PASO Federal/Indian Royalty Compliance Workshop February 11-12, 2015 Federal Royalty Unbundling Information Presented by: Doug Ginley and Linda Shishido-Sheahan PASO Federal/Indian Royalty Compliance Workshop February 11-12, 2015 Industry Compliance Accurate Revenues & Data Professionalism & Integrity

In This Presentation ONRR’s Unbundling Program The “basics” of Unbundling ONRR’s Engineering Solution ONRR’s Unbundling Strategy Answers to industry questions

Unbundling is Important to ONRR! ONRR has received special funding for an unbundling program. ONRR’s funding includes: 18 FTE for the program Purchase of Industry Accepted Engineering Software ONRR is working on the unbundling of over 35 gas plants and transportation systems ONRR has already published Unbundling Cost Allocations (UCAs) for 17 gas plants/transportation systems. UCAs may be found at http://www.onrr.gov/unbundling/default.htm

Unbundling is Important to ONRR! ONRR continues to present information on the Unbundling process to a wide array of companies and industry groups ONRR is implementing a new streamlined process for compliance activities ONRR is coordinating its new unbundling strategy with State and Tribal audit programs

What is Unbundling? Unbundling = the process of taking a gas transportation and/or processing fees, in an ARM’S-LENGTH situation, and determining the allowed and disallowed costs for Royalty Reporting and Payment. Includes: Determining marketable condition Separating the Transportation Fees from Processing Fees Applying the appropriate Unbundling Cost Allocations (UCAs)* to the fees you are charged for transportation, gathering, compression, dehydration, treatment, and processing *Note: A UCA is the percent of a fee that is allowable (there will likely be a different percentage for Transportation and Processing)

Unbundling Program Status Update Updates to the Website UCAs Examples More Guidance Information Compliance Reviews and Audits Requests for Data Responding to Requests for Information

Unbundling Efforts as a Percent of Gas Volume

How do we decide which plants to look at? Gas Plant Prioritization How do we decide which plants to look at? Cover 80% of production volumes* Variety of locations to represent gas industry Diverse set of owners/operators Leverage available data Subject to change dependent on ONRR’s ability to collect sufficient data for analysis *Based on FY 2013 data

2014 U.S. Dist. LEXIS 100900, *20 (N.D. Okla. July 24, 2014) Burlington Decision (Burlington Res. Oil & Gas Co. Lp v. United States DOI, No. 13-CV-0678-CVE-TLW, 2014 U.S. Dist. LEXIS 100900, *20 (N.D. Okla. July 24, 2014)  What the Burlington Decision means: You must show any costs you deduct were incurred only to transport and process the gas and were not necessary to place your gas in marketable condition (i.e. Unbundling) Lessees have the burden of establishing that gas is in marketable condition and where that occurs The marketable condition rule applies to POP contracts

What Does ONRR Expect of Industry? Properly Report and Pay Royalties Correctly calculate transportation and processing allowances – this means UNBUNDLING Calculate your own UCAs using a reasonable method Alternative 1 – Use ONRR UCAs if available Alternative 2 – Take no allowance

Reasonable Unbundling Effort? What Counts as a Reasonable Unbundling Effort? A reasonable effort includes providing ONRR with: The applicable transportation systems and processing plants Specific marketable condition requirements Inlet/outlet conditions for major equipment including (but not limited to) compression, dehydration, CO2 removal, and H2S removal Allowed and disallowed fee portions through a clearly explained methodology of unbundling (see ONRR Unbundling website for examples) Supporting documentation 11

The Unbundling Process START Identify Gas Plant and Transportation Systems Determine Marketable Condition Collect the Data Identify Data Needs Calculate the Unbundling Cost Allocations (UCAs) Apply the Unbundling Cost Allocations (UCAs) 12 END Report and Pay Royalties Correctly

More Information on the Unbundling Process

The Unbundling Process (a quick look) START Identify Gas Plant and Transportation Systems Determine Marketable Condition Collect the Data Identify Data Needs Calculate the Unbundling Cost Allocations (UCAs) Apply the Unbundling Cost Allocations (UCAs) 14 END Report and Pay Royalties Correctly

An Example of Unbundling Determine Allowed/Disallowed Equipment Use physical properties to determine Allowed/Disallowed Equipment Marketable Condition 800 PSIA 7 # H2O 2% CO2 100 PSIA 20 # H2O 8% CO2 400 PSIA 20 # H2O 8% CO2 400 PSIA 10 # H2O 8% CO2 900 PSIA 10 # H2O 8% CO2 X X X 8/9 C1 D C2 TO MAINLINE CDP GAS PLANT TRANSPORTATION WELLS CDP = Central Delivery Point PROCESSING C = Compressor D = Dehydrator

An Example of Unbundling Determine Allowed/Disallowed Equipment Use physical properties to determine Allowed/Disallowed Equipment 300 PSIA Bone Dry 2% CO2 Wet Gas 700 PSIA 10 # H2O 2% CO2 800 PSIA Bone Dry 2% CO2 400 PSIA 10 # H2O 8% CO2 CO2 Residue Gas X C4 900 PSIA 10 # H2O 8% CO2 Allowed C3 X AMINE Treating Allowed To Main Line Cryo Unit Dry Gas 800 PSIA 7 # H2O 2% CO2 Oil Liquids NGLs X 3/10 800 PSIA 10 # H2O 8% CO2 Dehydration 600 PSIA Bone Dry 2% CO2 Plant Boundary Water

Calculate Unbundling Cost Allocations (UCAs) Transportation System Processing Plant Equipment Cost (millions of dollars) Allowed Cost Compressor 3 5 Amine Treating 2 Dehydration 1 0.7* Cryo Unit 10 Compressor 4 Piping and other allowed equipment 35 Total 58 50.7 Equipment Cost (millions of dollars) Allowed Cost Compressor 1 15 Dehydrator 3 Compressor 2 1.67* Pipeline 50 Total 83 51.67 * = (1-8/9)*15 Transportation UCA = 51.67/83 = 62% * = (1-3/10)*1 Processing UCA = 50.7/58 = 87% Separating Transportation from Processing: Transportation percent = $83M/($83M+$58M) = 59% Processing Percent = 100% - 59% = 41%

Calculating Allowed Transportation and Processing Assume your bundled fee is $1.00/MMBtu Allowed Transportation Fee Transportation portion of bundled fee = 59% Transportation fee = $1.00 * 0.59 = $0.59/MMBtu Transportation UCA = 62% Allowed Transportation fee = $0.59 * 0.62 = $0.37/MMBtu Allowed Processing Fee Processing portion of bundled fee = 41% Processing fee = $1.00 * 0.41 = $0.41/MMBtu Processing UCA = 87% Allowed Processing fee = $0.41 * 0.87 = $0.36/MMBtu

The Unbundling Process But what if you don’t have the cost data?

ONRR’s Engineering Solution ONRR is implementing an Engineering Solution that uses: Industry-accepted engineering practices and data Sophisticated, “Industry Standard” computer modeling tools Replacement costs, adjusted for location, updated annually

ONRR’s Engineering Solution You too can use an Engineering Solution! An Engineering Solution has minimal data needs: Process flow diagrams Gas throughput Gas composition Inlet and outlet conditions for major process components

ONRR’s Engineering Solution Engineering Drawings Aspentech Software Suite Equipment Specifications Hypothetical Gas Plant Gas Specifications Replacement Cost Data Engineering Principles Unbundling Cost Allocations (UCAs)

UCA Comparison Aspen to Reasonable Actual Cost Comparison: UCAs for allowed cost: Aspen UCA Actual Cost UCA Difference T 60.5% 64.9% 4.4% T 70.6% 73.9% 3.3% P 28.4% 27.8% 0.6% Note: Work is underway to verify Aspen model results with multiple transportation systems and gas plants.

ONRR’s Unbundling Strategy Publish UCAs for high priority gas plants and transportation systems Respond to industry inquiries Perform limited scope compliance reviews (transportation and processing allowances) Perform Transportation and Processing Audits – Review reasonable actual costs

FY 2015 Unbundling Work * OG = Offshore Gulf

FY 2015 Unbundling Work * OG = Offshore Gulf

Limited Scope Compliance Reviews If you are claiming a bundled fee that includes costs to place gas into Marketable Condition, you must: Unbundle – submit methodology & documentation to the Unbundling Mailbox/Analyst* Correct and pay on all properties flowing to that plant for all sales months where you took a bundled fee * Unbundled Fees may be subject to review and audit

Limited Scope Compliance Reviews As an Alternative Method: Use published UCAs if available where you must correct and pay: Per the invoice for all sample months On all properties flowing to that plant for all non-sample sales months where you took a bundled fee* * Unbundled Fees may be subject to review and audit

Limited Scope Compliance Reviews Take no allowance where you must correct and pay: For sales months during the review period On all properties flowing to that plant for all sales months prior to, and after the review period, where you took a bundled fee

Resolution Process If not resolved at the Issue Letter stage, ONRR will issue an Order You must comply with the Order or Appeal You must file a Notice of Appeal and a statement of reasons or written arguments justifying a reversal or modification of the Order within 30 days of receiving the Order You cannot extend the time allowed for filing the Notice of Appeal

Transportation and Processing Audits Perform Transportation and Processing Audits to review reasonable actual cost (Non-Arm’s-Length) Verify allowed processing rate per unit cost Verify allowed transportation rate per unit cost Calculate UCAs based upon reasonable actual cost and use these UCAs to validate ONRR’s engineering solution

The ONRR Unbundling website is at: http://www.onrr.gov/unbundling/default.htm 32

Communicating with the Unbundling Team For questions, requests, and submitting methodologies/documentation regarding unbundling, email: onrrunbundling@onrr.gov

Communicating with the Unbundling Team Contact Information Doug Ginley 303-231-3845 Douglas.ginley@onrr.gov Linda Shishido-Sheahan 303-231-3820 Linda.shishido-sheahan@onrr.gov

Industry Questions Has ONRR accepted any alternative unbundling methodologies? Some are in the review process now. With ONRR’s compliance strategy, we anticipate more alternative methods from industry Would ONRR consider a “virtual” plant typical for an area in lieu of unbundling actual plants?  Provided you can demonstrate why this approach is reasonable, we would consider it

Industry Questions Who can use the ONRR posted UCA’s ? Arm’s-Length producers In ONRR’s “How to calculate a Transportation UCA”, why is the denominator for the allocation of compression the discharge pressure of the compressor?  This is a continuation of ONRR’s Marketable Condition policy Shouldn’t the pressure drop from one compressor to the inlet of the next compressor be identified as allowable transportation costs?  Not under the current ONRR Marketable Condition policy

Industry Questions If the lessee is paying for the cost of boosting the residue, why do ONRR examples also require the lessee to pay for the compression up to mainline pipeline specs prior to it being processed?    Lessee must place gas in marketable condition (30 C.F.R. § 1206.152(i) (federal gas), § 1206.174(h) (Indian gas)) The fact that a marketable condition cost also may be part of processing does not make it a deductible processing cost Shoshone & Arapaho Tribes v. Hodel, 903 F.3d 784 (10th Cir. 1990) Lessees may not deduct the costs for boosting residue gas, i.e., compression of the methane, at a gas processing plant. 30 C.F.R. § 1202.151(b) (federal gas)(Devon)

Industry Questions Are the costs of the booster compressor to be allocated to the gas used for “reflux” (typically 20-35%) and residue sales volumes, with the portion of costs applicable to the “reflux” taken as part of the processing allowance? Lessees may not deduct the costs for boosting residue gas, i.e., compression of the methane, at a gas processing plant. 30 C.F.R. § 1202.151(b) (federal gas)(Devon)

Industry Questions Should not all the pre-plant compression and related fuels be deductible for the NGL portion of the gas stream or have a different UCA rate than the residue gas? No, the entire gas stream is being compressed What meters are allowed and which ones are not, and why are they not an allowable deduction? Per case law: The 1998 Williams Production Company case (signed by the Acting Deputy Commissioner of Indian Affairs) follows the Handbook and allows the deduction of meters within processing plants

Industry Questions Are low or minimum volume fees an allowable deduction?  We do not participate in pipeline penalties. (30 C.F.R. § 1206.157(g)(3)) Has ONRR decided to unbundle fractionation plants? This question is currently under review

QUESTIONS Industry Compliance Accurate Revenues & Data Professionalism & Integrity