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August 23, 2000


The opinion of the court was delivered by: Joyce Hens Green, United States District Judge.


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 8.

Presently pending before the Court are plaintiff's motion for summary judgment and defendants' cross motion for summary judgment. For the reasons stated below, plaintiff's motion is granted and defendants' motion is denied.*fn1

I. Factual Background

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.").

II. Legal Background

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 taken.").


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 ...

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