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Mineral Owners Getting Cheated by Feds

This column, which has been split into two parts for publication, will cover issues surrounding transportation deductions and provide legal justification for the elimination of these deductions. This section will examine an article from the Office of the Solicitor, highlighting the errors in justifying transportation deductions. The second section of the article, to be published tomorrow at 8:00 a.m. EST, will continue this discussion and explain illegal contract violations which have taken place and outline legal recourse for landowners.

As most mineral owners know, contracts between owners and mineral companies are often complicated, covering a wide array of factors to be negotiated and agreed upon. Everything from the quality of the minerals to the length of time that the mineral company has rights to develop the land is open for negotiation. It’s all too easy for those unfamiliar with legal terms, contract law, and oil valuation methods to become overwhelmed by the information and miss crucial details, especially when professional legal assistance is not utilized. One of the areas most commonly overlooked by mineral owners, yet discussed by industry and regulators, is the potential for deductions from royalties for transportation costs.

Before discussing transportation deductions, a brief explanation of the two methods of mineral valuation will help clarify when these deductions can be considered. Oil and gas can be sold at one of two places: at the wellhead or at market. In either of these locations, the company that extracted the minerals is selling them to a third party, then takes that amount and pays the mineral owner a royalty from the sale. Each of these options includes different factors to consider, with the first being the price at which the minerals will be bought and sold. Selling the minerals at market will generally earn the mineral company, and thereby the mineral owner, a larger amount, although the difference between the two can often be small.

The other substantial difference comes from incurring transportation costs. As one might expect, selling minerals at the wellhead does not require transportation of the minerals, but considers the value of the minerals where they are extracted. Conversely, selling minerals at market requires transportation of the minerals to a pipeline terminal or processing facility, which results in transportation costs. The difference in valuation can often outweigh the increased cost, incentivizing the mineral company to sell minerals at market more often than not. At this point, a problem occurs. 

Many mineral owners are having their royalties wrongly deducted to cover these transportation costs. From misuse and misunderstanding of regulations and statute surrounding transportation deductions, poor application of valuation methods, and even to blatant disregard of basic contract law, mineral owners are losing out. The Office of the Solicitor and Office of Natural Resource Revenue seem uninterested in righting these wrongs or, at times, appear to simply be on industry’s side. By examining the relevant case law, and setting aside those that are often cited but have no bearing on the issue, clarification of mineral valuation processes, and a basic understanding of contract law, many mineral owners may find that they are being wrongly deducted for transportation costs.

The first issue that should be addressed is the validity of the regulations allowing transportation deductions. Regulations cannot simply be created, but instead must stand on existing statute or law. The Mineral Leasing Act and the Federal Oil and Gas Royalty Management Act have both been cited by federal government officials, as well as in a brief article by the Office of the Solicitor in August of 2013, as the legal backing for the regulations in question, but a simple examination of the acts and case law cited by the Solicitor shows that this cannot be true.

The Solicitor's article begins by citing the Mineral Leasing Act and the Outer Continental Shelf Lands Act as establishing how royalties are assessed. The Mineral Leasing Act deals specifically with public lands owned by the federal government. Lands that are tribally owned or allotted are not public lands and are not owned by the federal government, though they may be held in trust. Since the Mineral Leasing Act does not apply to tribal or allotted lands, it cannot provide legal authority for regulations. The fact that tribally owned and allotted lands are not part of the Outer Continental Shelf, which is the land under certain parts of oceans, seems rather obvious.

The Federal Oil and Gas Royalty Management Act does discuss Indian lands specifically, though transportation deductions are another issue. Nowhere in the Federal Oil and Gas Royalty Management Act are transportation deductions mentioned. It’s difficult to say why these Acts are brought up. Other than the fact that royalties are based upon the production realized under a lease agreement, which no one objects to, they have nothing relevant to present to the issue of transportation deductions on allotted land leases. 

However, the Solicitor's article continues with a quote from a “sample Indian allotted oil and gas lease”:

“(c) Rental and royalty - To pay, beginning with the date of approval of the lease by the Secretary of the Interior, a rental of $ per acre per annum in advance during the continuance hereof, the rental so paid for any one year shall not be credited on the royalty that year, together with a royalty of % percent of the value or amount of all oil, gas, and/or natural gasoline, and/or all other hydrocarbon substances produced and saved from the land leased herein…”

While using this sample does illustrate the need for the average mineral owner to hire a legal professional in decoding what can often seem like deliberately confusing and labyrinthine language, it does not help us understand the issue of transportation deductions. It is used to explain that royalties are paid based upon the amount of minerals produced. Again, this is not a point of contention.

The article then cites the Kettleman Hills case, stating that it was upheld later on appeal in Continental Oil Co. v. United States. While that may be true, it does not apply to this issue. First, the Continental case only relates to leases and regulations that exist under the Mineral Leasing Act. From the Continental decision: 

“The United States of America brought an action against Continental Oil Company, a corporation, and General Petroleum Corporation…for a declaratory judgment of the Secretary of the Interior to place, for royalty purposes, minimum limitations upon valuations of oil and gas produced from public lands leased [emphasis added] by the defendants, and for other relief.” 

This is the very first sentence of the decision, and it’s troubling to see something that so clearly does not apply to Indian leases cited in such a way. As mentioned, allotted lands are not public lands, so this cannot provide legal authority for regulations. Additionally, it’s specifically stated in the Continental decision that transportation deductions weren’t allowed in this case because the mineral company was transporting the minerals farther than necessary to reach a market. 

The use of these cases becomes even more confusing when we look at a quote chosen to support the Solicitor's argument. From the Kettleman case:

“It has been held that if there is no open market in the place where an article ordinarily would be sold, the market value of such article in the nearest open market less cost of transportation to such market becomes the market value of the article in question…”

This makes perfect sense. But remember: the mineral leases in question are not offshore rigs or in far-removed, remote areas. These leases are near terminals. The mineral owners are being approached by mineral companies looking to develop. Therefore, there is a market at the wellhead. When dealing with leases on land, as opposed to offshore, it is quite common for a market area to overlap with the wellhead area. Since there is a market, companies are not required to transport minerals in order to sell them. For example, any minerals produced under the previously mentioned Outer Continental Shelf Lands Act must be transported because there is no market present in the ocean. The article then goes on to cite four more articles that support transportation deductions specifically in the absence of a market. The Solicitor's article openly states this fact.

Even though it is stated clearly in the Solicitor’s own citation that this deduction should only occur when the minerals must be transported because of a lack of a market at the wellhead, government officials continue to shrug their shoulders and claim that, “Well, this is how we’ve done it for years.” This is a clear example of regulation and the federal government favoring industry at the cost of the mineral owner. The decision as to where the minerals will be sold is entirely at the discretion of industry. Time and time again, industry and the government will state that what is good for industry is good for the mineral owner. After all, the owners are getting a higher royalty rate, too. While this may be true, statements such as this only serve to obfuscate the injustice of what’s actually happening.

Roger Birdbear has a degree in Petroleum Engineering Management and received his Juris Doctor from the Strum College of Law at the University of Denver. He currently practices law on and off the Fort Berthold Reservation in North Dakota. He can be reached through his website, RogerBirdbear.com