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Continental Resources, Inc. v. Gould

United States District Court, District of Columbia

March 30, 2019

CONTINTENTAL RESOURCES, INC., Plaintiff,
v.
GREGORY J. GOULD, Director, Office of Natural Resources Revenue, United States Department of Interior, et al., Defendants.

          MEMORANDUM OPINION AND ORDER

          RANDOLPH D. MOSS UNITED STATES DISTRICT JUDGE

         Plaintiff Continental Resources, Inc. (“Continental”) extracts natural gas from federally leased land and pays royalties to the federal government based on the value of the gas that it sells. From 2003 to 2006, Continental reported and paid royalties to the Department of Interior's Minerals Management Service (“MMS”)-a predecessor to what is now the Office of Natural Resources Revenue (“ONRR”)-for leases in Washakie County, Wyoming based on Continental's assessment that it sold its unprocessed gas to an unaffiliated entity pursuant to an arm's-length agreement. Following an audit, MMS disagreed and found that both Continental and Hiland Partners, the entity that purchased Continental's gas, were owned or controlled by the same individual, Harold Hamm. MMS, accordingly, ordered that Continental pay additional royalties. Continental, in turn, appealed that decision to the Director of what by then had become ONRR, who agreed that Continental sold the gas at issue pursuant to a non-arm's-length contract but concluded that the audit letter applied the wrong benchmark for determining the value of a non-arm's-length sale. According to the Director, Continental should have valued its sale of its unprocessed gas under a provision of the governing regulation that values processed gas sold pursuant to a non-arm's length transaction based on:

consideration of other information relevant in valuing like-quality [processed gas], including gross proceeds under arm's length contracts for like-quality [processed gas] from the same gas plant or other nearby processing plants, posted prices for [processed gas], prices received in spot sales of [processed gas], [and] other reliable information as to the particular lease operation or the saleability of such [processed gas].

Dkt. 70-32 at 16 (quoting 30 C.F.R. § 206.153(c)(2)).[1] Under another subsection of the regulation, that value is then reduced by, among other things, the “applicable transportation allowances and processing allowances” to arrive at the “value of production for royalty purposes.” 30 C.F.R. § 206.153(a)(2); see also Dkt. 76 at 13 (Mar. 22, 2019 Hrg. Trans.).

         Continental challenges ONRR's determination on numerous grounds under the Administrative Procedure Act (“APA”), 5 U.S.C. § 701 et seq., the Mineral Leasing Act, 30 U.S.C. § 181 et seq., and the Due Process Clause, U.S. Const., amd. V, and the parties have now filed cross-motions for summary judgment. Dkt. 56, Dkt. 59. Because ONRR's determination is “plainly . . . inconsistent with the regulation, ” Bowles v. Seminole Rock & Sand Co., 325 U.S. 410, 414 (1945), and fails the APA test of “reasoned decisionmaking, ” Motor Vehicle Mfrs. Ass'n v. State Farm Mut. Auto Ins. Co., 463 U.S. 29, 52 (1983), the Court will set the determination aside and remand the matter to ONRR for further consideration consistent with this opinion.

         I. BACKGROUND

         Pursuant to the Federal Oil and Gas Royalty Management Act, 30 U.S.C. § 1701(a)(2), the Secretary of the Interior has promulgated a regulation “establishing methods for determining the ‘value of the production' for royalty calculation purposes.” Fina Oil & Chem. Co. v. Norton, 332 F.3d 672, 673 (D.C. Cir. 2003) (hereinafter “Fina”). “The regulation establishes three different valuation methodologies, depending on the particular entity to whom producers first sell the gas.” Id. at 673-74. Two provisions are relevant here: 30 C.F.R. § 206.152 (“Section 152”) and 30 C.F.R. § 206.153 (“Section 153”). Section 152 “applies to the valuation of all gas that is not processed and all gas that is processed but is sold or otherwise disposed of by the lessee pursuant to an arm's-length contract prior to processing, ” 30 C.F.R. § 206.152(a)(1), while Section 153 “applies to the valuation of all gas that is processed by the lessee and any other gas production to which” the regulation “applies and that is not subject to the valuation provisions of” Section 152, id. § 206.153(a)(1). Although the two provisions apply to different types of products, they use the same three valuation methods, as adjusted to account for the products at issue.

         The first methodology applies to gas sold to non-affiliated entities under arm's-length contracts. Unsurprisingly, this approach values the gas based on the “gross proceeds accruing to the lessee.” Id. § 152(b)(1)(i); id. § 153(b)(1)(i). The second methodology applies to gas sold to “marketing affiliates, ” a term that is narrowly defined to include only “entities that purchase gas exclusively from producers that own or control them.” Fina, 332 F.3d at 674. Under that methodology, the gas is valued based on the downstream sale by the marketing affiliate. Id. § 152(b)(1)(i); id. § 153(b)(1)(i). Finally, the third methodology values gas that is “not sold pursuant to an arm's-length contract, ” other than a sale to a “marketing affiliate, ” based on one of three benchmarks: (1) use of the lessee's gross proceeds, if those “proceeds are equivalent to the gross proceeds derived from, or paid under, comparable arm's-length contracts;” (2) use of “other information relevant to valuing like-quality [gas], including gross proceeds under arm's-length contracts for like-quality gas[, ] . . . posted prices[, ] . . . prices received in arm's-length spot sales[, ] . . . other reliable public sources of price or market information, and other information as to the particular lease operation or the saleability of” the gas; or (3) use of “a net-back method or any other reasonable method to determine value.” Id. § 152(c); id. § 153(c). Benchmarks (1) and (2), however, apply differently depending on whether the gas that is sold pursuant to the non-arm's-length contract is unprocessed or processed gas. In the case of unprocessed gas, the relevant comparators are contracts for the sale of unprocessed gas, id. § 152(c)(1) & (2), while in the case of processed gas-referred to in the regulation as “residue gas or gas plant products”-the relevant comparators are other sales of residue gas or gas plant products, id. § 153(c)(1) & (2).

         The present dispute involves valuation of natural gas that Continental extracted pursuant to a federal leasehold and sold between 2003 and 2006 to a natural gas processor, which ONRR variously refers to as Hiland, Hiland Partners, and Hiland Partners, LP. Although Continental challenges the ONRR decision, in part, on the ground that the agency misidentified, and misunderstood the relationships between, the various Hiland entities, that question is not relevant to the Court's decision. For present purpose, the Court will, therefore, simply refer to “Hiland.” In paying federal royalties, Continental treated its sales to Hiland as arm's-length transactions, and it, accordingly, applied the first methodology discussed above-that is, the gross-proceeds methodology.

         In 2010, however, MMS issued an audit letter concluding that Continental and Hiland were, in fact, affiliated entities and that, as a result, the transactions at issue were not arm's length. See Dkt. 70-32 at 7 (AR 4891). According to the audit letter, because Continental and Hiland were under common ownership or control, Continental erred in applying the gross-proceeds methodology under Section 152(a), and, instead, should have applied the valuation method set forth in Section 153(c)(1). Id. at 7-8 (AR 4891-92). That provision-the first benchmark for processed gas-values processed gas sold in a non-arm's-length transaction by looking to “[t]he gross proceeds accruing to the lessee pursuant to a sale under its non-arm's-length contract . . ., provided that those gross proceeds are equivalent to the gross proceeds derived from, or paid under, comparable arm's-length contracts for purchases, sales, or other dispositions of like quality residue gas or gas-plant products from the same processing plant.” 30 C.F.R. § 206.153(c)(1). MMS then calculated the corrected royalty rate using sales invoices provided by Hiland, not Continental. Dkt. 70-32 at 8 (AR 4892). MMS ultimately ordered Continental to report and pay $1, 772, 612.07 in additional royalties. Id.

         Continental timely appealed that decision to the Director of ONRR. The Director affirmed in part and reversed in part. First, the Director affirmed MMS's finding that Continental sold gas to an affiliated entity. The Director then explained that for Section 152 to apply, “one of two elements must be met: (1) the gas is not processed, or (2) the gas is processed, but is sold prior to processing under an arm's-length contract.” Id. at 13 (AR 4897). Although the Director did not address the first of these possibilities, the Court asked counsel to explain what it means to say that “the gas is not processed, ” and counsel represented that there are times that natural gas is sold and used without processing; that is, the gas is never processed. The Director did address the second possibility and, consistent with his conclusion that the sale from Continental to Hiland was not arm's length, he concluded that Section 152 “is not applicable here.” Id. at 14 (AR 4898). Because Section 153 applies to “gas that is processed by the lessee” and to “any other gas production . . . not subject to the valuation provisions” set forth in Section 152, and because he had concluded that Section 152 was inapposite, the Director turned to Section 153.

         Thus far, the Director's analysis tracked the audit letter's. The Director disagreed, however, with the audit letter's conclusion that the first benchmark was applicable. He explained that Section 153(c)(1) “allow[s] ONRR to use the gross proceeds accruing to the lessee where such gross proceeds are the equivalent to other gross proceeds derived from, or paid, under comparable arms-length contracts for processed gas from the same plant.” Dkt. 70-32 at 15 (AR 4899). Thus, “if Continental's gross proceeds-not Hiland['s] gross proceeds-are comparable to other arm's-length sales of the gas at the tailgate of the Hiland Plant, ONRR could value Contintental's gas by performing a comparative analysis of the arm's-length deals.” Id. But that comparison falls apart on the facts of the transactions at issue here. As the Director explained, “Continental's gross proceeds are those derived from Continental's sale of the unprocessed gas, ” and therefore “ONRR cannot compare Continental's non-arm's-length sales of unprocessed gas to other arm's-length sales of processed gas.” Id. (emphasis added). “In other words, ” he concluded, “there are no comparable sales.” Id. And, as a result, Section 153(c)(1) cannot apply.

         The Director concluded that, “[i]nstead, the proper benchmark in determining the value of the reside gas and gas plant products is [Section] 206.153(c)(2).” Id. at 16 (AR 4900). That benchmark uses a:

value determined by consideration of other information relevant in valuing like-quality residue gas or gas plant products, including gross proceeds under arm's-length contracts for like-quality residue gas or gas plant products from the same gas plant or other nearby processing plants, posted prices for residue gas or gas plant products, prices received in spot sales of residue gas or gas plant products, other reliable public sources of price or market information, ...

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