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ONRR’s Federal Oil & Gas and Federal & Indian Coal Valuation Reform: A Call for Comments, Industry Here’s Your Shot

April 28, 2017
By Modrall Sperling

As noted in a previous update,¹ on January 6, 2015 the U.S. Department of the Interior’s Office of Natural Resource Revenue (ONRR) announced a proposed rulemaking amending its regulations governing valuation, for royalty purposes, of oil and gas produced from Federal onshore and offshore leases and coal produced from Federal and Indian leases.² This Rule, known as the Consolidated Federal Oil & Gas and Federal & Indian Coal Valuation Reform, was finalized on July 1, 2016 and technically went into effect on January 1, 2017; however, on February 27, 2017 ONRR issued a stay of the rule, just one day before Federal and Indian lessees were required to report and pay royalties under the new Rule.³   Then, on April 4, 2017 ONRR issued two advance notices of proposed rulemakings.  The first notice is a notice of intent to repeal the recently issued rule (RIN 1012-AA20).⁴ The second notice is a notice requesting comments from industry members and interested parties concerning whether updated royalty valuation regulations are necessary (RIN 1012-AA21).⁵

More specifically, ONRR seeks comments on the following questions:

• In the event the January 1, 2017 rule is repealed, ONRR would like to know whether a new rulemaking would be beneficial.
• In the event the January 1, 2017 is not repealed, ONRR would like to know:
• Whether ONRR should have one rule addressing Federal oil and gas and Federal and Indian coal valuation, or two separate rulemakings?
• How should ONRR value non-arm’s length coal sales, and sales between affiliates?
• Should ONRR update the valuation regulations for arm’s-length sales of Federal gas?  If the answer is yes, how so?
• Should ONRR address the marketable condition rule, and unbundling issues?  If the answer is yes, how so?
• Finally, should ONRR have a default valuation provision that gives the Secretary discretion to establish values for production when there is misconduct, a breach of the duty to market, or in situations when a value cannot otherwise be verified?

These notices clearly indicate that the new administration is looking to make changes to the 2017 regulations. Industry involvement in the comment process will likely be given considerable weight, making this a good opportunity for industry to lobby for meaningful changes to the ever-problematic marketable condition rule and Unbundling Cost Allocations (UCAs set by ONRR).

As previously noted, one of the most notable changes issued by ONRR in the 2017 Obama-era rule was the creation of a “default provision” that would allow ONRR to “exercise considerable discretion” to establish a royalty valuation when “(1) a contract does not reflect total consideration, (2) the gross proceeds accruing to you or your affiliate under a contract do not reflect reasonable consideration due to misconduct or breach of the duty to market for the mutual benefit of the lessee and the lessor, or (3) it cannot ascertain the correct value of production because of a variety of factors, including but not limited to, a lessee’s failure to provide documents.”⁶  In sum, the Rule “changes how lessees value their production for royalty purposes and revises revenue-reporting requirements.”⁷  While the stated purposes of the rule were to “offer greater simplicity, certainty, clarity, and consistency in product valuation for mineral lessees and mineral revenue recipients[,] . . . ensure that Indian mineral lessors receive the maximum revenues from coal resources on their land, . . . decrease industry’s cost of compliance and ONRR’s cost to ensure industry compliance[,] and . . . [ensure] that companies have paid every dollar due,”⁸ many have questioned whether the new rule can achieve these goals.

Three separate Petitions were filed in the United States District Court for the District of Wyoming,⁹ challenging the Rule as arbitrary, capricious, and contrary to the law by exceeding ONRR’s authority under applicable statutes and lease terms. As the American Petroleum Institute states in its Petition for Review of Final Agency Action, filed December 29, 2016, “the Final Rule upends a longstanding valuation system and replaces it with widespread uncertainty and unconstrained agency ‘discretion,’ thereby placing both offshore and onshore federal oil and gas lessees in an untenable position going forward with respect to their royalty reporting and payment obligations.”¹⁰  The Petition goes on to state that the Rule’s net effect is “an attempt to inflate royalty demands beyond what is fairly, and legally, due from federal lessees based on the value of the oil or gas production at or near the lease.”¹¹

On February 17, 2017, the Petitioners in these cases requested that ONRR postpone the implementation of the Rule, pending the outcome of the lawsuits, due to their assertion that the “lessees affected by the Rule face significant hardship and uncertainty in the face of reporting under the rule for the first time on February 28, 2017.”¹²  The Petitioners also asserted that, not only are the payment requirements difficult, or impossible, to comply with by the royalty reporting deadline, but that “non-compliant lessees may be exposed to significant civil penalties.”¹³

Based on the pending lawsuits and request for postponement, on February 27, 2017, one day before Federal and Indian Lessees would have been required to report and pay royalties under the new Rule, ONRR announced its decision to postpone the effectiveness of the Rule, pursuant to 5 U.S.C. 705 of the Administrative Procedure Act, pending judicial review.  ONRR stated that this was necessary due to the potential consequences of the pending litigation.  Specifically, 5 U.S.C. 705 of the Administrative Procedure Act states:  “When an agency finds that justice so requires, it may postpone the effective date of action taken by it, pending judicial review.”  ONRR determined that justice required the postponement in this situation in order to “preserve the regulatory status quo while the litigation is pending,” recognizing the Petitioners’ concerns with regard to “the expansion of the ‘default provision’ and the use of the sales price of electricity for certain coal-royalty valuations.”¹⁴ ONRR stated that postponing the rule will save both the regulated community and ONRR time and money that it will take to correct and verify revenue reports and payments; time and money that will be wasted if the Rule is invalidated. ONRR went on to state that they have received “numerous legitimate questions from lessees on how to apply the 2017 Valuation Rule, some of which will require additional consideration and time before ONRR can definitively answer them; thus increasing the likelihood that lessees will initially report incorrectly and later need to adjust their reports. In addition, the Court may resolve some of these issues differently than ONRR, again increasing the likelihood that lessees will need to submit corrected reports.”¹⁵

While it is not yet known what will come of the newly issued advance notices of proposed rulemakings, it is clear that the new administration is aware of industry’s concerns related to the 2017 Rule.  Notably, based on statements made in issuing the stay, ONRR has already acknowledged some apparent problems with the Rule.  Industry should focus on some of these issues in their comment letters to the agency, along with other historic problems that have created significant reporting and royalty calculation challenges for payors.  Comments to both advance notices of proposed rulemakings are due May 4, 2017.

In the meantime, lessees that have already converted to the new 2017 reporting requirements have been instructed to convert back to the prior reporting rules by February 29th if possible, but if not, as soon as possible thereafter.

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