The opinion of the court was delivered by: Joyce Hens Green, United States District Judge.
MEMORANDUM OPINION AND ORDER
Plaintiff, EEX Corporation ("EEX"), commenced this action
seeking declaratory and injunctive relief against defendants,
United States Department of the Interior ("DOI" or "Interior"),
Bruce Babbitt, Secretary of the Interior, and Sylvia V. Baca,
Acting Assistant Secretary ("Assistant Secretary"), Department of
Interior Land and Minerals Management Service ("MMS"). EEX
challenges the Assistant Secretary's decision which affirmed in
part and reversed in part two MMS orders requiring EEX to
calculate and pay royalties on certain gas contract settlement
proceeds. EEX claims the Assistant Secretary's decision was
arbitrary and capricious in light of the Court of Appeals'
decision in Independent Petroleum Association of America v.
Babbitt, 92 F.3d 1248 (D.C. Cir. 1996), reh'g denied ("IPAA").
The defendants claim the Assistant Secretary's decision "properly
reconciles" IPAA with other judicial authorities "and with
Interior's statutory obligation to collect royalties on the
production of gas from public lands." Cross Mot. For Summ J. at
The material facts in this case are undisputed. Interior,
through MMS, issues and administers leases for offshore gas and
oil production under the Outer Continental Shelf Lands Act,
43 U.S.C. § 1331, et seq. ("OCSLA").*fn2 Lessees under the OCSLA
must pay royalties to the federal government calculated as a
percentage of the "amount or value of the production saved,
removed, or sold" by the lessee. See 43 U.S.C. § 1337(a)(1)(A).
EEX was a lessee under the OCSLA during the period at issue.*fn3
In or about 1969, EEX entered into numerous twenty-year term
contracts with Natural Gas Pipeline Company of America ("NGPL"),
to sell gas covered by EEX's various leases, including six
federal OCSLA leases, to NGPL. NGPL is a "pipeline-purchaser in
the business of buying and transporting gas in interstate
commerce for resale to local distribution companies." Mot. For
Summ J. at 2. The contracts in question provided that NGPL was
the exclusive purchaser of gas produced by EEX.*fn4 The
contracts contained "take-or-pay" provisions that required NGPL
to either purchase the minimum amount of gas for each given
period, or to pay for the minimum amount even if it did not take
the gas. However, if NGPL made a payment for gas it did not take,
it could subsequently apply that payment to gas taken in excess
of the contract minimum for up to five years after the payment
was made. This excess gas is called make-up gas. If NGPL did
not take the make-up gas within the five-year time period,
EEX kept the take-or-pay payment even though no gas was
ultimately taken. In return for the take-or-pay provision, EEX
agreed to dedicate its entire gas reserves to NGPL. These
take-or-pay provisions were fairly common in the industry at the
time EEX and NGPL contracted for them. See Diamond Shamrock v.
Hodel, 853 F.2d 1159, 1164 (5th Cir. 1988) ("Natural gas sale
contracts usually contain a standard "take-or-pay" clause.").
A. Diamond Shamrock and the Regulatory Background
In Diamond Shamrock v. Hodel, 853 F.2d 1159 (5th Cir. 1988),
the Fifth Circuit addressed the issue of how and whether royalties
should be assessed on take-or-pay contract payments (not
settlement payments). The OSCLA requires that gas leases contain
a provision requiring royalties to be paid as a percentage of the
"amount or value of the production saved, removed, or sold" by
the lessee-producer. 43 U.S.C. § 1337(a)(1)(A), (C), & (G). MMS'
general rule on royalties, known as the "gross proceeds" rule,
states that "under no circumstances shall the value of production
for royalty purposes be less than the gross proceeds accruing to
the lessee for lease production, less applicable transportation
allowances and processing allowances." 30 C.F.R. 206.152(h).
Before Diamond Shamrock was decided, MMS had assessed royalties
on take-or-pay payments at the time the lessee-producer received
the payment from the pipeline-purchaser, and not when the
pipeline-purchaser took the make-up gas. Interior had reasoned
that the take-or-pay payments, regardless of whether they had
been recouped through make-up gas, were part of the "value of
production" upon which royalties were assessed.
The Fifth Circuit disagreed, holding that take-or-pay payments
cannot be considered payments for the sale of gas unless the gas
is actually severed from the ground. This severance does not
occur unless and until the pipeline-purchaser takes make-up
gas.*fn6 The Court reasoned,
[i]n the context of the gas purchase contract and
industry practice, the take-or-pay payment is not
intended to be a payment for gas and is not a part
of the price of gas until it is applied at the time
of sale. The value to the producer of take-or-pay
payments forfeited by the purchaser is therefore
not treated as part of the price of gas purchased
currently. If the gas is made up, there has of
course been a first sale and the applicable ceiling
price is that in the month of delivery. We find no
basis whatever to conclude that earnings which
producers may realize on take-or-pay payments,
whether measured by interest actually earned or by
value, are part of the price paid for gas.
Interior subsequently adopted the Diamond Shamrock decision and
MMS amended its gross proceeds rule by limiting royalties only to
those take-or-pay payments that are recouped through make-up gas.
See 53 Fed. Reg. 45082, 45083 (Nov. 8, 1988) ("The Fifth
Circuit's ruling [in Diamond Shamrock] therefore requires that
MMS amend its regulations to remove the requirement to pay
royalties on take-or-pay payments at the time the payment is
made. Of course, royalties still are due when make-up gas is
In IPAA, Samedan Oil Corp. ("Samedan"), a producer-lessee,
entered into a settlement to resolve outstanding take-or-pay
obligations with the purchaser-pipeline, Southern Natural Gas
Company ("Southern"). The settlement provided for Southern to
make a lump sum payment of $100,000 to Samedan in exchange for
Samedan's release of Southern from the gas purchase
contract.*fn7 Most of the $100,000 payment was allocated as
compensation to Samedan to terminate the contract and alleviate
Southern from its remaining purchase obligations. A smaller
portion of the payment was allocated as compensation for
take-or-pay obligations that had accrued under the contract but
had not been paid by Southern. Samedan then sold the gas that
would have been sold to Southern under the now terminated
contract to other purchasers. MMS ordered Samedan to pay
royalties on both the portion of the settlement allocated to
unpaid take-or-pay liability, as well as the portion allocated
for termination of future contract obligations. MMS took the
position that the entire settlement payment compensated Sameden
for the lower price it would be forced to take for gas that would
have been sold under the higher priced Southern contract.
According to MMS, "[t]he compromise payment therefore properly is
regarded as a payment in anticipation of a lower price to be
received by the lessee if and to the extent that the lessee later
produces the volumes to which a take-or-pay payment would have
been applied." IPAA, 92 F.3d at 1255.
Throughout the IPAA litigation, Interior argued that if a lump
sum settlement payment is allocated toward gas that is ultimately
produced (i.e., the contract gas is severed from the ground and
sold after the contract has been extinguished), then that portion
of the settlement payment is subject to royalties at the time of
production regardless of whether the subsequent purchaser is the
original party under the contract or a third party, because the
benefit to the lessee is the same in either case. Id. at 1253.
The IPAA court rejected Interior's interpretation and, instead of
focusing on whether the gas was subsequently produced, looked ...