Technology Assessment Division

Past Initiatives on Taking Royalty Production In-kind

Abstract

A number of times over the years, DENR has looked at the possibilities of taking royalty production in-kind as a potential method to enhance revenue from State production. The end result of each foray into this was to continue the practice of taking royalty payments in cash.

The idea of enhancing revenue by taking royalties in-kind is a sound concept. It is a method of royalty collection that is seldom practiced by government entities in the U.S., but it has been successfully employed, as by the city of Long Beach, California and the states of Texas and California. On the other hand, the Minerals Management Service (MMS) lost revenue in a recent pilot program for taking natural gas royalties in-kind in the Gulf of Mexico. The devil is in the details, and the details vary from place to place.

For Louisiana, the details that cause the greatest deterrents to implementing a royalty in-kind program are:

• Lack of authority in state lease agreements prior to 1970 for the State to take royalties in-kind

• Lack of concentration of enough large volume leases with in-kind provisions in a suitable geographical area to provide the State the needed marketing power to meaningfully enhance revenue over the cash payment returns, and

• The administrative bureaucracy that would have to be created for the State to get into the business of marketing oil and gas and managing the transportation logistics of getting production to market.

Provided below is a discussion of some of these details.

Lease Provisions and Legal Authority

Legal authority for the State to take royalty production in-kind is determinant on when the lease was issued:

(1) 1930 and prior, the State's royalty is a stated share in-kind.

(2) From 1930 to 1970, leases were written giving the lessee the option of paying royalties on the basis of value or in-kind.

(3) From 1970 forward, R.S. 30:127(C) (copy attached) has required lessees to contain a provision specifically allowing the state to take royalty production in-kind. (Such action, however, may not be without litigation according to a past review by a legal advisor to the Mineral Board, since, for example, the majority of the State's royalty oil is sold under division orders, many of which have been in place more than 50 years. Division orders for affected leases would have to be canceled before a sale of in-kind oil could take place.)

The Mineral Board is also given statutory authority in administering the taking of royalty production in-kind. R.S. 30:142 (copy attached), specifies the right of the State to take royalty oil in-kind, but deals almost exclusively with the taking of gas in-kind. It explains in great detail the procedures to follow in taking royalty gas in-kind for human needs purposes. R.S. 30:144 (copy attached), on the other hand, establishes procedures for DENR to follow in promulgating regulations for selling royalty oil to small refiners. The in-kind provisions of both of these statutes were enacted during the time of federal controls on the price and use of oil and gas and would probably need revision to reflect the current regulatory environment and market realities that did not exist at the time of passage.

Significant DENR Initiatives

Louisiana Institutions Self-help Agreements (LISA)

LISA was a proposed cost savings program to take royalty gas in-kind and supply it to state institutions (universities, charity hospitals, prisons, etc.) at substantially lower prices than the state was paying gas suppliers. This initiative was proposed by a team led by Vernon Helms who was the Director of the Mineral Income Division of the Office of Mineral Resources. The other members of the team were Don Hebert of the Pipeline Division of the Office of Conservation, and Mike French of the Technology Assessment Division of the Office of the Secretary.

In 1987, State institutions were paying approximately $6.00 per MCF for gas delivered to their sites. Much of this gas was the same gas the Mineral Board was receiving a royalty price of $1.00 per MCF. The essence of the LISA proposal is that the Mineral Board would take delivery of royalty gas in-kind, provide it to LISA at $2.25 per MCF, arrange pipeline transportation for $0.35 per MCF and delivery through the existing local distribution companies for $3.00 per MCF for a delivered price to State institutions of $5.60 per MCF. State institutions would then save $0.40 per MCF, and the Mineral Board would receive $2.25 instead of $1.00 per MCF for royalty gas, for a net gain to the State of $1.65 per MCF, or a total of $3 million to $8 million per year, depending on the number of state institutions participating. The State of Texas implemented a similar program in August 1986 supplying royalty gas to 55 state institutions at considerable savings.

A public hearing was held on July 27, 1987, meetings were held with several state lessees from whom royalty gas was available in sufficient quantities at below prevailing market prices, and meetings were held with gas pipeline companies and local distribution companies to develop a workable plan to pursue LISA. In order to implement and operate LISA, it was determined that the Office of Mineral Resources, Mineral Income Division would need to add two new full time positions (a gas sales coordinator and a gas sales specialist) and utilize the services of an engineer part time, for an annual personnel cost of $90,000. The primary duties of these new personnel would be to manage the wellhead supply, pipeline transportation, local distribution company delivery, and cost accounting of moving royalty gas to state institutions.

A request for the additional personnel was made to the Division of Administration, and it was turned down. Apparently then Commissioner of Administration Brian Kendrick decided the State was getting into the pipeline business, which was something the State should not do.

Oil Royalty Task Force

Several DENR staff members who over the years had looked at various ideas about taking State royalty production in-kind decided it was time to lay the issue to rest by giving it a dedicated opportunity to work. Bill Howe, then Chief Landman of the Office of Mineral Resources, obtained the go-ahead from the Mineral Board and the Secretary of Natural Resources to assemble a Task Force to study the issue and make recommendations. The Task Force consisted of:

Bill Howe, P.E., Chairman	Chief Landman, Office of Mineral Resources
Warren Fleet	Chief Counsel, Office of the Secretary
Mike French, P.E.	Director, Technology Assessment Division, Office of the Secretary
John Gilcrease	Geologist Supervisor, Office of Mineral Resources
James Mergist, P.E.	Petroleum Engineer, Office of Mineral Resources
Richard Rush	Mineral Pricing Specialist, Office of Mineral Resources

The members of the Task Force agreed that if any form of in-kind program had a chance to work, it would be an oil in-kind program because gas can be transported only when there is access to a suitable pipeline; whereas, oil can be transported by pipeline, ship, barge, rail, or truck, and oil can easily be stored on site. Additionally, there is a greater demand for oil in the state than there is domestic supply, as opposed to gas, which the state exports a surplus (due to Louisiana OCS production). There is also a greater opportunity to receive a premium over posted prices for oil, than there is pricing flexibility in the market place for natural gas. Hence, the Task Force was named the ROYALTY OIL TASK FORCE. The Task Force proceeded to set up a one year trial oil royalty take in-kind program.

The Task Force gathered information from across the country on government entities that have in-kind programs, and reviewed copies of lease forms, financial records, and other documents from the states of California and Texas, the City of Long Beach, California, and the Minerals Management Service. California received premiums of $0.25 to $3.56 per barrel above postings. Texas gained an average of $0.37 per barrel above posted prices, and a professional marketer with whom the Task Force met thought Louisiana could get a premium of $0.54 per barrel that he was averaging for his customers.

In a recent assessment of the Texas program, Spencer Reid, senior deputy commissioner of the Texas General Land Office, said that over the past 14 years, the Texas in-kind program has increased royalty revenue for the Permanent School Fund by over $11 million in gas royalty and $5.1 million in oil royalty, saved state agencies over $90 million in gas utility bills, and saved untold thousands of dollars for the General Land Office and for oil and gas producers by eliminating the need for financial accounting for royalty volumes of oil and gas taken in-kind.¹

Texas had the advantage of having large blocks of production under state lease, giving Texas considerable marketing power to offer buyers a significant volume of production from one geographical area. Texas found that the mere threat of potentially taking production in-kind led producers to pay premiums to continue purchasing the state's royalty share of their production.

Unlike Texas and California, though, Louisiana does not have large volumes of royalty production located in close proximity and with lease provisions that give the State the right to take royalty production in-kind. Excluding Texaco production, which was not considered by the Task Force due to the then ongoing lawsuit over Texaco royalty payments, the Task Force found only 3354 barrels per day of royalty oil suitable for the take in-kind trial. This production was from 10 leases held by 7 lessees from about 20 fields. Though these fields were not all adjacent, and some were separated by significant distances, these were the best candidates available in which the lease gave the State the right to take royalty production in-kind.

The total royalty volume of the above leases was less than desirable, and the leases were somewhat scattered geographically, so the Task Force decided to pursue discussions with lease holders whose leases did not give the State the right to take royalties in-kind. The Task Force met several times with Chevron and Shell in their offices and at DENR. Much was learned in these meetings, particularly the information and details discussed with Chevron about the logistics, mechanics, accounting, legal, and marketing aspects of taking royalty production in-kind. Both companies expressed interest in being permitted to bid on any oil the State might take in-kind and then later offer for sale. Neither company was willing to release any royalty production not required by the lease to be available for the State to take in-kind. Chevron and Shell were chosen because they both had significant production from State leases near the leases previously mentioned that gave the State the right to take royalties in-kind.

To further explore all of the possibilities, complexities, and ramifications of instituting a take in-kind program, the Royalty Accounting Committee of the Mineral Board conducted an Informational Hearing on Royalty Oil on October 11, 1989 and solicited written comments from industry on the issue as well. All of the oral and written materials were evaluated by the Task Force. After further study and discussions with Texas and California officials, the Task Force presented a proposal to the Mineral Board to conduct a trial program in which royalty production from selected State leases would be taken in-kind and then sold by competitive bid at a premium over prevailing posted prices. All transportation logistics would be the responsibility of the purchaser. This recommendation was presented to the Mineral Board, which approved it for implementation.

With further research, the Task Force had hoped to be able to provide at least 5000 barrels of oil per day available for the in-kind program, but it was not feasible without Texaco production. Therefore, a bid package was issued in January 1991 soliciting bids for 8 offerings, The individual offerings ranged from about 81 to 1215 barrels per day for a total of 2902 barrels per day. The bid specifications used a base price of the average of the prices posted by Amoco, Chevron, and Exxon for South Louisiana Sweet of like gravity and quality at the day of delivery and required the bidder to pay a premium above this price plus and administrative charge to cover the cost of the Office of Mineral Resources to administer the contract for one year.

Interest on the offered take in-kind leases was extremely disappointing. No bids were received for 6 of the 8 offerings. Arco bid on 2 offerings. One bid for 1215 barrels per day was rejected because there was no price advantage. Arco's other bid for 236 barrels per day from Amoco's State Lease No. 42 would initially have increased the State royalty by $0.65 per barrel, but the bid was rejected when Amoco revised their posting of the West Hackberry production to an amount equal their South Louisiana Sweet posting, which negated the price advantage of Arco's bid.

Recent Experience of Minerals Management Service

In the days of oil supply interruptions, the federal Minerals Management Service (MMS) developed procedures and regulations to sell federal in-kind royalty crude oil to small and independent refiners under the Emergency Petroleum Allocation Act. On several occasions, MMS has sold royalty oil under these arrangements. In 1995, though, MMS began experimenting with royalty in-kind programs to enhance revenue to the federal treasury. Under this experimental program, MMS sold 45.6 billion cubic feet of natural gas from leases in the Gulf of Mexico. The mechanics and logistics of the sale worked well, but MMS received $0.09 per million BTU less in royalties than if the gas royalties had been paid under the existing system based on fair market value.¹ MMS Director Cynthia Quarterman said with more study and under favorable conditions a royalty in-kind program could be revenue neutral or positive and administratively more efficient for MMS and industry.

Conclusion

Royalty take in-kind programs have shown mixed results by those who have tried them. Some programs have been great success stories, such as those in the states of Texas and California and the City of Long Beach, California. In these programs, the governments have received significantly higher royalty revenue and / or obtained lower cost fuel supplies under take in-kind porgrams. Texas has even shown that the administrative financial accounting burden can be significantly reduced. Some experiments such as the recent MMS pilot program were disappointing, and some attempts by some states have been total failures.

In essence, the idea of taking royalty production in-kind appears much simpler than it really is. With careful planning and procedures and the appropriate legal authority, programs can be set up to work smoothly and to increase revenue flows to the government entity. The successful programs tended to have one thing in common -- the managing government agency stayed out of the oil and gas marketing and transportation business by establishing procedures by which industry performed those functions for the government entity owning the royalties.

References

¹Producers ask Congress to allow them to pay royalties with in-kind method, The Energy Report. Pasha Publications: Arlington, VA.; August 4, 1997, pp.585-586.

Department of Energy and Natural Resources

Office of the Secretary

Technology Assessment Division

Internal Memorandum

August 26, 1997

To: Jack C. Caldwell, Secretary of Natural Resources

From: Mike French, Director, Technology Assessment Division

Subject: Overview You Requested of Past Initiatives on Taking Royalty Production In-kind