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INDEPENDENT PETROLEUM ASS'N OF AMER. v. ARMSTRONG

March 28, 2000

INDEPENDENT PETROLEUM ASSOCIATION OF AMERICA, PLAINTIFF,
V.
ROBERT L. ARMSTRONG, ET AL., DEFENDANT. AMERICAN PETROLEUM INSTITUTE, PLAINTIFF, V. BRUCE BABBITT, ET AL., DEFENDANTS.



The opinion of the court was delivered by: Lamberth, District Judge.

MEMORANDUM OPINION

Plaintiffs, two gas industry trade associations whose members hold federal and Indian gas leases, challenge as arbitrary, capricious and not in accordance with law amended Department of the Interior ("Interior") regulations ("Rule") that impose royalties on costs incurred when lessees sell gas in downstream markets. Plaintiffs contend that the royalty obligations imposed by the Rule exceed Interior's statutory authority under the applicable statutes and have no basis in prior regulations or the gas leases themselves. Additionally, plaintiffs advance that the new Rule draws arbitrary distinctions between similar costs and impairs the obligations of leases executed prior to the enactment of the amendments. Defendants cross-move for summary judgment, asserting that the Rule was properly enacted after notice and comment and constitutes a reasonable interpretation of the regulations that Interior administers and the implied covenant of the gas leases. Upon consideration of the parties' cross-motions for summary judgment, the oppositions thereto, the record, oral argument, the applicable law, and for the reasons set forth below, the court GRANTS plaintiffs' motions for summary judgment and DENIES defendants' motion for summary judgment.

I. BACKGROUND

A. The Natural Gas Industry and Royalties on Federal and Indian Leases

The American Petroleum Institute ("API") is a nationwide trade association representing over 400 corporate members engaged in all aspects of petroleum exploration, production, refining, distribution, and marketing. API members hold oil and gas leases on federal and Indian lands. The Independent Petroleum Association of America ("IPAA") is a trade association representing more than 5,500 producers of oil and natural gas within the United States. Many IPAA members also hold leases on federal or Indian lands.

The present controversy grows out of the re-structuring of the gas pipeline industry brought about by Federal Energy Regulatory Commission Order No. 636. Pipeline Service Obligations and Revisions to Regulations Governing Self-Implementing Transportation; and Regulation of Natural Gas Pipelines After Partial Statutes and Regulations, Order No. 636, 57 Fed. Reg. 13267 (April 16, 1992), FERC STATUTES AND REGULATIONS (CCH) ¶ 30, 950 (August 3, 1992); order on reh'g, Order No. 636-B, 57 Fed. Reg. 57911 (December 8, 1992), 61 F.E.R.C. (CCH) 61,272 (November 27, 1992). Accordingly, to appreciate the instant dispute, it is necessary to highlight lessees' obligations as they existed prior to the amended Rule and FERC Order 636.

In the pre-FERC 636 gas market, lessees sold gas to pipelines at or near the lease. Thus, the essential bargain embodied in federal and Indian leases entitled the lessor to a royalty based upon the value of production at the lease when the lessee produced gas from the leased premises. Consistent with this practice of selling gas at the lease, royalties on federal gas leases were typically "calculated at values at the wells, not at the pipe line destination. . . ." Continental Oil Co. v. United States, 184 F.2d 802, 820 (9th Cir. 1950). The basic rule on royalties, known as the "gross proceeds rule," provides that "under no circumstances shall the value of production for royalty purposes be less than the gross proceeds accruing to the lessee for the lease production." 30 C.F.R. § 206.152.(h) (1995). Gross proceeds are "the total monies and other consideration accruing to an oil and gas lessee for the disposition of [gas]," minus allowances or deductions. 30 C.F.R. § 206.151 (1995).

Under the pre-existing regulations and the leases, lessees also have an express duty to place gas in marketable condition, which means that production costs are borne solely by the lessee. The marketable condition rule requires lessees to produce "lease products which are sufficiently free from impurities and otherwise in a condition that they will be accepted by a purchaser under a sales contract typical for the field or area." 30 C.F.R. § 206.151 (1997).

Prior to FERC Order 636, producers generally did not need to incur transportation costs to locate a market for the gas, as pipelines were the primary purchasers. Accordingly, allowances for transportation costs were largely irrelevant. But when a lessee did transport gas, the lessee was required to pay a pipeline rate or tariff to transport the gas and Interior permitted the lessee to deduct the entire rate or tariff from the value it received downstream from the lease.

A producer likely sells gas away from the wellhead because it can demand a higher price in that market. Moving gas away from the wellhead to downstream markets, however, entails costs that are not incurred when gas is marketed at the lease. Thus, from an economic standpoint, the higher sale prices obtained in a downstream market are, in part, a reflection of the costs and risks involved. For example, a lessee transporting gas to a market downstream of the well will typically need to pay for the aggregation or storage of gas produced by multiple leases, in addition to the cost of getting the gas to the hub or sales point. Other fees involve the necessary costs of intermediaries such as market hub operators or for the management of market or environmental risks, or for scheduling delivery.

In the pre-FERC Order 636 gas market, all costs associated with moving gas to downstream markets were treated collectively as transportation costs and, hence, were deductible from royalty value when the point of sale was downstream from the lease. That is, when downstream sales occurred, MMS would collect a royalty based on the enhanced value of production obtained in the downstream sale. Yet at the same time, MMS shared in the costs incurred by the lessee to transport the gas to the downstream market by tracing the value of production back to the lease or wellhead by deducting those costs associated with moving the gas downstream. Thus, while reaping the benefits of a higher value downstream sale through a higher royalty, MMS did not simply free-ride on the lessees' efforts to obtain value for the gas.

FERC Order 636 was designed to increase competition in the gas sales market by the mandatory unbundling of pipeline sales services. To that end, Order 636's unbundling mandate was directed at gas sales by pipelines, not producers, in order to facilitate gas purchases by suppliers other than the pipelines. It was thought that this unbundling would enable the development of more competitive markets for gas at the wellhead and downstream. FERC determined that without Order 636's unbundling, interstate pipelines would retain a substantial market advantage over alternative suppliers because pipelines included firm transportation service in their sales price and this more desirable capacity was reserved exclusively for pipelines' own sales customers. Firm transportation capacity was, therefore, unavailable to accommodate transactions between purchasers and alternative suppliers, and such sales were relegated to spot sales using interruptible transportation. In short, pipelines' bundling of sales and transportation precluded alternative suppliers from competing effectively in the premium firm, long-term sales market because such suppliers were unable to offer transportation service on par with that offered by pipelines.

To correct this market imbalance, Order 636 required pipelines to convert their existing bundled sales contracts into contracts for an equivalent amount of firm transportation service. Under this arrangement, pipelines could sell gas at market-based rates, but these sales would now have to compete on equal footing with the sales of non-pipeline suppliers. Accordingly, even though FERC Order 636 had a substantial effect on the identity of gas purchasers from federal and Indian leases, it did not alter the fundamentals of gas sales transactions by gas producers, and thus, did not directly alter their obligations under federal and Indian gas leases.

B. The Instant Controversy

Four years after FERC issued Order 636, Interior decided to amend its regulations on gas royalties, purportedly as a response to the demands of the changed gas market. Accordingly, on July 31, 1996, the MMS issued a Notice of Proposed Rulemaking ("NOPR"). Amendments to Transportation Allowance Regulations for Federal and Indian Leases to Specify Allowable Costs and Related Amendments for Gas Valuation Regulations, 61 Fed. Reg. 39931 (July 31, 1996). Through this informal rulemaking, the MMS proposed to amend its regulations governing valuation for royalty purposes of gas produced from federal and Indian lands. The MMS stated that it was revising its regulations as a result of FERC Order No. 636, which required, inter alia, interstate gas pipelines to separate, or unbundle their sales services from their transportation services. Thus, the NOPR was billed as a "clarification," which would "provide specific guidance to lessees and royalty payors" as to which transportation cost components were deductible for purposes of royalty valuation in the wake of FERC Order 636. NOPR, 61 Fed. Reg. 39,932. Specifically, MMS asserted that the unbundling achieved by FERC Order 636 now enabled MMS to isolate specific components of transportation costs that previously were not identifiable.

In addition to "clarifying" which cost allowances would be permitted after FERC Order 636, the NOPR also proposed to amend the product valuation regulations for natural gas to provide that federal lessees

must place gas in marketable condition and market the gas for the mutual benefit of the lessee and the lessor at no cost to the Federal Government unless the lease agreement states otherwise. Where the value established under this section is determined by a lessee's gross proceeds, that value shall be increased to the extent that the gross proceeds have been reduced because the purchaser, or any other person, is providing certain services the costs of ...

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