WRITTEN STATEMENT
OF
BOB ARMSTRONG
ASSISTANT SECRETARY, LAND AND MINERALS MANAGEMENT
U.S. DEPARTMENT OF THE INTERIOR
BEFORE THE
SUBCOMMITTEE ON ENERGY
RESEARCH, DEVELOPMENT,
PRODUCTION AND REGULATION
COMMITTEE ON ENERGY AND NATURAL RESOURCES
U.S. SENATE
REGARDING MMS' PROPOSED OIL VALUATION
RULE
June 11, 1998
Mr. Chairman, I am pleased to be here today to provide a status report on the Department of the Interior's (Department) efforts to revise regulations for valuing crude oil produced from Federal leases.
Two and one-half years ago, the Department embarked upon a modification of its Federal and Indian crude oil valuation regulations. This was necessary because changes in the crude oil market had evolved to the point where many royalty payments to the Federal Government, based on the regulations in effect, no longer were calculated on the market value of the production. These regulations, which were drafted in the mid-1980's and published in 1988, are still in effect today and are used by the industry to calculate royalty payments on Federal production.
The current regulations rely heavily on so-called "posted prices" for valuation. Because of this reliance, as I will present later, these regulations need to be revised to ensure that the American public receives a fair return on the mineral resources extracted from its lands. The warning signs of a crude oil undervaluation problem have surfaced from several individual sources -- interagency task force studies, significant royalty underpayments, numerous lawsuits across the country, and, finally, the attention this issue has received from Members of Congress and the press.
This is a serious problem that needs a cure quickly. Every day that royalties are allowed to be computed and paid under the current system, taxpayers are losing hundreds of thousands of dollars. It is imperative that the Department's new regulations be implemented and reflect the fair market value of Federal production. Federal lands and the oil that is produced from them belong to each and every American. In his statement on the 1998 Supplemental Appropriations and Rescissions Act, which prohibited our publishing a final rule until October 1, 1998, the President stated, "I am very concerned about the limitations placed on the Government's ability to ensure a fair return for oil and gas resources extracted from Federal lands. My Administration will oppose any efforts to make these limitations permanent."
Therefore, Mr. Chairman, consistent with this clear position of the President, legislation carrying a provision that will prohibit the Department from moving forward with the final rule on oil valuation would be unacceptable.
As I stated earlier, the Department's rule was not done overnight. In fact, it has evolved over several years. Beginning in December 1995, under my guidance, the Minerals Management Service began an extensive rulemaking effort to revise its regulations on valuing oil produced from Federal leases. We have gone to great lengths to work with our constituency in the rulemaking process. We have requested public comment in five separate Federal Register notices and have held 14 public meetings or workshops in five States and the District of Columbia to get input on this issue. In addition, we hired five consultants and talked to numerous other experts in the industry to obtain advice on this matter and have worked closely with the States of Louisiana, Wyoming, New Mexico, Colorado, and California. We asked for comments on whether the rulemaking should proceed under a negotiated rulemaking, but received a negative response from industry. We have also been mindful to keep Congress informed during this rulemaking, by providing numerous staff briefings over the past 2 ½ years.
I believe we have exerted an extraordinary effort to include our constituents in developing a rule that would reduce reliance on posted prices for royalty valuation, reflect true market value, provide certainty to all involved, simplify royalty valuation, reduce the need for audit, minimize royalty disputes, and provide maximum flexibility to adapt to changing market conditions, and assure that the taxpayers of this nation get a fair return for their oil and gas resources.
In this effort, we have acted within our full authority under applicable statutes and lease terms to develop and issue proposed regulations for valuing Federal oil. Section 32 of the Mineral Leasing Act of 1920 (MLA) 30 U.S.C. 189, authorizes the Secretary to prescribe rules and regulations that are necessary to carry out the requirements of the MLA relating to leasing of onshore Federal lands, including the provision that royalties "be not less than 12 ½ per centum in amount or value of the production removed or sold from the lease." The Outer Continental Shelf Lands Act of August 7, 1953, has similar provisions relating to the OCS at 43 U.S.C. 1334. Finally, most Federal oil leases provide that the Secretary shall establish the value of production.
In addressing this matter, it is important to understand the nature of posted prices and the problems posed by using this measure to ascertain market value for federal oil and gas. Posted prices are set by the marketing or refining arms of oil companies as an offer to buy crude oil. Posted prices are not an obligation to buy, but merely a reference point or starting point for negotiating a market price on the open market. Frequently, premiums are paid above posted prices in non-affiliated transactions. Based on our analyses of company transactions, we know that these premiums can range from $0.25 per barrel to $2.00 per barrel. However, when the producing arms of large integrated oil companies (the lessee) transfer oil in-house to their marketing or refining arms, they typically pay royalties on their posted price. In other words, some oil companies have been selling oil at one price and paying royalties on a lower price. This is unfair to the American taxpayer, and it violates the basic principle that royalty must be paid on no less than gross proceeds.
Investigations by an assortment of concerned parties have confirmed the inadequacy of posted prices as a basis for valuing production for royalty purposes. A number of States (e.g., Alaska, California, New Mexico, Texas, and Louisiana) have brought suit against several major oil companies primarily for basing royalties, severance taxes, and other payments on posted prices that are below market value, and have received settlements ranging from tens of millions to billions of dollars. At least seven class actions against the industry have been filed on behalf of private landowners over the past two years. One of these has been settled for several million dollars.
In February, the Department of Justice (DOJ) announced it would intervene in qui tam suits against four major oil companies accused of undervaluing oil production from Federal leases and, in May, DOJ added a fifth company to its investigation. In addition, the Department of the Interior, has issued bills for $257 million as a result of audits for the period 1980 - 1995 on undervaluation of crude oil royalty payments in California alone. We are currently auditing oil royalty payments on all other Federal lands.
This is what our proposal does with respect to arm's-length sales of crude oil. Our proposed rulemaking continues to accept the actual price paid under a contract as the best indicator of market value and as acceptable for royalty purposes. This is precisely the guidance we received from industry commenters early on. Further, we have twice modified our proposal to respond to comments that we should expand the use of arm's-length sales prices where actual sales occurred.
However, the situation becomes extremely complex when no actual sale occurs. This occurs in many ways, such as oil volume exchanges between oil producers and in-house transfers to marketing or refining arms. To address these valuation problems, our proposed rulemaking relies on publicly-available spot market "index" prices, to establish royalty value in those instances. These index prices are established in the open-market and have become widely accepted by industry as a pricing mechanism in crude oil contracts. Our audits show that these index prices are being referenced in many oil contracts. Index prices were developed as a direct result of demands in the marketplace to make information about the value of crude oil more publicly accessible. In the 1980's, there were changes in the crude oil market, and as a result, a futures market developed to deal with the volatility in crude oil prices. As in the international oil market, traders, resellers, and brokers began to take on an increasingly important role in the United States crude oil market. The trend in the domestic market was away from long-term contracts and toward the spot market as a means of buying and selling crude oil.
Based on advice we received from crude oil brokers, refiners, commercial price reporting services, companies that market oil directly, producer marketers, and private consultants knowledgeable in the crude oil market, our first proposed rule issued in January of 1997 proposed using the Alaska North Slope spot price for crude produced in California and Alaska and the New York Merchantile Exchange (NYMEX) for all other areas of the country. In response to comments from industry and States, our current proposed rule remains the same for California and Alaska, but relies on various geographic spot prices, rather than NYMEX, for all other areas of the country.
In general, index prices, adjusted for location and quality differentials, have the following distinct advantages over posted prices for valuing crude oil in those instances where no arm's length transaction exists:
One testament to the validity of index pricing is that several of the oil litigation cases mentioned earlier were settled using an index-based formula for future production.
As you know, the oil industry is opposed to our proposal. However, the rule would not affect the independent companies that sell oil at arm's-length. This group makes up about 95% of the producers who pay Federal royalties. Because about two-thirds of Federal oil is produced and refined by large, integrated companies, these companies would be affected by the revised regulations. We estimate that those affected companies would owe an additional $66 million dollars each year by using index instead of posted prices.
The States, on the other hand, support the use of index pricing and our proposed rule. In fact, the States of New Mexico, Wyoming, Alaska and Louisiana specifically commended our efforts to develop oil regulations that are fair to all parties in a difficult and litigious environment.
Finally, with the Committee's approval, I would like to submit for the record a copy of the report requested by the Subcommittees on Interior and Related Agencies, Committee on Appropriations. House Report 105-337 on the Department of the Interior and Related Agencies Appropriations, 1998, requested a report describing the Department's rulemaking efforts on valuing crude oil produced from Federal lands prior to finalizing the regulation. The Department was prepared to submit this report last month prior to finalizing its rule. However, before it could do so, the Supplemental Appropriations and Rescissions Act was signed on May 1, 1998. The accompanying report (House Report 105-504), requested additional information on the rulemaking process. Therefore, we redrafted the report to respond to the second request and submitted it to the Committees on June 3, 1998.
Mr. Chairman, our new oil valuation rule brings "value" certainty to the oil industry and more importantly, it is the right thing to do for the millions of Americans who own the Federal lands and associated oil resources. They are entitled to a fair return on their resources and our ability to finalize this rule quickly will guarantee that.
Mr. Chairman, that concludes my prepared remarks. I would be happy to entertain any questions that you or other Members of the Subcommittee may have.