F.R. 1183 (1988). It specifically rejected a proposal to use a net-back methodology on a routine basis to check against prices received under arm's-length contracts. MMS stated: ''To routinely perform labor-intensive net-back calculations is impractical.'' 53 F.R. 1182, 1186 (1988).
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The Mineral Leasing Act of 1920 provides that royalty from onshore Federal leases is a percentage of the ''value of the production removed or sold from the lease.'' The term ''value'' as used in the Mineral Leasing Act means the ''reasonable market value;'' that is a price which a product will bring in an open market, between a ''willing seller and a willing buyer.'' In addition, the Act defines the point at which value is determined, namely, at the wellhead or some other point within the lease boundaries. Therefore even though an affiliate transaction may be occurring, the foregoing laws still require the use of reasonable market values when present in an open market in the field or area.
At this juncture I want to describe some cases and other events with which I've had direct experience which demonstrate the failure of the in-value system. Most of these examples will show that some auditors do not apply the existing valuation regulations properly because of the lack of proper training or experience or that they simply ignore the regulations in order to base royalty values on prices received in distant markets located well beyond the field of production. Most IPAMS members sell Federal production in arm's-length contracts at the wellhead but in some instances independents may sell production to either a gathering affiliate or a marketing affiliate. When affiliate sales occur they are treated as a non-arm's length contract under the regulations. Current regulations provide that proceeds received by the lessee in non-arm's length transactions will be acceptable for royalty purposes if prices received are equivalent to comparable arm's length sales in the same field or area according to a hierarchy of benchmarks. Current MMS policy provides that a resale price received by an affiliate is another price which is factored into the benchmark analysis but only if the resale occurs in the same field or area. However, in the cases described below, the auditors have not followed this policy but have ignored prices received in arms-length contracts in the same field or area of production and have used prices received by the affiliate which are derived from resales into markets far distant from the field of production.
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The first example involves an independent producer who has a marketing affiliate. Its marketing affiliate buys and sells not only gas produced by its affiliate but also buys and resells gas produced by unaffiliated third parties. In 1993 the producer sought a value determination from MMS under applicable regulations to establish as the value for royalty purposes published index prices in the same field or area.
The request was denied and the MMS ordered the lessee to apply the benchmark regulations. The lessee complied and filed the appropriate reports with the MMS. In 1996 the lessee was audited and ordered to pay additional royalties. The MMS' claim for additional royalties was not based on any errors in complying with the MMS order but solely upon the perceived failure of the lessee to compute and pay royalties on resale prices its marketing affiliate received in distant, out of state markets. Shockingly, the order to pay stated that the lessee was ''seeking to avoid payment of its royalties'' by using values derived from benchmarked arms-length sales in the same field or area. The auditors did not follow the valuation order of the MMS. The lessee was shocked to receive such a statement and asked the obvious question. How can one be accused of avoiding the payment of royalties when they complied with an MMS order? I seriously doubt whether the MMS order was given to the auditors until the lessee provided them with a copy of the valuation determination during an audit visit. The lessee has requested that because of the auditors statement quoted above the audit is prejudiced, the auditor should be removed and MMS should reperform the audit.
In another case the lessee, a small independent, sold gas to its gathering affiliate and once again based its royalty calculations on third party arms-length sales in the same field or area. Once again, the auditors rejected such prices and issued an order demanding that additional royalties be paid on downstream prices at an interstate transmission connect point out of the field or area of production. The auditors did not accept comparable arms-length prices in the same field or area and misapplied MMS policy on affiliate resales.
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The third case involves a similar situation and in particular involves the use of gas index prices published in Inside FERC, a nationally recognized publication which lists prices paid by shippers on interstate gas transmission lines throughout the United States. Again, the auditors refused to accept these prices even though the lessee was paying royalties based upon a price which was a premium above the published index price for gas in that field or area. Instead the auditors based claims for additional royalties on resale prices received by the affiliate in markets which were located in several states and several hundreds of miles away from the field of production.
In another instance of flawed auditing, the auditors refused to allow a lessee to exclude volumes of gas put to beneficial use (as permitted by the Bureau of Land Management under Notice to Lessees No. 4-A) from volumes reportable for royalty purposes. The auditors confused that exclusion with another regulation of the MMS which prohibits lessees from deducting a proportionate share of any costs relating to gathering, dehydration, compression or other expenses incurred in conditioning the gas for market. In this case the auditors treated the value of the beneficial use gas as a conditioning cost and added that value back into the reportable royalty volumes. Under Federal regulation production which is used to enhance production, its delivery or which otherwise benefits the lease is not subject to royalty.
The lessee appealed the issue but the MMS Director denied the appeal. Thereafter, an appeal was taken to the IBLA but the appeal was dismissed because the lessee's law firm lost the certified mail receipts establishing the timely filing of the appeal with IBLA. Under Departmental regulations proof of timely filing is jurisdictional. Thereafter the lessee sued the law firm for malpractice and was successful. The Court found that if the appeal been timely filed, the lessee would have prevailed on the merits. I testified on behalf of the lessee that the audit finding was erroneous and contrary to applicable regulation.
This pattern of improper auditing has become very consistent lately and other cases of which I'm aware indicate that a subtle unpublished change of policy is occurring within the Department to which lessees/payors are not privy until they are visited by auditors. It appears to me that MMS's policy is to ignore arm's-length values present in the field or area of production and instead turn to downstream values received in distant markets without any authority to do so. The MMS policy is to ignore entirely comparable arms-length sales in the field or area and to seek the benefit of the downstream values without sharing in the risk of getting the product to that market and obtaining the higher price.
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In effect, this policy pierces the corporate veil of the affiliate contrary to established departmental precedent. In the case of Getty Oil Co., IBLA 80-430, 51 IBLA 47 (1980), the Interior Board of Land Appeals held that while interaffiliate transactions should be scrutinized carefully, they may nevertheless represent a fair price if the price is comparable to arm's length prices paid in the same field or area. The Getty decision also stated that before the interaffiliate sales transaction could be rejected, it was incumbent upon the Department to establish that the downstream affiliate was not a valid, subsisting and properly maintained corporation but was a sham or artifice to promote fraud and injustice.
The Getty Oil Co. case remains controlling precedent in the Department and has not been overruled or reversed by the Department or by the courts. This example demonstrates the lack of training of auditors with respect to a crucial issue in audits of affiliated sales. It may also demonstrate that the Department may be anticipating the adoption of proposed regulations before either their formal publication for rulemaking or final adoption. While most of our members are small independents who sell their production from Federal lands in arms length transactions, many of them have to establish gathering companies to get their production to a market because purchasers are not willing to invest in pipelines to gather production in the field. When the lessees sell the gas to the gathering affiliate and immediately they encounter the problems which I have just described in any audits by MMS.
These cases are also examples of ignoring prior Congressional policy with respect to the valuation of gas. In 1987 Congress passed the Notice to Lessees No. 5 Gas Royalty Act (Public Law 100–234) which was necessitated due to falling prices for gas that was subject to price regulation under the Natural Gas Policy Act (''NGPA''). Under the latter Act Congress established maximum ceiling prices for various types of natural gas. Upon the enactment of the NGPA, the Department of the Interior issued Notice to Lessees No. 5 which required the lessees to pay on the higher of either the price received by the lessee or the price established by the NGPA for that particular category of gas.
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In the early 1980s gas prices suffered a substantial decline because pipelines were marketing out under their existing contracts and refusing to pay the prices established by the contract and by the NGPA. MMS attempted to resolve this problem by removing the requirement of paying on the NPGA price if the lessee was not receiving it. This created considerable tension among the state and Indian royalty recipients. However, the Notice to Lessees No. 5 Gas Royalty Act alleviated the tension by providing that NGPA prices were no longer mandatory if they were not being received by producers. The Act further provided that market prices received in arms-length transactions in the same field or area would be acceptable for royalty value purposes even if such prices were below the maximum lawful ceiling price established by the NGPA. The oil and gas producing states of the United States entered into a compact with this valuation principle as its cornerstone and it was upon this principle that Congress enacted the law. IPAMS submits this Congressional policy will be fostered through royalty-in-kind.
If the MMS continues to insist on seeking the benefits of downstream prices without sharing in any of the risks, it is reasonably foreseeable that litigation will only increase because of industry's opposition to the new MMS approach. This will cost the taxpayers of the United States a great deal of money.
Recently the Department of the Interior published proposed regulations for the valuation of crude oil. While these regulations continue to recognize gross proceeds received under an arms-length contract as value for royalty purposes, the proposal introduces a troubling element which may cast some doubt over the acceptance of such prices depending upon how the ''duty to market'' proposal will be viewed by auditors in the future.
IPAMS recognizes that every oil and gas lease has at least an implied duty to market, but in light of the manner in which auditors have approached valuation in the cases I have described to you, IPAMS is concerned that an audit may seek to second guess the decision from the always advantageous position of hindsight. If this approach is taken, I can only predict further tension and potential litigation over this issue.
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However, this can be avoided entirely by enacting RIK legislation and requiring the government to take its royalty in kind. The Federal Government has tremendous quantities of oil and gas. According to financial information published by MMS, Federal oil and gas royalty revenues for the fiscal year 1996 were well over $5 billion. With such vast quantities of production to market, I believe the Federal Government can reap even greater benefits through an in kind program and minimize the expensive, time consuming and contentiousness which exists in the current regulation of royalty valuation. With such substantial volumes at its disposal, the Department will be one of the biggest aggregators of large volumes of production for sale into the market. It will command higher prices received under an in-value system.
In their further quest to find new reasons to change existing valuation regulations, the MMS investigated the use of oil valuation techniques employed by foreign countries. MMS officials visited Norway and studied the practices of the Norwegian Oil Pricing Board (''NOPB''). In Norway a panel of Norwegian government employees sets the price of oil. After research into world oil pricing information and other information which might influence the price of oil, the NOPB dictates the price. This is the only piece the NOPB will accept from producers. This technique can hardly be called determining price or value through the interaction of market forces. In my judgment this is not appropriate for the market-based economy in the United States.
Finally there is another reason why I believe royalty-in-kind is the way to go. I am IPAMS representative on the Royalty Policy Committee of the Department and served as the Chairman of its Appeals and ADR Subcommittee. The Royalty Policy Committee recommended substantial revisions to the administrative royalty appeal process. The recommendations seek to eliminate appeals to the Director, MMS and instead to limit those appeals directly to the Interior Board of Land Appeals. Appeals to the Director are time consuming, unnecessary and are fraught with all of the shortcomings in any agency's review of subordinates' decisions. The proposal was accepted by the Secretary and upon the adoption of a final regulation, appeals will go directly to the IBLA who will make the final decision for the Department. The IBLA was created as a result of the work of the Public Land Law Review Commission which saw the need for a quasi-independent tribunal within the Department to review decisions so as to avoid litigation in the Courts. This Commission was established by the Congress of the United States and Representative Wayne Aspinall of Colorado was Chairman of the Commission. The work of the Commission also led to the passage of the Federal Land Policy and Management Act. IPAMS supports the maintenance of IBLA in the function for which the Commission designed for it. Occasionally rumors filter back to us in the Rocky Mountain states that the Department may seek to eliminate the Board. If this happens, I believe it is all the more reason to implement a royalty in-kind program because more expensive court litigation could possibly ensue.
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IPAMS believes that the illustrations I have discussed are inherent in any royalty program based on an in-value system. The real reason is because no one has been able to adequately define the term ''value.'' In reality it is a hypothetical, difficult of ascertainment, definition and resolution. The difficulty is best described by the following quote:
Men have all but driven themselves mad in an effort to definitize its meaning . . . . the word ''value'' almost always ''involves a conjecture, a guess, a prediction, a prophecy. . . . We cannot, by the use of a symbol, ''value'' convert the risky into risklessness. . . . Indeed, ''value'' because of its troubled history, evokes such a multitude of its troubled history, evokes such a multitude of conflicting associations that it might be well to abolish its use in legislation and judicial opinions. Andrews v. Commissioner of Internal Revenue, 135 F.2d 314 (2nd Cir. 1943)
Interestingly the 1988 Royalty Valuations recognized this difficulty and cited this same case. 53 F.R. 1233 (1988). Thank you again for the opportunity to present IPAMS views regarding this legislation. I will be happy to answer any questions.
SUPPLEMENT SHEET TO IPAMS STATEMENT
Hugh V. Schaefer, Esq.
Welborn Sullivan Meck & Tooley, P.C.
1775 Sherman Street, Suite 1800
Denver, CO 80203
(303) 830-2500
The Independent Petroleum Association of Mountain States (''IPAMS'') recommends the enactment of Federal Royalty-in Kind Legislation requiring the Department of the Interior to take Federal oil and gas royalty in kind rather in value. The in-value program currently in effect is time consuming, costly and delays collection of Federal royalty revenues because of the numerous administrative appeals pending within the Department. Auditors are not adequately trained to fully understand applicable laws and regulations which they must follow in conducting audits. The changing and increasingly complex environment in oil and natural gas markets dictate the adaption of a system which is equipped to deal with this changing environment.
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The United States commands vast quantities of oil and gas and through aggregation, the United States is in a particularly advantageous position to realize greater revenues by controlling and directly market such vast quantities of production.
STATEMENT OF L. POE LEGGETTE, REPRESENTING THE INDEPENDENT PETROLEUM ASSOCIATION OF AMERICAN AND THE DOMESTIC PETROLEUM COUNCIL
The standard for royalty valuation is simple. The Department of the Interior is to obtain the fair market value of the oil or gas at the wellhead. To this the Department has added the qualification that ''[u]nder no circumstances shall the value of production for royalty purposes be less than the gross proceeds accruing to the lessee for lease production. . . .'' 30 C.F.R. §206.152(h). Exactly what constitutes ''gross proceeds,'' is quite a different question and has given rise to innumerable controversies between the United States Department of the Interior (the ''Department'') and the oil and gas industry. The most contentious of these disputes are briefly summarized.
1. Royalties on Contract Settlement Proceeds.
The origins of this dispute go back to the early 1980s. Two Federal circuit courts of appeals have addressed the issues and reached differing, though not necessarily inconsistent, results. IPAA v. Babbitt, 92 F.3d 1248 (D.C. Cir. 1996); United States v. Century Onshore Mgmt. Corp., 111 F.3d 443 (6th Cir. 1997), cert. denied, — U.S. — 118 S. Ct. 880. At least twelve other cases concerning royalties on contract settlement proceeds were filed in the United States District Court for the District of Columbia and hundreds of administrative appeals are pending. Under typical oil and gas sales contracts, the buyer agrees to pay for a certain minimum volume of gas per month or year whether or not he actually takes delivery of that volume. Frequently, purchasers make lump-sum payments to resolve accrued take-or-pay liabilities and alter the future relationship of the parties. When the payment reduces the future price of production, it is known as a buydown. If the settlement payment terminates the contract, it is a buyout. Some of these payments are recoupable over subsequent years while others are not. In the early 1980s, the Department's position was that royalties were due on take-or-pay payments under natural gas sales contracts when the lessee received the payment and on take-or-pay settlement payments when they were received.
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After the Fifth Circuit's ruling in 1988 that ''royalties are not owed unless and until actual production, the severance of minerals from the formation, occur,'' the Department changed its regulations to require royalties only when make-up gas is taken, i.e., the payment is recouped. Diamond Shamrock Exploration Co. v. Hodel, 853 F.2d 1159, 1165 (5th Cir. 1988). In May 1993, the Department announced that it would assess royalties on recoupable and nonrecoupable take-or-pay contract settlement payments which ultimately led to the current dispute.
The DC Circuit's decision in IPAA v. Babbitt prohibits the assessment of royalties on nonrecoupable buyouts and buydowns. The Sixth Circuit's ruling in Century Onshore Mgmt. Corp. allows the assessment of royalties on at least one type of contract settlement when there was no breach of the contract prior to settlement and production was sold to the original purchaser after the settlement. The Department, however, continues to issue orders to producers assessing royalties on both buyout and buydown proceeds.
Affiliate Resales.
In Shell Oil Co. v. Babbitt, 125 F.3d 172 (3rd Cir. 1997), the Third Circuit ruled that the Department's Minerals Management Service (''MMS'') could require an affiliate purchaser (one affiliated with the producer seller) to produce records of its arm's length resales so that MMS could determine whether the producer was properly valuing production in compliance with the lease terms and regulations.
Similarly, in Santa Fe Energy Products Co. v. McCutcheon, 90 F.3d 409, 414 (lOth Cir. 1996), the Tenth Circuit ruled that ''[u]nder the gross proceeds rule, the MMS could reasonably require information relating to [the affiliated purchaser's] sales in order to ascertain the oil's fair market value and to determine the gross proceeds accruing to [the producer].''
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The Department of the Interior has now applied the Shell and Santa Fe cases to assess royalties on a lessee by using the downstream resale price of its affiliate. In Xeno, Inc., 134 IBLA 172 (1995), some of the lessees producing in the Battle Creek gas field in Montana, unhappy with the wellhead price offered by two prospective purchasers, formed a joint venture to construct a gas gathering and transportation system to move the gas to an existing pipeline connection point. The joint venture bought the gas at the wellheads from the lessees, shipped in downstream, and resold it. Per unit of gas, the difference between the resale price and the wellhead price was about double the cost of building and operating the system. The Department agreed that the lessees' gas was in marketable condition at the wellhead. It also agreed that the lessees received at the wellhead the highest price for gas that anyone received in eastern Montana. The lessees were not required by the leases or MMS regulations to build the gathering system to market the gas. But because they did, MMS ordered them to pay royalties on the profits the joint venture made from moving the gas downstream for resale. This is a classic example of the ''uplift'' in price that a lessee can obtain by engaging in midstream marketing activities. It also is a classic example of the disincentive MMS creates for lessees engaged in midstream marketing to undertake the risks and costs, knowing that MMS will claim a royalty share free of those risks and free of most of those costs.
3. Duty to Market.
The ''duty to market'' or ''duty to place in marketable condition'' is a particularly contentious issue today and will continue to be for many years to come. The Department's position is that it is ''well settled that marketing expenses necessary to market production from a Federal lease must be performed at no cost to the lessor.'' Amoco Production Co., MMS-92-0552-OCS at 4 (1996) (citing California Co. v. Udall, 296 F.2d 384, 388 (D.C. Cir. 1961)). In this regard, the Department recently issued a final rule on gas valuation, 62 Fed. Reg. 65753 (Dec. 16, 1997), and a proposed rule on oil valuation. 63 Fed Reg. 6113 (Feb. 6, 1998). The gas rule prohibits the deduction of many transportation costs which were previously included in bundled FERC tariffs on the theory that those costs are really marketing costs. The oil rule is also designed to impose royalties on added value from midstream marketing activities under the same theory.
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The Independent Petroleum Association of America and the Domestic Petroleum Council have strongly objected to this codification of the duty to market because, although the duty is ostensibly for the mutual benefit of the lessor and lessee, the lessor does not share in the costs. Two trade associations have filed suit challenging the final rule on gas transportation. Independent Petroleum Assoc. of America v. Armstrong, Civ. No. 98CV00531(RCL); American Petroleum Institute v. Babbitt, Civ. No. 98CV00631(RCL). Oil and gas producers have also submitted extensive continents on the proposed oil rule as it has developed.
Recent decisions of the Department's Interior Board of Land Appeals (''IBLA'') have also endorsed the lessee's duty to market. In Texaco Inc., 134 IBLA 109 (1995), IBLA ruled that a Federal lessee's duty to put lease production into a marketable condition includes ''sweetening'' sour gas by removing hydrogen sulfide. IBLA further held that the costs of sweetening the gas are not deductible from the lessee's royalty base no matter who performs the sweetening. In other words, the lessee always bears the cost and the Department receives the benefit of royalties based on the improved quality of the production.
In a case currently pending before IBLA, the Department has taken the duty to market even further. In Amerac Energy Corp., IBLA 96-———— (appeal of MMS-93-0868-OCS), Amerac's predecessor, Wolverine Exploration Company, entered a contract to sell crude oil to Essex Refining Company. The terms of the contract entitled Wolverine to 50 percent of the net profits Essex received for marketing the gas. Wolverine paid royalties based on its share of Essex's post-sale profits but did not pay royalties on the portion of profits retained by Essex. MMS thereafter challenged Wolverine's royalty calculation methodology as failing to include ''the full consideration received, directly or indirectly, for its sales of oil to Essex,'' including the ''total value of marketing services performed by Essex.'' MMS's position is that Wolverine also owed royalties on Essex's share of the net profits because Wolverine was simply paying Essex to market the oil.
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4. Statute of Limitations.
Whether or not the statute of limitations at 28 U.S.C. §2415 applies to MMS demands for additional royalties has been litigated in various Federal courts since the early l990s. Although the Royalty Fairness and Simplification Act of 1997 expressly creates a statute of limitations applicable to royalty orders, it only applies to production after August 1996. Litigation over the applicability of section 2415 will therefore continue over oil and gas produced before that date.
Section 2415 prohibits the United States from bringing an action on a contract for money damages more than six years after the right of action accrued. In 1993, the Tenth Circuit agreed with the lessee that section 2415 applies to MMS demands for additional royalties. Phillips Petroleum Co. v. Lujan, 4 F.3d 858 (lOth Cir. 1993). The Fifth Circuit subsequently determined that royalty orders do not seek money damages and therefore section 2415 does not bar the Department's attempts to collect additional royalties due more an six years earlier. Phillips Petroleum Co. v. Johnson, 1994 WL 484506 (5th Cir. 1994).
Since then the district courts have gone both ways. Industry continues to challenge demands for royalties due more than six years past due, and the government has advised one company that it will use its pending case to relitigate the issue in the Tenth Circuit. Shell Oil Co. v. Babbitt, Civ. No. 96-CV-1078-K.
5. Conclusion
Although the Department's program for taking the government's royalty share in value has spawned controversy from its inception in the 1920s, the program has never been more contentious than it is now. Controversy is inherent in any system of royalty in value, as this very brief review of the current controversies illustrates.
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STATEMENT OF THE AMERICAN PETROLEUM INSTITUTE, MID-CONTINENT OIL AND GAS ASSOCIATION, THE NATIONAL OCEAN INDUSTRIES ASSOCIATION AND THE ROCKY MOUNTAIN OIL AND GAS ASSOCIATION
I. Overview
The American Petroleum Institute, Mid-Continent Oil and Gas Association, National Ocean Industries Association, and the Rocky Mountain Oil and Gas Association (''Associations'') strongly support the concept of a mandatory and comprehensive royalty-in-kind (''RIK'') program. The Associations believe the recently proposed legislation (H.R. 3334) is the foundation for creating an RIK system that simplifies and streamlines the royalty collection process and provides benefits to the government, industries, and the public. The Associations will continue to work with Congress to improve and enact the legislation.
A comprehensive RIK program, properly designed, is a means by which the royalty collection system could be streamlined and enhanced. By remitting royalty payments in kind (i.e., in physical units) to the MMS at or near the lease, disputes over the value of royalty production could essentially be eliminated. The MMS would receive the value for its royalty production directly by having its private marketing agents sell the royalty production in transactions on the MMS' behalf. Thus, the MMS and producers would benefit by eliminating what has been and is a costly source of disputes.
II. Federal Royalty Disputes
The Federal and state governments, as well as private landowners, have long collected royalties on oil and natural gas production. While royalty disputes are not uncommon, most Federal disputes have until very recently involved gas.
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A 1996 Interagency Report led to an increase in Federal audit activity for past valuation practices and Federal rulemaking to address future valuation practices. Specifically, the Minerals Management Service (MMS) in January 1997 proposed a new basis for determining the value of oil production. Supplemental proposals were issued in July 1997 and February 1998.
The oil and gas industry, including private royalty owners, commented extensively on January 1997 proposal and the July 1997 supplemental proposal. The Associations believe the 1998 supplemental proposal is even more complicated and uncertain and will file extensive comments by April 7. The valuation methodology proposed by the MMS is neither simple nor certain.
The industry believes that a comprehensive RIK program could provide the government with at least as much revenue as it receives under the current system. Such an RIK program could also benefit the Federal Government, states, industry, and United States citizens by removing the contentious issue of royalty valuation and simplifying the royalty collection process. Indeed, a properly designed RIK program could increase net revenues to the Federal Government through profits from the value that may be added from time to time as its production moves into the market downstream of the lease to the consumer.
Collecting Royalties
Traditionally, the Federal Government has collected most of its royalties in value, i.e., cash payments under the terms of the leases and current regulations. The amount received is based on the value of production at the lease. For arm's length transactions, the cash amount is based on the gross proceeds received. For non-arm's length transactions, the cash amount is based on imputed gross proceeds estimated by reference to several benchmarks listed in the regulations (e.g., comparable sales in the area). In either case, the royalty amount is calculated by applying the applicable royalty rate to the actual or imputed gross proceeds, less deductions for certain post-production activities (e.g. transportation of oil and gas, gas processing).
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The MMS has stated that some of its goals in looking at the new valuation method are (1) payment within 30 days after the month of production; (2) certainty about the payment; and (3) ability to verify payment easily. The MMS stated in its February 5, 1998 News Release that ''Royalty must be based on the value of production at the lease.''
In general, the MMS' present rulemaking addresses both arm's length and non-arm's length contracts. For arm's length contracts, it would narrow the definition of ''arm's length contracts'' and thereby reduce use of gross proceeds as a measure of the value of production. For non-arm's length contracts, it would scrap the existing benchmarks altogether in favor of some indexing scheme.
Specifically, the MMS' January 1997 proposal used a two-region approach: Alaska North Slope (ANS) spot prices for Alaska and California; NYMEX future prices for the rest of the nation. In its February 1998 proposal, the MMS uses a three-region approach: ANS spot prices for Alaska and California; NYMEX prices and some other measures for the Rocky Mountain Region; and spot prices for the rest of the nation. In either case, MMS-established quality/location differentials would be used in order to adjust the index prices.
Industry comments on the January 1997 proposal were uniformly negative, asserting, among other things, that NYMEX prices and ANS spot prices, when used in combination with the MMS-set differentials, were not a sound measure of the value of production at the lease, and that the definition of ''arm's length contract'' was far too narrow. Industry comments on the February 1998 proposal will be just as critical, scoring the further complications of a three-region approach and reiterating the problems with spot prices.
Valuation standards aside, industry comments will also be critical of the MMS' February 1998 Proposal's expanded use of a downstream proceeds tracing requirement that would be very costly and, in some cases, impossible to implement. Furthermore, the MMS proposals would establish valuation procedures that are complex and shot through with the need for interpretation by the lessee, to which the MMS would only be willing to offer ''non-binding'' valuation determinations.
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In a nutshell, the MMS crude oil valuation proposals are neither simple nor certain and do not accomplish the MMS' own stated objectives.
IV. Royalty-in-Kind as an Alternative to Royalty Valuation
Dissatisfaction with inadequacies of the MMS oil valuation proposals and continuing disputes under the current system have prompted Federal lessees to support an alternative: that the MMS take its royalty in kind. Authority for using such an alternative already exists in Federal leases. Briefly, the MMS would receive its royalty in physical barrels of oil or cubic feet of gas and would establish a process whereby private marketers would bid to market this royalty oil and gas on behalf of the MMS. MMS would directly receive the proceeds from the sale of its royalty production. The government could capture the value of any enhancements made to its royalty production.
The Federal Government, states, industry, and the citizens of the United States would benefit from reduced auditing, accounting, and litigation costs. The current system of auditing production value has given rise to protracted and costly document retention and management, administrative appeals and litigation as companies and the MMS have disagreed on the interpretation and application of the regulations. The case of Alberta, Canada is instructive: currently 33 employees administer an RIK program that sells 146,000 barrels of royalty oil per day. For a similar amount of royalty production, the MMS employs hundreds more employees to interpret, account, and audit under the current regulations.
V. Government Royalty Revenues Are Not at Risk Under An RIK Program
Concerns have been raised that an RIK program would jeopardize government royalty revenues. However, the states and industry believe that a properly designed, comprehensive RIK program would not lose money for the government. An RIK program has the potential to provide additional revenue, especially when one considers the benefits, such as reduced administrative and monitoring costs, and acceleration of revenues. While MMS has expressed doubts about RIK programs, it has not addressed what a comprehensive RIK could achieve.
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Vl. Principles of an RIK Program
1. An inter-association task force representing all segments of the oil and gas producer community reviewed the lease contracts, regulations, case law, other RIK programs, and MMS reports on RIK. This task force also analyzed its own experience with the RIK pilot and with other RIK situations. It determined that a successful RIK program would reflect the following principles which H.R. 3334 incorporates in most respects:
1. An RIK program should reduce administrative and compliance burdens while providing Federal and state governments an opportunity to maximize the value of their royalty.
One of the motivating forces behind the effort to devise an RIK program is the desire on the part of industry to reduce the administrative and compliance burdens and costs currently incurred by the MMS, states, and industry in the MMS valuation process. This process includes audit, maintaining and providing thousands of documents, explaining methods used, and correcting MMS' misunderstandings, as well as those activities associated with defending the interpretation and application of current regulations on valuation of royalty oil and gas. MMS audits often lead to disputes, and ultimately litigation, that require a significant amount of time and expense to address. An RIK program would eliminate most of the resources expended by the MMS and by the lessees on administration and compliance.
It is important to emphasize that an RIK program does not require direct participation in the oil and gas markets by the MMS. This would be left to knowledgeable private marketers who compete to sell the government's oil and gas and then arrange for its transportation to downstream markets.
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2. Lease obligations be fulfilled by transactions at or near the lease.
Lease obligations require the royalty production to be delivered in kind to the MMS at or near the well. Upon delivery, the lessee's royalty obligations are satisfied. As provided in the lease and under current regulations, the lessee has no duty to market or transport royalty production once it is tendered for delivery to the MMS. The MMS proposal moves the valuation point downstream of the lease. This proposal imposes additional costs on lessees, which are not required under current leases and MMS regulations. Under the RIK program, the marketing agent who takes delivery of royalty production on behalf of the government should assume risks and costs outlined in the contract between it and the U.S.
3. The government should take its full share of royalty in kind.
One of the primary goals of an RIK program is to design and implement a comprehensive Federal royalty management program that can be administered for all Federal production. Certainty and simplicity are also major goals of an RIK program. To accomplish these worthwhile goals, a mandatory RIK program is a prerequisite. Without a mandatory program, there would be additional burdens such as: the administration of dual accounting systems, one for royalty in kind and one for valuation; continuing disputes over the complex and unclear valuation methodologies being proposed; and higher costs to states receiving net profit interests because of the resulting overhead. Finally, mandatory RIK allows for aggregation of U.S. Federal production in areas and regions with low volume wells which can be a benefit in marketing the U.S. share of production.
4. The government should rely on private marketing agents to dispose of its royalty production.
There is no need for the government to become involved in the business of transportation or marketing of its royalty production. Having the government (i.e. the MMS) market its own production is unworkable and inefficient, as pointed out in the MMS' 1995 offshore RIK pilot project. Additionally, competition among knowledgeable private marketing agents is sufficient to enable the government to receive a market driven price for its royalty share of production. Marketing agents can aggregate volumes, invest in the marketing of oil and gas, and arrange for transportation. In effect, the government will let private firms bid to undertake these activities, just as it allows private firms to bid for the right to explore for and produce oil and gas.
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5. States should have the opportunity to assist in the design and implementation of an RIK program.
In general, states receive one-half of the proceeds from any Federal onshore oil and gas royalties located in the state and twenty-seven and one-half percent for some Federal offshore lands (Section 8g lands). These proceeds are netted by overhead deductions determined by the Federal Government. Thus, states stand to share in any benefits effected by an RIK program, that reduce this administrative overhead. Some states (Wyoming) have actively promoted an RIK program or have put a limited RIK program in place (Texas).
6. Royalties taken in-kind should be broadly available for public purchase.
Oil and gas royalty production should be made available on a competitive basis to a broad-based market. No entity should be excluded from having the right to purchase the government's royalty share of production.
VII. Issues Raised by the RIK Proposal
The proposal to implement a comprehensive RIK program has raised a number of additional issues. One issue is whether government sales of its oil and gas royalties might be disruptive to petroleum markets. Here, it must be recognized that the unit of production taken in kind by the U.S. is not a new unit in the market and thus should not affect supply and demand.
Another issue is whether an RIK program implies direct government involvement in the oil and gas industries. By allowing private marketing agents to handle sales of royalty production, the government avoids direct involvement of its employees who do not possess the requisite marketing expertise. These private marketing agents would be firms with the expertise to find the markets where oil and gas is most highly valued. In effect, the government could collect its royalty revenues from private marketing agents rather than from lessees. Hence, government involvement can be decreased, resulting in cost savings to the taxpayer while net revenues to the government are increased or, at worst, unaffected. An RIK program could be analogous to the Federal leasing of acreage to private firms for oil and gas exploration and production. The government is not engaged in exploring for and producing oil and gas. Rather, private firms with the highest bid win the right to explore and produce from the Federal lands.
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Any affiliation the qualified marketing agent and lessees or between the qualified marketing agent and the purchaser is irrelevant as long as the sales process is open, competitive and nondiscriminatory to all potential buyers. It is the open process, not the affiliation or lack of affiliation between such parties, which assures that the MMS will maximize receipts for sale of its royalty share. Any proscription against affiliated qualified marketing agents or purchasers could actually reduce MMS' royalty revenues by eliminating those who might compete in the bidding for or in purchasing royalty production.
VIII. Concluding Remarks
A comprehensive RIK program permits the government and producers to reduce the administrative and compliance costs associated with the payment of royalties. By eliminating the current royalty valuation system, and streamlining the royalty collection process, an RIK program can benefit all parties. The Associations believe that the legislative proposal for an RIK program is on the right track and are examining the legislation to determine whether it should recommend any modifications.
LETTER FROM THE DOMESTIC PETROLEUM COUNCIL TO HON. THORNBERRY
The Honorable MAC THORNBERRY,
412 Cannon House Office Building,
Washington, DC 20515
The Domestic Petroleum Council (DPC) strongly supports a comprehensive, mandatory, royalty-in-kind program for Federal oil and gas resources.
As a result, the large independent natural gas and crude oil exploration and production company members of the DPC would appreciate your including this letter in today's House Energy and Minerals Subcommittee hearing record to demonstrate that they:
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• strongly support H.R. 3334, the Royalty Enhancement Act of 1998 you introduced with Representatives Barbara Cubin and Kevin Brady as cosponsors;
• appreciate Subcommittee Chair Cubin's holding today's hearing as the next step in the public policy process to explore why and how a royalty-in-kind, or RIK, approach will maximize benefits to our citizens and reduce or eliminate inefficient and costly disputes and litigation over royalty valuation;
• urge prompt markup of this legislation; and,
• commit to working with others who have an interest in the Federal royalty program to improve H.R. 3334 at each stage of the legislative process until a sound RIK program is in place.
Regrettably, the current Federal oil and gas royalty program is a mess. For our members the Federal Government is often, in effect, one of our largest partners in developing oil and gas resources. But regardless of their commitment to pay the Federal Government every penny owed in royalties, our members face constant uncertainty and threat of audit, non-productive reexamination of royalty valuation decisions, and litigation, under the current royalty program.
Worse, the Minerals Management Service has proposed most recently a series of sweeping changes in the crude oil royalty program that would in many instances add greater uncertainty and audit exposure. The various changes proposed, then modified, re-proposed and once again the subject of further comment, have been based on too little understanding of today's oil markets. The most recent oil proposal is also the latest of the MMS efforts to change the fundamental contract producers rely upon to find and produce energy for the nation from Federal lands. Our members have spent enormous amounts of time, energy and resources to help educate MMS personnel, outright oppose many of the MMS ideas, and to offer counter proposals to others, with little success.
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Witnesses before you today and in the future will explain in detail the shortcomings of the current royalty program and the attempts to change it. But the overall message will be that it is time for a basic change in our entire royalty approach.
It is time to end uncertainty over royalty value.
It is time to sharply reduce the number of Federal employees it takes to try to monitor, track and second-guess dynamic market transactions that are necessary in a changing and increasingly complex energy market.
It is time to cut down on litigation expenses that sap both government and company staff time and budgets.
It is time to harness the market to enhance Federal oil and gas royalty production value just as the market does in the sale of millions of barrels of oil and billions of cubic feet of natural gas for the private sector every day.
It is time for the Federal Government to take its royalty share of production in kind, and to encourage professional, private sector, marketers to compete to sell it at the highest prices the market will allow.
It is time for a comprehensive and mandatory royalty-in-kind program.
We urge your continuing efforts to put such a program in place.
One word of encouragement about the financial bottom line of an RIK program. The DPC members know that such a program must return as much revenue to the Federal Government as does the current program in order for it to be adopted. We firmly believe that a good program will do that and more. And we welcome solid analysis of those financial implications.
We also know that others who do not understand today's energy markets, or who oppose a change in the status quo for various reasons, will be quick to claim that an RIK program does not meet the revenue test. We are confident that the Energy and Minerals Subcommittee and others in Congress will ask the necessary questions about the assumptions used in developing such claims so that they can be fairly evaluated and the economic benefits of a RIK can be fully recognized.
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The Domestic Petroleum Council looks forward to working with you and your colleagues toward the RIK program the country needs.
Thank you.
Sincerely,
| William F. Whitsitt, |
| President |
HEARING ON H.R. 3334, THE ROYALTY ENHANCEMENT ACT OF 1998
THURSDAY, MAY 21, 1998
House of Representatives, Subcommittee on Energy and Mineral Resources, Committee on Resources, Washington, DC.
The Subcommittee met, pursuant to notice, at 1:18 p.m., in room 1334, Longworth House Office Building, Hon. Barbara Cubin, [chairwoman of the Subcommittee] presiding.
STATEMENT OF HON. BARBARA CUBIN, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF WYOMING
Mrs. CUBIN. The Minerals and Resources will please come to order.
The Subcommittee meeting today is meeting today to hear testimony on H.R. 3334, to provide certainty for, reduce administrative and compliance burdens associated with, and streamline improved collection royalties from Federal and Outer Continental Shelf oil and gas leases, and for other purposes.
The Subcommittee meets today to take testimony on H.R. 3334, a bill to reduce administrative compliance burdens associated with the collection of royalties from—yes, we repeated ourselves here. So I'll just read to myself and then skip.
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[Laughter.]
And I am sure you can all hear what I am thinking. I think he can, too.
Two months have elapsed since our first hearing, and if nothing else, this bill certainly has engendered much debate in the trade press and occasionally even in the popular press. Unfortunately I really believe that the rhetoric has escalated way beyond the rational discourse of the merits of the bill and almost to the point of name-calling between the government and industry.
This is not helpful to those of us in Congress charged with oversight of the issue and who want to tackle an obvious problem and search for common sense solutions. That truly is the goal here today.
The oil industry flexed its muscles with appropriators a few weeks ago to delay the publication of crude oil valuation rule. The sparks flew over that. The rider that was put on the Appropriations bill, and I believe that the rule will surely be litigated when it does go into effect or if it does go into effect because it is such a large departure from decades of practice by the Department of the Interior.
However, the market uplift envisioned in that rule, some $66 million per year, is something which the sponsors of this bill, myself included, want to utilize to benefit the Federal and State treasuries by putting private marketers to work for Uncle Sam. We can get that value-added increment by taking in-kind volumes aggregated from many leases to downstream marketers, and do so without the litigation fight over whether the Secretary has the authority to compel lessees to market production at no cost to the lessor.
Now, I am pleased with the direction the formal revenue estimates of the Department have gone since we last met from a half a billion dollar annual shortfall preliminary estimate to only one-seventh to one-third is, indeed, progress. And I really trust when we are through here today we will see that those estimates can actually turn into positive territory, as indeed they must before any bill will come out of this Subcommittee or even be marked up in this Subcommittee.
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I think we have had a failure to communicate. My intent as co-sponsor of this bill was not to use an RIK bill to overturn precedents regarding proper processing and transportation allowances. We have made that clear all along. And it was also not to give treatment cost deductions which are not granted under the current practice. I keep hearing that over and over, and we've said all along that is not the case.
There can be no revenue consequence to those provisions of the bill when our intent is known, and if the words don't say it properly then it is incumbent on the MMS to help us write the words so that they do say it properly.
Yes, there are a few places in the bill where we do intend to change current rules; for example, the provisions for rate of return for upstream pipeline investments, or for allowances for affiliated pipeline transportation from actual costs to market rates. But, let's calmly discuss why such a change may or may not be warranted for deep water infrastructure development, when investments in geothermal power plants are granted such an advantage by MMS regulation.
I think most people will agree that a large fraction of our Nation's energy supply for some time to come will be met by oil and gas from increasingly more distant portions of the Outer Continental Shelf, not from geothermal steam. So why don't we take the opportunity to encourage pipeline building to get more oil and gas onshore? But let's also get the real cost data behind this idea. The industry will need to provide evidence to when continuing support for such a change, and the time is getting short.
I do intend to announce a Subcommittee markup of H.R. 3334 in the very near future. The 105th Congress is in session for only a few more months, and the fiscal year 1998 funding limitation provision expires in four months. There is good reason for all sides to begin in earnest discussions. If the Department of Interior believes it can simply stall away the fiscal year and publish a final oil valuation rule without further consultation from the Committee, they will not have learned anything from their previous indifference to Congress, and quite possibly find themselves stymied for 1999 as well.
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On the other hand, if the industry is not forthcoming with the kind of cost-benefit data necessary to sustain provisions of this bill and clearly demonstrate the positive effects on revenue it should have, well, then they better not look for lightning to strike twice. An oil valuation rule will be waiting for you on October 1st.
So I urge both sides to come forward with the information, to talk together, because we are going to either have a legislative solution to this problem or a courthouse gamble to this problem.
I am ready to do my job to broker a compromise, but there has to be some willingness by both parties to negotiate, and I haven't seen very much of that, quite frankly.
Now that I have taken up more time than I should have, I'd like to recognize the Ranking Member.
Mr. ROMERO-BARCELÓ. Thank you, Madam Chair. We have previously heard from the Director of the Minerals Management Service, and we'll hear again today the administration who is strongly opposed to H.R. 1334, and they have indicated that it would be vetoed by the President.
The economic analysis estimates that at very least $367 million will be lost per year if the bill is enacted, and this estimate reflects only those costs that the Minerals Management Services could extrapolate from the existing system. New activities such as the small refiner provisions increase litigation costs, imbalance provisions, triple volumes at remote locations, marketing agent manipulation and oversized supplied markets are not yet quantified.
Since the last hearing in March the States of Texas, New Mexico and Alaska have provided written comments to the Subcommittee which I submit for the record, and all three states oppose the bill or major portions of it.
[The information may be found at end of hearing.]
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Mr. ROMERO-BARCELÓ. In a related action the Justice Department announced on Monday, May 18th, that the United States has intervened against Texaco in the ongoing Quiatum litigation. Quiatum or Quiatum, I don't know which one. I guess it's Quiatum. The Quiatum litigation, filed under the False Claims Act, was initially brought by private citizens in Texas two years ago. Fourteen major oil companies were accused of knowingly undervaluing oil extraction from public and Indian lands.
In February Justice intervened against four companies, and with this announcement the number of companies that the U.S. is suing rises to five. The Quiatum litigation is part of the growing hostilities between the Federal Government and the oil industry or the value of Federal royalty oil and gas and how much the taxpayer is sold.
The oil rider recently attached to the emergency supplemental bill stops the Minerals Management Services from issuing new regulations that would have respectively required evaluations to be based on the published price of oil and gas. Under the current system the oil companies use posted prices to value their oil; however, they set those prices among themselves. Critics of the current system assert that oil companies purposely set low posted prices in order to lower the royalty and their tax costs.
They negotiate separate but related exchange agreements that equal the difference between the posted price and the published index price. H.R. 3334 would fundamentally change the way the Federal Government sells the Nation's oil and the gas resources. H.R. 3334 would shift the cost for gathering, for importing, for assessing and marketing Federal royalty oil and gas from the oil industry from the taxpayers, and H.R. 3334, as written, would result in a permanent reduction of Federal royalty.
Clearly, and I believe the Chair agrees with it, H.R. 3334 will need extensive revision, as the chairwoman has indicated before, it can be reported out of this Committee. And there are serious pay-go issues that must be resolved, and there are serious issues to be resolved.
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Along the vein, our colleague, Representative Carolyn Maloney, has offered an alternative for us to consider. Her bill, the Federal Oil Royalty Protection Act, introduced today, would codify the Minerals Management Service Rule, currently blocked by a rider of the emergency appropriations bill. It is my hope that the Chair will schedule hearings on this bill before we markup H.R. 3334 so that we can consider both.
I look forward to hearing from our witnesses today, and perhaps we will hear some recommendations for improving H.R. 3334. Thank you, Madam Chair.
Mrs. CUBIN. Thank you. Mr. Thornberry.
Mr. THORNBERRY. Thank you, Madam Chairman, and the formal statement that I would ask be made part of the record, and I also would like to mention to you and my colleagues that after the next vote I'll be detained on the floor for a bit because of an amendment that will be considered there.
[The prepared statement of Mr. Thornberry follows:]
STATEMENT OF HON. WILLIAM M. ''MAC'' THORNBERRY, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS
Madam Chairman, I would first like to thank you for holding this hearing today.
As you know, this is an important issue for me and one that I have worked on for several years. I would like to again restate my reasons for pushing legislation to mandate that the government take its share of oil and gas royalties in kind rather than in value.
• First, the current valuation system does not work. The system is complicated, and provides no certainty for the states, the taxpayers or the oil and gas industry. Moreover, efforts to mend the system have created concerns by all parties involved. In my view, if The Royalty Enhancement Act, H.R. 3334, before October 1, the Minerals Management Service will publish a final rule that—regardless of its merit—will be litigated for years to come. This, I believe, is a disservice to U.S. taxpayers and the states.
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• Secondly, I believe—like Ms. Quarterman has stated before—that a well-designed and well-crafted royalty in kind program can provide increased revenues for the states and American taxpayers.
Litigation and confrontation does not benefit anyone. And while we cannot put a dollar figure on the government's past, present, and future legal battles with the oil and gas industry, I think it is safe to assume that those costs will be substantial.
I have said many times that The Royalty Enhancement Act is a work in progress—a starting point. From what I have heard over the last few months changes are needed and warranted. I welcome constructive criticism and suggestions on how to make this bill better.
I would also like to thank Ms. Quarterman and the Minerals Management Service for their time and efforts in preparing their report on the effects of H.R. 3334. While I disagree with some of their findings, I do believe when we change this bill using many of their suggestions, The Royalty Enhancement Act will receive a positive score.
Again, Madam Chairman, I thank you for holding this hearing today and I look forward to hearing from the witnesses.
Mr. THORNBERRY. I want to make a couple of quick comments in response to your statement and the Ranking Member's statement. It does seem to me that the attention which the moratorium has raised in the press and elsewhere proves to us all that there has got to be a better way.
Mr. Romero-Barceló mentions the growing hostility between government and the oil companies. I think he is exactly right, and trying to find the better way to reduce that hostility and the litigation and the contentiousness which has enveloped this issue is the reason that I got into this think to begin with.
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And in accordance with your wishes, moving toward an markup early next month with some changes and improvements in the bill I think make sense, and I'll certainly intend to do that.
I also want to say briefly that I appreciate MMS's work and coming to us since the last hearing with greater detail on their comments and their cost estimates. I think they make some good points in their analysis. I think there are some misunderstandings, as you mentioned, and if they misunderstand it, we need to take another look at the language and make it even clearer on what we intend.
There are some errors. For example, they talk about the Mensa Field in the Gulf as an oil field when in fact it's a gas field. So there's some just clear errors, but we need to talk about those and resolve them. And there is going to be differences that we always have, and we will need to narrow those.
I know that MMS will never support RIK legislation, but the dialogue I think that has been going on is helpful to work out some of these problems, to talk about how this program works now, what some of the problems are, how this bill can be improved and some of the pitfalls we face.
And so I think we are on a good track. I am encouraged, and I appreciate other members of the Subcommittee working with us as we try to find a better way.
Mrs. CUBIN. Mr. Gibbons, do you have an opening statement?
Mr. GIBBONS. Thank you, Madam Chairman. I would just like to join my colleagues in welcoming our panels here today and look forward to their testimony, and I applaud you in your leadership in this effort.
I think royalty-in-kind is an issue of today. It's one which I think is going to help us improve our competition in the industry, whether it's oil and gas or whatever with our overseas partners and in some times our overseas competitors in this area.
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If America is to remain competitive we have to move forward with modernization of our oil and gas industry, including the royalty-in-kind. And I think this bill, this effort, is going to take a large step in that direction.
And thank you, Madam Chairman, once again for holding this hearing, and I look forward to the testimony.
Mrs. CUBIN. I too would like to express my gratitude to MMS for sending the technical people over to work with the Committee staff and work through that. It was very, very helpful, and I think lots of things were uncovered. And we know, as Mac said, we know that improvements need to be made, and they will be, but thank you for that very much.
Now I would like to introduce our first panel. I routinely swear in all the witnesses that in front of the Committee. So we'll be doing that in a minute, but first I'd like to introduce the Honorable Malcolm Wallop, United States Senator from the greatest State of Wyoming, who is chairman of the Frontiers of Freedom Institute. I also want to welcome Cynthia Quarterman, the Director of MMS, who is accompanied by Debbie Gibbs-Tschudy, Chief of the Royalty Valuation Division; and Mr. Roger Vicenti, the Acting President of the Jicarilla Apache Tribe.
[Witnesses sworn.]
Mrs. CUBIN. Let me remind the witnesses that under our Committee policy that testimony should be limited to 10 minutes.
So I will start with you, Senator Wallop.
STATEMENT OF MALCOLM WALLOP, A FORMER UNITED STATES SENATOR FROM THE STATE OF WYOMING, AND CHAIRMAN, FRONTIERS OF FREEDOM INSTITUTE
Mr. WALLOP. Thank you, Madam Chairman, and let me offer my appreciation to you for the invitation and express my real pleasure at the honor of testifying in front of your Subcommittee. I appreciate your invitation to testify on H.R. 3334, a bill to provide certainty, reduce administrative and compliance burdens with, and streamline and improve collections of royalties from Federal and OCS oil and oil gas leases.
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I am Malcolm Wallop and serve as chairman of the Frontiers of Freedom Institute, an independent, non-partisan public policy research group, and I also have a stint here as Wyoming's senior Senator from 1987 until 1995. As your constituent and as a citizen of Wyoming, I have followed recently the intensifying dispute over oil royalty and valuation with increasing dismay.
And Madam Chairman, it's a troubling paradox of our time that nearly a decade after the collapse of Communist centrally planned economies the managerial state not only persists but flourishes in the United States of America, where meddlesome and intrusive regulations by bureaucrats almost defy compliance and restrict human creativity. Both Republicans and Democrats claim the era of big government is over, and the administration talks about reinventing government, but overreaching by government regulators not only remains the norm at the IRS but throughout the government.
In the late Roman Empire the clerks and scribes of officialdom were known as the ''clerisy,'' in distinction from the clergy of priestly sector that was also economically unproductive, at least in the material realm. In our day the clerisy of officialdom in government finds its counterpart—its mirror image—outside of government in a legion of lawyers and lobbyists. These forces, contending over how much power to cede to the regulators, do constant battle in both the legislative and judicial arena.
The hard reality is that in the name of fairness, health and safety, no segment of life or the economy is left private. And worse yet, the only people judged capable of treating citizens fairly and keeping them safe and healthy is modern clerisy, the ruling class on the Potomac.
The endless night of regulatory rule making followed by court battles enriches the clerisy of bureaucrats and the lawyers at the expense of taxpayers and business people. Consumers always end up bearing the cost of these wealth transfers. A telling case is the current bitter and costly dispute between the oil and gas industry and the MMS of the Department of Interior over the valuation of petroleum royalties due to Federal and State governments for oil and gas extracted from public lands. Madam Chairman, an accounting dispute ought not to be dragged down into the criminal courts. Some people have a disagreement as to accounting. This is a disagreement as to accounting and is a reflection of the complexity of the regulations that neither side can interpret consistently from one administration to the next, let alone one decade to the next.
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In our home State of Wyoming petroleum royalty payments are set aside for education. The salaries of MMS auditors and the fees of lawyers significantly reduce the net revenue available. Regulators thrive on complexity and specialization. Simple solutions are the natural enemy of power.
Earlier this year Frontiers of Freedom Institute commissioned two well regarded energy economists, Dr. Walter J. Mead, Professor Emeritus of the University of California at Santa Barbara, and Dr. Robert Bradley, who heads the Houston-based Institute on Energy Research, to develop a simpler, free market approach to resolving the oil royalty valuation dispute. I am pleased to submit these results, Madam Chairman, as part of my official statement for the record.
[The information may be found at end of hearing.]
Mr. WALLOP. And I do so with confidence that there are simple solutions to apparently complex matters. In an introduction to the Mead-Bradley Study, former Secretary of Interior William Clark joins me in commending their analysis for consideration.
Doctors Bradley and Mead begin their work by taking a fresh look at the entire concept of royalty payments and advocate sub-soil privatization as the optimal policy objective for the long term. Their analysis is thoughtful and well reasoned. I regret that circumstances did not permit either of the authors to join us for the hearing, but their study traces the evolution of the valuation controversy since the energy crisis of the 1970's and the attempt by MMS regulators to return to Carter-era energy market complexity where royalty determination turns from objective, transaction specific cases into full blown regulation and subjectivity.
The latest MMS rule proposal is predicated on imputed or synthetic valuation and is imbued with command-and-control central planning precepts. The large majority of Federal lease transactions that the MMS has defined as non-arms's length, their proposal would determine value at downstream points, in a different market, from where it is contractually obliged to do so. In effect they have changed the terms of the lease contract by requiring that only some costs could be netted back to the lease under specific rules. And only government gets away with freewheeling breaking of contracts.
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The authors identified payment of royalty-in-kind as a workable compromise to solve today's valuation dispute. Under such a system, the government would take ownership of the actual product—oil or natural gas—at the least and let qualified marketers use their skill to maximize the return for the government. A similar system in Alberta, Canada, enabled that government to increase oil production, increase royalty payments and significantly reduce the size of government bureaucracy while eliminating—and this is important—disputes between producers and the provincial government.
Now the Frontier of Freedom Institute is please to offer what we believe is a fresh approach by scholars who are not parties to the current controversy. And again, I thank you, Madam Chairman, for allowing me the opportunity to appear before your Committee and I would be happy to entertain any questions.
[The statement of Mr. Wallop may be found at end of hearing.]
Mrs. CUBIN. Thank you, Senator Wallop.
Ms. Quarterman
STATEMENT OF CYNTHIA QUARTERMAN, DIRECTOR, MINERALS MANAGEMENT SERVICE
Ms. QUARTERMAN. Good afternoon, Madam Chairwoman and members of the Subcommittee. I am pleased to return before you today to continue discussing issues related to royalty-in-kind programs for Federal oil and gas leases. First, I'd like to offer some perspective on several issues that surfaced during the Committee's last hearing. Then I will briefly summarize our detailed analysis of H.R. 3334 which we provided to the Subcommittee last month. One of the things I mentioned to the chairwoman last time was that my knowledge on the issues about an inch deep and a mile wide, so I have brought with me today Debbie Gibbs-Tschudy who is the resident expert on valuation issues. She's the Chief of the Royalty Valuation Division in Denver.
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First, I think it's important to review—in my view—how far we have come in a short period of time in royalty management. By providing some historic reasons why MMS was created. As you know, MMS was created 16 years ago. Prior to that time the Department of Interior was repeatedly criticized for mismanaging the royalty program, because of its failure to collect underpayments of hundreds of millions of dollars in royalties every year.
An independent Commission on Fiscal Accountability of the Nation's Energy Resources was formed to address those allegations. The Commission recommended creation of an independent royalty and minerals management agency to ensure effective accounting, production verification, royalty collection, and enforcement. Accordingly, MMS was established and has since resolved the issues that were identified by that commission.
Along the way MMS's royalty management program has accumulated an enviable array of awards and commendations, including the President's Council on Management Improvement Award for management excellence. Just this past month MMS reached the $2 billion mark in audit and compliance collections from companies who have underpaid their royalties.
It's necessary to refer to this historical context because at the time of MMS's creation the Commission urged that the oil and gas industry should carry out its obligation as lessees to pay royalties in full and on time. This statement goes to the very heart of our concern with this bill, which is that it disregards the Commission's recommendations or more pointedly, its admonition, by forgiving the oil and gas industry of its lease obligations to pay royalties in full and on time. By relieving the industry of their long-established obligations and denying the public its rights under the lease, this legislation will return us to the days of when the public was not assured of getting fair market value for its mineral resources.
I fully understand the current debate. I believe that we must look back to the original deal that was struck between the United States, as custodian of the public's lands, and the oil industry, as lessee. In that bargain, the United States entrusts oil and gas lessees with the right to explore for, develop, and produce minerals from Federal lands.
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The lessee benefits by retaining most of the mineral products from those lands. In exchange, the lessee agrees to care for those lands and return to the United States a very small portion of the proceeds in value or in-kind, at the government's option. In addition, the lessee agrees contractually to be bound by the government's reasonable determination of what royalty value is. To eliminate the government's choice in how to collect proceeds would deny the public its rights under the lease and ultimately return less than the fair value due and owing.
Last month we provided the Subcommittee with a detailed analysis of the bill. Before answering any questions, I would like to briefly summarize our conclusions concerning the bill. In sum, this bill would drastically change the options and legal rights of the Federal Government as mineral lessor and hinder the government in its duty to assure a fair return to the public. Certain provisions of the bill, such as those addressing transportation cost reimbursements, will maximize costs to the government and reduce royalty revenues commensurately. We estimate that the government's costs of just storing, processing and transporting the oil and natural gas to the buyer, as proposed in this bill and which are now the responsibility of the lessee, are at a minimum in the hundreds of millions of dollars per year, while the administrative cost savings are less than $8 million per year in the first eight and a half years.
Our estimates for potential revenue effects vary from the negative to tens of millions of dollars in theoretically possible gains. However, any such potential revenue gains can be realized without this legislation. MMS's existing right to take royalties in-kind and our capability to do so, which is being developed though our royalty-in-kind pilots, allows us to realize all of the possible revenue gains for the taxpayer without the costs associated with this legislation, and without revenue losses from areas where RIK is not a feasible option. Thus, as I testified earlier, H.R. 3334 will have a substantial negative annual cost impact on the Treasury and will not enhance revenue compared to current statutory ability.
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It's also important to note that our analysis of the costs associated with this bill are very, very conservative and do not include a number of clearly negative provisions that we could not quantify in the time that was available to us.
In contrast, the administrative cost savings used in the analysis are very liberal because they do not take into account the costs necessary to start up and implement the royalty-in-kind provision of the bill. In addition, the cost of contracting, overseeing, and auditing qualified marketing agents under this bill could easily wipe out the $8 million in administrative cost savings.
Another $6.2 million in revenues could also be lost through the net receipts sharing provisions of the bill. Since the bill does not explicitly rule out potential QMA conflicts or conflicts of interest situations, our auditing and litigation costs are likely to increase. In an opinion submitted by the Department of Justice on this bill to the Office of Management and Budget they concurred.
Finally, the potential revenue enhancement figures used in the analysis are extremely generous because we assume ideal conditions for royalty-in-kind program despite the provisions in the bill which provide for the opposite.
H.R. 3334 will have a substantial negative annual impact on the Treasury. Specifically we estimate increase in cost at a minimum of between $183 to $368 million per year. This estimate is comprised of the following items: Government transportation would increase due to the assumption of payment for gathering and to increases in the price paid for transportation. The total increase, and you should have this in either a chart before you or the chart here to my right doesn't spell these out. It gives you the totals. It ranges from $77 to $136 million a year. Processing costs will increase some $4 to $8 million annually due to payment of higher commercial rates rather than the lessee's actual costs. Treatment costs will increase due to the assumption of field treatment processes that are beyond the delivery point, which are estimated to be between $85 and $178 million a year. Marketing costs will increase between $17 to $46 million per year due to the government assuming marketing costs.
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These cost increases, plus several additional relatively minor costs increases, are offset by a maximum of $7.3 million in annual administrative savings and $36 million in maximum theoretical annual revenue uplift due to RIK implementation. Again, we realize any revenue uplift from RIK without this legislation, and its substantial costs, under current authorities, using a more deliberate approach. That is, we can realize these revenue uplifts without the legislation.
Other provisions of the bill having a negative revenue impact we could not quantify in the time available. They are on the chart to my left and your right. From the above comments it should be clear our position on the bill remains unchanged from the last hearing. You have also heard concerns about this legislation expressed by officials from the States of Texas and New Mexico. I have heard from or my staff has heard from officials from Louisiana, California and Alaska.
We believe that the time has come to agree on a more productive course in our mutual desire to improve the royalty management systems and to experiment with royalty-in-kind options. In that spirit, I'd like to reiterate our request from a year or so ago that the people directly involved in oil and gas production, marketing, and accounting advise us and the Committee on the options that are available for RIK before we go forward with any legislation of this sort.
I noticed that many of the prepared statements of those testifying today relate to our crude valuation rule, a matter that I am not prepared to testify about here today, but I would be more than happy to provide a briefing to the members of the staff and their staffs on the crude oil valuation rule at your pleasure.
That concludes my prepared remarks. Thank you.
[The prepared statement of Ms. Quarterman may be found at end of hearing.]
Mrs. CUBIN. Thank you very much.
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Mr. Vicenti.
STATEMENT OF RODGER VICENTI, ACTING PRESIDENT, JICARILLA APACHE TRIBE
Mr. VICENTI. Good afternoon, Madam Chairman, and members of the Committee. I am Rodger Vicenti. I am the Acting President of the Jicarilla Apache Tribe. Before I get into my statement I would like to introduce some people that I brought along with me. I have Councilman Hubert Valardi. I have the Department of Taxation Director, Dave Wong. I have the tribal attorney Allen Carterax, and a consultant attorney on oil and gas, David Harris.
Mrs. CUBIN. I'd like to welcome all of you folks.
Mr. VICENTI. Thank you. I've got a written statement here, but I think it would be to our benefit to just explain to you a situation that we've been through. We've been in the oil and gas business for the last 50 years. And of the 50 years, the last 20 years we've been active in this royalty-in-kind revenue—and I can't think of the word, but I'll go on—where we were getting our revenues from royalty-in-kind, and the reasons it worked for us at that time was the conditions were there. We were able to establish a set ratio where we would get a certain amount of money for oil that was being produced, and while that lasted it was real beneficial to the tribe.
The thing that we would like to express to the Committee is that the government should consider putting themselves, you know, them having an option to give themselves either royalty-in-kind or royalty-in-value. We have that option today so we can decide what direction we want to go to that is more beneficial to us.
I understand that this law or this bill does not really affect the tribes. It is intended not to affect the tribes, but it does affect us in the way the policies are followed, if there an entity that is off the reservation that have been able to get their oil and gas at a lower price that would take our ability to get the oil and gas from our reservation because our practices are quality at a higher level.
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We're really not that big on the MMS's concerns because we're only 3 percent as tribe of what the royalties of MMS has to worry about on the reservation, but this 3 percent is a 100 percent of our revenues that we get to support our tribe. The way the government is making all these cuts, we're having to be self-sufficient in a lot of these areas. We're here to try to advise the Committee of the issue that we went through and keeping an open option would be most beneficial to the government because the government itself is going to be losing a lot more money they've lost in their past.
We've had some problems with a compliance on our oil and gas and how do the oil companies owe this money, and they've done everything they could not to pay out to what they really actually owed us. We had to file several law cases, and I am sure you're read our position paper, in order to get some of this funding back.
Our biggest concern is that we've been affected by other laws or other Acts that have been passed. For instance, the Oil Simplification and Fairness Act. It was intended not to affect the tribes, but in the long run it turned out to affect us. We had finally developed some kind of a recording process and that was taken away from us so we had to develop our system in working with MMS on auditing these oil companies so they could come and pay us the monies that were due to us.
I want to thank you for giving us the opportunity to testify. I am not long at words, and I think I just wanted to be as specific as I could on the reasons why we as the Jicarilla Apache Tribe wanted to let our concerns be heard.
Thank you.
[The prepared statement of Mr. Vicenti may be found at end of hearing.]
Mrs. CUBIN. Thank you very much for your testimony. I will begin the round of questions. First I'd like to thank Senator Wallop for the work that he did in 1993 to help make the nets receipt sharing more fair. Even though it still costs Wyoming about $7 million a day, it's much better than it was before.
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I wonder, Senator Wallop, could you tell us some of your experiences that you've had during your years in Congress in dealing with the MMS, as Chairman of the Energy Committee. This isn't the first time that you have dealt with MMS on an issue like this?
Mr. WALLOP. No, I was there and as I recall it was Senator Melcher who was the proud parent of this little beast, and it was put in place because of the same kind of thing that's going on now— that is a series of complex arguments as to the relative valuation.
I think Ms. Quarterman kind of put her fingers on it when she was talking about what is the cost to the government, but every time you apply these costs in one way or another, the first thing that happens is that they cost the people who are the beneficiary of the royalties, in our case Wyoming.
What would happen is that the—following a lead that Congress is quite good at—every time somebody was cross-wired with the provisions of a rule the first thing they would do is to put up a board and kind of whack that person with it, but they'd also change the rule. And every time they changed the rule then the idea of compliance became more remote and more complex and more subjective.
And our problem with MMS has been and remains that their interpretation of things are hugely subjective and now they're making the claims that these things are criminal conspiracies, which I just simply do not believe. First of all, anybody who knows the industry knows that it's pretty hard to get to them to conspire.
[Laughter.]
Mrs. CUBIN. I know that.
Mr. WALLOP. But Ms. Quarterman's testimony indicates really that MMS has no knowledge of the industry and that remains the source of the disagreement. You have this view somehow or another that these disputes are all on one side.
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You have an indication that somehow or another that everybody is out to get the government, but the working knowledge of how royalties are collected is lacking—I mean if you listened to her anxieties expressed as having to train marketing agents. Well, they exist. You don't have to train them. They're there.
As you listen to her talk of government having to store oil, government is not going to have to store anything. In fact what they can do is pool relatively inefficient amounts of oil that are there—and probably be of benefit both to producers and to the government—as they pool these stripper well productions and move batches of larger economic size into the marketplace.
So the list of anxieties that MMS has produced here this afternoon as to why it is not going to be easy to do RIK, belie a knowledge of how the industry works. And if they haven't gotten a knowledge of how the industry works, it is not a surprise that we have criminal charges being brought and more litigation. And litigation takes not from their pockets but from the pockets of the Justice Department, which is all the rest of us.
So we have a system that is now hugely expensive. I don't understand why it seems so mysterious that Alberta which is a highly productive Canadian province has had such a success and has eliminated so many of the confrontations between the industry and the government by going to this and increased their revenues and increased the efficiency, that we can't take it for granted that there is a means under which we can get this underway.
Mrs. CUBIN. Thank you. I just have one question for you, Ms. Quarterman. In your testimony you referred to an opinion by the Department of Justice that was submitted to OMB. Do you have a copy of that opinion that you could furnish to the Committee?
Ms. QUARTERMAN. I don't think it was an opinion. It was part of the regular intergovernmental process of approving testimony. Everybody in different departments look at it, which is why we are often late in getting testimony to you through OMB, and they give their opinions on it—not a formal legal opinion but their thoughts on it.
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Mrs. CUBIN. Well this is what your testimony says, ''The opinion submitted by the Department of Justice on this bill to the OMB agrees.''
Ms. QUARTERMAN. When I say opinion there, I did not mean a legal brief.
Mrs. CUBIN. My staff contacted OMB yesterday to ask about that opinion and they were not even aware that there was anything pending. They said that they had not made an opinion and that there weren't of anything even pending. So I would just like you to give me the information, the report, whatever that opinion was from DOJ, I would just like to see it please.
Ms. QUARTERMAN. I will be happy to get back with OMB for you. I am not sure that it's something that we ever received a copy of. I believe that OMB itself put that language into our testimony, but we can straighten it all out.
Mrs. CUBIN. Thank you. Mr Romero-Barceló, do you have questions for the panel?
Mr. ROMERO-BARCELÓ. First of all, I'd like to thank the panel for their testimony and the persons here today and thank you, Senator, for expressions here. One of the comments you made, Senator, I want to congratulate you. I think I believe very, very strongly that simplicity is the enemy of power. There's no doubt about that. Simple procedures are easier to manage and definitely undermine the ability of a person in office to do what they want. There's no doubt about that.
But Senator, there are many significant differences between the Alberta RIK Program and H.R. 3334. For instance in Canada the government can choose the oil that it wants to, and under this bill the Government would not be able to choose. And also in Alberta the government does not pay the transportation, whereas in this bill it would.
Those two are basic, basic, substantial differences. Do you think with those arrangements that Alberta has, where they can choose their oil and transportation would not be paid by the government, do you think those amendments would be adequate for this bill?
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Mr. WALLOP. I think that in one respect I hear what you are saying, that there is a significant geographic and demographic between Alberta and the production of these things in the country. At some moment in time the government needs to bear some costs and not be just the harvester of revenues. You spoke and the chairman spoke of changes that they had in mind, and those may be some of them, but the fact of it is, that could be worked out. What can't be worked out now is what is so obnoxious to my friends in the industry, namely that the government is now seeking to change the nature of the contract of which Ms. Quarterman spoke.
When they all went into this, the contract was pretty well understood as to where valuations took place and what those costs were, and those are being changed quite subjectively and quite arbitrarily.
Mr. ROMERO-BARCELÓ. By the new rules?
Mr. WALLOP. By new rules. And I guess what I am saying is that if you can work out the problems of which you spoke, and I don't deny that there are problems within the bill, and neither has the chairman. Having done that, you significantly lower the level of confrontation between the government and the producers, at a great benefit to both.
Mr. ROMERO-BARCELÓ. Thank you. Thank you, Senator. Ms. Quarterman, Senator Hutchison recently included language in the emergency spending bill prohibiting the Department from issuing the final rules of valuating oil produced from Federal and Indian leases, and the Senator argued that the Department had tried to change the law through the back door of government regulations. And what authority does the Department have to issue regulations governing the value of oil and gas production on Federal and Indian lands?
Ms. QUARTERMAN. The Department has full authority under the existing laws. Both the Mineral Leasing Act and Lands Act give the Secretary authority to value oil and gas. That language is carried over into the lease terms into the contracts. There was no legislative change or change of a legislative nature that was being pursued. It was strictly within the bounds of the Secretarial discretion.
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Mr. ROMERO-BARCELÓ. Thank you, Ms. Quarterman. What happened during the posing of the publication of the Department's Federal Oil Valuation rule? What harm—does that cause any harm, and if it does, what is the harm?
Ms. QUARTERMAN. I think it causes substantial harm. We were very close to finalizing that rule, and our estimates are that it cost the taxpayers $66 million per year. It is something that I have been working diligently—I and my staff—for the past two and a half years with industry, holding multiple workshops at 14 different places—14 different times—5 different states, 5 different Federal Register notices.
We have moved substantially closer we think to the opinions that were given to us and comments, and we're very close to going final. So this is a devastating effect.
Mr. ROMERO-BARCELÓ. Another question, Mrs. Quarterman. There are several States that receive royalties from the Federal oil and gas leases. What has been the reaction of these States to H.R. 3334?
Ms. QUARTERMAN. As I mentioned in my testimony earlier, we have heard from some of the larger producing States around the country: California, Alaska, Texas, Louisiana; all of whom think that H.R. 3334 in its current form should not proceed, and they would not be happy if it were entered into their own states.
Mr. ROMERO-BARCELÓ. And they proposed changes to the bill or they're opposed to the bill?
Ms. QUARTERMAN. I would have to go back to each individual comment on that. We'd be happy to supply copies for the record of all the things that we've received from States thus far.
Mr. ROMERO-BARCELÓ. Madam Chair, I would ask that they be submitted.
Mrs. CUBIN. Without objection.
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[The information may be found at end of hearing.]
Mr. ROMERO-BARCELÓ. Thank you, Madam Chair.
Mrs. CUBIN. I do want to make just make one statement. CBO scored the Hutchison Amendment as zero revenue impact, as opposed to the $66 million. Mr. Thornberry, I know you have to go to the floor so would you like to take the round of questions? You can take longer if you want since you can't come back.
Mr. THORNBERRY. I appreciate it, Madam Chairman, and Senator, let me thank you for you appearance. Your testimony helps remind me, among others, that we are not just dealing with green eyeshade accounting stuff here, that there are some principles about central control management versus the market; and sometimes I find myself getting lost in some of the details and forgetting some of the bigger picture. And I appreciate your comments.
Ms. Quarterman, I know that you will not be able to—I am sure—stay through all of the panels we are going to hear today, but I hope that maybe some of your folks can because later on some of the witnesses are going to provide detailed comments on some of your analysis, and I think it would be helpful.
I would like for your folks then to come back, and if they disagree with that analysis—come back and tell us why because we will—from reading the testimony—I believe we will receive testimony later—from someone who is in the business of scoring these sorts of bills that, clarifying three or four misunderstandings, he can show that the bill gets to a positive impact on the Treasury rather quickly.
And so, we do have some disagreements, but I would like to continue to discuss with your folks about how that came come about.
And let me just ask this question in that regard: If we are able to change H.R. 3334 in ways so that it receives a positive score from the Congressional Budget Office which is what matters up here, would MMS still oppose it?
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Ms. QUARTERMAN. Well, first let me go to your first request which is that we stay around. Miss Tschudy is going to be available here after I leave. I should warn you in advance that we received a copy of industry's response to our report late last evening, and we have not had an opportunity to do any sort of in-depth reaction to that. We would be happy to provide one over the course of the next several weeks, if you would like us to; but to the extent that we can response based on off-the-cuff comments, we will do that.
Mr. THORNBERRY. But I really meant just I thought it might be helpful for your folks to hear the testimony of the other witnesses. I know you've got a busy schedule, but I just thought it might be helpful.
Ms. QUARTERMAN. Certainly we want to hear what everyone else has to say. In terms of being able to respond to some of the details, I think Debbie will be able to do that. Be kind to her. This is her first experience here, please.
Mr. THORNBERRY. She is holding up well.
[Laughter.]
Ms. QUARTERMAN. She is one of our best employees. You're in luck. As to the second request about whether or not something could move forward, I would refer you back to my testimony last week which said very clearly that the Department currently has the authority to take its royalty-in-kind at its option.
Having said that, let me also draw your attention to my testimony which offered I hope an olive branch to say that there is a possibility that royalty-in-kind could make sense in some instances, and we talked about this last year when I came before the Committee, we would love it if the Committee were to become involved in looking at our pilots, and once we have those complete, talking about what authority, if any, is necessary to proceed.
Mr. THORNBERRY. Let me clarify one other brief thing that kind of related to what the chairman mentioned. Your estimates on H.R. 3334 are comparing it with what you would expect to receive under your proposed rule?
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Ms. QUARTERMAN. That is incorrect.
Mr. THORNBERRY. It is under existing law?
Ms. QUARTERMAN. It is under the existing rule making. You would have to add another——
Mr. THORNBERRY. Under existing rule making?
Ms. QUARTERMAN. Under existing rules. Sorry.
Mr. THORNBERRY. Okay. Okay. Because I think there's a difference between CBO and MMS on how you are scoring both H.R. 3334 and the effect of the moratorium. I am not really interested in the moratorium, but my only point is that there is a difference on how these things are being scored out.
Ms. QUARTERMAN. Well, I asked my staff to put together an analysis of the effects. They are not up-to-date on the rules that CBO uses, and there are a number, I understand. Over the years we have learned about many of them. So CBO very well might have a different analysis.
Mr. THORNBERRY. Okay. Let me get to one of the substantive issues that you have raised last time and this time as far as objections to the bill, and that is the mandatory requirement that you have to take production even from small marginal wells in remote areas.
If there were a provision in the bill that would basically allow either MMS or the State or the lessee to request a buyout or a prepayment and if you can't agree on how much it is then a mandatory arbitration to work out the amount—what would your attitude toward using that mechanism to deal with the marginal wells or remote wells?
Ms. QUARTERMAN. Well, I would just respond, as I did earlier, to the fact that we have full authority to take royalty-in-kind and add that it's difficult to respond to a hypothetical in a situation like this.
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Mr. THORNBERRY. But I am trying—your first point is the mandatory royalty-in-kind is your first objection. I am trying to look for a way to solve your objection by not requiring—and I am throwing this out—not requiring it to be in-kind in a State like Wyoming where you have got stripper wells spread out all across the country. If any of the parties request a buyout or a prepayment then that would be an option instead of royalty-in-kind.
As a matter of fact that was, as I understand it, part of the provisions of the Royalty Simplification and Fairness Act that we already passed, that you all haven't issued the regulations for. But isn't that a way to solve your objections to the mandatory part with stripper wells and marginal wells. And doesn't that remove really your first objection that you've always posed to this bill?
Ms. QUARTERMAN. It does not, and Debbie will tell you why.
Ms. GIBBS-TSCHUDY. Yes, sir. You are correct that the Royalty Fairness and Simplications Act does contain at section 7 a provision for producers to prepay their royalties for qualifying marginal properties. We've held three workshops with States and industry representatives over the last couple of years to get input into developing regulations to implement section 7 of RISPA, and based on that feedback we do not believe that there will many producers that apply for prepayment for a number of reasons: Number one, section 7 allows government to request additional royalties over and above the prepayment if we find that the assumptions upon which we calculated the prepayment changed significantly. Number two, the States have the absolute veto power over any prepayment applications and approvals.
We've heard from a number of States that they object to the prepayment: Number one, because it disrupts their cash flow. Many states rely on royalty revenues to fund their schools and a prepayment disrupts that annual cash flow. Number two, many states would have substantial exposure from prepayment. Of the qualifying marginal properties, 50 percent of Wyoming's properties qualify as marginal wells, and 70 percent of Montana's qualify as marginal properties. So many of them have felt that provision gives them a great deal of exposure.
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Mr. THORNBERRY. Well, I find it a little bit curious to argue that you're opposed to prepayment because you're expecting the money over time, and you don't want it all now at the present value. That's kind of like the lady that won the lottery last night. She want's it now, and she'll worry about the future years, you know, as it comes, and that—I think she's going to come out okay on that.
[Laughter.]
But let me get back. I am sorry. I'll never pronounce your last name right. Gibbs——
Ms. GIBBS-TSCHUDY. Tschudy.
Mr. THORNBERRY. Tschudy. Ms. Gibbs-Tschudy, if we were to fix the provisions where they come back and get additional royalty, and the other objections that producers have now in a provision that we may include in here to allow buyouts or prepayments to deal with the marginal wells or the remote wells, doesn't that really fix this first objection that you folks have had for H.R. 3334, which is that it's mandatory, regardless of how much the production?
Ms. QUARTERMAN. I think Debbie's point was that in theory that would solve the problem but in practicality it does not because it would not ever be exercised based on what we have heard so far in trying to write a rule.
Mr. THORNBERRY. Well, it seems to me maybe we need to write a better law and you all need to write better rules so that it fits with the people, but it doesn't seem to me to be something completely prohibits us from moving ahead.
Let me ask one other——
Mr. WALLOP. Mr. Thornberry, can I offer just a quick observation? One of the things that is troubling to us in Wyoming who have this number of small producing wells is that every time you raise royalties you actually reduce the revenue so they're going to—ultimately go to the States, and the reason is because you hasten the end of economic viability.
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These stripper wells are not hugely prosperous to begin with, and you start changing the rules and making them endlessly more complex, as they are now, and the value of production simply is outrun by the cost of compliance.
Mr. THORNBERRY. Let me ask briefly, Ms. Quarterman, one of the statements I think you have made is that—or one of the objections that's raised in the bill is that it does not allow to sell or give directly to other agencies so that other government agencies might be able to utilize this oil or gas, for example use the gas to heat their schools or hospitals or prisons.
GSA has told us that they're pretty interested in that, but you all don't seem very interested in that. Do you have a position on whether it's a good thing for us to make available to other government agencies say natural gas that they might be used in heating Federal facilities?
Ms. QUARTERMAN. I don't believe that we've said that we are opposed to the bill for that reason but only point out that the bill as currently constructed does not permit us to do so, and frankly I am surprised that GSA has told you any such thing because we have been working closely with them and trying to give them creative ideas about how they might take gas in particular in-kind from us.
Mr. THORNBERRY. So you think it's a good thing?
Ms. QUARTERMAN. Could be.
Mr. THORNBERRY. Madam Chairman, if I might, one last thing. One of the interesting problems that I get into in trying to look at some of you all's comments is that in certain areas we leave complete discretion to the Secretary to write regulations on how to deal with situations like who the QMA is going to be and what the relationship has to be.
And yet we get criticized in the bill when we decide something, and we get criticized when we don't decide something, leaving it up to regulations by saying that it's going to create more auditing and litigation costs. So I kind of left in a point where you lose either way. Either we decide something, and you don't like the way we decide, or we leave it completely to you all to decide, and you don't like that either because that's going to result in more litigation, according to you. Don't you think that's going on a little bit here?
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Ms. QUARTERMAN. Not at all.
[Laughter.]
You may be surprised to hear that. I don't know what specific provision you are talking about, where you think the bill leaves it to us to decide.
Mr. THORNBERRY. Well, the QMA in particular, where the Secretary comes up with whatever regulations he sees fit to govern QMAs and who they may deal with, to make sure their arm's length transactions. If he doesn't want affiliates selling to affiliates, he can make a rule doing that. If he doesn't want affiliates selling to affiliates in California, he can make a rule dealing with that. It's completely up to him, and yet that gets criticized.
Ms. QUARTERMAN. Well, what we have been able to ascertain so far looking at the bill, we believe that you're simply shifting who we litigate with, from the producer to probably the QMA.
Mr. THORNBERRY. Well, Madam Chairman, I would just end by saying that there are several situations in this bill where we give discretion to the Secretary and do not intend to overturn current regulation but wanted to give him maximum flexibility to do it the way that makes sense, and yet the criticism from MMS is ''Oh, you can't do that. That just increases litigation.''
So, sometimes we do seem to be in a lose-lose situation, but I look forward to continuing to work with their comments and hopefully continuing to improve the bill. Thank you.
Mrs. CUBIN. Thank you. Mr. Pallone—I mean Dooley. Mr. John.
Mr. JOHN. Just very briefly. First of all, I appreciate the chairman for calling these hearings. They have been very educational, and it's been very worthwhile to try to understand this whole situation because as I have sat here—I think this is the third or maybe the fourth hearing—I've had people sitting at that table that not only have supported and opposed RIK, but have had hands on experience in both of the situations with some pilot programs, such as Texas that does it at a State level, and with some other States that do it, and they all have vastly different stories.
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My interest in this has been to try to make it a more fair, more simple system and get through some of the litigation that so often clouds not only the State of Louisiana from where I am from but also the Federal Government.
The crux of the matter it seems with all of the complications with this bill—and there are quite a few—seems to be the fiscal impact to the Federal Government. The chart to my left and to your right, Ms. Quarterman, you ran through it very quickly. Could you maybe touch on it just a little bit more about how you come up with these figures, where they've come and just a little bit more information to guide me because I think that that it's very, very important that we get down to the bottom of the costs in these charts because I think RIK is a great idea and concept.
And I think we need to continue to move forward, but we need to get down to the bottom of the costs of this bill because that's going to really make up the minds of a lot of folks because as you're aware, the State of Louisiana and the Secretary of DNR is very lukewarm to this bill, and I've been working with him to try to get down to the bottom of why. So could you maybe just kind of hit it just a little harder?
Ms. QUARTERMAN. Okay, if you don't mind I will have Ms. Tschudy go through the elements.
Mr. JOHN. Sure. I know transportation is something that is very much of concern, and I don't see that word anywhere up here. So I would like to know where that fits in. I am sorry. Go ahead.
Ms. GIBBS-TSCHUDY. Yes, sir. Beginning first with the revenue losses under royalties which ranges from $182.4 million to $336.6 million, that's comprised of four components. The first is transportation. The proposed legislation establishes the point where the QMA takes delivery of production at the royalty meter. This is the point upon which volume is determined for royalty purposes.
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Mr. JOHN. Okay, and that's at the well head?
Ms. GIBBS-TSCHUDY. It's not always. It's sometimes at the well. It's sometimes at a point remote from the lease, if approved by the Bureau of Land Management for onshore leases or offshore Minerals Management for offshore leases.
Under the current regulations, the lessee incurs the costs of moving production from the lease to the royalty meter. That's considered gathering. Under the proposed legislation the government would pay those costs, as a result in the changes to the definition of transportation and gathering.
In addition, the costs incurred to transport the production beyond the royalty meter are increased under the proposed legislation for a number of reasons. The total impact of this provision is $76 million to $135 million per year.
Mrs. CUBIN. Would the gentleman yield for a moment?
Mr. JOHN. Sure.
Mrs. CUBIN. As far as the government having to pay transportation costs, that is not the intent of the bill. If that's what the words say to MMS we want to work with them to change that. That is not the intent of the bill. I don't think that's what it says, but at any rate so.
Mr. JOHN. I appreciate the lady's comments, and that's kind of why we are having this discussion to make sure that that it's very clear how we handle transportation costs. So it's comprised of—the numbers that you have, it comprises 76 to 135, correct?
Ms. GIBBS-TSCHUDY. Yes, sir. The second component is marketing. Under the proposed legislation the government would assume the costs of marketing production. For our analysis we assumed that the cost of marketing for gas is in the range of one to three cents per NMBTU, for oil in the range of 7 cents to 15 cents a barrel. The impact is $17 million to $46 million per year.
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Mr. THORNBERRY. And if the gentleman would yield briefly.
Mr. JOHN. Sure
Mr. THORNBERRY. This is another situation where I think that the bill explicitly says the opposite, that it is not the intention to have the government pay marketing costs, and if there's a way to make it clearer we certainly want to look for a way to do that. But that's one where you flip the whole amount real quick by, that they allege, by making it clearer.
Ms. GIBBS-TSCHUDY. The third provision is treating costs. Under the proposed legislation the definition of marketable condition is modified from a condition that's acceptable to a purchaser, as is the current situation, to a condition that is acceptable by a transporter.
The proposed legislation also changes the definition of gathering to be to a central accumulation point and eliminates the term ''and or treatment point.'' Those provisions and others within the legislation which shifts the cost of treating production from the lessee to the government. We estimate those costs to be in the range of $85 million to $178 million per year.
Mrs. CUBIN. In my opinion, if the gentleman will yield.
Mr. JOHN. Yes, ma'am.
Mrs. CUBIN. This is most egregious of the misinterpretation of what the bill actually says. Nowhere do we expect that the government should pay for the treatment of the oil. I just can't even understand where in the bill that comes from.
Ms. GIBBS-TSCHUDY. It comes largely—pardon me.
Mrs. CUBIN. Go ahead.
Ms. GIBBS-TSCHUDY. It comes largely from having the QMA take delivery at the royalty meter. Frequently treatment occurs downstream of the royalty meter. So we if we take, though our QMA, possession at the royalty meter, we are going to have to incur the costs of treating production downstream of the royalty meter.
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Mrs. CUBIN. But the product has to be in marketable condition. Yes. We do have to go vote, and we'll be right back.
[Recess.]
Mrs. CUBIN. Please come to order. Congressman Brady has some questions for the panel, and Senator Wallop had to leave. If there are any questions for him we can submit them in writing and put them in the record later. Mr. Brady.
Mr. BRADY. Thank you, Madam Chairman. I appreciate all the witnesses being here today. And I guess we had visited with Ms. Quarterman last time about the numbers that were used to arrive at the $500 million revenue loss projection from last session. Now it has been revised but clearly appears to be a case where everything possibly negative about the bill has been expanded or exaggerated, and everything positive has been minimized or simply not included.
I guess my question to you is twofold. First, when will we truly have a revenue impact for this bill from your office that reflects a true, fair, accurate estimation of this impact? Secondly, I noticed in the testimony the agency had recently received management improvement award for management excellence.
I assume not based on the revenue estimations from last hearing, but in that the agency had just past a $2 billion mark in audit and compliance collection from companies that have underpaid their royalty. My second question would be: Do you think that oil companies are deciding not to pay their royalties or is it that the current royalty process is so convoluted that it is difficult to make a proper royalty assessment?
And given the estimation from the office so far just on this bill, I sort of lean toward which answer I think is the case. Ms. Quarterman?
Ms. QUARTERMAN. Yes. I believe at the first hearing I was very fearful to say both times that our revenue analysis was an early estimate, not complete, and at that point we believed that the effect could be up to as much a half a billion dollars. What you have here today is a refinement of the calculations that were just an estimate at the time. Those calculations show a range up to $373 million, and quite frankly, they do not include everything that is feasible.
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I think you didn't come in at the beginning of my testimony where I tried to make it perfectly clear that this is a very, very conservative estimate and that we think the revenue effect could be much greater, but we went to great lengths to ensure that we did not over-calculate the effects. We've narrowed the range of costs. On the point of administrative costs, we did not include certain costs. There are a number of ways that we tried to make it as conservative as possible.
Having said that, we are not necessarily saying that this bill will not have a half a billion dollar impact because there are still a number of things. There was a chart to the left here, six different items that we have not completely analyzed, and some of them I am afraid we will probably never be able to completely analyze the effect of.
Some of them are surely negative but not easily ascertainable. Others of them will take more time for us to try to put our arms around a more legitimate estimate, but once that is done I would not be surprised if the estimate were to go back up to a half a billion dollars or more.
Mr. BRADY. Actually just to clarify for me, at the last hearing in the press conference beforehand if I recall you said that this bill would create a half a billion dollar loss to American and State taxpayers; and based upon that loss, you would recommend a veto to the President. Now, of course, we are seeing completely different numbers. Plus, just in the first four criteria that you have presented, there is tremendous dispute whether those are real or imagined.
And I guess my question still stands: When do you think we really will see, based upon working with members of this Committee and the authors, a true, fair, accurate appraisal of this impact?—because that's truly what I think we are trying to get to, and it sort of reminds me of the Lyndon—LBJ story from long ago where the school teacher is interviewing for a job before the school board in Texas. One of the board members ask him, ''How do you teach the world? Do you teach it round or do you teach it flat?'' The response is ''I can teach it any way you want it,'' and in this case I think you are teaching this bill flat, as negative as it can possibly be, and if we continue this we will never get I think to a fair assessment from members of this Committee to make decisions on.
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Ms. QUARTERMAN. I would be happy to provide for you both citations to the record of the last hearing where I stated very clearly that the effect would be up to a half a billion dollars.
Mr. BRADY. On the second question do you think that the $2 billion mark is because that royalty assessment is so difficult or because oil companies are deciding simply not to pay?
Ms. QUARTERMAN. Do you mean the $2 billion in compliance?
Mr. BRADY. Yes.
Ms. QUARTERMAN. Collections that we have seen so far? I could not speak for any individual company on why they have not paid appropriately and on time. I am sure it varies from company to company.
Mr. BRADY. I need to yield back the time, Madam Chairman, but I would encourage you to sit down with the author and with members of this Committee and deal with some of the real true disagreements in this and come up with a revenue impact that we can base some decisions on. Thank you, Madam Chairman.
Mrs. CUBIN. I just have two quick things for you, Ms. Quarterman. I believe Ms. Tschudy referred to—or maybe it was you—referred to the governors of certain States thinking that the prepayment regulation would not be good for them; they weren't interested in it; wouldn't take part in it or whatever. Could you furnish those comments to the Subcommittee from the governors who have expressed those concerns?
Ms. GIBBS-TSCHUDY. The comments were received from state representatives that attended the workshops that we held and we'd be happy to provide you the minutes of those workshops.
Mrs. CUBIN. So are there transcripts or just minutes? I mean would that be referred to in the document that you can provide to the Committee?
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Ms. GIBBS-TSCHUDY. Yes, they are minutes, not transcripts.
Mrs. CUBIN. Okay. Well, we'd appreciate it if you would give those to us. Our Ranking Member today, Ms. Quarterman, mentioned the legislation that Congresswoman Maloney and Congressman Miller filed today. And I wonder if you could tell this Subcommittee what your position on that piece of legislation would be?
Ms. QUARTERMAN. Certainly not having seen the piece of legislation and since it was brought forward today, your staff person came over and told us shortly before the hearing. I have not seen it and if there is a hearing on it I am sure the administration will be happy to supply comments and a position on it.
Mrs. CUBIN. I guess maybe a better way to ask that question would be—and the bill does implement the rule that—the legislation would implement the rule that you have come up with and that would make it law, that would put it in statutorily. What would be your opinion of that?
Ms. QUARTERMAN. I don't know that that is what the bill says. I haven't seen——
Mrs. CUBIN. Assuming it just implements your rule.
Ms. QUARTERMAN. I can't speak on behalf of the administration on that matter. As a general matter, I would recommend that we look very closely at any such legislation.
Mrs. CUBIN. Thank you very much. Thank you for your testimony. I just have one question for you, Mr. Vicenti. You told the Committee about the difficulties that your tribe has had with their royalty-in-kind program. I wondered, could part of the reason be that the Indian Mineral Development Act of 1935 that governs your leases does restrict transportation allowances? Could that be part of the reason?
Mr. VICENTI. I would love to answer your question, but I'm not the one that has answers. But, I do have an individual who could probably answer for—if that's okay?
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Mrs. CUBIN. Sure. Could you state your name for the record, please?
Mr. TARADASH. Yes. My name is Alan Taradash, and my firm is general counsel to the Jicarilla Apache tribe.
Mrs. CUBIN. Could you spell your name?
Mr. TARADASH. Yes. T--like in Thomas—A-R-A-D--like in Denver—A-S-H.
The Indian Mineral Development Act of 1938 is the Act that you're referring to. There is no provision in our leases under that Act for transportation. The reason being that at the time of the Act's passage, it was contemplated that the sale would occur at the wellhead, hence, no transportation was necessary to contemplate. Because of changing market conditions and the building of the pipelines that did not exist in the current fashion back in the late 1930's, the transportation allowance has been created by implication, and that's not the problem with the complexity that Mr. Vicenti referred to. The royalty-in-kind program that the tribe had for over twenty years—from 1975 to 1995—was successful because of regulatory prices. And, the ceiling prices in effect at that time permitted us to enter in to contracts to get guaranteed ceiling prices. When the deregulation occurred in pipelines and the elimination of ceiling prices, because we had the option, we did not suffer the loss we would have otherwise suffered had we not had the options. The royalty-in-kind program was successful, but it was because factors were very different then.
Mrs. CUBIN. Thank you. I think the fact that mandatory royalty-in-kind might not be the best way to go. I think that's been stated pretty well here today, and I know Mr. Thornberry and I are willing to look at that and work with MMS to come up with something that might be acceptable, but anything—I would think anything that is not taken in royalty-in-kind would have to be valued at or near the lease. Maybe we can work on some language or work on something like that.
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Thank you. Mr. John, did you have further questions?
Mr. JOHN. No, actually not. I just wanted to thank this first panel and talk about looking forward to the next panel—the industry panel—to talk about some of the questions and some of the statements that were made relative to how these costs are being developed. I look forward to hearing their testimony. Thanks.
Ms. QUARTERMAN. Just one other thing. I just wanted to note that Ms. Tschudy has a plane—she has to leave here at 4:30. So, she will be available until then.
Mrs. CUBIN. Thank you very much. Would you mind leaving the chart so that we can refer to those and then we'll see that you get them back afterward? Thank you very much for your testimony and the answers to the questions. It's very helpful and we appreciate it. You did a great job for your first time—even for your second or third. Thanks for being here.
I'd like to call the next panel forward to give their testimony: Mr. Diemer True of the True Company; Mr. Fred Hagemeyer, consulting manager, Marathon Oil Company; Bob Neufeld, vice president, Environmental and Government Relations for Wyoming Refinery; and Poe Leggette.
I'd like to swear the witnesses.
[Witnesses sworn.]
I have to start by welcoming my friend and former colleague in the Wyoming legislature, former Wyoming senate president, Diemer True. We grew up together and went to junior high school, student council—we've worked together for a long time. So, I'm delighted to have you here with us today, Mr. True, and look forward to it. Would you like to begin with your testimony?
[Laughter.]
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You thought I was going to say something else. You're not gone from that table yet, so I still may.
Mr. TRUE. I was thinking the last time you swore at me, not swearing me in.
[Laughter.]
Mrs. CUBIN. This is better, isn't it?
[Laughter.]
We all like it better.
STATEMENT OF DIEMER TRUE, PARTNER, THE TRUE COMPANY
Mr. TRUE. Well, thank you, Madam Chairman. It's a pleasure to be here. I am Diemer True, a partner in True Oil Company, an independent oil and gas producer from Wyoming. I will summarize my comments today, but I ask that my full written statement, along with my exhibits, be submitted for the record.
I am here as chairman of IPAA's Land and Royalty Committee and representing a number of other associations. I submit their names for the record. We appreciate the opportunity to testify before you today regarding H.R. 3334. The IPAA, along with other supporting associations, strongly support the Royalty Enhancement Act of 1998. The introduction of this bill and your examination of the Federal royalty rules could not be more timely. The downturn in world oil prices has exposed America's half a million low-volume marginal wells to great risk. Many producers have shut down wells because they are too costly to operate at current prices. The Royalty Enhancement Act has laid a foundation from which we can build a permanent remedy to an uncertain and costly royalty system.
Can the American people make money under a more simple and certain system? Yes. By greatly reducing the administrative costs and replacing government accountants and lawyers with private marketing companies, we can maximize Federal royalties. I wish I could only be as eloquent in addressing that as our former Senator, Malcolm Wallop. If H.R. 3334 falls short of this goal, IPAA stands ready to work with the administration, Congress, the States, and other trade associations to make improvements. We believe much of the current criticism of H.R. 3334 stems from MMS's resistance to change, a misinterpretation of the legislation—which I think you pointed out—and minor design problems, which can be easily resolved. The MMS needs to come forward and help resolve the design issues that they will ultimately face in their pilot programs.
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One cannot discuss royalty-in-kind without examining MMS's oil and gas royalty rulemaking efforts. Even though IPAA presented the MMS with a cost-effective approach for valuing oil production at the lease, it intends to issue a final regulation that assesses a royalty beyond the boundaries of the law. You could say MMS is impersonating the IRS by trying to raise—and I use the word in quotes—''taxes''—because royalty is not taxes—on producers without changing the law. Congress needs to analyze this new rule for its complexity and to be sure it is consistent with the contract, which is the oil and gas lease between oil producers and the Federal Government.
It would appear Congresswoman Maloney agrees with the need of Congressional action by the mere introduction of her bill today. Simply put, the MMS is proposing a rule that does not capture value at the lease. The MMS is ignoring this legal mandate and is attempting to assess royalties on values downstream of the lease without full consideration of all the costs and risks associated with these markets.
We have legally challenged the same arbitrary position in MMS's gas transportation rule. Parenthetically, the suggestion that litigation would shift from the producer to the QMA is remote at best. MMS will hire and supervise the QMA under a contract. Also, there would be dramatically fewer QMAs than the thousands and thousands of producers. MMS wants it both ways. On the one hand, it says that royalty-in-kind will cost the government money because the Agency will have to pay to market its production. On the other, it says that industry is required to pay royalties on the value of the crude after it has been sent downstream. If MMS recognizes these marketing cost for itself, why doesn't it recognize it for the industry?
The industry has fully cooperated in MMS's rulemaking and submitted thousands of pages of comments, much of which has been ignored. The industry has flowcharted the MMS's complex and uncertain proposed rulemaking. The chart was labeled ''dungeons and dragons.''
It's to my left. It's on the floor over here.
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I might mention that Director Quarterman has countered with their own proposal, which is here I believe, which has grossly oversimplified the flowchart. We have drawn the chart—I believe it's at the bottom down there—which we would suggest is how the MMS would flowchart the Internal Revenue Code.
Recognizing that my time is about out, the complicated and litigious debate surrounding valuation leads one to conclude that the only way to put a final end to the endless confusion and possible litigation is royalty-in-kind. The administration must concur because they are proceeding with their pilots. I'm told the administration supported the advancement of royalty-in-kind language as part of the Royalty Fairness Law. It appeared to us at the time they thought legislative language was needed to do any further experimenting with royalty-in-kind.
Again, I'd like to thank you for the opportunity to testify on these important matters today. We look forward to working with MMS, the States, and the Committee in developing fair and reasonable oil valuation rules as we implement a successful royalty-in-kind program.
Thank you Madam Chairman.
[The prepared statement of Mr. True may be found at end of hearing.]
Mrs. CUBIN. Thank you, Mr. True.
Mr. Hagemeyer.
STATEMENT OF FRED HAGEMEYER, COORDINATING MANAGER, MARATHON OIL COMPANY
Mr. HAGEMEYER. Good afternoon, Madam Chairman. It's a pleasure to be here again for your Committee.
I'm Fred Hagemeyer, coordinating manager of Royalty Affairs for Marathon Oil Company. I am pleased to appear here today in support of H.R. 3334 on behalf of the American Petroleum Institute.
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As Representative Thornberry pointed out when he introduced the Royalty Enhancement Act, it provides a started point to begin the debate on the royalty-in-kind issue. I want to assure you of API's willingness to work with the Subcommittee, MMS, the States, and other interested parties to resolve issues that may arise during the legislative process. API's written submission to the Subcommittee in March of this year endorsed the concept of royalty-in-kind and a progressive measure that would simplify the royalty payment system for the Federal and State governments, and the oil and gas industry.
The central advantage of RIK is certainty. Production taken in-kind and sold in an agreed upon price eliminates the need to resolve years after the fact the reasonable value of production at the lease. RIK would also provide Federal and State governments the flexibility to participate in downstream markets with the opportunity to enhance their net revenues.
Based on a lot of the comments made regarding gathering and transportation, I think it's appropriate that I make a few comments on the gathering and transportation provision of H.R. 3334. To understand these provisions, one must first understand the role of the delivery point. As set forth in the bill, the delivery point is the measurement point approved by the Department of the Interior. The measurement point can be on the lease, adjacent to the lease, or some distance from the lease. However, the delivery point, as defined by the bill, is not in all cases the dividing line between gathering and transportation.
Gathering has traditionally been on or near the lease, and the bill does not change that lease concept. Transportation is generally all other off movement of production—off-lease movement. We agree that lessees should continue to bear all costs of gathering royalty production, while the government should retain responsibility for transportation of royalty oil and gas.
Looking at the bill's provision for transportation allowances prior to the delivery point, there are two areas that we feel need clarification: One would be where transportation costs are currently allowed by MMS, and another is subsea transportation. To the extent that the bill may not clearly provide that the movement of production in both instances is transportation, then the bill should be amended accordingly.
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H.R. 3334 is consistent with the nondiscrimination provisions of the OCSLA. It provides that royalty production shall be transported at rates not exceeding regulated rates or charges paid by third parties. If an unregulated pipeline affiliated with the lessee transports royalty production then the bill's extensive safeguards would ensure that the charge for transportation of royalty production is commercially reasonable.
There have been concerns raised about who would pay the cost of processing and treating royalty gas. Under current law, processing is deductible, but the cost of treating, or putting the production into marketable condition, is not. In the majority of cases, treatment is done by the lessee at or near the point of production and upstream of the delivery point. So, we do not believe that the bill would affect any material change in cost responsibility for treating gas. A gas processing plant is a facility that utilizes physical processes to remove elements or compounds from gas. Gas processing plants are located downstream from the point of production and often process production originating from one or more fields.
Currently, a lessee can sell its gas outright or enter into a gas-processing agreement to recover the substances entrained in the produced gas stream, such as ethane, propane, butane, and natural gasoline. Under the bill, the QMA, or qualified marketing agent, would decide whether or not it was advantageous for the government to process royalty gas.
The final issue I would like to address is the concept of a qualified marketing agent or QMA. The use of experienced QMAs instead of the government to market royalty volumes would provide at least four benefits: First, QMAs could maximize flexibility by marketing royalty volumes either at the lease market on in downstream markets.
Second, they offer the opportunity of cost savings in arranging transportation by aggregating the government's royalty volumes from individual leases into larger packages. Also, there is the opportunity of aggregating royalty volumes with other volumes handled by the marketer.
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Third, QMA's and their expertise allow for quick response to a rapidly changing lease market or downstream market.
And, fourth, the government can use an established and expert marketing organization rather than creating and training an MMS government marketing group.
The MMS's concern about QMAs not performing in an open, competitive, nondiscriminatory manner in transactions with affiliates is unfounded. The MMS can structure its regulations and contractual arrangements with its QMAs in such a way that they have an incentive to maximize revenues realized on their sales of royalty production.
In closing, I thank you for the opportunity to present API's position on this important undertaking. We believe that RIK is not only simpler, it is better; and a comprehensive royalty-in-kind program deserves careful consideration. API is interested in working with this Subcommittee, MMS, the States, and other stakeholders toward achieving a workable solution that meets the needs of all parties. And as part of this effort, API welcomes an opportunity to discuss differences between MMS and the industry concerning provisions in this bill with a common goal of successfully reinventing an important government process.
Thank you.
[The prepared statement of Mr. Hagemeyer may be found at end of hearing.]
Mrs. CUBIN. Thank you, Mr. Hagemeyer.
Mr. Neufeld.
STATEMENT OF BOB NEUFELD, VICE PRESIDENT, ENVIRONMENTAL AND GOVERNMENT RELATIONS, WYOMING REFINING COMPANY
Mr. NEUFELD. Thank you, Madam Chairman and members of the Committee.
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My name is Bob Neufeld. I am the vice president of Environment and Governmental Relations for Wyoming Refining Company. I am here representing a group of small refiners in the country who have denominated themselves as the Small Refiners Coalition. Those other refiners are Calcasieu Refining Company; Placid Refining Company—Calcasieu and Placid are both located in the State of Louisiana—Gary-Williams Energy Corporation, with headquarters in Denver and refining operations in Oklahoma; and Giant Industries with operations in New Mexico and headquarters in Arizona.
Madam Chairman, Members of the Committee, I would like to visit with you on three points with you today. We are in support of H.R. 3334 and I would like to talk about: Number one, why it is we feel that H.R. 3334 is necessary? The egregious and horrible effects, unintended consequences that have come about by not having certainty in price of oil valuation. Secondly, how H.R. 3334 addresses those effects. And third, I would like to talk a little bit about the mistaken conceptions of how H.R. 3334 is being scored.
Just to review for the Committee, and I went over most of these points in my testimony before this Committee in the oversight hearings last September, I will use Wyoming Refining as an example. We started purchasing royalty oil from the United States Government in 1987. This is a program authorized by Congress in 1946 as an amendment to the Mineral Leasing Act of 1920. Under that program, a lease is chosen for the royalty oil refiner to take oil from. The oil is delivered from that lease to the refiner. The producer reports the value to MMS, and MMS pastes the value in the invoice, sends it to the refiner, and the refiner pays the invoice on time and in full.
Some time around 1988, MMS started auditing the producer from our leases without telling us—we didn't know the audit was going on. In about a year later, they concluded that maybe the prices the producer was reporting to MMS weren't quite kosher. But, they didn't tell us that either. They kept taking the producer's reported prices, which MMS thought were suspect, put them in our invoices, and sold us the oil. It wasn't until 1995 that we got a demand letter from MMS saying ''We have underbilled you for the oil you purchased from us. You now owe us more money for the oil you purchased eight years ago.'' We didn't quite agree with that, and we are in litigation with the Minerals Management Service. The problem, though, is that we have to file a letter of credit in order to continue that litigation, and it occupies our line of credit that we need to purchase crude oil that we need to continue operations. We have approximately a $10 million line of credit, and the letters of credit that we need to continue to challenge these demand letters are going to squeeze that line of credit down to a minimal amount where we will be out of business and not be able to continue. We will never get our day in court if this process carries on.
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The other refiners in the coalition feel that this is also an egregious situation, and they have not received their demand letters yet on leases that they have been purchasing oil from MMS. However, they have been told that they can be expecting some very nice Christmas letters this year from the Federal Government. So, while we are hanging by a thread over the fire, they are about ready to be strung up also.
Two of things that are particularly bad about this situation are one, as I said, MMS was aware that the prices were suspect. Second is by waiting eight years to tell us we owe them more money for the oil, they denied us the opportunity to cancel the contract and stop purchasing oil on a basis in which every barrel purchased became a contingent liability.
On to my second point, Madam Chairman, I'd like to explain a little bit about how section 12 of the bill works. First of all, the bill has consolidated the small refiner definitions that exist for the onshore and the offshore programs for royalty-in-kind to a level of 120,000 barrels. Next, the bill has provided that if the Federal Government or the QMA is going to sell the oil, 40 percent of what would be sold will be offered to the small refiner at exactly the same price. So, whether it's sold to the small refiner or whether it's sold to the offeror or the intended purchaser, the same price is going to be garnered for the Federal Government. There will be no price reduction.
That is essentially it. The Secretary of Interior will keep a list of small refiners and will keep a list of QMAs. The small refiners will be told who the QMAs are and what type of oil they're selling. The small refiners will subscribe to the QMA and say ''I'm interested in what you're selling. Please let me know when you sell it.'' When a sale is made, the small refiner gets an opportunity to purchase 40 percent of it.
With respect to the scoring—and I will finish up quickly—we believe a mistake is made in that the bill says that we get the oil at the price of the lowest—40 percent of the oil receiving the lowest successful offers. MMS has said
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we will get the oil at the lowest offered prices. Somewhere in there they have missed the word ''successful.'' The offer has to be successful before that is the price that is imputed to the small refiner sale.
With that I will conclude my remarks and wait for some questions. Thank you, Madam Chairman.
[The prepared statement of Mr. Neufeld may be found at end of hearing.]
Mrs. CUBIN. Thank you.
Mr. Leggette.
STATEMENT OF POE LEGGETTE, ESQ., JACKSON AND KELLY
Mr. LEGGETTE. Thank you. I'm Poe Leggette—or Leggette—here on behalf of the IPAA. I have a svelte written statement and grossly overweight attachments to submit for the record. But, my oral presentation I hope will be even slimmer than svelte.
I appreciate the opportunity to be back here today to address the concern that MMS's proposed crude oil rule, the dungeon and dragons rule—which, evidently, kept Mr. Tauzin from reappearing at today's hearing——
[Laughter.]
Mr. LEGGETTE. [continuing] violates several principles of law governing Federal royalty. And, in the course of doing so, I will give you a brief glimpse of what life would be like if there is no H.R. 3334.
Under the current crude oil rule, which was adopted in 1988, a lessee who sells its oil at arm's length pays royalties based on it gross proceeds from that sale. Oil that is sold not at arm's length is valued at the higher of the lessee's gross proceeds received from its affiliate or a value based on benchmarks. Now to the extent possible, these benchmarks look to arm's-length sales at the lease as the correct measure of royalty value. And, if the MMS decides that even an arm's-length sale has an unreasonably low value because of lessee misconduct, then it will use those lease-level benchmarks to make the lessee pay a higher royalty. A net-back method evaluation, which starts with a downstream price, and revised to make deductions back to the lease, is used, but only as a last resort.
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Now, the proposed rule, in contrast, treats arm's-length sales at the lease as essentially unreliable to value non-arm's-length sales. All non-arm's-length sales and any arm's-length sales based on lessee misconduct or arm's-length sales that in MMS's opinion breach the duty to market at no cost to the lessor, will be valued using downstream prices; a NYMEX price; an Alaskan North Slope spot price in Los Angeles; spot market prices in Oklahoma, Texas, Louisiana; or a lessee's affiliate's downstream resale price. Many, but not all, transportation costs may be deducted. No other downstream costs or any other deductions reflecting risks undertaken after the oil leaves the lease will be allowed on the theory that these are all marketing costs.
Now, the proposal has several defects in law, and I'll mention just three. First, royalties are owed only on the value of production at the lease. By using downstream prices, by limiting deductions for transportation costs, and by denying deductions for all other costs and risks, MMS generally will claim royalty on more than the value at the lease. In effect, it will unlawfully claim royalty on value added to the oil by the midstream marketing activities undertaken after the oil leaves the lease.
Second, the best evidence of the value of oil at the lease consists of prices paid at arm's length for oil sold at the lease or at nearby leases. MMS is rejecting the use of the best evidence in favor of downstream prices, prices in a different kind of market.
Third, MMS refuses to deduct all value added by midstream marketing activities on the grounds that Federal lessees have an implied duty to market crude oil at no cost to the lessor. However, as noted in my written testimony, this position is in conflict with the Continental Oil case that Representative Tauzin read from at the last hearing, which says that duties don't exist unless they're stated expressly, and the Marathon Oil case, which says that under the Federal lease gross proceeds clause, the lessee may deduct both marketing and transportation costs from the downstream sales price.
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IPAA and the Domestic Petroleum Council have invested great effort in presenting the MMS with revised benchmarks based on arm's-length sales at the lease. These royalty valuation procedures are depicted on the chart to my left and are explained in fuller detail in Attachment 2 to my written statement. As you can see, just by a visual comparison, IPAA's proposal has a certain virtue of greater simplicity. But, MMS has refused to consider this, and its preamble to its most recent proposal that it issued back in February offered no explanation for that refusal. Therefore, the Subcommittee may safely anticipate years of litigation over MMS's proposal.
I thank you for your attention.
[The prepared statement of Mr. Leggette may be found at end of hearing.]
Mrs. CUBIN. Thank you for your testimony.
I'll start the questioning with you, Mr. True. You're not a lawyer or a lobbyist are you?
Mr. TRUE. No, I'm not.
Mrs. CUBIN. So, do think you need to be lawyer or a lobbyist to be able to help MMS devise a better way to collect royalties?
Mr. TRUE. Actually, I think as a producer of oil and gas on Federal lease, I think maybe the independent producer sector of the group that's interested in this is probably in better position to offer advice as a practical matter than lobbyists and lawyers, although, they certainly have their role in all of this.
Mrs. CUBIN. Now, that was a real softball, so you owe me.
[Laughter.]
One of the reasons that MMS objects to mandatory RIK is because it said there will be revenue losses because oil and gas markets in the same area will be limited and oversupplied. What is the situation in Wyoming?
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Mr. TRUE. Madam Chairman, that's a good question, and there are actually three or four different ways to respond to that. There is an ebb and flow in gas and crude oil markets domestically. For example, in Wyoming most recently, we had a situation several years ago where there was an undersupply, and we were actually receiving bonuses up to $4 a barrel for crude oil. As you and I have both seen, the Express Pipeline has brought in Canadian barrels, which we now see as an oversupply of crude oil in the Rocky Mountain region, and those bonuses have evaporated.
The reason I cite that as a specific example is I think royalty-in-kind would better position the Federal Government to respond as a practical matter to the ebb and flow of over-and undersupply of crude oil and natural gas markets.
Mrs. CUBIN. Thank you. So, you would disagree that—MMS takes exactly the opposite position that you do on this. They think that it would hinder competition.
Mr. TRUE. I think quite the contrary. I think the minute you inject a QMA or some other free enterprise aspect of the administration of this program, you will see an enhancement of the value of the royalty as it moves downstream. And, I think that enhancement will more than offset any incremental costs that are incurred by the Federal Government in that regard—more than offset that.
And, again, I think it's the knowledge of the marketplace. And, I would also like to say that the royalty-in-kind program, in my opinion, cannot be administered by government employees. You have to take it into the marketplace to where there's a profit incentive, and then you're going to maximize the value of it. And, that's how the RIK is going to accrue additional revenues to the Federal Government.
Mrs. CUBIN. Thank you.
Mr. Hagemeyer, would you address for me the mandatory aspect of the legislation in front of us. We have a lot of opinions that it won't work, and there are some reservations from some States about having RIK be mandatory. Would you just discuss that for me for a minute.
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Mr. HAGEMEYER. Sure. I'd be happy to. As we read H.R. 3334, of course, it is indicated that the Federal Government would take 100 percent of the oil and gas. There are a few exceptions, but they're, generally speaking, having to do other types of leases and so forth. The way we view this, I guess, is, first of all, starting from a restructuring point of view. When we started a lot of this discussion, there were a lot of comments about reinvention, reengineering, and ''let's look at the process,'' and how would you eliminate parts of the process which you either can't figure out how to make work or are too inefficient. So, one of the real benefits when you talk about a mandatory or an overall comprehensive program is that you, in essence, eliminate what we've talked about—I've heard here the valuation issues and the complexity of those, and that's a key element of those. If you don't go to something that's very comprehensive, then you will always have the valuation issue. I'm not sure where the line would be drawn in that situation. But, without eliminating the process, it's not clear that you can have some of the significant savings that may be possible.
Going further to that, the concern, in many cases, I hear about is marginal or small properties, and I know Wyoming has a lot of those and we're very active there also. You kind of slice those, in our opinion, in maybe three different ways, maybe four. First of all, because gas, for the most part, is pipe connected and as soon as you pipe connect it, a lot of the issues about the administration and so forth become rather workable, actually. And then you look at the oil side. Even with small, marginal properties, there are still a lot of those that are pipe connected, in many cases they did have significant production at one time and it's ebbed down, or for whatever reason their pipe connected into a complex that brings them into a battery, and that makes it much easier to aggregate those volumes.
Then you have another segment of that group, which generally would be trucked, but it's at a high-enough volume. Even if you're talking about 5 or 10 barrels a day, you can aggregate enough over a period so that you can justify transportation or trucking on a regular basis. It's rateability that matters.
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And, then you may have another segment. When you get down to that last segment where you may have a fractional barrel kind of situation, then I think that's really the area that you flow into a Fairness Act, where you would try to eliminate that issue completely.
Mrs. CUBIN. Thank you very much. Mr. Brady?
Mr. BRADY. Madam Chairman, thank you. Thank you each for testifying today. I'll direct this question to Mr. Neufeld but will invite any of the panelists to respond.
You talked for a moment about section 12 and pointed out the fundamental difference between lowest offered prices and lowest successful offered, which I think is a pretty clear and obvious difference. My question to you is: How different is that? How fundamentally different are those two concepts? How would that impact the revenue impacts the Agency has developed for this bill? And, for all of you: What other areas of evaluation should we be looking at if we truly want to get to a fair and accurate revenue estimation in this bill?
Mr. NEUFELD. I can only speak for the small refinery aspect of this, Representative Brady. It seems to me that one other thing they might be looking at is, although the bill does eliminate the small refinery administrative fees that would be coming to the Federal Government, I can't, for the life of me, figure out why the United States is going to have to incur any expenses for administering the small refiner program. We will be, essentially, in the same position as any other purchasers except that we will be guaranteed the option to purchase a certain percentage of the royalty oil that the Federal Government has on hand.
I would like to take this opportunity to point out that this is a model that is working now. It is a model that, I believe, the Department of Defense uses in marketing oil from the Elk Hills Naval Reserve, and it is being done very successfully. We do not believe it will have any depressive effect on prices or markets for the oil, even though that has been suggested, for instance, in the testimony of the city of Long Beach, and I hesitate to take them on at this point knowing that they get to testify after I do and will have the last word. But, our sense is that if you know that there is, perhaps, 10 thousand barrels per day of oil that's being offered, and the QMA gets a bid for 2,000 barrels at $18, 2,000 barrels at $17, 2,000 barrels at $16, etc. Somewhere down the line there's going to be some offers to purchase that oil that aren't successful. They're just not even on the books. The bottom 40 percent of the offers will be offered at the average of those prices—of the successful offers will be offered at those prices to the small refiners. Now, if we were bidding on the oil and not a small refiner, I sense that a logical case can be made that you would want to bid as high as you possibly can so that your bid comes in at the top 60 percent and that it may have an elevating effect on oil prices.
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The marketers in our companies tell me that, as a practical effect, in situations where they are looking for oil and know they may not get—if they put in a request and say ''I want to buy 5,000 barrels a day from you'' and know they may only get about 3,000, they still price their offers if they're going to get the whole 5,000 barrels. And, we find the same thing being true on the other side of our business when we're selling our refined products to the Federal Government where we offer to sell 15 million barrels a year, we know we may only get an order for 7 million barrels a year, but we price it at the 15 million barrels a year.
So, we think the depressing arguments are probably not—may make some sense in theory, but in practicality, don't come into play.
Mr. BRADY. Great. Thank you. To the other members of the panel: Are there areas of devaluation by the Agency that we ought to be looking at to determine a more fair and accurate impact?
Mr. TRUE. Mr. Brady, I'd like to defer to the witness who's coming up behind us who has done a great deal of economic analysis. I'm afraid, at least from my perspective, I would just add confusion to this subject. Thank you.
Mr. HAGEMEYER. Mr. Brady, as far the valuation numbers that you're asking about, I would like to make a couple of comments and I think——
Mrs. CUBIN. Mr. Hagemeyer, are you a lawyer or a lobbyist?
Mr. HAGEMEYER. No.
Mrs. CUBIN. I just wondered if that's why Diemer didn't know the answer.
[Laughter.]
Excuse me.
Mr. HAGEMEYER. Maybe he wants to respond.
[Laughter.]
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I think, and it's been quoted as maybe misinterpretation or whatever the case may be, but as we read H.R. 3334—and I think in particular this is an area that is very important to us all in gathering and transportation. I guess I heard earlier here particularly about from the lease to the meter, which, as it is described in the bill, would be the delivery point. And, as I tried to point out earlier, the delivery point is not necessarily the point of demarkation. The key here, though, I think is the way we see it, gathering as we know and love it today is related to the movement of product from the lease to an accumulation point. We don't see that as being materially different. When we look at where the meters are, in many cases on shore, they are on the lease or on an adjacent area, communitized area, and the gathering is before, and that would not change. When we see offshore there are situations, for example, where condensate is moved onshore in the gas stream, is separated onshore, and that's where it's measured. We would foresee that is where the meter would be. That's where it is today for condensate. Prior to that, there is a rather extensive piece of pipe, and that is transportation today. It's an allowable deduction. We don't see that as being materially different. As we've read it, we did not see a big change. We just fundamentally aren't reading it the same way apparently.
Mr. BRADY. Thank you. Madam Chairman, thank you very. I'm just now grateful that I didn't go to junior high with you.
[Laughter.]
It would be hell up all year long.
[Laughter.]
Mrs. CUBIN. I used to write notes to Diemer and sign them ''the queen of mean.''
[Laughter.]
Mr. Leggette, could you comment or elaborate for me your comment that the proposed rule is essentially a new tax on some producers? I believe I read that in your testimony.
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Mr. LEGGETTE. Yes, that's correct. It's—speaking metaphorically, of course. But basically, what the proposal here does is to try to tax through the name of a royalty the profits of midstream marketing activities. Basically, its value added beyond the lease. It's giving a little bit of deduction, but basically claiming a royalty share of most of the uplift you get when you move oil from 150 miles offshore to St. James, Louisiana. It's in effect a tax.
Mrs. CUBIN. Well, it's money out of the pocket of the producer.
Mr. LEGGETTE. Exactly.
Mrs. CUBIN. Mr. Neufeld, there is a difference between this bill and the bill that's sponsored in the Senate by Senator Nickles. Could you—you're familiar with that bill. Could you explain the differences for us.
Mr. NEUFELD. The basic differences between the bills have to do with the way in which the small refiner portion is calculated and at what point the small refiner has to commit to purchasing the oil. H.R. 3334 is written in such a way that the small refiner portion or the option to purchase 40 percent applies to each sale. It was drafted in that fashion because if it's written in a way that only over a cumulative period of time does the small refiner portion need to be offered, or some volumes have to be offered to the small refiner and some don't, there's a possibility that the QMA could game the system and offer choice volumes to favorite customers and dregs of the barrel to small refiners. And, we simply want to be in on every sale and have the option to purchase the same oil that everyone else is purchasing.
Another provision is thats. 1930 would require that the oil be valued—that 40 percent be set aside before it is sold and that 60 percent be sold and priced. Once the average price of that 60 percent is sold, the 40 percent will not only be offered to the small refiners, but the small refiner will be required to purchase it without knowing what the price is going to be. Once you subscribe, you obligate to purchase that portion of the oil.
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H.R. 3334 is quite different. The oil is priced—the entire amount is priced. And then, you take the lowest price—40 percent of the successful offers——give the small refiner a look at it, and if he's says yes, he purchases it. If the small refiner says no, the successful offer or takes the oil home with him.
Those are the basic differences between the bills. There are some other administrative differences. We have been working with the producers and IPAA on that, and we think we have been come up with language in seven of eight sentences that we have agreed on and that significantly reduce the administrative burden on the QMA for the bill.
Mrs. CUBIN. Good. Seems like the Senate version, then, would not change your position that much from what it is right now: not knowing what you're going to pay until later.
Mr. NEUFELD. The Senate version—yes, that's correct, although, except we won't get the bill eight years later. We will get the bill 30 days after knowing that we've committed to the oil. We are, however, committed to working with the IPAA and the industry to work out our differences. It's a stickier situation than we thought, but we are confident that we can get there and be there within a few days.
Mrs. CUBIN. Good. Well, I thank the panel for their testimony and the answers to their questions. Thank you for being here.
I'd like to call the next panel forward. Mr. Brian McMahon, Mr. James McCabe, Professor Joseph Kalt, Mr. Ralph DeGennaro, and Mr. Lin Smith.
[Witnesses sworn.]
Mr. McMahon, we'll ask you to begin the testimony this afternoon.
Mr. MCMAHON Actually, I'm going to defer to Mr. McCabe, and he's going to give our testimony.
Mrs. CUBIN. Great.
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STATEMENT OF JAMES McCABE, DEPUTY CITY ATTORNEY, CITY OF LONG BEACH, CALIFORNIA ACCOMPANIED BY M. BRIAN McMAHON, McMAHON AND SPEIGEL
Mr. MCCABE. Madam Chair and members of the Committee, my name is Jim McCabe, deputy city attorney for the city of Long Beach. The city of Long Beach is trustee for the State of California for the purposes of oil produced locally and is involved in oil matters throughout the State to some degree.
We are here today to speak against H.R.——
Mrs. CUBIN. Could I have you pull the microphone up a little closer?
Mr. MCCABE. Sure. We are here today to speak against H.R. 3334. That bill is fatally defective for two primary reasons. First, it will not yield market value for federally royalty oil, because the refiners, especially the majors, will not bid for RIK oil. Second, the bill gives no discretion to the Secretary of the Interior to withhold RIK oil from sale even when there are no bids or extremely low bids.
The State of California and the city of Long Beach are in a unique position to be commenting upon H.R. 3334. We have over 25 years experience in selling royalty-in-kind oil, longer than any other governmental entity in the country, we believe. We have learned that major oil companies rarely bid on royalty-in-kind sales. In over 25 years, only three major oil companies out of the seven operating in California have ever bid on city and State royalty oil. These are Texaco, Arco, and Shell. Of these three, Texaco is the only major that has ever won any competitive bid. As publicly stated, they will not bid more than the posted price for any crude oil production.
We have also learned from our long experience with royalty-in-kind sales is that one essential feature of the State's and city's royalty-in-kind sales program is the right of the city and State to cancel royalty-in-kind sales when bids are too low. Both the city and State have had to exercise that right on occasion to prevent sales at very low prices.
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The city and State have also learned through documents produced in litigation with the same major oil companies challenging their posted prices that they frequently pay each other prices higher than posted prices through complex and hidden exchanges. We have also discovered that some producers have been paid prices in excess of posting at the lease, although these higher prices have not been passed on to the royalty owners.
It would be a mistake to pass H.R. 3334 without any successful Federal royalty-in-kind sales. We find it incredible that no major oil company has made any public submissions to this Subcommittee either stating its intention to bid competitively on the royalty-in-kind crude oil or to defend posted prices, which have been, up until now, the basis for Federal royalty oil valuation. Independent refiners are also notable for their absence before the Committee.
What I'm getting at here is that no one is going to come, in my belief, before the Committee to defend the posted prices. They have a vast influence on the market, and I don't believe anyone's going to come to this table to successfully defend the posted prices before you.
Without any credible assurances that refiners will compete for Federal royalty oil, it would be folly to pass this legislation. Although we have objections to some aspects of the regulations proposed by MMS, we strongly support MMS's general approach. We do so, principally, because the valuation method proposed by MMS closely tracks the method used by the major oil companies in making their internal valuations of crude.
The duty to market is a red herring. Under the proposed MMS regulations, producers have no duty to aggregate production and sell it downstream. If producers sell royalty oil at the wellhead, they pay royalties on the basis of the prices they receive. For royalty crude oil, which is not sold at arm's length, for example, if it is sold to an affiliate of the producer, it is to be valued at the nearest market center less the cost to transport the crude from the lease to the market center. This is exactly the same approach used by the Federal Court in the U.S. v. General Petroleum in valuing Kettleman Hills crude oil when the oil companies had underpriced it. The proposed MMS regulation does not require lessees to bear the transportation costs from the lease to the market centers.
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Madam Chair and members of the Committee, Long Beach is ideally suited to a successful RIK program if there was to be one. We have a large field amidst many refineries in the middle of the largest gasoline market in, perhaps, the world: Los Angeles, Southern California. Yet, our experience with royalty-in-kind crude sales, which we call sell offs, is that they clearly do not yield market value—market value as judged by the internal documents of the oil companies with which we have dealt.
Mr. McMahon will expand, perhaps, on our chart here, which I think illustrates this point.
Mr. MCMAHON We have essentially three prices over the last six, seven years. One is the posted price of crude oil, which we receive on a monthly basis. The middle number represents the sell-off prices that we get for substantial volumes of crude, I might add—up to 4,000 per day for a year to a year to a half. And, the third column, the tallest one, represents sales of ANS crude oil in the same location as where we have the sell offs. This chart adjusts the quality differences between ANS and the crude we sell in the Wilmington Oil Field. So, the higher price is not attributable to fact that it's a better quality. This has been adjusted using the gravity price differentials in the posted prices that the major oil companies post in California.
Mr. MCCABE. We thank the Subcommittee and certainly would be willing to answer any questions.
[The prepared statement Mr. McCabe and Mr. McMahon may be found at end of hearing.]
Mrs. CUBIN. Thank yo for your testimony.
Professor Kalt?
STATEMENT OF JOSEPH P. KALT, FORD FOUNDATION PROFESSOR OF INTERNATIONAL POLITICAL ECONOMY, JOHN F. KENNEDY SCHOOL OF GOVERNMENT, HARVARD UNIVERSITY
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Mr. KALT. Thank you Madam Chairman and Members of the Committee. I appreciate the opportunity to appear before you today. My name is Joe Kalt, I'm the Ford Foundation Professor of International Political Economy at Harvard University's John F. Kennedy School of Government. I also work as a senior economist with the Economics Resource Group, Incorporated.
For the last several years, I have been retained by a number of oil companies to provide analysis of issues involving crude oil pricing and royalty payments. I actually began research into such issues many years ago in the course of my doctoral thesis and when I worked for the President's Council of Economic Advisors in the 1970's. My work has allowed me to acquire extensive data and information concerning the operation of the various stages of the crude oil production, disposition, and refining chain, from the lease on downstream to the refining center.
In the course of my work, I have conducted an extensive examination of the domestic crude oil industry, in particular, sales at the lease. As a result of this examination, I have acquired a large database and related information on arm's-length transactions occurring at the lease level in U.S. crude oil fields. This database consists of more than a million transactions drawn from the early 1990's onward—transactions that are outright transactions between unrelated third parties, cash on the barrelhead, not involving buy/sells or exchanges. This data on outright arm's-length transaction prices produces results that bear directly on the proposed legislation at issue in this proceeding.
Specifically, my examination of outright, arm's-length transactions at the lease has revealed at least four particularly relevant findings. First, throughout the United States, there's an active arm's-length market at the lease. The arm's-length transactions at the lease include substantial recurring volumes on outright, cash-on-the-barrel-head basis in trades between unrelated and well-informed buyers and sellers. At any particular oil field, the observed prices in such outright, third-party transactions typically span a range that reflects the influence of highly localized supply and demand factors pertaining to particular characteristics of particular crude oils, locational and transactional logistics, and buyers' and sellers' negotiating strategies and objectives. Moreover, and of particular relevance here, the range of prices of outright, third-party transactions typically spans the range of posted prices that we see applied to particular crude oils and fields.
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Second, transactions at the lease are highly competitive. The commerce at the lease commonly involves numerous major and minor integrated and nonintegrated producers on the supply side, and numerous large and small integrated and independent refiners, plus a very large number of independent marketers and brokers, on the buying side. Insinuations and, occasionally, explicit allegations of some collusive mechanism by which lease-level crude oil prices are artificially depressed are wholly inconsistent with the structure of the lease-level trade in crude oil, and inconsistent with basic anti-trust economics.
Third, some, but not all, crude oil producers move some, but seldom all, of their crude oil away from the lease via buy/sell, exchange, or similar contractual mechanisms. Such transactions typically involve multiple levels of commerce, with crude oil given up at the lease and offsetting volumes of another crude oil received at some downstream locale. There is no evidence that buy/sell and related transactions somehow systematically hide value that would otherwise accrue at the lease. These transactions are commonly carried out a posted prices, plus or minus compensation for locational, quality, and transactional differences. Yet, as I have noted, posted prices commonly lie within the range at which willing buyers and willing sellers are observed to trade crude oil outright at the lease in cash-on-the-barrelhead transactions. The use of posted prices to value crude oil and buy/sells and exchanges is consistent with fair market value at the lease.
Fourth, so-called netback methods for valuing crude oil typically begin with crude prices at some trading center distant from the lease and then subtract transportation and other direct handling charges to arrive at netback values. The proponents of netback values, such as those contained in the proposed MMS rulemaking, put them forth as measures of fair market value at the lease. These netback values are commonly found to exceed the actual arm's-length prices observed in outright transactions and to exceed posted prices by on the order of $.50 to $1 per barrel. However, the gap between netback prices and observed lease-level prices represents value added downstream of the wellhead. To an economist, the litmus test of this lies in the sustained existence and growth of hundreds of nonintegrated independent marketers who make their living by buying crude oil at the lease and retrading that crude oil at downstream locales or in buy/sell-type transactions. These independent marketers live off of the gap between netback prices and lease-level prices. They live off this gap by providing a wide array of downstream middleman services—from transaction processing and transportation arrangement to risk bearing and supply aggregation. If these middlemen did not add value downstream of the lease, the competition among them would compete the gap away and drive them out of existence and drive lease-level prices up to netback levels.
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Let me end by noting that it is understandable, of course, that a royalty owner would like to share in value added downstream of the lease. Tapping into such value added, however, would base royalty payments on more than the fair market value of what the royalty owner brings to the party. I believe that the evidence is clear that outright, third-party transactions at the lease provide the best measures of fair market values of crude oil at the lease. The clear implication for Federal policy is that if and when the Federal Government desires to assess the fair market value of its crude oil at the lease, a well designed, in-kind tendering program will provide it with a test. Thank you.
[The prepared statement of Mr. Kalt may be found at end of hearing.]
Mrs. CUBIN. Thank you very much.
Mr. DeGennaro?
STATEMENT OF RALPH DEGENNARO, EXECUTIVE DIRECTOR, TAXPAYERS FOR COMMON SENSE
Mr. DEGENNARO. Thank you, Madam Chair. My name is Ralph DeGennaro. I'm executive director of Taxpayers for Common Sense. We're a national budget watchdog organization dedicated to cutting wasteful government spending, subsidies, and tax breaks, and promoting a balanced budget. We're politically independent. We seek to reach out to taxpayers of all political persuasions to work for a government that costs less, makes more sense, and inspires more trust. Taxpayers for Common Sense receives no government grants or contracts and is not party to any royalty litigation.
To put my testimony in context, I would like to underline two principles that underlie our approach. First, we believe that oil, gas, and other minerals on public lands belong to the taxpayers. They are taxpayer assets. Second, that these taxpayer assets should be disposed of in a way that maximizes the return to taxpayers of today and tomorrow as well as minimizes the burden on the government. In accordance with these principles, Taxpayers for Common Sense opposes H.R. 3334 because the legislation is likely to lose revenue and place new burdens on the government. These new burdens would contradict current efforts to reduce the size of government and get the government out of things it shouldn't be doing.
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I think today we've heard a lot of folks beat up on the bureaucrats and that's pretty common. I think the Minerals Management Service deserves a big thanks from the American taxpayer for standing up to those who are trying to gain from the system, who have a questionable history in the past, and who are trying to pass legislation that we believe would not serve the taxpayers.
I think there are two fundamental common sense points here that need to be underlined. The first is where the burden of proof should be. The burden of proof should not be on the taxpayers or the Minerals Management Service to show that H.R. 3334 would lose money. Rather, the burden of proof should be on industry and supporters of the bill to prove that it would make money. That has not been done. The second common sense fundamental point that's been ignored here is that it should be up to the folks who are being paid—the taxpayers—to decide how they want to be paid. Just to use common sense, Madam Chair, if someone owes me ten bucks, I would like to have the choice of receiving the money in cash or in gasoline. That's just common sense. Now, it may be that today my car is out of gas, or it's nearby, or I feel like carrying this thing, and I feel like being paid in gasoline. Maybe it would be exactly what I want. Another day maybe I walked, maybe I'm going somewhere else afterward, I'm not going back to the car, for whatever reason, I want to be paid the money I'm owed in cash. We think the taxpayers have that right. We think that MMS's position seeks to preserve that right, and that's the fundamental flaw of H.R. 3334, section 3(a), which would require a mandatory RIK.
Thank you.
[The prepared statement of Mr. DeGennaro may be found at end of hearing.]
Mrs. CUBIN. Thank you.
Mr. Smith?
STATEMENT OF LIN SMITH, MANAGING DIRECTOR, BARENTS GROUP
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Mr. LINDEN SMITH. Thank you, Madam Chair. May name is Lin Smith and I'm managing director of Barents Group LLC. I'm appearing today on behalf of 17 industry trade associations listed in my written statement. These associations represent producers of essentially all of the oil and gas produced in the U.S.
I'm here today to discuss the Federal revenue effects of H.R. 3334 and, specifically, to discuss the revenue estimates prepared by MMS. In background, in April, Barents filed a Freedom of Information Act request for MMS data to have information to complete our own scoring analysis of H.R. 3334. To date, we have received no substantive response from MMS. We are desirous of having the MMS data as soon as possible and it will assist in our analysis.
It is first necessary to understand that MMS estimates do not conform to government scorekeeping conventions. Rather, the report appears to be a general economic commentary on some revenue implications of H.R. 3334. Our analysis follows MMS's framework, but it's important to understand that MMS does not estimate the effects over the required five-year budget scorekeeping period. It appears to use constant 1997 dollars rather than current dollars, and it ignores net receipt sharing with the States. As you know, the Federal Government keeps half of onshore revenues, rather than 100 percent as the MMS report implies.
Regardless of what MMS says about MMS Federal budget effects, the Congressional Budget Office is responsible for developing official estimates. We expect that these estimates will be prepared when H.R. 3334 is reported out of the full Resources Committee.
A more detailed report provides a point-by-point substantive review of how MMS believes provisions of the bill would score. Our review shows that MMS revenue impact is substantially in error due to numerous analytical flaws, including misinterpretations of how H.R. 3334 would operate, errors in economic analysis, and for most of the calculations presented, insufficient documentation to allow the findings to be verified or carefully evaluated.
Because there are only few minutes, I will only discuss a few highlights of our review and use the time to discuss MMS's largest estimating errors. Our more detailed review of MMS's analysis, based solely on the MMS information provided to date, is being submitted for the record.
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MMS marketable condition estimate is substantially in error. MMS principally cites a Purvin and Gertz report as the basis and source for its estimated $85 million to $178 million cost per marketable condition. A review of the original report shows that MMS misinterpreted the analysis. MMS applied gas treatment costs to 44 percent of all natural gas, when the Purvin and Gertz figures are only valid for a small fraction of gas production—6 percent in their original report. Had MMS contacted the original authors of the report, they would have learned that corrected data indicate that such costs may apply to less than 2 percent of natural gas, and most of these costs are currently deductible under extraordinary cost allowances already approved by MMS. As result, virtually all of MMS estimated treatment costs are eliminated.
Marketable condition costs are, however, largely irrelevant under H.R. 3334. MMS incorrectly asserts that H.R. 3334 would require MMS to pay for all gas treatment costs. The express language of H.R. 3334 requires that the lessee bear of placing royalty oil and royalty gas in merchantable condition at the delivery point. Even if it had been calculated correctly, MMS marketable condition cost estimate is not based on the language of H.R. 3334.
MMS significantly understates the potential for added value related to crude oil. MMS's own analysis used for estimating the impact of its proposed oil valuation rule indicates a potential crude oil uplift of at least $83 million annually. I can detail that more in questions, if you wish. This is higher than the $66 million that they publicly announced. This is in addition to MMS's estimated increase in value of zero to $35 million scored for the bill, which is largely from natural gas.
MMS did not take into account at least one significant revenue raiser equal to approximately 3 percent of annual revenues. Our preliminary estimates indicate that first year revenue increase of $113 million attributable to this revenue raiser was not considered by MMS.
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In conclusion MMS's H.R. 3334 revenue analysis is flawed technically and substantively. MMS substantially overestimated the cost and ignored or understated certain positive benefits or revenue raisers. Where MMS provides a sufficient description to understand the data sources and methodology, its costs estimates can be shown to be overstated. Three simple adjustments to MMS's findings illustrate the magnitude of these errors. By simply correcting the largest areas, beginning with the upper end of MMS cost estimate range of $366 million, subtracting the $.78 million of erroneous marketable condition cost estimate, adding the $83 million of additional crude oil uplift, and adding the $113 million of accelerated audit revenues yields $8 million increased government net revenues. When corrections are made to the MMS's report for other flaws, even larger net revenue gains will occur.
As I previously testified before the Subcommittee last September, royalty-in-kind legislation can raise net revenues for the Federal Government and the States. By making corrections to MMS's own analysis, it is clear that H.R. 3334 can accomplish that purpose.
Thank you
[The prepared statement of Mr. Smith may be found at end of hearing.]
Mrs. CUBIN. Thank you very much. I want to start with you, Mr. Smith. Could we get the charts back up there that the MMS had? What I'd like you to do is just cover, just briefly, the points where you think those charts are not accurate.
Mr. LINDEN SMITH. Okay. The royalty line—it may be easier to——
Mrs. CUBIN. Those other ones—yes.
Mr. LINDEN SMITH. [continuing] work with some of the other ones. They're more detailed. That's an overview chart.
Why don't we actually start with the one that's up there right now, referring to the treating costs. The treating cost estimate is $85 million to $178 million. I mentioned that in my oral testimony. It's based on a complete misinterpretation of the report they cited as relying on, the Purvin & Gertz report. They misinterpreted the data. And, it is not valid for what they are trying to do with it, and they are applying it to a huge quantity of gas when it should be applied to only a small fraction of gas, and that amount is already covered. The treatment cost are already covered under their current extraordinary cost allowance rules.
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In addition to that, as I mentioned, on this provision in particular, the legislation, as we understand it, does not contemplate the government would bear the cost of treatment.
The next one, I guess, is marketing costs.
Here MMS is estimating a revenue loss of $17 million to $46 million. There would be, indeed, some marketing costs under the bill because the legislation does contemplate that the government would compensate QMA's for their marketing activities. So, there will be some cost. This is one in particular where we have a difficult time commenting on their assumption on natural gas marketing costs. What they do is to cite a number of $.01 to $.03 per million BTU cost, but there's absolutely no documentation. There's nothing that says where that came from. So, we can't really comment on any methodology or anything else other than to say that that range sounds more on the high side. That's about all I can say about the gas cost.
On the crude oil cost, it's a little bit more complicated. What they are doing is saying that the marketing cost should range between $.07 and $.15 a barrel based on an IPAA study of marketing costs. What I would say there is that these are looking at average costs, as they're asking IPAA members how much on average does it cost to market their production. In fact, what would happen under the bill is that crude oil would be added at the margin. That is, a QMA would take quantities of oil in addition to that which it's already marketing. And then, marginal cost—that's the cost of trading that additional barrel—should be much less. That is, they are already going to have their computers in place, if you will, they'll have their intellectual capital, their knowledge of markets. And so, if you give them an additional quantity, we would not expect the cost of doing that to be equal to their average cost.
The only other piece of information we can look at is an independent source of oil. That oil marketing cost would be Alberta. Alberta pays a nickel a barrel Canadian for marketing. It would be about $.04 a barrel in U.S. dollars. So, we would suggest that the MMS estimate is significantly on the high side, but, nevertheless, we do acknowledge that there would be some marketing costs under the bill.
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Let's talk about processing for a moment. This is a relatively small cost. They estimate $4 million to $8 million in increased cost due to processing. They're saying that the Federal Government will bear the cost of the QMA paying commercial rates as opposed to so-called actual costs, which is specified calculation that MMS requires. What's wrong with this estimate is simply that they are assuming a 100 percent processing cost would bear that commercial rate increase in value. That is, they're saying today that processing costs are $38 million. That's the value of the current deduction. What they do is they say that there will be a 10 to 20 percent increase in those costs, and 10 to 20 percent of $38 million is about $4 to $8 million. That's their number. The problem with that analysis is that it assumes that 100 percent of processing occurs under nonarm's-length transactions today and would go to commercial rates. To the extent that there are third party processing costs today, those would not bear an increase in cost. They ignored that. Their analysis implicitly assumed that everything is nonarm's length today and would go to commercial rates.
In addition to that, they also assume that, in effect, the QMA has no bargaining power. The QMA is going to control some fairly large quantities of gas and should be able to bargain effectively to get lower rates in any event.
Transportation: $76 million to $135 million. Transportation is, again, a tough one. First of all, their charts assumes lessee pays for moving production from the lease to the royalty meter. That's not contemplated largely under the bill. There may be a few cases where that applies, but, as Mr. Hagemeyer already went through, this is not what's going to happen in most cases. So, we're starting out with largely a faulty premise.
This is also another case where MMS makes some rather sweeping assumption about increased transportation costs but provides no documentation on most of their analysis. Where they do provide some documentation is sort of interesting. They do say that the bill allows transportation costs for non-royalty bearing minerals. It's largely water. The bill does not say that the cost of water transportation is allowed. What is said is transportation is allowed for royalty oil and royalty gas. Yet, in their examples building up to their revenue loss, they cite two properties where they say the government would bear the cost, and they add that to their revenue loss.
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In addition, to that, as Mr. Thornberry pointed out earlier, one of their examples includes the Menza Platform, which is the largest source of cost for nonroyalty-bearing cost on the oil side, and, if fact, Menza's a gas platform. Then, they cited specific costs per barrel for movement of crude oil from that platform. I don't know what they were referring to. Maybe they got the wrong name for the platform. But, it's just not a relevant example. It's simply incorrect.
In any case, we've got a combination of problems here with the misinterpretation of the bill, a lack of documentation of the data, and a mischaracterization or misunderstanding of how Menza and other fact situations like that would apply.
Those are all comments on the cost side, and certainly there are additional items on the revenue side as I briefly went over in my report.
Mrs. CUBIN. Thank you very much. Mr. Brady?
Mr. BRADY. Thank you, Madam Chairman. I was just going to ask if you could elaborate on the revenue side of it.
Mr. LINDEN SMITH. Certainly. MMS has one source of revenue as being potential uplift of zero to $35 million that covers crude oil and natural gas as the production is moved downstream of the lease. They largely discount any benefit for uplift on crude oil. Almost all of the $35 million is for natural gas. The problem with that is that MMS's proposed oil valuation rule has in it a statement that the government will get $66 million a year of additional revenues from using an index pricing method. Now, we got the underlying data for that under a Freedom of Information Act request, tried to pour through it. What we looked at was the calculations where they had the actual price on which royalties were paid at the lease and they compared that to the price at a spot market. And, that difference, with an adjustment for transportation and quality, when accumulated over all lessees with refineries, accounted for their $66 million. They did not include any uplift in that $66 million for lessees without refineries.
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Now, how does that compare to what would happen under RIK? Under RIK legislation, the QMA would take the production at the lease and would have the opportunity to move the production to those same markets. The QMA has even more flexibility because the QMA isn't restricted to just moving it to that index pricing point but can move it to any point, which achieves the maximum value for its own benefit and the benefit of the Federal Government. And so, at a minimum, we start off with saying that the QMA should at least be able to achieve the $66 million of crude oil uplift that MMS already agrees to, in effect, would occur under the proposal evaluation rule. In addition to that, the government would get another $17 million—and again, this is using their data—another $17 million for lessees without refinery capacity, because that same production would be taken at the lease and also could be moved downstream or, again, to whatever market maximizes value. That totals $83 million of uplift, which we believe is there for crude oil in addition to what MMS scores. And, we do believe that additional revenues beyond that would be available because the QMA is not locked into that single downstream market.
In addition to that, we believe that $113 million of revenues are available annually. We actually went through it on a five-year scorekeeping period, where it would be $447 million over five and about $915 million over 10 years, because the government is going to be getting all of its revenues that it now receives with a substantial lag under audit. They'll be getting all those revenues at the time the production is sold. That is, today MMS receives audit revenues on average roughly seven to ten years after the crude or the gas is produced. And, under the bill, there would be an arm's-length transaction for value at the lease that occurs at the same time the oil is produced, so that full value will be received today. In comparison with a substantial lag in receipts as a result of long audit delays, all that money will come in up front, and that will fall in within budget scorekeeping windows as using the standard CVO conventions for scoring. So that's all a scorable revenue increase.
Mr. MCCABE. Madam Chair, may I add something at this point?
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Mrs. CUBIN. Certainly.
Mr. MCCABE. In think the point that Long Beach would like to make—one of the points Long Beach would like to make through its long experience in this area is that aside from the strictly quantitative aspects—and I can't quantify what I'm going to say now, but it's very, very important—you set aside in this bill 40 percent for the independent refiners, and they are presumably satisfied by this volume, although I can speak for them. You then are left with a situation in which the major oil companies—the major refiners—will not bid on this oil. And, you're dealing with a situation that is by definition no longer competitive. You've attempted to construct a competitive marketplace-based system in which the competitors won't come to the party. I would invite comment by the other panelists if they truly believe the majors will come and bid against their own posted prices. We don't believe that will happen.
Mrs. CUBIN. You may continue, Mr. Brady.
Mr. BRADY. Could you run back the number you were talking about—the scorable number—as a result of timely receipt of royalties. You gave figures of what range?
Mr. LINDEN SMITH. The first-year revenue impact would be an increase of $113 million. The five-year revenue impact would be $447 million. The ten-year effect would be $915 million. Now, let me add to this that we do expect to get information from MMS under our Freedom of Information Act—whenever they choose to respond to that—that will quantify that with more precision than we have now. This is based on audit numbers that they provided in their RIK gas pilot study, and we basically just adopted that methodology. They are saying there that there is a 3 percent uplift due to audit revenues.
Mr. BRADY. Thank you, sir. I was just going to ask Mr. McCabe, it sounds like from the presentation you run a model program of RIK. I'm just curious—under Mr. Thornberry's bill, QMA is given the flexibility to sell the crude oil in a manner that achieves the highest value for it, whether it's on the spot or term contracts. Your program, though, is limited to and mandated an 18-month term contract that had to be firmed up six months prior to the delivery of it. I also wonder if your program was at times offering volumes smaller than those needed by the larger purchasers. And I'm wondering if there are any years of your program where any of the major oil companies were prohibited by statute or contract from purchasing the crude oil.
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Mr. MCCABE. There—answering the last question first—there was a period of time when the majors when they were part of the operators that were taking oil out of our field could not bid. For a number of years now, those majors, with the exception of ARCO, have not been part of that consortium taking oil out of our field. They have been at liberty to bid but still declined to do so. When I spoke earlier, I spoke not only of our field but throughout California in California royalty situations.
Mr. BRADY. So, the fact that perhaps they needed more flexibility or they needed larger volumes than you were able to provide, don't you think that entered into the decisions—they're not mandated to bid on these contracts, are they?
Mr. MCCABE. No, but in order to have a market-based competitive system, major players need to show up and bid. They're not going to under the proposed bill.
Mr. BRADY. Thank you. Thank you, Madam Chairman.
Mrs. CUBIN. Certainly. I'd like to just make a comment, Mr. McCabe, about your statement that it's like having a party, inviting people, and nobody will come. The majors won't bid on the RIK. But, when you think of the quantity of oil that would come at one-sixth of the oil that would come out of the Gulf, that is way too huge to not be bid on. It's just too enormous. The majors would have to bid on that. One-sixth of the oil coming out of the Gulf that is owned by the United States would be bigger than that owned by Shell or Texaco or anyone singularly. So, I think the quantities here might be so much different that it might not apply.
Mr. MCCABE. The majors may end up with that oil. They can get it through intermediaries and through middlemen. But, they're not going to come to the party where they're needed to bid for the oil in question. They will be bidding against their own posted prices.
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Mrs. CUBIN. I doubt they would want their refineries to sit empty because they didn't bid on the oil, but then, somebody would——
Mr. MCCABE. They would, in fact, get the oil, but through intermediaries and middlemen. The would not bid on the oil.
Mrs. CUBIN. Thank you. Dr. Kalt, would you comment for me on Mr. McMahon's remarks about how California crude prices are depressed versus that of ANS delivered to Southern California refineries, and do you think that could be because some of the majors that are producing ANS crude own refineries in California?
Mr. KALT. In my investigations of that situation, several things stand out. One, ANS crude is not the same as California crude, and simple gravity scale adjustments don't achieve a quality parity. There are substantial differences. Crude is not crude. There's lots of different kinds and different quality characteristics. Secondly, at least at certain times in the California situation, what we find is that the capacity that is used to upgrade refined the low-quality California has tended to be quite fully utilized. When that capacity gets fully utilized, the incremental volumes of the crude that drive the market are going to get a lower price because the capital that is most effective at using the California crude is fully utilized, and there's no additional ability to upgrade the crude oil.
So, when you have a situation like that, when you try to do comparisons between two physically distinct crude oils—ANS and California crude oil—it's not going to be surprising that you will find differences in the value. I think that when one looks at bid processes that you can see Mr. McCabe talking about, what one does see is that in the State of California, multiple parties show up and bid. Mr. McCabe has just noted that intermediaries or independent marketers show up and bid—the EOTTs and KOCHs are showing up in California. From a competitive standpoint, it doesn't matter the name of the party that shows up. It's supply and demand. If the demand is registered, then, of course, in supply and demand, it affects the price. When you put all that together—I read the evidence considerably differently. With all due respect to the attorneys, the economist reads it differently compared to the two attorneys to my right. And, what I see is there is a pattern that seems quite consistent with what we've seen elsewhere in the country with other parties who have had RIK sales. The demand is registered. There are large numbers of bidders. The bids appear within a range around posted prices. In the California case, as I understand it, the bids have to be at the bonus above posted price so you don't get to observe anything below that. As Mr. McCabe said, during the long period, the majors were not able to come bid for his oil.
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Mrs. CUBIN. This chart that Mr. McMahon showed for us—do remember the differences there? Do you think now that ANS crude can be sold in Asia—that the difference will be less here?
Mr. KALT. I'm not sure. I'd have to look at that and study it from that perspective. Off the top of my head, that doesn't seem to be the case, though. I don't think you'd necessarily expect that, no.
Mrs. CUBIN. Thank you. Mr. DeGennero, I just wanted to comment——
Mr. MCMAHON Could I make a comment? First of all, Mr. Kalt's study that he presented today does not even purport to address California. I think that should be clear. He addressed the midcontinent area, the Gulf coast area. Second, there is no evidence that, in fact, the processing units that grind up the heavy crude in California, were full during any of this period of time. There's always been excess capacity. Number three, there is no competition in California. Eighty-five percent of the refining capacity in California is owned by the major oil companies. And, when you take that amount of demand from the selloffs from the royalty-in-kind sales, you don't have a competitive market, by definition.
Mrs. CUBIN. Thank you. I wanted to make a comment to Mr. DeGennero. I completely agree with you that this bill should not be moved forward if we can't show that it will have a positive impact on the Treasury. I think that's our obligation, our responsibility, and nothing will go forward if we can't prove that beforehand.
Mr. DEGENNARO. Thank you.
Mrs. CUBIN. I just want to ask you one question. When you—I'll just be real blunt with you. It seems to me that you have bought into the rhetoric against RIK, but I'm not sure how much background or how much information your group has to substantiate that. For example, I'm not asking you to answer this question, but do you know how many people are employed and how may of the taxpayers funds are spend in auditing and litigation and all those kinds of things. You see, those are the sort of things where we think we could save money if we didn't have to go through all those things. Would you like to comment on that?
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Mr. DEGENNARO. No, I am not a lawyer or oil industry lobbyist——
Mrs. CUBIN. A lobbyist or a lawyer. Good.
[Laughter.]
Mr. DEGENNARO. We do not have the background in the industry, and obviously there are wiser heads here that speak to some of the details. I do think there is something to be said for common sense. If I'm offered the choice between money or a product, and the question is: Who should be able to decide how I am paid, I know the answer to that question. And, I don't think you have to be a lawyer or lobbyist to answer the question.
Mrs. CUBIN. Well, if that were the question I would agree with you. But, I think the question might be: How much do I owe you, not whether I owe you.
Mr. DEGENNARO. But, the question is the bill—section 3(a) of the bill reads, ''all royalty and royalty gas accruing to the United States under any oil and gas lease shall be taken in kind by the United States.'' That does remove the choice for me as the taxpayer and my representatives, the MMS.
Mrs. CUBIN. And, is that your only reservation about the bill then?
Mr. DEGENNARO. No, and I summarize——
Mrs. CUBIN. If we were to not make it mandatory, then would you continue to have objections to the bill?
Mr. DEGENNARO. I summarized my testimony because I believe in being brief, and it's been a long afternoon already.
Mrs. CUBIN. Yes, it has.
Mr. DEGENNARO. We did raise some other concerns in the bill, among them flexibility. It is our feeling that no legislation is needed at this time. A bill's been proposed and brought forward, just in the space of this afternoon, and I'd like to give you credit, Madam Chair and Congressman Thornberry. A lot of comments have made about things in the bill that could be changed. I think maybe what we ought to examine is the option of no legislation at all. Let MMS write some rules. Let's give it two years to try. They've got some pilot programs going on. Then, let's see what's necessary.
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Mrs. CUBIN. I appreciate your opinion.
Mr. DEGENNARO. To answer the second question you asked—well, I'll let that go.
Mrs. CUBIN. Okay. Well, I do thank all of you for being here. I know some of you came a long way, and I really do appreciate it. We are going to set this bill for a markup, and hopefully we will have a lot of common ground to work from.
Mr. MCCABE. Madam Chair? Just a brief invitation to the Subcommittee. We have substantial documentation on this litigation which we think would bear on your question. We would certainly welcome a request from the Committee to provide those documents.
Mrs. CUBIN. Thank you very much. We appreciate that very much, and we will take advantage of that.
The Subcommittee is now adjourned.
[Whereupon, at 4:35 p.m., the Subcommittee adjourned subject to the call of the Chair.]
[Additional material submitted for the record follows.]
STATEMENT OF HON. MALCOLM WALLOP, CHAIRMAN, FRONTIERS OF FREEDOM INSTITUTE
Madam Chairman, thank you for inviting me to testify at this hearing on H.R. 3334, a bill to provide certainty, reduce administrative and compliance burdens with, and streamline and improve collection of royalties from Federal and OCS oil and gas leases.
I am Malcolm Wallop and I serve as Chairman of the Frontiers of Freedom Institute, an independent, non-partisan public policy research group. I also represented the State of Wyoming in the U.S. Senate from 1977 until 1995, where I served on the Senate Energy Committee. As a citizen of Wyoming I have recently followed the intensifying dispute over oil royalty valuation with increasing dismay.
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It is a troubling paradox of our time that nearly a decade after the collapse of Communist centrally planned economies the managerial state not only persists, but flourishes in the United States of America, where meddlesome and intrusive regulations by bureaucrats almost defy compliance and restrict human creativity. Republicans and Democrats proclaim ''the era of big government is over,'' and the Administration talks about ''reinventing government,'' but overreaching by government regulators remains the norm at the IRS and throughout the government.
In the late Roman Empire the clerks and scribes of officialdom were known as the clerisy, in distinction from the clergy or priestly sector, that was also economically unproductive, at least in the material realm. In our day the clerisy of officialdom in government finds its counterpart—its mirror image—outside of government in a legion of lawyers and lobbyists. These forces, contending over how much power cede to the regulators, do constant battle, in both the legislative and judicial arenas. The hard reality is that in the name of fairness, health and safety, no segment of life or the economy is left private. Worse yet, the only people judged capable of treating citizens fairly and keeping them safe and healthy is the modern clerisy, the guardian class on the Potomac.
The endless night of regulatory rulemaking followed by court battles enriches the clerisy of bureaucrats and lawyers at the expense of taxpayers and businesspeople. Consumers always end up bearing the cost of these wealth transfers. A telling case is the current bitter and costly dispute between the oil and gas industry and the Minerals Management Service of the Department of the Interior over the valuation of petroleum royalties due the Federal and state governments for oil and gas extracted from public lands. In my home state of Wyoming, petroleum royalty payments are set aside for education, but the salaries of MMS auditors and the fees of lawyers reduce the net revenue available for schools. Regulators thrive on complexity and specialization. Simple solutions are the natural enemy of program expansion.
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Earlier this year, Frontiers of Freedom Institute commissioned two well regarded energy economists, Dr. Walter J. Mead, Professor Emeritus of the University of California at Santa Barbara, and Dr. Robert Bradley, who heads the Houston based Institute on Energy Research, to develop a simpler, free market approach to resolving the oil royalty valuation dispute. I am pleased to submit the results of their research as part of my official statement for the record; I do so with confidence that there are many simple solutions to apparently complex matters. In an introduction to the Mead-Bradley study, former Secretary of the Interior William P. Clark joins me in commending the authors' analysis for consideration by policy-makers.
Drs. Bradley and Mead begin their work by taking a fresh look at the entire concept of royalty payments and advocate sub-soil privatization as the optimal policy objective for the long term. Their analysis is thoughtful and well reasoned. I regret that circumstances did not permit either of the authors to join us for this hearing. Their study traces the evolution of the valuation controversy since the energy crisis of the 1970's and the attempts by MMS regulators to return to Carter-era energy market complexity where royalty determination turns from objective, transaction specific cases into full blown regulation and subjectivity. The latest MMS rule proposal is predicated on imputed or synthetic valuation and is imbued with command-and-control central planning precepts. For the large majority of Federal lease transactions that the MMS has defined as non-arm's length, the proposal would determine value at downstream points, in a different market from where it is contractually obliged to do so, in effect changing the terms of the lease contract, and requiring that only some costs could be netted back to the lease under specific rules.
The authors identify payment of royalty in kind as a workable compromise to solve today's valuation dispute. Under such a system, the government would take ownership of the actual product—oil or natural gas—at the lease and let qualified marketers utilize their skill to maximize the return for the government. A similar system in Alberta, Canada enabled the government to increase oil production, increase royalty payments, significantly reduce the size of government bureaucracy and eliminate disputes between producers and the provincial government.
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The Frontiers of Freedom Institute is pleased to offer what we believe is a fresh approach by scholars who are not parties to the current controversy. Again, Madam Chairman, I thank you for giving me the opportunity to appear before this Committee. I would be happy to answer any questions you may have.
INSERT OFFSET FOLIOS 128 to 154 HERE
STATEMENT OF CYNTHIA L. QUARTERMAN, DIRECTOR, MINERALS MANAGEMENT SERVICE
Madam Chairwoman, I am pleased to return before the Subcommittee today to continue discussing issues related to royalty in-kind (RIK) programs for Federal oil and gas leases. First, I would like to offer some perspective on several issues that surfaced during the Subcommittee March 19, 1998 hearing. I will then summarize our detailed analysis of H.R. 3334, which we provided on April 30.
I think it is important to recognize how far we have come in a short time in royalty management by providing some historical background on the reasons for the creation of the Minerals Management Service (MMS). As you know, MMS was created some 16 years ago. Prior to that time, the Department of the Interior (DOI) was repeatedly criticized for mismanaging the royalty program, because of its failure to collect potential underpayments of hundreds of millions of dollars in royalties every year. An independent Commission on Fiscal Accountability of the Nation's Energy Resources (Linowes Commission) was formed to address those allegations. The Linowes Commission recommended creation of an independent royalty and minerals management agency to ensure effective accounting, production verification, royalty collection and enforcement. Accordingly, MMS was established and has since resolved all the issues identified by the Linowes Commission. In addition, along the way, MMS's royalty management program has accumulated an enviable array of awards and commendations, including The President's Council on Management Improvement Award for management excellence. Just this past month MMS reached the $2 billion mark in audit and compliance collections from companies who have underpaid their royalties.
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It is necessary to refer to this historical context because at the time of MMS's creation, the Linowes Commission urged that the ''oil and gas industry should carry out its obligation, as lessee, to pay royalties in full and on time.'' This statement goes to the very heart of our concern with this Bill, which is that it disregards the Commission's recommendation—or more pointedly, its admonition—by forgiving the oil and gas industry of its lease obligations to pay royalties in full and on time. By relieving the industry of their long-established obligations and denying the public of its rights under the lease, this legislation will return us to the days of when the public was not assured of getting fair market value for its mineral resources.
To fully understand the current debate, I believe that we must look back at the original bargain struck between the United States, as custodian of the public's lands, and the oil and gas industry, as lessee. In that bargain, the United States entrusts oil and gas lessees with the right to explore for, develop, and produce minerals from Federal lands. The lessee benefits by retaining most of the mineral proceeds from those lands. In exchange, the lessee agrees to care for those lands and return to the United States a small portion of the proceeds in value or in-kind, whichever the government prefers. In addition, the lessee agrees contractually to be bound by the government's reasonable determination of what that value is. To eliminate the government's choice in royalties would deny the public its rights under the lease and, ultimately, return less than the fair value due and owing.
It is instructive to look at an illustration of why that happens under this Bill:
First, a 100 percent royalty in-kind program forces the government to accept oil and gas in those circumstances where everyone agrees we would lose money compared to accepting royalties in value. In accordance with the Administration's initiatives to run government more like a business, MMS has begun to identify the conditions under which it is prudent from a financial or business standpoint to exercise its lease contractual rights to take royalties in-kind. The Texas General Land Office recently informed the Subcommittee that it follows the same policy. This is simply the most responsible and businesslike way to proceed. To do otherwise would abdicate our stewardship responsibilities over the public's land. Where it is not prudent to take royalties in-kind, we will simply continue to require lessees to honor their obligations to pay royalties in-value pursuant to their lease contracts with the United States.
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Second, this legislation relies on an unproven premise that aggregating crude oil volumes taken as in-kind royalty would enhance royalty revenues, including revenues from leases with de minimis production. Contrary to that premise, MMS has been told repeatedly by many producers that aggregating crude oil does not significantly enhance value, and we concur in that assessment. As Phillip Hawk of the EOTT Energy Corporation testified last month, crude oil value depends on a long list of characteristics related to individual properties. It is precisely such an assessment that makes us move cautiously when choosing which properties to include in—and which to exclude from—an oil royalty in-kind pilot. Aggregation of de minimis volumes could theoretically increase value, but the administrative costs of taking small volumes from numerous leases would almost certainly more than offset any revenue enhancement. That is probably why the Texas General Land Office does not take royalties in-kind from wells producing less than 10 barrels per day and why the Alberta crude oil RIK program requires the producer to bear those administrative costs. Most of our onshore Federal oil leases are de minimis leases, and most also have low royalty rates. Therefore, we may be forced to take one half a barrel or less of royalty oil per day from thousands of leases at large administrative costs. Since MMS or its marketer would be only aggregating 10 percent or less of the volumes taken from these de minimis leases, MMS necessarily must do at least 10 times the cost per unit to realize the same revenues as the producers. This is simply not cost effective. In these situations, it would be virtually impossible to obtain a revenue gain over what the producer, who owns and transports over 90 percent of the production, obtains. The risks to royalty revenue and the costs that reduced oil and gas revenue to the government will also reduce annual state revenue sharing of oil and gas revenues. H.R. 3334 shifts to the taxpayer extend to all Federal oil and gas producing areas.
Last week, we provided the Subcommittee a detailed analysis of the bill. Before answering any questions, I would like to briefly summarize our conclusions concerning the bill.
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MMS ANALYSIS OF H.R. 3334
In summary, this Bill would drastically reduce the options and legal rights of the Federal Government as mineral lessor and hinder the government in its duty to assure a fair return to the public for its oil and gas resources.
Ambiguities and vagueness in many areas of the Bill make it difficult to discern exactly how certain provisions operate. Certain provisions of the Bill, such as those addressing transportation cost reimbursements, will maximize costs to the government and reduce royalty revenues commensurately. We estimate that the government's costs of just storing processing and transporting the oil and natural gas to the buyer, as proposed in the Bill and which are now the responsibility of the lessee, are at a minimum in the hundreds of millions of dollars per year, while the administrative cost savings are less than $8 million per year in the first 8 1/2 years. Our estimates for potential revenue effects vary from negative numbers to tens of millions in theoretically possible gains. However, any such potential revenue gains can be realized without this legislation. MMS's existing right to take royalties in-kind and our capability to do so—being developed through our RIK pilot programs—allows us to realize all of the possible revenue gains for the taxpayer without the costs associated with this legislation, and without revenue losses from areas where RIK is not a feasible option. Thus, as I testified earlier, H.R. 3334 will have a substantial negative annual cost impact on the Treasury and will not enhance revenue compared to current statutory authority.
It is also important to note that our analysis of the costs associated with this Bill are very conservative and do not include a number of clearly negative provisions that we could not quantify in the time available. In contrast, the administrative cost savings figures used in the analysis are very liberal because they do not take into account the costs necessary to startup and implement the royalty in-kind provisions of the Bill. Additionally, the costs of contracting, overseeing, and auditing qualified marketing agents (QMA) under this Bill could easily wipe out the $8 million in cost savings. Another $6.2 million in revenues could also be lost through the net receipts sharing provisions of the bill. Since the Bill does not explicitly rule out potential QMA conflicts of interest situations, our auditing and litigation costs are likely to increase. The opinion submitted by the Department of Justice (DOJ) on this Bill to the Office of Management and Budget (OMB) agrees. Finally, the potential revenue enhancements figures used in the analysis are extremely generous because we assume ideal conditions for this royalty in-kind program despite provisions of the Bill which provide the opposite.
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The following summarizes the major issues that concern the Department with respect to H.R. 3334.
1. Mandatory Royalty in Kind
The Bill requires the government to take royalty volumes of both oil and gas in-kind for all Federal leases onshore and offshore. Requiring RIK for all Federal oil and gas production virtually guarantees revenue losses because:
• The value of the current option of taking in-kind and taking in-value in areas where each are economically justified is eliminated.
• Taking de minimis volumes of production in remote areas is administratively inefficient and will be a revenue loser compared to the current system.
• Oil and gas markets in some regions are limited and oversupplied. Adding another major player to such markets without infrastructure will not add value.
2. Imposition of a Rigid Statutory System
H.R. 3334 would impose a rigid ''one size fits all'' statutory scheme that eliminates the ability of the executive branch to use its existing RIK authority to develop jointly with affected parties a flexible system that works best for individual areas/situations. Just a few examples of the Bill's inflexibility are:
• Sales would only be made by marketing agents, precluding direct sales to government facilities without marketing agent involvement and costs.
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• No provisions exist to address when no bids or unacceptable bids are submitted.
• State in-kind programs for just the State's share are not allowed.
3. Technical Provisions
H.R. 3334 contains a variety of technical requirements for gathering, transportation, treatment, and processing that in sum transfer obligations to the government and increase many of the costs and responsibilities historically borne by producers.
a. Marketable condition
The Bill would replace the current requirement for lessees to place production in a condition acceptable to purchasers with a requirement for acceptance by transporters. This is a significantly less stringent condition that would now require the U.S. to begin paying for sweetening, treating, and conditioning services. The initial transporter is often owned by the lessee or its affiliate. Thus the Bill creates the potential for the lessee to self-define marketable condition.
b. Gathering
Although the distinction between gathering and transportation in the Bill is confusing, the overall effect will be to move the dividing line between gathering and transportation closer to the wellhead, thereby shifting costs from producers to the government. It appears that under the Bill all movement is transportation (i.e., costs borne by the government) except movement of bulk, unseparated production on the ''lease premises.'' Approximately 25 percent of offshore and 50 percent of onshore crude oil movement and 10 percent of offshore and 25 percent of onshore natural gas movement upstream of the royalty meter now paid for by lessees would be paid for by the U.S.
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c. Transportation
The Bill would require the U.S. to begin paying for transportation of non-royalty-bearing substances (e.g., water) in bulk production volumes moved from the lease. Movement of bulk production downstream of the lease is a growing phenomenon that would require the U.S. to assume an increasingly large cost burden compared to today. Further, the rates that the U.S. would be required to pay for transportation under the Bill would also increase dramatically compared to those currently paid by lessees. The U.S. would in some cases be required by the Bill to pay the highest rates charged to third parties.
d. Processing/Treating
Taken together with a redefined ''marketable condition,'' the Bill would shift to the government much of the cost of cleaning, decontaminating, and other field services. Further, the substantial amount of production currently processed by lessee's affiliates at actual (relatively low) costs would be processed at much higher, commercial rates under the Bill.
e. Marketing
All costs to market oil and gas production would be assumed by the U.S. under the Bill, whereas, under the current royalty system, these costs—which are substantial—are now borne by lessees. Ironically, the Bill would actually create marketing costs (to be borne by the U.S.) in many cases where there now are currently no such costs (e.g., for the substantial volumes of crude oil production simply moved from major producers to their own refineries).
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4. Negative Revenue Impacts
H.R. 3334 will have a substantial negative annual impact on the Treasury. Specifically, we estimate increases in costs to the U.S. at a minimum of between $183 million and $374 million per year, depending on assumptions used. This estimate is comprised of the following items, summarized in the charts you see before you:
1. Transportation: Government costs would increase due to the assumption of payment for gathering, and to increases in the price paid for transportation. The total increased cost to the U.S. ranges from $76 to $135 million annually.
2. Processing: Costs will increase some $4 to $8 million annually due to payment of higher commercial rates rather than the lessee's actual costs.
3. Treatment: Government costs will increase due to the assumption of field treatment processes beyond the delivery point, estimated at $85 to $178 million annually.
4. Marketing: Costs will increase some $17 to $46 million per year due to government assumption of marketing costs.
5. Other: The costs of eliminating the small refiner administrative fee and the net receipt sharing for states who participate in the RIK program will range from $0.8 to $7.2 million annually.
These cost increases are offset by only a maximum of $7.3 million in annual administrative savings and $35 million in maximum theoretical annual revenue uplift due to RIK implementation. Again, we can realize any revenue uplift from RIK without this legislation, and its substantial costs, under current authorities, using a more deliberate approach.
Other provisions of the Bill having negative revenue impacts which we could not quantify because of the many unknowns associated with them include:
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• The requirement that the government must offer 40 percent of royalty oil to eligible small refiners at the lowest prices prohibits the government from receiving the highest and best price for 40 percent of royalty oil. This requirement alone almost completely undercuts the assumption on which the Bill's proponents' claims of increased revenues are founded.
• Increased litigation costs. The Department of Justice believes that H.R. 3334 may impose serious new litigation burdens on it.
• Imbalance provisions that are biased heavily in favor of the producer.
• Price manipulation between a QMA and its affiliate.
CONCLUSION
From the above comments, it should be clear our position on the Bill remains unchanged from our 3/19/98 hearing statement. You have also heard concerns about this legislation expressed by officials from the States of Texas and New Mexico. DOI staff and I have also heard negative comments from officials in Louisiana, California and Alaska. We believe the time has come to agree to a more productive course in our mutual desire to improve royalty management systems and to experiment with royalty-in-kind options.
In this spirit, I would like to reiterate our request that people directly involved in oil and gas production, marketing, and accounting, rather than lobbyists or lawyers, both advise MMS on its pilots and offer independent opinions to the Subcommittee as we all explore how we can best use the RIK option to everyone's advantage.
This concludes my prepared remarks. I would be pleased to answer any questions you may have.
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INSERT OFFSET FOLIOS 155 to 207 HERE
STATEMENT OF DIEMER TRUE, PARTNER OF THE TRUE COMPANIES AND CHAIRMAN OF INDEPENDENT PETROLEUM ASSOCIATION OF AMERICA'S (IPAA), LAND AND ROYALTY COMMITTEE
Madam Chairman:
I am Diemer True, a partner in True Oil Company, an independent oil and gas producer from the state of Wyoming. In 1997 True Oil Company produced approximately 130,000 Barrels of Oil Equivalent (BOE) of Federal production.
I am here today as Chairman of IPAA's Land and Royalty Committee and the Wyoming Independent Petroleum Association.
IPAA is a national trade association representing over 8,000 of America's independent oil and natural gas exploration and production companies. IPAA members operate in all 33 states that have oil and natural gas production. They drill about 85 percent of all wells in the United States (including Alaska), produce about 37 percent of the domestic crude oil and are responsible for about 64 percent of the natural gas production.
Madam Chairman and members of the Committee, we appreciate the opportunity to testify before you today regarding H.R. 3334, the Royalty Enhancement Act. IPAA's support for the Royalty Enhancement Act of 1998 should come as no surprise to the Committee. Throughout the 104th and 105th Congress, independent oil and gas producers have been strong advocates for designing a mandatory royalty in-kind system that will be a win-win for the American public. We want a fair system for all—taxpayers, the Federal Government and industry.
Madam Chairman, and members of the Committee, the introduction of this bill and your examination of the Federal royalty process could not be more timely. The downturn in world oil prices has exposed America's half-a-million low volume marginal wells to great risk. Many producers have shut down wells because they are too costly to operate at current prices. Some are reducing their exploration and production budgets for the remainder of the year. Others will have to stop operating if prices don't recover soon.
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If we are to maintain a viable domestic industry, we need Federal regulations and policies that encourage production from Federal lands. As prices fall, the impact of regulatory costs becomes a greater and greater burden. As an independent producer of Federal production, I am facing shrinking returns on investment. It is not in the best interest of the American people to have scarce investment dollars being allocated to royalty compliance as a priority to the detriment of exploration and development. Royalty in-kind allows royalty regulatory costs to be redirected to exploration and production investment in America's energy future. Producers can invest these savings into sustaining production for future generations. The government can invest its savings into creating greater revenue for the American public.
The Royalty Enhancement Act has laid a foundation from which we can build a permanent remedy to a problem that has haunted America's royalty collection system for decades—uncertainty accompanied by high regulatory compliance costs. Under royalty in-kind, the government gets one barrel for every eight we produce (assuming a 1/8th royalty). This would be one mcf out of every eight mcf's and generally offshore one Bbl or mcf out of every six. It can't get any more certain than this. Under-deliveries can be easily detected and resolved in a timely fashion.
Can the American people make money under a more simple and certain system? Yes, by greatly reducing administrative costs and replacing government accountants and lawyers with private marketing companies who can maximize Federal revenues. If H.R. 3334 falls short of this goal, IPAA stands ready to work with the Administration, Congress, states, and other trade associations to make improvements to this legislation. We believe much of the current criticism of H.R. 3334 stems from either a misinterpretation of the legislation or minor design problems which can be easily resolved.
Although some may not believe royalty in-kind is the solution, we must remember that the Federal Government was the first to believe that it was the answer. Royalty in-kind was introduced as part of the Clinton Administration's Reinventing Government project in 1992. This program concluded that royalty in kind could streamline royalty collections and enhance revenues. The Administration cannot now deny that royalty in-kind can accomplish this goal given that it is proposing future pilot projects.
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Nevertheless, if royalty in-kind is being advanced via mandatory legislation or pilot programs, the operational aspects of a royalty in-kind program remain the same. We encourage MMS to come to the table and suggest workable improvements consistent with lease terms to the royalty in-kind program outlined in H.R. 3334. We sincerely want to work toward a fair solution, and not battle rhetortic in the media.
Most of the criticism from MMS focuses on how costs will be distributed in an in-kind environment. Mr. Linden Smith (Barents Group), will provide testimony on the validity of these claims. However, MMS faces these same design issues (transportation, marketing, processing, etc.) in its own pilot programs, plus statutory and regulatory barriers that are resolved by H.R. 3334. It is MMS' duty to the Congress and the American public to come forward and help resolve these design issues, so any future royalty in-kind program will be successful. Too much of the taxpayers' money has been invested in royalty in-kind to walk away and not attempt to build a successful program. Again, we want to engage in meaningful and thoughtful discussions that move toward resolution of the issues.
MMS' Valuation Rulemakings
Madam Chairman, and members of the Committee, one cannot discuss royalty in-kind without examining MMS' oil and gas royalty rulemaking efforts. Over the last couple of weeks, a lot of public attention has been drawn to MMS' proposed rulemaking for oil royalties. In this debate, a great deal of misinformation has been circulated by defenders of a complex system that would lead us down a road filled with uncertainty, costly disputes and litigation.
Even though we have presented MMS with a fair and cost-effective approach for valuing oil production, it intends to issue a final regulation which captures downstream values at no cost to the government by creating a very complex and burdensome system. This could not come at a worse time for America's oil and gas producers and for our country's energy security. We strongly recommend that Congress intervene to ensure MMS promulgates rules that are well reasoned and are consistent with the law.
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Madam Chairman, I would like to set the record straight concerning the role and views of IPAA, its members, and other trade associations and their members in MMS' oil royalty rulemaking process:
1. Is MMS proposing an oil royalty rule which captures value at the lease?
No. This is why Congress must intervene. The oil and gas lease and the law, require royalties to be paid on the value of production removed or sold from the lease. The MMS is ignoring this legal mandate and is attempting to assess royalties on values downstream of the lease without full consideration of all the costs and risks associated with these markets. Simply put, it proposes to assess royalties on values in the wrong markets.
The agency is trying to move the starting point for royalty valuation as far from the leases as it can. MMS might argue that after ''netback'' (allowing costs to be deducted), the result ends up with a value at the lease. Nothing could be further from the truth. For example, MMS disregards the fact that there are costs associated with marketing. By not recognizing these costs, MMS clearly is attempting to collect royalties on more than the value of oil and gas at the lease.
MMS wants it both ways: On the one hand, it says royalty in-kind will cost the government money because the agency will have to pay to market the production. On the other, it says industry is required to pay royalties on the value of crude after it has been sent downstream. If MMS recognizes these marketing costs for itself, why doesn't it recognize it for industry?
2. Does the law give MMS the authority to disregard these marketing costs?
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No! We believe the law and the contracts are on our side. Congress intended for value to be set at the lease. If you move to a market downstream from the lease market, marketing costs will be incurred.
Independent producers take this issue, on the deductibility of costs, very seriously—so seriously, in fact, that we have filed a lawsuit against the DOI challenging the validity of the new natural gas transportation regulation. The gas rule went into effect February 1st. IPAA filed the lawsuit in D.C. District Court on March 2 following a unanimous vote in favor of the complaint by the association's Board of Governors.
Why are we suing DOI? Because we believe the rule is illegal. It threatens future gas production. It will discourage drilling on Federal lands because it forces producers to market gas downstream of the lease at no cost to the government. That drives up the cost of the gas and means producers end up paying an inflated royalty that is greater than what is due under the lease contract. We cannot overstate this fact—what the Federal Government is asking us to do is in violation of the terms of the lease contract. And now, MMS has repeated this outrage by extending it to oil. I refer you to my letter written to the Oil Daily on April 17, 1998, regarding our views of the duty to market issue which is part of Exhibit 3.
If Congress doesn't intervene, then the American public loses, because the gas and oil rules will generate years and years of costly litigation on both sides. MMS was headed to a final rulemaking this June. Fortunately, Congress blocked its efforts and is going to fully examine the extent to which MMS has usurped the legislative role. You could say MMS is impersonating the Internal Revenue Service, by trying to raise ''taxes'' on producers without changing the law, but through more complicated regulations on the value of crude oil. Congress determines taxes, not the IRS. MMS should follow the same rules.
3. Has the industry thwarted MMS' efforts to change its oil valuation rules?
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Again, the answer is no. Thousands and thousands of pages of comments have been provided to MMS by all sectors of the industry. The MMS decided to write a new valuation rule based on alleged problems with the current rule. Independent producers also supported regulatory changes. The MMS' response to our dedicating hundreds of hours to develop new and reasonable valuation methods has been a proposal that makes it harder for independents to determine the appropriate royalty value with certainty. The rule is so complex that independents are referring to it as the ''auditor employment act.''
During the March 19th hearing, an IPAA witness introduced a flowchart displaying the complexity and uncertainty associated with MMS' rulemaking proposal (known as the ''Dungeons and Dragons'' chart). Director Quarterman has since sent you a letter dated April 30, 1998, stating that our chart was highly distorted (See Exhibit 1). Yet she fails to point out a single error in the industry chart.
As an alternative, MMS offered a simplistic chart depicting its proposed rulemaking. We must respectfully point out that producers will not be able to resort to such simplistic solutions when filing their royalty reports, should the proposed regulation be made final in its current form. This oversimplification is much like the IRS creating an extremely high level flowchart that does not reflect the hundreds of decision points, exceptions, and complications contained in the tax code.
IPAA, along with the Domestic Petroleum Council (DPC), has submitted a proposal providing changes to the existing oil rules. Unlike the MMS proposal, our proposal complies with the law and terms of the contract. With each round of comments (four in total), independents continued to refine their proposal. Exhibit 2 reflects our current proposal for changing MMS' rulemaking, which is our fourth round of comments dated April 6, 1998. These proposed changes use the best evidence from the lease market for crude oil (consistent with the lease contract). This proposal provides a consistent, uniform, and simple approach to valuing non-arm's-length sales or exchanges of crude oil. Simply put, it preserves gross proceeds for arm's-length transactions, allows producers who have an affiliate to look to their arm's-length purchases/sales in the field or area, and provides for a netback methodology from index or an affiliate's resale minus all costs, including marketing costs. If significant quantities of arm's-length purchases or sales exist, then there is no reason for these transactions to be ignored for valuation purposes. Poe Leggette's testimony will provide a more detailed description of our rulemaking suggestions.
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As we move to a comprehensive royalty in-kind program, IPAA recommends to the Committee that MMS adopt our suggested changes to the rulemaking (subject to further refinement). We would be glad to sit down with MMS and other industry representatives and work out any of the proposal's details to satisfy its concerns about receiving fair market value. We believe there are better ways to value oil production than the ''Dungeons and Dragons'' approach.
4. Did MMS' most current proposed rulemaking satisfy the independents?
In the same letter dated April 30, 1998, MMS suggests that it adopted a recommendation made by IPAA. Director Quarterman states ''You should be aware that this tracing provision for multiple exchange agreements was inserted into the current proposed rule upon the oral and written recommendation of the IPAA in public comment on the record. We have not been informed why they have changed their opinion in their most recent comments.''
We have already explained to MMS and in public comment (April 6, 1998), that MMS initially forced a tracing discussion by arbitrarily requiring any producer who has more than one arm's-length exchange to pay royalties based on NYMEX. We responded by stating that this restriction on exchanges was not fair and suggested the use of multiple arm's-length exchanges and marketing costs as one method for arriving at a value at the lease. However, IPAA also has stated that it only supports this tracing method as a part of a group of valuation options to be used by lessees in valuing their royalties. In its latest proposed regulation, MMS has chosen to ignore all of those options except one: tracing. There is simply no inconsistency between supporting tracing as an option given to the lessee and opposing mandatory tracing, which rejects marketing costs. Our complete response to Director Quarterman's letter, dated May 15, 1998, has been attached for the record (See Exhibit 3).
We would also point out that the MMS has in the past consistently and repeatedly referred to tracing as the ''least desirable'' means of determining royalty value. We agree. Tracing, in the manner described in MMS' proposed regulation on oil valuation, is impossible in many cases. Industry has made every effort to inform MMS of the complexities involved, but to no avail.
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The Administration seems intent upon placing the least desirable regulation possible into effect and continues to ignore suggestions on how to more efficiently capture values at the lease. What MMS is doing is picking only those fragments of our suggestion that perpetuate a complex and costly royalty system that illegally raises additional revenues.
Royalty In-kind—The Solution
MMS' proposed valuation system makes even the simplest royalty concept the subject of endless confusion and possible litigation. After years of failed royalty policies, all parties, including industry, government, and states, must come to the table and put an end to costly regulatory and legal debates surrounding royalty payments. Just as America needs to reform its tax system, we need to reinvent our royalty system.
Some have said that royalty in-kind is not supported by independents. This is not true. As an association that represents thousands of this country's independent oil and gas producers, we can report that our members enthusiastically support the Royalty Enhancement Act, as do the independent members of other trade associations jolning IPAA in these comments today. Let's not forget that just over a year ago, the MMS proposed that all producers, including independents of all sizes, pay their royalties using an impossible NYMEX scheme. While MMS has retreated from this position, its current proposal is still fatally flawed. The continued threat by MMS to challenge our proceeds on the sale of production at or near the lease has led independents to support the Royalty Enhancement Act. However, I would also point out that virtually all producers, including the largest oil companies, support royalty in kind legislation.
As I stated earlier, MMS must appreciate the potential benefits of royalty in-kind because it has already conducted a pilot royalty in-kind program and it is planning three additional pilots. In its first pilot, which was performed with natural gas in the Gulf of Mexico, MMS made some critical mistakes and the program did not live up to its full potential. MMS failed to use the expertise of the private sector marketers. We believe similar mistakes will occur with the upcoming pilot programs. Private marketers could enhance revenues through aggregation and the assumption of costs and risks in the downstream market. In the past, MMS used its own staff who ignored the downstream marketplace. These same design flaws are resurfacing into the government's next round of pilot programs.
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There are current successful model programs we can look to. Alberta has already shown that royalty in-kind provides a win-win situation for governments, taxpayers and oil and gas producers. In Alberta, 33 people run a royalty in-kind program, which sells 146,000 barrels of oil per day. MMS' royalty program employs hundreds of employees to collect its royalties. Accounting for all this revenue from a myriad of sources requires an army of accountants, auditors and clerical staff at a tremendous cost to the government—in excess of $60 million annually. Under a royalty in-kind system, MMS will only need to oversee a handful of private marketers, thus reducing the administrative burden and the number of Federal employees that will be necessary to account for oil and gas royalties.
The MMS continues to challenge the validity of applying the Canadian royalty in-kind model to Federal onshore and offshore production. We should not quibble over the details of the programs. Yes, lease terms and producing conditions are different. However, if our neighbor to the North can make royalty in-kind work, so can the United States. Be it in Canada or in the United States, the basic tenets of a workable royalty in-kind program are the same. Through the use of private sector expertise, a successful royalty in-kind program can be developed for Federal production, which will yield efficiencies.
Royalty In-kind Principles
IPAA and a number of other trade associations testified before this Subcommittee on July 31, 1997, on royalty in-kind, outlining six principles of a well-designed, royalty in-kind program. The Royalty Enhancement Act embraces these principles:
1. Reduce administrative and compliance burdens while providing the opportunity for the Federal and state governments to maximize their revenues.
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The Act provides for a much smaller and more efficient government agency. No one can dispute this fact. The need for auditors and lawyers will be dramatically reduced.
Further, the Act provides the government with a golden opportunity to increase its revenues. The government will use outside marketing experts to aggregate its volumes, arrange for transportation, and negotiate the terms and conditions of the sale. Unlike MMS, we believe that the Congressional Budget Office will recognize a revenue uplift associated with the government's opportunity to bring production to a downstream in aggregated packages. It should be noted that the government's total volume of production exceeds that of any single lessee.
The Royalty Enhancement Act does contain some cost centers, such as marketing and transportation. Any increase in price the government would experience through its qualified marketer should exceed marketing costs. The same marketing costs we believe are deductible from the government's proceeds under the law today. After all, marketing companies are created to make a profit. If they were not profitable, they would not be in business.
Transportation costs must be the responsibility of the government; otherwise the integrity of the program is compromised. Once the government receives delivery, the government and its marketer assume exclusive responsibility for transportation or other downstream costs.
As I mentioned earlier, testimony provided by Mr. Linden Smith will provide a more detailed analysis the economic benefits of a royalty in-kind program. If improvements need to be made to H.R. 3334 to ensure how costs for transportation, processing, and treating are to be handled, then we stand ready to work with the Committee to make these improvements.
2. Require transactions at or near the lease that fulfill the lease obligations.
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We believe the Act meets this principle by providing a workable mechanism for delivery of royalty production and outlining costs responsibilities that comply with the lease terms.
3. Require that when the government takes in-kind, it must take all royalty production for a time certain.
The Act requires that all production be taken in-kind and does not give the government the right to defer its take obligation or leave its production in the ground. By having all production taken in-kind, the Federal Government will receive all of its royalty value in the most efficient manner. To have two systems, royalty in-kind and royalty in-value, would not provide significant cost savings opportunities. It would increase uncertainty as the government flip-flops between programs, and it would take away volumes from the government's portfolio for aggregation. It would require lessees and the government to maintain dual accounting systems.
For marginal wells, the Act acknowledges two principles: (1) if the production is flowing into a pipeline, there are no additional burdens for the government's marketer to take the product; and (2) for trucked volumes, it is geared to utilize the existing transporter instead of having the government's marketer bring in its own truck to a remote well location. By approaching marginal wells in this manner, the American people have an opportunity to maximize their benefits from a comprehensive royalty in-kind program.
There are a number of ways to handle marginal well production. Keep in mind, the government may realize more revenues by aggregating marginal production typically sold at the well, and moving this production downstream. Other options include allowing the producer to prepay its production or provide a royalty barrel credit in more prolific wells. If the government claims it is not cost effective to take production in-kind from marginal wells, then it probably isn't efficient to send in a monthly royalty payment that is subject to audit. A prepayment program resolves this issue and prevents the government from spending dollars to collect dimes. We suggest that the Committee consider developing legislative language bolstering the prepayment option.
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4. Require use of private marketing expertise to streamline operations.
This Act ensures the American people that experts, not bureaucrats, will be marketing the royalty oil and gas. Through the development of competitive contract terms with its selected marketers, the government will be able to maximize returns to the public.
5. Provide the states with the opportunity to be involved in designing and implementing the program.
This Act allows a state to assume responsibility for the royalty in-kind program. IPAA strongly supports this position. We will leave the details of this involvement to be further refined by the states and the Committee. As long as all of the production is being taken in-kind and there is no more than one gas marketer and oil marketer per lease, state involvement is encouraged.
6. Make royalties taken in-kind broadly available for public purchase.
We believe that the concept of continuing to make royalty in-kind volumes available for sale on a competitive and broad-based manner is embodied in the Act. We further support the Secretary's right to promulgate regulations that establish the mechanism for competitively selecting the government's marketer.
Conclusion
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Independents take royalty issues very seriously and for a good reason. We've been down this road before. You may recall the lawsuit IPAA filed against the Department of Interior in 1993 to prevent the illegal collection of royalties involving take-or-pay contract settlements. MMS was insistent that its position was correct and that producers should ''just pay up their fair share'' of royalties on those settlements. It was the same tune we're hearing now from some quarters. But the Court of Appeals in Washington ruled that Interior had unlawfully departed from its own rules through a novel interpretation of law.
Five years later, not much has changed. The Federal Government is trying to claim a larger share of royalties through regulation. And its consultants and advisors are attempting to collect these royalties by applying the rules retroactively vis-a-vis a recent lawsuit.
Yes, the Royalty Fairness Law did reform MMS' accounting practices. However, it did not reform the government's valuation procedures. The Royalty Fairness Law is the safety net for producers and states. It ensures that the government will perform its audits of these complex valuation rules in a timely manner. But let's not forget that the Royalty Fairness Law, passed in the 104th Congress, contemplated royalty in-kind. Those provisions were struck from the bill due to procedural obstacles in the Senate. To the best of my recollection, we thought the Administration supported advancement of royalty in-kind language as part of Royalty Fairness. It appeared to us that at that time they thought statutory language was needed to do any further experimenting with royalty in-kind. We believe statutory language is needed today.
Unfortunately, a year and a half later, we are once again discussing the Federal royalty program with Congress. The government has again changed the rules of the game. And, like the Federal tax system, changes to this system's rules increase confusion, frustration levels and administrative costs.
We need to end the royalty debate once and for all, and give the American people the opportunity to maximize the value of production from Federal lands in the most cost-effective manner consistent with the terms of the lease. A well-designed royalty in-kind program has significant potential to increase economic efficiency, increase Federal and state revenues, reduce controversy, and constitute a fairer approach for Federal and state governments, oil and gas lessees, and the nation's taxpayers. Independents urge the Congress to ensure MMS promulgates a reasonable oil royalty rule which is consistent with the law as we proceed with passage of the Royalty Enhancement Act. We ask the MMS, States and Committee to work with us in developing fair and reasonable oil valuation rules and a successful royalty in-kind program.
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STATEMENT OF FRED D. HAGEMEYER, COORDINATING MANAGER—ROYALTY AFFAIRS, MARATHON OIL COMPANY
I. Introduction
Good afternoon, Madame Chairman and members of the Subcommittee. I am Fred D. Hagemeyer, Coordinating Manager of Royalty Affairs for Marathon Oil Company. I am pleased to appear here today on behalf of the American Petroleum Institute, whose membership includes companies actively involved in oil and gas operations on Federal onshore and offshore lands. The American Petroleum Institute (API) represents more than 400 companies involved in all aspects of the oil and natural gas industry, including exploration, production, gathering, transportation, refining and marketing.
II. Background
There is widespread industry support for royalty-in-kind (RIK). Last summer, more than a dozen oil and gas trade associations formed a task force to develop a workable RIK program. In addition to API, the multi-association task force included the Independent Petroleum Association of America (IPAA), the Rocky Mountain Oil and Gas Association (RMOGA), the Domestic Petroleum Council (DPC), the Independent Petroleum Association of Mountain States (IPAMS), the Mid-Continent Oil and Gas Association (MCOGA), as well as numerous state and regional associations.
The group's mission was ''To design a Federal royalty-in-kind (''RIK'') program that will eliminate valuation uncertainty and that will be attractive to Federal, state and private sector stakeholders while recognizing the differences between oil and gas production.'' The group was able to achieve a broad industry consensus in favor of a program that both streamlines and simplifies the current system and provides an opportunity to the Federal and state governments to maximize revenues.
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I am here today representing API in support of H.R. 3334, the Royalty Enhancement Act of 1998. As Representative Thornberry pointed out when he introduced the Royalty Enhancement Act, it provides a starting point to begin a debate on the royalty-in-kind issue. I want to assure you of API's willingness to work with the Subcommittee to resolve issues that may arise during the legislative process. We understand that any change in the current system must meet the needs of government, as well as those of the oil and gas industry, and we will cooperate to achieve that goal.
III. Overview of Royalty-In-Kind
API's written submission to this Committee in March of this year endorsed the concept of royalty-in-kind as a progressive measure that would simplify the royalty payment system for the Federal and state governments and the oil and gas industry. It lays out the reasons why an RIK program would be a substantial improvement over either the existing oil and gas valuation system or the proposed valuation system. Six principles were identified as important to a successful RIK program:
First, it should reduce administrative, compliance and conflict resolution burdens, while providing the opportunity for Federal and state governments to increase revenues.
Second, an RIK program should require that lease obligations be fulfilled at or near the lease.
Third, the government must take all royalty production for a time certain.
Fourth, the government's oil or gas should be marketed through a competitive, privatized system.
Fifth, state governments should have the opportunity to participate in the design and implementation of the RIK program.
And sixth, the royalty production should be made available on a competitive basis to a broad-based public market.
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We believe that, in large part, these six principles are embodied in H.R. 3334.
Support for an RIK program comes from both states and industry. Representatives of the states of Wyoming and Texas testified before this Subcommittee in July, 1997, that a well designed RIK program would substantially reduce administrative costs and royalty disputes while providing the royalty owner with an opportunity to obtain an enhanced return in markets downstream of the lease market. Understandably, the states are concerned about the enormous cost of collecting and verifying royalties paid in value as these costs directly affect the net revenues they receive from Federal leases. The attractiveness of RIK lies in the fact that it would reduce administrative costs. Another important advantage of RIK from a revenue perspective is that production received in kind may be sold anywhere, in the lease market or in remote downstream markets. In contrast, when the government takes royalty in value, it is contractually limited to the value of production at the lease. We understand that some states have design concerns about H.R. 3334. We stand ready to work with them on these concerns, whether they need rewording for correct interpretation or some amendment is necessary. Creating a workable program is our goal.
Industry's support for RIK results from the need for certainty in satisfying the royalty obligation. Federal leases require that royalty in value be reported and paid by the end of the month following production. Even the existing valuation regulations setting forth how royalty payments in value must be made are extremely complex and subject to constant reinterpretation, requiring the expenditure of considerable resources by both industry and government to handle this onerous process. All royalty payments made in value are then subject to audit by the government, usually many years after the payment is made. Claims for additional royalty take years to resolve through costly administrative appeals and litigation. As a result, valuation disputes continue for years, and Federal lessees are simply unable to have certainty regarding the value of production at the time royalty payment is due.
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The central advantage of RIK is certainty. Production taken in kind and sold at an agreed upon price eliminates the necessity for the government to try to determine, years after the fact, the ''reasonable value of production at the lease.'' API believes that a comprehensive RIK system would result in significantly fewer disputes than an in-value system. RIK would also give Federal and state governments the flexibility to participate in downstream markets.
Today, my testimony will focus on how H.R. 3334 could reduce compliance and conflict resolution burdens and administrative costs for both the government and industry, while creating an opportunity for the government to increase revenues from its oil and gas holdings.
IV. How and Why RIK Would Work
Vice President Gore has called for reinventing government. The proposal for a comprehensive RIK program shows how a government function can be reinvented to the benefit of all parties. An RIK program would substantially simplify royalty collection for oil and gas compared to the existing system or to the MMS's most recent proposal.
Under an RIK program, producers would discharge their royalty obligations by tendering at the ''delivery point'' physical units of production, i.e., barrels of oil or cubic feet of gas. The government would take delivery of its royalty share, which would be marketed on its behalf by ''Qualified Marketing Agents'' (QMAs) who would be selected in a competitive bid process to serve as the government's royalty agents. These private marketing firms would combine royalty production volumes into packages that are attractive to purchasers. They could also arrange for transportation and other services so that royalty production could be moved downstream in a cost efficient manner. In this way, marketers could seek opportunities for the sale of royalty production which could enhance the net revenue realized by the government.
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In addition, an RIK system would result in significant administrative efficiency gains for government and industry, stemming from reductions in resources devoted to royalty valuation, auditing and valuation dispute resolution. Rather than relying on the complex valuation regulations to determine value at the lease, an RIK program would empower the government to determine value by direct entry, through the QMA, into the marketplace whether that be at the lease or in downstream markets. For example, aggregating the government's oil and gas royalty volumes from the Gulf of Mexico would give the government as large a volume as any other producer in the Gulf. Moreover, the competition for that sizable market share of supply is likely to be vigorous, with many buyers and sellers. Further, the government would be able to leverage the expertise of the QMA to link up with buyers in various markets.
V. Gathering/Transportation
Three objectives regarding gathering and transportation should be addressed in a royalty-in-kind program. First, the lessee should continue to be responsible for gathering costs for royalty purposes, and the government should continue to be responsible for the costs of transportation of royalty oil and gas.
Second, the gathering and transportation sections of an RIK program should comply with the provisions of the Outer Continental Shelf Lands Act. Section 5 of this Act obligates the Secretary of the Interior to require open and non-discriminatory access to pipelines. This section also prohibits unlawful discrimination in transportation arrangements for oil. These requirements should apply to RIK production by providing that the government's royalty portion be moved on the same terms and conditions as lessee and third-party production. It would be illogical, and inconsistent with the OCSLA, for government oil or gas to be transported at a different rate than the rates paid by other producers to transport production in the same pipeline on the same day. In fact, the OCS lease form itself provides that ''the lessee shall be entitled to reimbursement for the reasonable cost of transporting the royalty substance.'' The best measure of that cost is the rate other nonaffiliated third parties pay to move production through the same pipeline on the same day.
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The third objective of the gathering and transportation provisions is to clarify the definitions and interpretations of these terms. The bill should clearly delineate the movements which constitute ''gathering'' and the movements which constitute ''transportation.'' The bill should also clearly specify the basis for determining the transportation rates the government would incur to transport its royalty production.
In order to understand how these objectives are incorporated into the gathering and transportation sections of H.R. 3334, one must first understand the role of the delivery point. As defined in the bill, the delivery point is the measurement point as approved by the MMS (offshore) or BLM (onshore). Separated production is measured at this point, and it is a location where custody transfer can easily take place. The measurement point can be on the lease, adjacent to the lease, or at some distance from the lease. The MMS may move it to a point closer to or further from the lease during the life of the lease. The definition of delivery point in the bill is not intended to be a dividing line between gathering and transportation movements. The distinction between gathering and transportation should not be based on the location of the measurement or delivery point.
''Gathering'' is defined in the bill as ''the movement of lease production to a central accumulation point on the lease, unit, or communitized area.'' This definition parallels language in the existing leases providing for delivery of production on or near the lease or reimbursement of costs for transportation downstream of the lease. Gathering has traditionally been on or near the lease and the bill is not intended to change that lease concept. The language does, however, need to be clarified to address those situations where the delivery point is not on or near the lease to clarify that not all movements of production prior to the delivery point are gathering.
As defined in the bill, ''transportation'' of royalty oil and royalty gas includes all movement of production downstream of the delivery point as well as the movement of bulk production prior to the delivery point in limited circumstances. This language should be clarified to make it consistent with the lease terms. Generally, the lease provides for royalty-in-kind to be delivered at a point on or immediately adjacent to the lease. Offshore leases may provide for delivery by the lessee to a point onshore with reimbursement by the government for such transportation.
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Looking at the bill's provisions respecting transportation allowances prior to the delivery point, there are two areas that need clarification: (1) where transportation costs are currently allowed, and (2) where subsea transportation is currently being disputed. We feel that the movement of production in both situations is transportation, and the transportation language in the bill should be amended to parallel the lease where transportation is the movement to a point not on or adjacent to the lease.
The movement of bulk production from subsea production facilities in deepwater developments does not differ from the situations in which transportation allowances are currently allowed prior to delivery point. The use of subsea facilities is a recent technological advancement that has enabled development of fields remote from existing infrastructure, and which fields, in many instances, would not have been economic utilizing traditional surface platform developments. Movement of production from subsea facilities on a lease may be for great distances, up to sixty miles or more.
Another issue involving subsea production is where pipeline quality gas is produced at the well and does not require further treatment prior to compression for movement to shore. Such production is, by necessity, transported via pipeline significant distances away from the lease to other locations onshore. Categorizing this type of movement as transportation is consistent with lease language and other approved transportation allowances.
H.R. 3334 clearly recognizes three basic categories of transportation applicable to RIK volumes: (1) shipment through pipelines not affiliated with the lessee, (2) shipment through non-regulated pipelines owned by or affiliated with the lessee, and (3) shipment through regulated pipelines owned by or affiliated with the lessee.
First, with regard to transportation on pipelines not owned by or affiliated with the lessee, the legislation provides that the lessee will be reimbursed for transportation upstream of the delivery point. The QMA will arrange downstream transportation directly with the carrier. Guidelines are provided for costs upstream of the delivery point to be the actual costs incurred by the lessee. We believe that the government will control sufficient volumes of production to negotiate favorable downstream transportation arrangements. Further, if the transporting pipeline is subject to rate regulation under existing law, the government will never pay more than the maximum approved rate for transportation.
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Second, for transportation on affiliated pipelines, the proposed legislation distinguishes between regulated and non-regulated pipelines owned by a lessee or an affiliate. If an affiliated pipeline is regulated, then, as with non-affiliated regulated pipelines, the government will reimburse the tariff rate upstream of the delivery point or negotiate a rate downstream of the delivery point with the carrier, but the government will never pay more than the maximum regulated rate for transportation.
Third, with reference to transportation on unregulated pipelines of affiliates of lessees, the bill contains extensive safeguards to ensure that the government is never charged more than a commercially reasonable rate.
To further ensure against the possibility of excessive charges on affiliated pipelines, H.R. 3334 provides that the negotiated rate charged to the MMS or QMA on behalf of the United States may not exceed the highest rate charged a non-affiliated shipper by the pipeline. That rate cap reflects a market-determined price and is an appropriate measure to use in setting the upper limit of commercial reasonableness. If the pipeline moves only the production of its producer affiliate, then the negotiated rate cannot exceed the fair commercial value of the transportation services provided. If the affiliated pipeline and the QMA cannot agree on a rate, the bill provides for arbitration to determine the appropriate rate payable for transportation services rendered by the affiliated pipeline.
Furthermore, movement of water was not intended to be a responsibility of the government, but only the transportation of royalty oil and royalty gas. We would support an amendment, if needed, to clarify that the costs associated with the transportation of water are the responsibility of the lessee.
VI. Processing of Royalty Gas
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Under existing MMS regulations, a gas processing plant is a facility that utilizes physical processes to remove elements or compounds (hydrocarbon and non-hydrocarbon) from gas, including absorption, adsorption, or refrigeration. Gas processing plants are located downstream of the point of production and often process production originating from more than one field. Under H.R. 3334, the processing of royalty gas can occur downstream of the delivery point for royalty gas.
Currently, a lessee can sell its gas outright or enter into a gas processing agreement to have its gas processed and thereby recover the substances entrained in the produced gas stream; these include hydrocarbon products such as ethane, propane, butane, and natural gasoline. The removal of such products may or may not be required in order to make the gas comply with the specifications of the transporting gas pipeline.
Generally, gas processing agreements are entered into only if each party, the producer and the plant owner, expects to realize a long-term economic benefit. For the plant owner, processing the producer's gas stream must yield sufficient revenues to justify the very significant cost of constructing and operating the plant. These same principles will apply when the government takes its royalty gas in kind and seeks to have it processed by a plant owner.
H.R. 3334 leaves processing terms for resolution by market forces through negotiations between the government, acting through the QMA, and the plant owner.
Processing is generally distinct from ''treatment,'' which refers to operations typically performed at or near the lease, in order to put production in marketable condition. Costs, including treatment, to put production in marketable condition are not deductible under current royalty valuation regulations. Since in the majority of cases, treatment is done by the lessee at or near the point of production and upstream of the delivery point, we do not believe the bill would affect any material change in cost responsibility.
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VII. Imbalances
H.R. 3334 requires producers to deliver, and the government's QMA to take, 100 percent of the Federal royalty volumes at the delivery point. H.R. 3334 also recognizes that normal operational imbalances occur on a well from month to month and provides a mechanism to assure that all parties, including the United States, will receive their proper shares of the production.
Oil and gas transporters and purchasers operate on a system which requires the seller, shipper, and purchaser to nominate quantities prior to actual shipment. Since it is impossible to know the precise quantity that will be produced the next month, there is always a difference, though usually a small one, between the nominations and actual production.
Although H.R. 3334 requires the government to take its full royalty share, it provides a mechanism to permit adjusting future quantities taken in kind to bring these small monthly differences into balance over time. The provision also provides a mechanism for final settlement of any imbalance that is remaining after the production ceases on an individual Federal lease. These procedures are consistent with industry practice and ensures that all parties are treated fairly.
VIII. Qualified Marketing Agents
This Subcommittee has heard from some mid-stream marketers who are potential QMAs under an RIK program. These marketers are very supportive of RIK legislation and are interested in the opportunity to act on behalf of the Federal Government in seeking to maximize royalty revenues from Federal oil and gas production. The experience and expertise of these marketing companies and individuals are the key to the benefit that the government can derive from RIK.
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The use of experienced QMAs, instead of the government marketing its own production, will benefit the government in at least four respects:
• First, QMAs offer the ability to maximize flexibility by marketing royalty volumes either at the lease markets or away from the lease in downstream markets.
• Second, they offer the opportunity for cost savings in arranging transportation by aggregating the government's royalty volumes from individual leases into larger packages. Also, there is the opportunity of aggregating royalty volumes with other volumes handled by the marketer.
• Third, QMAs' expertise provides the ability to respond quickly to rapidly changing lease and downstream markets.
• And fourth, the government can use an established and expert marketing organization, rather than creating and training an MMS government marketing organization.
Under H.R. 3334, the government is not restricted in its choices of QMAs. By soliciting competitive bids, government agencies, both state and Federal, can acquire the best available marketing expertise. The QMA would then handle the disposition and sale of the government royalty share taken in kind. Furthermore, the MMS would monitor and assess the performance of QMAs. If performance were deemed inadequate, the government could change marketing agents.
The MMS' concern about QMAs not performing in an open, competitive and non-discriminatory manner in transactions with affiliates is unfounded. Indeed, the exclusion of producing companies or their affiliates from consideration as QMAs, or the marketing of royalty oil and gas by QMAs to affiliates, would place considerable marketing expertise off-limits to the government. Moreover, the MMS can structure the regulations and its contractual arrangements with its QMAs in such a way that they have an incentive to maximize the revenues realized on their sales of royalty production.
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IX. Revenue Implications
Given the huge volume and diversity of transactions, scoring—or estimating the effect on government revenues—for Congressional Budget Office (CBO) purposes may be difficult, but it can be accomplished. In particular, the CBO should start with the terms used to define the lessee's royalty obligation in current oil and gas leasing statutes. For example, the OCS Lands Act requires that royalty be paid on a percentage in ''amount or value'' of the ''production saved, removed or sold from the lease.''
This statutory language is important because the MMS and industry agree that the value of production does not include the cost of transportation. What the MMS and industry disagree on is whether the value of production should include all downstream costs. This MMS view on downstream costs and its increasing tendency to apply netback methodologies to inflated downstream market values shows up in its pending crude oil valuation proposal and its final gas transportation allowance rule. This skews its revenue expectations under its existing—and proposed—valuation regulations upward and therefore by comparison understates the revenues that would be generated under the pending RIK legislation. The outcome of this debate is of critical importance to the pending RIK legislation, because it affects the baseline against which any projections of future revenue are measured.
MMS points to the 1995 gas RIK pilot program as an example of RIK resulting in a possible revenue loss, and it maintains more RIK pilots are necessary before moving forward with RIK. In actuality, the 1995 gas pilot was enormously successful. It proved that MMS, Federal lessees, operators and purchasers could easily accommodate RIK from an operational standpoint. Lines of communication between operators and purchasers were established, transportation services were arranged, and reports by lessees and purchasers were generated, all with relative ease. Significantly, a mere handful of MMS employees were able to manage the pilot, far fewer than would have been required to collect and verify royalty paid in value on the same production.
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MMS analyzed the revenue impact of the 1995 gas pilot by comparing values reported by RIK gas purchasers against values reported by lessees for the working interest share of production. As a general matter, there were some problems—previously identified by API in a critique of the MMS natural gas RIK pilot program—with the manner in which the revenue impact analysis was performed. In fact, had the revenue analysis been appropriately conducted, it is possible that MMS would have concluded the pilot actually made money. In addition, MMS failed to effectively measure administrative cost savings.
Certainly, any more pilots that do not take advantage of the lessons learned in the 1995 gas pilot are unwarranted and would be a waste of time. The problem is that MMS cannot obtain the private marketing expertise it needs in order to contract with a marketing agent to sell RIK production downstream without legislation. H.R. 3334 provides the legislative framework that will enable MMS to take advantage of downstream markets.
X. Conclusion
In summary, my purpose here today is to help re-engineer an important government function for the benefit of all concerned: the state and Federal Governments, the public, and the oil and gas industry. A properly designed RIK program can be fair to all stakeholders. It can be more efficient by streamlining administration and eliminating unnecessary valuation disputes. Finally it can offer Federal and state government the opportunity to increase royalty revenues in markets downstream of the lease.
In closing, I thank you for the opportunity to be here today representing the API and to participate in this important undertaking. We believe RIK is not only simpler, it is better, and a comprehensive royalty-in-kind program deserves careful consideration. API is interested in working with this Subcommittee, the MMS, the States, and other stakeholders toward achieving a workable solution that meets the needs of all parties. As part of this effort, API would welcome an opportunity to discuss differences between MMS and industry concerning provisions in this bill with the common goal of successfully reinventing an important government process.
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STATEMENT OF BOB NEUFELD, VICE PRESIDENT, ENVIRONMENT AND GOVERNMENTAL RELATIONS, WYOMING REFINING COMPANY REPRESENTING WYOMING REFINING COMPANY, CALCASIEU REFINING COMPANY, GARY-WILLIAMS ENERGY CORPORATION, GIANT REFINING COMPANY AND PLACID REFINING COMPANY
Chairman Cubin and members of the Subcommittee:
My name is Bob Neufeld. I am the Vice President of Environment and Governmental Relations for Wyoming Refining Company. Wyoming Refining Company is a member of a coalition of five small and independent refiners called the Small Refiner Consortium (Consortium) who are purchasing or have purchased Federal royalty oil from the Minerals Management Service. The United States have been selling some of their Federal royalty oil since the Federal Mineral Leasing Act was amended in 1946 to ensure that small, independent refiners would have secure access to crude oil markets. That program which has operated successfully to the benefit of small refiners and the Nation for fifty years is now becoming an instrument for the elimination of the small refining industry in this country. As I testified at the Subcommittee's September 18, 1997 oversight hearings on the Federal oil and gas royalty program, current MMS dependence on a methodology that mimics rather than participates in the markets for crude oil is misguided. This dependence has led to retroactive crude oil price adjustments for small refiners as many as 8 years after invoices issued for the sale of the oil were paid in full and on time.
My company is now in litigation with MMS over amounts, based on producer audits conducted without our knowledge, that may exceed our stockholders' equity. These amounts cover oil sold by MMS after MMS had concluded, without informing us, that prices in our invoices might be wrong because of a producer's reporting error. Wyoming Refining was lured, therefore, into increasing its financial exposure by purchasing oil whose price was suspect, but only to MMS. Furthermore, MMS effectively ensured that our right to cancel further deliveries of over-priced oil would lapse unexercised by waiting for years after delivery to raise the issue. While the other four members of our coalition have not as of this writing received MMS demand letters for retroactive Federal royalty oil price adjustments, MMS has informed them that demand letters to refiners other than Wyoming Refining Company will be issued by December of this year. All members of the Consortium fear that the impact of these letters on them could be as bad or worse than the disaster facing Wyoming Refining Company.
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Madam Chairman and members of the Subcommittee, I am testifying today on behalf of all members of the Consortium and in favor of H.R. 3334 to ensure that this impending disaster is never, ever repeated. The current Federal dependence on market mimicry, second guessing and non-market, wastefully expensive adjudication to set royalty values must end. Actual market participation is the only reliable, irrefutable and final measure of Federal oil values.
Before commenting on the more important eligible small refiner provisions in H.R. 3334, I want to state on behalf of the entire Consortium that we categorically disagree with MMS' mis-characterzation of §12 of the bill as ''minimizing the value of 40 percent of the government's royalty oil'' and as requiring ''the government to provide 40 percent of its oil to small refiners at the lowest offered prices.'' To the contrary, the bill requires that the eligible small refiner portion of oil volumes be offered to refiners for exactly the same price as that oil would otherwise be sold to successful purchasers or bidders. It is difficult to see how this lowers the price of oil and, in fact, it is just as plausible to assume that the price of oil will be increased by purchasers or bidders competing to stay above the bottom 40 percent of successful offers.
The Consortium is particularly disturbed by MMS' equating the ''lowest successful offers'' language in H.R. 3334 with ''the lowest offered prices'' description in the agency's report. The two concepts are fundamentally different, and MMS should know better. MMS' comments are subtly but crucially off target. When serious factual discussion is required, deliberations are not furthered by obfuscation that clouds the debate. Misguided analysis such as this raises questions of whether MMS has similarly mis-characterized any more of H.R. 3334 in its report to the Subcommittee.
The Consortium participated in drafting the eligible small refiner provisions of H.R. 3334 contained in §12 and related definitions of the bill. We believe we have been successful in keeping the original intent of existing eligible small refiner royalty-in-kind authority which §12 would replace while merging together the existing onshore and offshore programs and simplifying overall program administration. The following narrative discusses the key eligible small refiner provisions contained in H.R. 3334.
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SECTION 2. DEFINITIONS.
(6) ELIGIBLE SMALL REFINER.—The term ''eligible small refiner'' means a refiner that——
(A) has applied to the Secretary for and has received certification as an eligible small refiner;
(B) has a total crude oil and condensate refining capacity (including the refining capacity of any person who control, is controlled by, or is under common control with such refiner) not exceeding 120,000 barrels per day;
(C) is a corporation, company, partnership, trust or estate organized under the laws of the United States or of any State, territory, or municipality thereof, or is a person who is a United States citizen; and
(D) has continuously operated a refinery in the United States for no less than 6 months immediately preceding the date of application for certification as an eligible small refiner.
This proposed definition of ''eligible small refiner'' ensures that the program continues to benefit the domestic refineries of American small refiners who would not otherwise have equitable access to Federal oil production.
It is necessary to change the current size criterion of eligible small refiner in the above manner and to consolidate the different definitions into one to reflect industry changes and the current refining environment. The existing offshore definition is tied to the Small Business Administration definition which caps refining capacity at 75,000 barrels per day and the employee count at 1,500. The existing onshore definition is tied to the Emergency Petroleum Allocation Act of 1973 which caps refining capacity at 175,000 barrels per day and addresses historical sales to independent wholesalers and jobbers.
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With the recent industry consolidations and strategic alliances, the traditional small refiner may not survive without growing in both the refining and the market sectors. In the refining sector, only inherent efficiencies and economies of scale will allow a refiner to remain competitive. Economies of scale are generally achieved by geometric growth versus incremental growth. However, the need exists to have an overall cap on refining capacity to stay within the intent of the small refinery royalty-in-kind concept. At 175,000 barrels per day a refiner is truly no longer small in size. A restriction of 75,000 barrels per day severely restricts growth through acquisition or merger. Discussions were held and 120,000 barrels per day distillation capacity was determined to be an acceptable boundary between those refiners who truly are small and those who are not.
Growth in the market sector primarily occurs through wholesale, retail, military and commercial sales as well as through supplying intermediate feed stocks and specialty products to other refiners. The only guarantee a small refiner has for refinery out turn is through controlled retail outlets and preference sales to the military. By growth on the retail level, the refiner is creating jobs, adding a labor intensive business and guarantying an outlet for the product. This expansion in a small refiner's corporate size has no relationship to its refining capacity or the need to preserve a diverse base of domestic refiners. Therefore, the employee count cap was eliminated.
(7) ELIGIBLE SMALL REFINER PORTION. The term ''eligible small refiner portion'' means the portion of all royalty oil volumes required to be offered for sale to eligible small refiners. The eligible small refiner portion shall be 40 percent of all royalty oil volumes, unless the Secretary determines that a greater share is in the public interest.
The Minerals Management Service has stated that in 1996, the last date for which information is available, forty percent (40%) of all royalty oil revenues were received from participating refiners in the royalty-in-kind programs. The definition of the eligible small refiner portion reflects what has occurred in the program. Smaller percentages for earlier years reflect a period when offshore Federal royalty oil was not available to eligible small refiners thereby inaccurately skewing the royalty-in-kind revenues, derived solely from onshore sales, toward a lower percentage of total Federal oil revenues.
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SECTION 12. ELIGIBLE AND SMALL REFINERS
(a) SALE OF ROYALTY OIL TO ELIGIBLE SMALL REFINERS
(2) The sale of royalty oil from the eligible small refiner portion to an eligible small refiner is intended for processing, or trading for equivalent barrels for processing, in the eligible small refiner's refineries located in the United States and not for resale in-kind or value.
The participating refiner must process, directly or indirectly, the Federal royalty oil received under this Section 12.
(4) The eligible small refiner portion shall be offered to eligible small refiners from royalty oil volumes to be sold by each qualified marketing agent. The Secretary shall maintain a current list of all eligible small refiners. Upon the selection of a qualified marketing agent by the Secretary, the Secretary shall promptly notify all eligible small refiners of the selection of the qualified marketing agent. The notification shall contain the name and address of the qualified marketing agent as well as a brief description of the Federal leases and lease products to be marketed by that qualified marketing agent. Any eligible small refiner who is interested in receiving royalty oil from the leases of the qualified marketing agent, shall submit a notice of interest to the qualified marketing agent. The notice of interest shall generally state the volumes, location and quality of royalty oil desired by the eligible small refiner. When marketing royalty oil, each qualified marketing agent shall contact the eligible small refiner(s) who has (have) submitted a notice of interest and shall offer to sell the eligible small refiner portion to the eligible small refiner(s) who submitted a notice. If there are successful offers for all royalty oil volumes to be sold, the eligible small refiner portion price shall be the weighted average price of the 40 percent of royalty oil volumes to be sold for which the lowest successful offers have been received. If a part of the royalty oil volumes to be sold does not receive a successful offer, for weighted average pricing purposes, that part shall be valued using the price of the lowest successful offer.
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This concept is very similar to the manner under which the Naval Petroleum Reserve Elk Hills Field oil was sold with very successful results and an apparent minimum amount of administration. The concept guarantees that Federal royalty oil will be sold at a price no less than it would have otherwise have been sold and overall has the potential to generate additional revenue.
I must note for the Subcommittee's information that H.R. 3334 and the companion Senate bill, S. 1930, contain differing language in this section. We have been working with the producing industry to reconcile this difference between these two bills. The language appearing in this testimony represents agreement between the Consortium and the producing industry representatives except for the last two sentences. Both sides are endeavoring to find a mutually acceptable position on this one remaining issue, and we believe any differences will be resolved shortly. For the Subcommittee's information, in lieu of the last two sentences discussed above, S. 1930 contains the following language, ''The eligible small refiners shall purchase such royalty oil at the weighted average price for the remaining volumes of like quality at the same location sold by the qualified marketing agent.''
(c) FEES, CREDITWORTHINESS, AND SURETY REQUIREMENTS.—(1) The purchase of royalty oil from the eligible small refiner portion pursuant to this section shall not be subject to any fees or charges not required of all purchasers of royalty oil.
(2) The Secretary shall establish conditions for each eligible small refiner's creditworthiness at the time of determining and reviewing eligibility.
(3) Creditworthiness requirements for eligible small refiners shall not exceed standard industry requirements governing non-Federal crude oil purchasers, and the Secretary may not require surety in excess of the estimated value of 60 days anticipated deliveries of royalty oil from the eligible small refiner portion to individual eligible small refiners.
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With a global royalty-in-kind program as introduced in this bill, eligible small refiners should be held to the same fees and credit requirements as any other arms-length purchaser from the qualified marketing agent.
(d) ELIGIBLE SMALL REFINER ADVISORY PANEL—The Secretary shall convene an eligible small refiner advisory panel to develop policies and procedures to implement the provisions of this Act. The eligible small refiner advisory panel shall be comprised of representatives from 3 small refiners who have previously participated in the small refiner program established pursuant to section 36 of the Mineral Leasing Act (30 U.S.C. 192) or section 1353 of the Outer Continental Shelf Lands Act (43 U.S.C. 1353) and 3 qualified marketing agents. Pursuant to the recommendations of the small refiner's advisory group, the Secretary shall develop and implement procedures to ensure a fair and equitable opportunity for interested eligible small refiners to purchase royalty oil from the eligible small refiner portion.
We are encouraging the MMS to team with the eligible small refiners and qualified marketing agents to develop workable policies and procedures to minimize the administration and implement the intent of the Act.
(g) REPEAL OF EXISTING ROYALTY-IN-KIND AUTHORITY.—Section 36 of the Mineral Leasing Act (30 U.S.C. 192) and section 1353 of the Outer Continental Shelf Lands Act (43 U.S.C. 1353) are repealed.
This bill would repeal all existing authority for eligible small refiner royalty-in-kind programs.
CONCLUSION
In closing, Madam Chairman and members of the Subcommittee, the Consortium states that its members support H.R. 3334 as a constructive effort to change the Federal oil and gas royalty program from a system that constantly looks backward to one that sees the future from a market based perspective. In so doing, we believe H.R. 3334 preserves and improves upon the best aspects of the current eligible refiner royalty-in-kind program, a program that after fifty years remains relevant today in its goal of maintaining a diversified and healthy refining industry in America. By the same token, H.R. 3334 ensures that the errors of today's small refiner program which are posing unintended and unbelievable burdens on these important businesses through no fault of their own will, thankfully, be discontinued. The Consortium urges your support and favorable consideration of H.R. 3334. Thank you for the opportunity to appear on this panel today.
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STATEMENT OF L. POE LEGGETTE, JACKSON & KELLY ON BEHALF OF INDEPENDENT PETROLEUM ASSOCIATION OF AMERICA
On December 20, 1995, the Minerals Management Service (''MMS'') published in the Federal Register an advance notice of proposed rulemaking on the subject of crude oil valuation. In that notice, MMS focused primarily on the concern that crude oil posted prices ''don't always reflect market value and in fact may often be no more than a beginning point for negotiation.'' 60 Fed. Reg. 65610 (1995). Nothing in the notice, however, indicated that the MMS had begun to view prices on the New York Mercantile Exchange (''NYMEX'') as the true ''market value'' of crude oil.1
According to documents released under the Freedom of Information Act, on September 5, 1996, MMS was briefed by a Mr. J. Benjamin Johnson on modifications he advocated to MMS's rules on valuing crude oil. Mr. Johnson advocated using a NYMEX price for oil to be delivered in Cushing, Oklahoma, as the starting point in royalty valuation. Recognizing that Cushing is hundreds and sometimes thousands of miles from the Federal leases in question, Mr. Johnson proposed a complicated series of adjustments to the NYMEX price to try to reflect differences. These included using ''grade trade differentials'' among various ''major market centers'' for crude oil (such as Midland, Texas, and St. James and Empire, Louisiana), and requiring lessees and their affiliates to report all exchange agreements to permit MMS to create a national average exchange differential.
This September 1996 briefing has special significance for two reasons. First, Mr. Johnson had already filed in Lufkin, Texas, a complaint under seal under the False Claims Act seeking for himself up to 30 percent of what he alleged were billions of dollars of underpayments and penalties associated with crude oil from Federal leases. Second, MMS adopted his recommendations with little modification and proposed them in its January 1997 proposed rule.2
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I do not yet have the evidence to tell the Subcommittee whether MMS was Mr. Johnson's witting or unwitting accomplice in his effort to promote his litigation position. Needless to say, however, it would lend significant credibility to his extreme litigation position to have MMS dramatically revise its rules in response to his allegations that Federal lessees have systematically underpaid royalties on crude oil.
Since January 1997, independent producers have been fighting to beat back MMS's proposal that initially would have required virtually all independents to pay royalties based on NYMEX prices. While their efforts have met with some success, the rule remains objectionable for reasons detailed in the several sets of comments filed in that rulemaking by the Independent Petroleum Association of America (''IPAA'') and the Domestic Petroleum Council (''DPC''). One significant objection is the proposal's complexity, visually depicted on what Representative Tauzin has aptly named the ''Dungeons and Dragons'' chart, presented at the Subcommittee's March 19 hearing on H.R. 3334. Independents' other key objections are founded on the proposed rule's departure from legal precedent.
The Congress historically has given the Secretary of the Interior significant latitude in determining what the ''value of production'' is for production from a given lease, as long as his determinations remain within the perimeter fence of reasonableness. But Congress, the courts, and the Department itself have been clear on several fundamental principles by which these determinations are to be made.
• First, the value of production is to based on the value of production at the lease, not, as one court put it well, ''at the pipe line destination.''3
• Second, the value of production is to be determined by the terms of the lease contract and by any regulations incorporated into that contract on the date the lease was issued.4
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• Third, because of the Secretary's unilateral power to draft lease forms and regulations, the Secretary is not permitted to enforce royalty-related powers or duties ''implied'' in the lease. If the Secretary fails to write a duty expressly into the lease or regulations, it does not exist.5
These three primary principles have corollaries, the most important of which for today's purpose are two.
• The value of oil at the lease is best reflected in prices paid at the leased.6
• When the first sale of oil occurs away from the lease, the ''gross proceeds'' clause of the Federal lease form requires that the value be based on the lessee's ''gross receipts'' from the sale ''less the costs of marketing and transportation.''7 These deductions are needed to account for the fact that when production ''is valued at a point downstream from the wellhead where the value of production is ordinarily determined, allowances are generally required for the value added to the gas [or oil] after production.''8
The Subcommittee will find in the testimony of Dr. Joseph P. Kalt that these two corollaries of law fit hand in glove with fundamental economic reasoning and sound public policy.
Throughout the MMS's 1997-98 rulemaking, producer associations have urged MMS to return to a system of valuation more closely aligned with these bedrock legal principles. For example, in an eleven-association letter dated December 5, 1997, producers urged MMS to pursue policies and rules consistent with 6 points.
• Royalty must be based on the value of production at the lease.
• For arm's-length contracts, royalty value should be based on the lessee's gross proceeds.
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• For non-arm's-length contracts, MMS should continue to rely on comparable sales at the lease, including sales under so-called ''tendering programs'' and purchases at the lease by lessees' affiliates. The associations specifically agreed with the prospective elimination of posted prices from any set of valuation benchmarks.
• Any lessee duty to market cannot result in values greater than the value of production. In other words, MMS must recognize that it cannot have a free ride on a lessee's downstream activities which add value to crude oil.
• Uniform rules are preferable to separate rules applying to different regions.
• Royalty in kind remains the best way to end the complications and uncertainties of royalty valuation.
Even more specifically, IPAA and DPC invested extensive time in preparing an alternative sets of royalty valuation procedures (''RVPs'') to simplify the current rules and to fix MMS's perceived deficiencies in them. RVPs basically use a lessee's own arm's-length sales, or its affiliate's own arm's-length purchases, of oil in a given field as the primary means of valuing oil sold not at arm's length. This proposal has the twin virtues of relying on arm's-length sales at the lease and of simplicity in auditing, for the lessee would not need to worry about expense and legal risk of learning what its competitors were selling oil for.
Under the RVPs, if a lessee has no arm's-length sales or purchases to rely on, it must use a netback method of valuation. This could include using its differentials in exchange agreements as deductions from an arm's-length sales price for oil it sells downstream or using a index price with deductions for all value added by the movement of oil from the lease to the index pricing point. (See Attachment 2.)
Obviously, MMS has yet to embrace these principles and procedures. Its most recent proposal does not rely on lease market sales to value non-arm's length sales, except in the Rocky Mountain region where highly restrictive benchmarks are available to integrated companies, but not to independents. It limits the amount of transportation costs a lessee can claim as a transportation allowance. It forbids the deduction of any downstream service which MMS determines is not a cost of transportation on the ground that those are marketing expenses which the Federal Government need not share in. It discriminates irrationally between lessees who sell at arm's-length at the lease and those who sell to an affiliate, essentially imposing a tax on much of the value the affiliate adds to the lease value of oil by moving it downstream.
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In conclusion, MMS and producers stand at the brink of years of litigation over the crude oil rule, a particularly unfortunate development when one considers that 10 years of litigation have brought increased stability and certainty to the implementation of the 1988 value rules currently in force. MMS has yet to advance a legally sufficient reason to end its historical reliance on lease market sales to value crude oil.
ENDNOTES
1. The notice contained a single hint that MMS might be considering a scheme relying on prices agreed to for contracts for the future delivery of crude oil: a one-sentence question on whether ''oil 'futures' prices provide meaningful bases for royalty valuation.'' 60 Fed. Reg. 65611 (1995).
2. 62 Fed. Reg. 3742 (1997).
3. Continental Oil Co. v. United States, 184 F.2d 802, 820 (9th Cir. 1950). Congress has required the Secretary to reserve a royalty based on the ''value of production removed or sold from the lease.'' 30 U.S.C. §226(b)(1)(A). MMS Director Quarterman acknowledged in an April 7, 1998, article in The Oil Daily that ''the government is entitled to a royalty on the value of production in marketable condition at the lease.''
4. Attachment 1 is a compendium of Federal lease forms. See Tab Q. for example. The lease expressly incorporates regulations ''in existence upon the effective date of this lease. . . .'' §1.
5. Continental Oil Co., 184 F.2d at 810; United States v. Seckinger, 397 U.S. 203, 210 (1970).
6. This view is reflected in the Department's historical practice of valuing non-arm's-length sales at the lease by comparison with arm's-length sales at the lease, e.g., Getty Oil Co., 51 IBLA 47 (1980), and by its practice of valuing production when there is no market at the lease by using the value of oil at the ''nearest potential market'' and allowing a deduction for transportation only to that point. Viersen & Cochran, 134 IBLA 155, 165 (1995).
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7. Marathon Oil Co. v. United States, 604 F. Supp. 1375, 1384 (D. Alaska 1985), aff'd 807 F.2d 759 (9th Cir. 1986), cert. denied 480 U.S. 940 (1987).
8. Xeno, Inc., 134 IBLA 172, 180 (1995) (citing Marathon Oil Co.). To be sure, the Interior Board of Land Appeals has issued a few decisions holding that lessees have an implied duty to market production at no cost to the Federal lessor. The error of those holdings—which no court has ever affirmed—is currently the subject of a petition for reconsideration pending before IBLA in Taylor Energy Co., IBLA 94-828R, and is set forth in the attached amicus brief filed by IPAA. (Attachment 3.)
ATTACHMENTS
ATTACHMENT 1 Independent Petroleum Association of America and Domestic Petroleum Council's April 7, 1998 Compendium of Federal Lease Forms
ATTACHMENT 2 Independent Petroleum Association of America's Modified Valuation Proposal
ATTACHMENT 3 Taylor Energy Co., Motion and Brief Amicus Curiae of the Independent Association of America, IBLA 94-828R, dated April 24, 1998
STATEMENT OF RALPH DEGENNARO, EXECUTIVE DIRECTOR, TAXPAYERS FOR COMMON SENSE
Good afternoon. Madam Chair thank you for the opportunity to testify before this Subcommittee. My name is Ralph DeGennaro and I am the Executive Director of Taxpayers for Common Sense (TCS).
TCS is dedicated to cutting wasteful government spending and subsidies and keeping the budget balanced through research and citizen education. We are a politically independent organization that seeks to reach out to taxpayers of all political beliefs in working toward a government that costs less, makes more sense and inspires more trust. Taxpayers for Common Sense receives no government grants or contracts and is not party to any royalty litigation.
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To put my testimony in context, I would like to outline two principles that guide TCS's work. First, oil, gas, and other minerals on public lands belong to the taxpayers—they are taxpayer assets. Second, these taxpayer assets should be disposed of in a way that maximizes the return to taxpayers of today and tomorrow as well as minimizes burdens on the government.
In accordance with these principles, TCS opposes H.R. 3334 because the legislation is likely to lose revenue and place a new burden on the government. This new burden of marketing and selling oil and gas would contradict current efforts to reduce the size of government bureaucracy and get the government out of inappropriate roles.
I. LIKELY TO LOSE REVENUE
Though supporters of H.R. 3334 claim that mandatory royalty in kind (RIK) payments increase government royalty revenue, or at least maintain current revenues, we believe it will be a money loser.
A. FRAMEWORK RIGGED AGAINST TAXPAYERS
Supporters of RIK legislation point to examples in Texas and Alberta where governments have been able to make money under an in kind system. We believe there may be cases where the government can make money under RIK, but there are many others where it will lose. In cases where MMS can make money through RIK, it currently has the statutory authority to do so, making this bill unnecessary.
H.R. 3334 does not provide the same framework that has enabled RIK to succeed elsewhere, but instead is rigged to virtually guarantee that the Federal Government would lose money. Garry Mauro, Texas Land Commissioner and administrator of Texas's RIK program, pointed out in his letter to Representative William Thornberry that the factors that have enabled RIK to succeed in his state are the very elements that the proposed Federal program would lack. For example, Texas' program is flexible and allows the state to decline RIK for leases which have small volumes or are in remote areas. In contrast, the proposed Federal program would be inflexible. The Federal Government would not be able to select the lands on which RIK would be beneficial, but instead would be forced to take oil and gas in kind for all leases. Key differences such as these led Mr. Mauro to conclude that ''Based upon our experience with the State program, we think this Bill [H.R. 3334] will result in a loss of revenue to the Federal Government and the states.'' The States of New Mexico, California, and Alaska have also opposed the reduction to their oil and gas royalties they believe will result from the above provisions. The State of Alaska has concluded that ''this legislation is a bad idea and will cost Alaska money.''
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B. MINERALS MANAGEMENT SERVICE ANALYSIS DEMONSTRATES LOSSES
There is no evidence that mandatory in-kind royalty payments will be helpful to taxpayers or raise government revenue. According to MMS's 1997 Royalty in Kind Feasibility Study, ''despite direct inquiries, marketers were not able to provide convincing arguments or evidence that oil RIK would be revenue positive.'' Therefore claims of increased revenue are only speculation.
However, there is tremendous evidence that mandatory RIK would lose revenue. Loss estimates range from $140 to $360 million annually, according to MMS. Under H.R. 3334, the Federal Government would be required to accept all oil and gas as a payment in kind. This means that the government would receive some oil and gas at less than marketable conditions as well as small volumes of production in remote locations, where it would be subject to high transportation costs. Furthermore, the bill calls for taxpayers to assume new costs that they do not have to pay for currently, such as marketing. These factors are likely to cost taxpayers hundreds of millions of dollars per year, according to MMS, leading the agency to conclude that H.R. 3334 is ''primarily designed to enhance the interests of oil and gas producers, at the expense of the American taxpayer.''
C. SPECIFIC EXAMPLES OF HOW H.R 3334 IS RIGGED AGAINST TAXPAYERS
Section 4 (a) will require the government to pay to remove impurities, such as carbon dioxide, from the oil or gas. Currently, the government does not pay these costs.
Section 4 (b) of the bill will require the government to pay transportation costs for non-royalty bearing substances. For example, in some wells in the Gulf of Mexico, oil is shipped with as much as 40 percent water by volume. Currently the government does not pay such costs.
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II. CHANGE NOT JUSTIFIED
A. MMS HAS STATUTORY AUTHORITY TO ACCEPT RIK
Under current law, MMS already has statutory authority to accept RIK payments—legislative changes are not necessary. In cases where it makes sense, MMS can already accept RIK. In other cases, MMS can choose cash payment.
B. ADMINISTRATIVE SAVINGS WOULD BE OVERWHELMED BY NEW BURDEN
Supporters of H.R. 3334 claim that RIK will reduce costs and eliminate bureaucratic burdens, possibly allowing for MMS staff to be reduced. MMS may deserve some of the criticism it receives and may need to have its bureaucracy trimmed. But the small cuts RIK may allow for in MMS's $63 million royalty collection budget are not worth risking the $4 to $5 billion in royalties the current system generates annually. In a 1995 gas marketing pilot program, MMS reported substantial royalty losses which ''overwhelmed small administrative savings,'' according to MMS Director Cynthia Quarteman's testimony.
Even the possibility that mandatory RIK would allow for MMS's budget to be significantly cut is unrealistic. Auditors would still be needed. In addition, with the new burdens of sale and marketing placed on MMS or some other agency, bureaucracy is likely to increase not decrease.
C. PROPOSED NEW RULE FIXES MANY PROBLEMS
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Basing oil royalties on posted prices—as is currently done—has been fraught with problems for both taxpayers. However, MMS's proposed new rules will minimize many of these problems by relying more on market mechanisms such as published market prices for the major oil companies. Second, the proposed rules are supported by the many lawsuits against the oil companies for underpayment of royalties. In the current False Claims Act case against 4 major oil companies, intervention by the Justice Department indicated that there is evidence of systematic underpayment of oil and gas royalties.
MMS's proposed rule will not only assure true market value for the taxpayer's oil, but will provide the certainty, through widely available published prices, to end much of costly audit and litigation burden on both industry and government. H.R. 3334 is not needed, and can not reduce this burden as effectively as the proposed rule. As a plaintiff in the False Claims Act case, a self-described oil and gas industry man for 50 years put the issue: ''it simply is a matter of living up to formal agreements made to lease government lands.'' Industry need not and should not be asked to pay one cent more than it owes, but it can and should pay what is required under the terms of its current leases.
III. CREATES AN UNNEEDED NEW PROGRAM
H.R. 3334 would require the creation of an unneeded Federal program in conflict with current efforts to reduce the size of government bureaucracy and get the government out of inappropriate roles. Bureaucracy would expand in order to market and sell large quantities of oil and gas. Additional employees would be required to figure out how to maximize government profit, market the plan, and sell the assets.
Furthermore, advertising, marketing, and selling a market product are not traditionally U.S. Government roles, nor something it usually does well. There are cases where the government can and should act more like a business, but in this instance the government does not need to mimic private business, because private businesses already market and sell oil and gas reasonably well. Even if the government contracts out some aspects of marketing and sales, it would still be substantially involved in new aspects of the industry and would have to increase administrative costs to oversee and implement it.
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Finally, increased government competition with oil and gas companies could be problematic. General revenues might somehow be used to subsidize the government marketing and sales team, enabling the government to undercut private industry. Or, if the government was able to use its size and ability to combine large supplies of oil and gas to assert market power—as H.R. 3334 supporters urge—industry could rightly complain that the government was unfairly competing. Private utilities complain that their competitors, Power Marketing Administrations (PMAs) and rural coops, receive an unfair leverage through Federal subsidies and other advantages. As Ward Uggerud, Otter Tail Power Company Vice President, argued before Congress in 1996, ''The PMAs are unregulated monopolies that are pursuing monopoly practices in the marketplace.'' We do not need to recreate this type of problem in the oil and gas industry.
At a time when the Federal Government is pulling out of functions that private industry is able to well serve, this new Federal role makes even less sense. Congress has recognized that the Federal bureaucracy no longer needs to be in the business of helping sell tea and may other market commodities. The 104th Congress finally killed the almost 100 year old Board of Tea Experts whose job it was to touch, sniff, and taste samples of imported tea to test their purity, quality, and fitness. We have just sold off the Elk Hills Naval Petroleum Reserve, primarily as the industry proponents argued, because the government should get out of the oil business. Now the industry is telling the government it has to get back in the oil business. H.R. 3334 is clearly a step in the wrong direction and reverses progress made in killing unnecessary and outdated government programs.
IV. EXAMPLE OF PROBLEMS
To illustrate many of the problems with this legislation, allow me to construct this slightly silly scenario. Let's pretend I owe $10 to each of the members of this Committee. But what if instead of cash, I offer you a can of gasoline instead. For some of you this might be a good deal. You noticed you were low on gas this morning and could use the can to fill up your tank. Others of you might even be able make a profit because you remember that a friend ran out of gas this morning and would be willing to pay top dollar for delivery of gas. However, others of you would much rather have the cash. Possibly you walked to work and would be stuck lugging a heavy can home. Or maybe you do not want the hassle of trying to sell gas and think that the gas station down the street would not give you a good price. All of you would better off if you have a choice between the cash and the gas.
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Likewise, taxpayers are better served by reserving the right to choose between cash payments and RIK as they do under the current system. By rejecting H.R. 3334 and any similar bills, this Committee can preserve that choice and ensure that taxpayers receive the royalties they deserve.
Thank you.
INSERT OFFSET FOLIOS 1 TO 56 AND 61 TO 378 HERE
HEARINGS ON H.R. 3334, THE ROYALTY ENHANCEMENT ACT OF 1998
HEARINGS
before the
SUBCOMMITTEE ON ENERGY
AND MINERAL RESOURCES
of the
COMMITTEE ON RESOURCES
HOUSE OF REPRESENTATIVES
ONE HUNDRED FIFTH CONGRESS
SECOND SESSION
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MARCH 19 AND MAY 21, 1998, WASHINGTON, DC
Serial No. 105–92
Printed for the use of the Committee on Resources
HEARINGS ON H.R. 3334, THE ROYALTY ENHANCEMENT ACT OF 1998