Updates on The Marketable Condition Rule and its application

Updates on The Marketable Condition Rule and its application
PASO Federal/Indian Royalty Compliance Workshop Presented February 9, 2017 by: Bonnie Robson: ONRR Program Manager, Appeals & Regulation Carrie Wallace: Attorney/Advisor RMR Office of the Solicitor L. Poe Leggette and Rosario C. Doriott Domínguez (BakerHostetler) Tim Engel and Erich Almonte (King & Spalding)

Learning Objectives Upon completion of this course, attendees will be aware of: Historical oil and gas marketable condition principles established by case law. Recent marketable condition cases decided or soon to be decided by the Department of the Interior’s Board of Land Appeals (IBLA). Industry and ONRR’s method for determining what compressor costs are allowable, and what compressor costs are not, when reporting and paying gas royalties. Industry and ONRR’s method for allocating the costs of a partially allowable compressor when the lessee provides inlet pressure, and when the lessee does not. Industry and ONRR’s position on allowing some or all of the costs of a booster compressor.

background Brief review of the marketable condition rule and applicable regulations Review and analysis of recent rulings from the Interior Board of Land Appeals and federal courts involving application of the marketable condition rule and/or unbundling

Industry QUESTION #1 ONRR’s unbundling methodology for calculating UCAs uses the “discharge pressure” rather than the “pressure differential” in the denominator in determining the allowable portion of such a compressor. How is that formula “reasonable” or even mathematically correct? Were the ONRR-published UCAs calculated using the ONRR’s unbundling methodology (i.e., using the “discharge pressure” rather than the “pressure differential” in the denominator)? Will the ONRR be refunding lessee overpayments based on this mathematical error?

Industry QUESTION #2 The regulations show residue boosting can be an allowable deduction under certain circumstances (30 CFR (b) states that boosting is not allowed “except as provided in part 1206”). What are some of those exceptions and has any portion of a residue compressor been allowed in ONRR’s published UCAs?

Industry question #3 Does “the marketable condition rule” require a lessee to first fully and completely compress and/or dehydrate the gas to meet the requirements of the pipelines that serve its purchasers before any supplemental compression or dehydration is allowed, or can “marketable condition” be reached in segments? Did ONRR require marketable condition to be reached “first” when creating all its Unbundling Cost Allocations (UCAs)? In the Devon Energy Corp Valuation Determination, upheld in Devon v. Kempthorne in 2008, the agency stated “where – and in how many phases or steps a lessee chooses to compress the gas to the necessary pressure is up to the lessee.” Do ONNR’s UCAs and agency-issued guidance documents on the “marketable condition rule” follow the holding in Devon and permit the lessee to place the gas in “marketable condition” in segments of the lessees choosing?

The Marketable Condition Rule and Recent Rulings
Presented by: Carrie Wallace: Attorney/Advisor RMR Office of the Solicitor Erich Almonte (King & Spalding)

Disclaimer The statements or opinions Bonnie Robson and Carrie Wallace express in this presentation and in panel discussions at the PASO 2017 Conference do not necessarily represent the views of ONRR, the Solicitor’s Office, or the Department of the Interior. 8

Marketable Condition – The Regulations
The lessee must place gas in marketable condition at no cost to the Federal Government. 30 C.F.R. § (i) (federal gas), § (h) (Indian gas). If a lessee sells “unmarketable” gas at a lower cost, the lessee must increase the gross proceeds for purposes of royalty calculation “to the extent that the gross proceeds have been reduced because the purchaser, or any other person, is providing certain services” to place the gas in marketable condition. 30 C.F.R. § (i) (federal gas), § (h) (Indian gas). 9

Marketable Condition – The Definition
Marketable condition means “lease products which are sufficiently free from impurities and otherwise in a condition that they will be accepted by a purchaser under a sales contract typical for the field or area.” 30 C.F.R. § (federal gas), § (Indian gas).

What Processes Are Covered
Treating gas to put it into marketable condition involves: Gathering – the movement of lease production to a central accumulation and/or treatment point on the lease, unit, or communitized area, or to a central accumulation or treatment point off the lease, unit, or communitized area as approved by BLM or BSEE operations personnel for onshore and OCS leases, respectively.” 30 C.F.R. § (federal gas), § (Indian gas). Compression – means the process of raising the pressure of the gas. 30 C.F.R. § (federal gas), § (Indian gas). Dehydration – the removal of water vapor. Removal of acid gases – usually the removal of hydrogen sulfide or carbon dioxide. Also referred to as “sweetening” and “treatment.”

Major Principles from Marketable Condition Cases
The lessee must gather, dehydrate, and compress gas at no cost to the lessor. The Texas Co., 64 I.D. 76 (1957); California Co. v. Udall, 296 F.2d 384 (D.C. Cir. 1961); Devon Energy Corporation v. Kempthorne, 551 F.3d 1030 (D.C. Cir. 2008), cert. denied,130 S. Ct. 86 (2009). The lessee must remove sulphur (H2S) and carbon dioxide (CO2) at no cost to the lessor. Apache Corp.,127 IBLA 125 (1993); Texaco, Inc. v. Quarterman, No. 96-CV-008J (D. Wyo. Aug. 20, 1996); Amoco Prod. Co. v. Watson, 410 F.3d 722, 725 (D.C. Cir. 2005), aff'd sub nom., BP Amoco Prod. Co. v. Burton, 549 U.S. 84 (2006). The lessee cannot deduct what it pays another entity to perform the processes necessary to place the gas into marketable condition. Placid Oil Co., 70 I.D. 438 (1963); Exxon Co. USA, 121 IBLA 234 (1991).

There is no bright line or “geographic limitation” to the marketable condition rule, except for gathering. Amoco and Devon. The fact that a purchaser agrees to accept untreated gas does not mean the gas was marketable in its natural state. In other words, the fact that you sell or transfer title at the wellhead does not mean the gas is in marketable condition at the wellhead. California Co., Amoco, and Devon. Gas may be in marketable condition at the wellhead if there is a market at the wellhead evidenced by competing offers from multiple purchasers, the sales price is the same as that for gas that is compressed, and the pressure of the gas at the wellhead is adequate to gain access to the pipeline market. Xeno, Inc., 134 IBLA 172 (1995). We’ve had a number of good discussions with different lessees about the requirements for written and signed contracts. Here is the language from the rule – read language and explain on next slide.

Marketable condition means gas treated so that it is marketable for delivery to the pipeline. Amoco, Devon, R.E. Yarbrough Co., 122 IBLA 217, 221 (1993), Shoshone, The Texas Co., J-W Operating Co.,159 IBLA 1 (2003) If a lessee sells some gas that meets the definition of marketable condition for a particular market, that does not convert all gas sold into marketable condition. One must look to the market into which the gas at issue is sold to determine what marketable condition is for that gas. Amoco, Devon, Encana, and Beartooth Oil and Gas Co. v. Lujan, No. CV BLG (D. Mont. Sept. 22, 1993) Lessees must offer affirmative evidence to support an assertion the costs of compression, dehydration, and treatment are not necessary to place the gas in marketable condition or that the gas was already marketable prior to compression, dehydration, and removal of acid gases. IBLA held the “burden rests properly on the lessee to demonstrate that these costs [of compression, dehydration, and removal of acid gases] were not necessary to place the unprocessed gas in marketable condition and incurred only to transport and process its gas.” Burlington Resources Oil & Gas Co., 183 IBLA 333, 352 (2013); Citation Oil & Gas v U.S. DOI, 448 Fed. Appx. 441, 445 (5th Cir. 2011) (“MMS is not required to ‘comb a lessee’s records to determine if that lessee is entitled to a transportation allowance.’”) Amy, let’s chat about the last bullet on this slide… In the new regulations, lessees and their affiliates must have all of its sales, transportation, and processing contracts in writing, signed by all the parties to those contracts. Where a lessee does not have the contract in writing, signed by all the parties, ONRR may use the default provision to determine the value of the commodity or the allowance. Verification ONRR has the responsibility to verify that a lessee properly pays royalties on all consideration actually transferred, either directly or indirectly, from the buyer to the seller. Oral contracts make it difficult for ONRR to accurately determine the lessee properly identified its gross proceeds and paid royalties on those gross proceeds. Requiring fully-executed contracts means ONRR no longer has to rely on the lessee’s written documentation outlining the terms of the contracts (this answers the question – why). Base contracts need a clear linkage to updates; oral updates still need to be documented, and all documentation needs to be kept in accordance with ONRR’s recordkeeping requirements. Electronic signatures ONRR will accept electronic signatures using e-signature methods, not just s. Failure to permit an audit  civil penalties? Failing to provide written documents may rise to the level of “failure to permit an audit” depending on the circumstances surrounding the audit. Has the lessee made a good faith effort to obtain the documents? Should the lessee be in possession of the documents. ONRR’s choice to invoke the default provision will not impact the lessee’s obligation to provide documents or ONRR’s ability to assess civil penalties for failure to permit an audit. There are a variety of facts that ONRR will, and always has considered, before assessing civil penalties. Lessee’s burden to provide contracts Generally, ONRR believes companies should acquire the necessary contracts when those companies acquire interests in federal leases. Failing to provide such contracts may result in misconduct or failure to permit an audit depending on the same circumstances. Although getting the contracts may be more cumbersome on the lessee when a company acquires an interest in a lease from another company, the lessee still bears that burden. If the lessee cannot produce a written contract to support its royalty calculations, ONRR may view that as misconduct under the valuation regulations that will allow ONRR to use the default provision.

Recent Marketable Condition Cases
XTO Energy, 185 IBLA 219 (Feb. 4, 2015) The Order pertains to gas produced from XTO’s Federal onshore oil and gas leases transported on the San Juan Gathering System to the Chaco processing plant. ONRR determined XTO erred in calculating royalties by failing to place the gas in marketable condition at no cost to the United States, and by improperly deducting the costs of compressing the gas from the gross proceeds. IBLA held: Where there is no evidence that an appellant’s gas could have been sold as it emerged from the field compressors, appellant has not established that a true market existed for the gas in its uncompressed state. The question in each case is whether the typical third party purchaser would accept the gas without the added compression, carbon dioxide removal, and/or dehydration required by the mainline pipeline. While compression, dehydration, and removal of CO2 may serve to facilitate transportation or processing, once it is determined that such costs were incurred principally to place gas in marketable condition, those costs cannot also be the subject of a transportation or processing allowance.

Encana Oil and Gas (USA), Inc., 185 IBLA 133 (Sept. 30, 2014) If a lessee sells some gas that meets the definition of marketable condition for a particular market, that does not convert all gas sold into marketable condition. One must look to the market into which the gas at issue is sold to determine what marketable condition is for that gas. A sales contract typical for the field or area reasonable refers to contracts that are typical in the field or area into which the gas is actually sold, which may or may not be the field or area where the gas was produced. A reasonable amount of residue gas shall be allowed for operation of the processing plant free of royalty, but no allowance shall be made for boosting residue gas or other expenses incidental to marketing, except as provide in 30 C.F.R. Part 206. IBLA noted that Encana did not identify a provision in 30 C.F.R. Part 206 that would otherwise authorize an allowance.

Devon Energy Production Company, L.P, ONRR O&G and O&G (Aug 21, 2015) Director’s Decisions denied Devon’s entire transportation deduction associated with the fee Devon paid a third party to compress, dehydrate, and remove acid gas from its production. IBLA held: It is the lessee’s burden to prove the gas is in marketable condition, not ONRR’s burden to prove that it is not. A lessee’s failure to secure information from third party service providers so that it may separate non-allowable expenses of putting gas in marketable condition from allowable transportation expenses is not an excuse. “Even if we accept Devon’s assertions as true, the law is currently settled and places the burden on Devon to demonstrate that some or all of Williams’ fees are deductible as a transportation allowance.”

ONRR Director Decisions appealed to the IBLA West Ridge Resources, MMS MIN (May 05, 2015) Order determined: West Ridge’s “intercompany relative sales adjustment” improperly reduced the total monies it received for coal produced. Because West Ridge could not meet the quality standards in certain sales contracts without blending the Lease coal with non-Lease coal, the intercompany relative sales adjustment represented the cost of putting the Lease coal into marketable condition, which is a cost a lessee must incur at no cost to the Federal government. Director’s Decision held: Allowing West Ridge to deduct the intercompany relative sales adjustment from its gross proceeds results in passing a cost to place coal in marketable condition onto the United States.

Citation Oil & Gas Corporation, ONRR O&G (August 18, 2015) Citation deducted, as transportation costs, the entire fee charged by a third party for gathering, compression, removal of acid gas, and dehydration services. Citation did not provide any affirmative evidence in support of its assertion that the costs of compression, dehydration, and removal of acid gas were not necessary to place the gas in marketable condition or that the gas was already in marketable condition prior to compression, dehydration, and removal of acid gas. Director’s Decision held: Citation is responsible for the costs to gather, compress, remove acid gas, and dehydrate its gas to meet pipeline specification regardless of whether it performs those services or pays a third party to perform those services. Citation cannot deduct the entire service fee charged for compression, dehydration, and transportation when the fee includes costs to place the gas into marketable condition. Nor can it foist its responsibility to segregate allowable form unallowable costs to ONRR. Once it determines what is necessary to place the gas in marketable condition, it may segregate or “unbundle” the third party service fees and calculate an appropriate transportation allowance. Until such time, no transportation deduction is allowed.

ONRR Regulations on Marketable Condition and Compression
Title 30, Code of Federal Regulations (i): The lessee must place gas in marketable condition and market the gas for the mutual benefit of the lessee and the lessor at no cost to the Federal Government…. (b): A reasonable amount of residue gas shall be allowed royalty free for operation of the processing plant, but no allowance shall be made for boosting residue gas or other expenses incidental to marketing, except as provided in 30 CFR part 1206. (f)(9): Supplemental costs for compression, dehydration, and treatment of gas. ONRR allows these costs only if such services are required for transportation and exceed the services necessary to place production into marketable condition required under §§ (i) and (i) …. 20

Presented by Rosario C. Doriott Domínguez
Industry Question #1: The ONRR’s unbundling methodology for calculating UCAs uses the “discharge pressure” rather than the “pressure differential” in the denominator. How is that formula “reasonable” or even mathematically correct? Presented by Rosario C. Doriott Domínguez

Example Transportation System
Royalty Measurement Points or Central Delivery Points Pipelines Dehydrators Pipelines Pipelines Interstate Pipeline: Gas Quality Requirements: Pressure (psig): 700 Stage 1 Compression 50 – 100  375 Stage 2 Compression 375  750 Presented by Rosario C. Doriott Domínguez

Example Two-Stage Compression
Interstate Pipeline: Gas Quality Requirements: Pressure (psig): 700 Presented by Rosario C. Doriott Domínguez

Stage 2 Compression Results Comparing Methodologies
Using ONRR Methodology: Using Pressure Differential (Part-to-Whole Ratios): Allowed Percentage using Part-to-Whole Ratios: Part of Pressure Added Whole Pressure Added Calculation Percentage Allowable (750 – 700) 750 6.67% (750 – 700) (750 – 375) 13.33% Non-allowable (700 – 375) 750 43.33% 86.67% Total: 50% 100% ( ) X 100 Presented by Rosario C. Doriott Domínguez

Full Unit (Stages 1 & 2) Compression Results Comparing Methodologies
Using ONRR Methodology: Using Pressure Differential (Part-to-Whole Ratios): Allowed Percentage using Part-to-Whole Ratios: Part of Pressure Added Whole Pressure Added Calculation Percentage Allowable (750 – 700) 750 6.67% (750 – 700) (750 – 50) 7.14% Non-allowable (700 – 375) 750 43.33% (700 – 50) 92.86% Total: 50% 100% ( ) X 100 Presented by Rosario C. Doriott Domínguez

Industry Question #1: Were the ONRR-published UCAs calculated using the ONRR’s unbundling methodology (i.e., using the “discharge pressure” rather than the “pressure differential” in the denominator)? Will the ONRR be refunding lessee overpayments based on this mathematical error? Presented by Rosario C. Doriott Domínguez

ONRR Answer to Industry Question #1 presented by: Bonnie Robson, Program Manager, Appeals and Regulations

INDUSTRY QUESTION #1 ONRR’s unbundling methodology for calculating UCAs uses the “discharge pressure” rather than the “pressure differential” in the denominator in determining the allowable portion of such a compressor. How is that formula “reasonable” or even mathematically correct?

ONRR Answer to Industry Question #1
A compressor increases the pressure of gas. If ONRR determines that a portion of, but not all of, a compressor’s increase in the pressure of gas is an allowable cost of transportation or processing, ONRR uses, and accepts a lessee’s use of, the following formula to allocate the costs of the compressor in those instances where the lessee provides the compressor’s inlet pressure. Discharge Pressure of Compressor – Marketable Condition Pressure Allowed % = Discharge Pressure of Compressor – Inlet Pressure 38

A compressor increases the pressure of gas. If ONRR determines that a portion of, but not all of, a compressor’s increase in the pressure of gas is an allowable cost of transportation or processing, ONRR uses, and accepts a lessee’s use of, the following formula to allocate the costs of the compressor in those instances where the lessee fails to provide the compressor’s inlet pressure. Discharge Pressure of Compressor – Marketable Condition Pressure Allowed % = Discharge Pressure of Compressor 39

Method Comparisons to Allocate Costs of Partially Allowable Compressor
Where Marketable Condition = 700 psig C1 C2 100 psig 750 psig 375 psig 400 psig COMPRESSION Compressor Number Inlet Pressure (psig) Discharge Difference (psi) One (C1) 100 400 300 Two (C2) 375 750 Lessee Provides Inlet Pressure Allowable Calculation Allowed % Not MC 0% (750 – 700) (750 – 375) 13.3% Lessee Does Not Provide Inlet Pressure Allowable Calculation Allowed % Not MC 0% (750 – 700) (750) 6.67% 40

POTENTIAL UNBUNDLING REFUNDS
Presented by: Tim Engel Industry Question #2: The regulations show residue boosting can be an allowable deduction under certain circumstances (30 CFR (b) states that boosting is not allowed “except as provided in part 1206”). What are some of those exceptions and has any portion of a residue compressor been allowed in ONRR’s published UCAs?

NEED FOR UNBUNDLING OF COSTS
A problem has long existed (particularly for gas production) where third-party invoices for transportation and processing services include both deductible costs and nondeductible costs required to put production in marketable condition. For competitive reasons, third-party service providers refuse to reveal cost information to customers.

ONRR UNBUNDLING COST ALLOCATIONS
Royalty payors must either estimate costs or rely on ONRR Unbundling Cost Allocations (UCAs). Beginning in 2010, ONRR has published percentages of non-deductible and deductible charges based on audits of third-party service providers. The UCAs thus purport to determine what portion of costs are related to putting gas in marketable condition. A number of federal lease gas producers rely on ONRR’s UCAs, or have received orders to pay that (subject to further audit) can be satisfied using UCAs.

OPEN LEGAL ISSUES IN UCAs
ONRR used several legal assumptions in the UCAs that many in industry disagree with, particularly where gas is processed in a cryogenic plant. Courts have not directly addressed these legal issues. These fundamental legal interpretations applied by ONRR include: First, ONRR asserts that plant tailgate boosting costs are never deductible, even when gas has already been placed in marketable condition at no cost to the government (and even when certain reflux compression adds more NGLs);

OPEN LEGAL ISSUES IN UCAs (cont.)
Second, ONRR asserts that even if boosting costs are not deducted, gas must be placed in marketable condition first, before any supplemental transportation or processing deductions are allowable; and Third, ONRR applied a math error in calculating compression costs – even after gas is put in marketable condition first, costs of any allowable supplemental compression (excluding boosting) were measured by the ratio of (i) the amount of compression added by a particular unit that exceeds pressure needed for marketable condition, to (ii) the total pressure in the system up to that point, as distinguished from the total pressure added by the particular unit.

SIX-YEAR STATUTE OF LIMITATIONS ON REFUNDS
If a court were to agree with industry on any of the disputed issues, then companies that have paid royalties using the UCAs might be entitled to significant refunds. A six-year statute of limitations period based on any request for a refund of royalties is approaching for certain royalty payments under the UCAs (or estimates using ONRR guidance). Companies might want to think about ways to protect potential refunds from expiring if courts were eventually to decide in industry’s favor.

ONRR’s “BOOSTING” POSITION
ONRR takes the position in its UCAs that costs of plant tailgate compression (or “boosting”) are never deductible from royalties, even when gas is already in marketable condition at the start of the cryogenic process. In ONRR’s view, even if a lessee were to bear all of the costs of placing gas in marketable condition prior to processing, the lessee must do so again at the plant tailgate at no cost to the government.

VALUATION REGULATIONS ALLOW DEDUCTIONS FOR “BOOSTING”
ONRR’s position is based on 30 C.F.R. § (b), which provides: “A reasonable amount of residue gas shall be allowed royalty free for operation of the processing plant, but no allowance shall be made for boosting residue gas or other expenses incidental to marketing, except as provided in 30 CFR part 1206.” But the argument that boosting costs are never deductible renders the phrase “except as provided in 30 CFR part 1206” entirely superfluous.

VALUATION REGULATIONS ALLOW DEDUCTIONS FOR “BOOSTING” (cont’d)
Part 1206 states that a lessee must place gas in “marketable condition” at no cost to the government, but may otherwise deduct “the reasonable actual costs of processing.” 30 C.F.R. § (a). Part 1206 further states that a lessee may deduct “supplemental costs for compression” that “exceed the services necessary to place production into marketable condition.” 30 C.F.R. § (f)(9)

“BOOSTING” IS PART OF “THE REASONABLE ACTUAL COSTS OF PROCESSING”
In a cryogenic plant, gas must begin the process at a very high pressure, usually added by a plant inlet compressor. The cryogenic process then requires a major drop in gas pressure to create the extremely cold temperatures (approximately -145°F) necessary to recover NGLs. Frozen liquids are separated from the decompressed gas.

“BOOSTING” IS PART OF “THE REASONABLE ACTUAL COSTS OF PROCESSING” (cont’d)
The plant tailgate “boosting” compressor then raises the pressure back to approximately the same pressure that began the process. In a cryogenic plant, without the recompressor, gas could not flow through the plant, a pressure drop could not occur, temperature reduction could not occur, and NGLs could not be recovered. Indeed, NGL processing is initiated by starting the recompressor, which causes the gas to flow through the plant and the pressure to drop downstream of an expander.

UNBUNDLING MODEL Compression Added psig psig psig psig = 1,275 psig

ONRR UNBUNDLING INFORMATION

THE DEVON DECISION ONRR argues that a footnote in the Assistant Secretary's Valuation Determination in Devon Energy Corp. (which involved coalbed methane production and which was affirmed by the D.C. Circuit in 2008) stands for the proposition that the boosting provision at § (b) creates an “exception” to the “general rule” that a lessee need only place gas in marketable condition once at no cost to the government.

BUT THAT IS NOT WHAT THE DEVON COURT HELD
First, the Devon footnote did not state there was an exception; it stated only that “[i]t may be argued that” § (b) creates an exception “in some circumstances.” Second, the footnote was purely dicta, because the boosting issue was in no way relevant to the Devon decision. Devon involved coalbed methane, which is not processed. No processing plant, and no “boosting,” were involved. Third, because boosting was not relevant, the footnote ONRR relies upon was never considered by the D.C. Circuit on appeal. And, of course, finally, the statement in the footnote that an exception arguably exists “in some circumstances” is inconsistent with ONRR’s assertion that boosting costs are never deductible.

REFLUX COMPRESSION

REFLUX COMPRESSION Supplemental compression used to extract additional NGLs that exceeds compression services necessary to place the residue gas into marketable condition, should be deductible. Even if one were to accept that the Devon decision always prohibits boosting cost deductions, it’s hard to justify disallowing costs for reflux compression.

CODE OF FEDERAL REGULATIONS
ONRR’s Revised Oil & Gas Valuation Rule (c)(8) – Transportation - Other nonallowable costs. Any cost you or your affiliate incur(s) for services you are required to provide at no cost to the lessor, including but not limited to, costs to place your gas, residue gas, or gas plant products into marketable condition disallowed under [ ] and costs of boosting residue gas disallowed under 30 CFR (b).

ONRR Answer to Industry Question #2 Presented by: Bonnie Robson, Program Manager, Appeals and Regulations

INDUSTRY QUESTION #2 The regulations show residue boosting can be an allowable deduction under certain circumstances (30 CFR (b) states that boosting is not allowed “except as provided in part 1206”). What are some of those exceptions and has any portion of a residue compressor been allowed in ONRR’s published UCAs?

§ Royalty on processed gas b) A reasonable amount of residue gas shall be allowed royalty free for operation of the processing plant, but no allowance shall be made for boosting residue gas or other expenses incidental to marketing, except as provided in 30 CFR part In those situations where a processing plant processes gas from more than one lease, only that proportionate share of each lease’s residue gas necessary for the operation of the processing plant shall be allowed royalty free. 63

The regulations show residue boosting can be an allowable deduction under certain circumstances (30 CFR (b) states that boosting is not allowed “except as provided in part 1206”). What are some of those exceptions and has any portion of a residue compressor been allowed in ONRR’s published UCAs? When ONRR issues an Order, it does not allow boosting. A lessee may appeal the Order, at which time the Director will consider any part 1206 exception identified and argued for by the lessee. ONRR’s Director has yet to issue a decision in a lessee appeal that identified and argued for a part 1206 exception, though 30 CFR (f)(9) has been identified and argued for as the basis for an exception before other tribunals. No administrative or judicial decision has been rendered on 30 CFR (f)(9) as the basis for an exception as of this time. 64

Method Comparisons on Allowable Compression, Including Boosting
Industry Proposal If lessee does not provide inlet pressure. If inlet pressure provided, formula is ( )/( ) and 13.3% is allowed.

Devon Energy Corp. 2003 Valuation Determination
“It may be argued that the provision in the processed gas rule that prohibits deduction of the costs of boosting residue gas at a gas processing plant is an exception to this principle in some circumstances. See 30 C.F.R. § (b) (1988-present); see also former 30 C.F.R § (b) ( ), formerly codified at 30 C.F.R. § (b) ( ). Depending on the circumstances, gas could be at the pressure required for it to be in marketable condition before it enters the processing plant. If it were, the lessee nevertheless could not deduct the costs of boosting the residue gas at the plant after processing. In the instant matter, the CO2 extracted at the Buckshot Plant is not sold, and Devon consequently cannot claim a processing allowance. In the event that Devon were to sell the CO2, Devon would then deduct a processing allowance in determining the value of the CO2 under 30 C.F.R. §§ , and, at the same time, the rule discussed here would prohibit Devon from deducting the costs of boosting at the Buckshot Plant.”

Presented by L. Poe Leggette
Industry Question #3: Does the “marketable condition rule” require a lessee to first fully and completely compress and/or dehydrate the gas to meet the requirements of the pipelines that serve its purchasers before any supplemental compression or dehydration is allowed, or can “marketable condition” be reached in segments? In the Devon Energy Corp. Oct Valuation Determination, upheld in Devon Energy Corp. v. Kempthorne, 551 F.3d 1030 (D.C. Cir. 2008), the predecessor agency to the ONRR stated: “Where – and in how many phases or steps a lessee chooses to compress the gas to the necessary pressure is up to the lessee.” Presented by L. Poe Leggette

Industry Question #3: Did the Office of Natural Resources Revenue require marketable condition to be reached “first” when creating its Unbundling Cost Allocations (UCAs)? Do the ONRR-published UCAs and agency-issued guidance documents on the “marketable condition rule” follow the holding in Devon Energy Corp. and permit the lessee to place the gas in marketable condition in segments of the lessee’s choosing? Presented by L. Poe Leggette

ONRR Answer to Industry Question #3 Presented by Bonnie Robson, Program Manager, Appeals and Regulations

INDUSTRY QUESTION #3 Does “the marketable condition rule” require a lessee to first fully and completely compress and/or dehydrate the gas to meet the requirements of the pipelines that serve its purchasers before any supplemental compression or dehydration is allowed, or can “marketable condition” be reached in segments? Did ONRR require marketable condition to be reached “first” when creating all its Unbundling Cost Allocations (UCAs)? In the Devon Energy Corp Valuation Determination, upheld in Devon v. Kempthorne in 2008, the agency stated “where – and in how many phases or steps a lessee chooses to compress the gas to the necessary pressure is up to the lessee.” Do ONNR’s UCAs and agency-issued guidance documents on the “marketable condition rule” follow the holding in Devon and permit the lessee to place the gas in “marketable condition” in segments of the lessees choosing?

Does “the marketable condition rule” require a lessee to first fully and completely compress and/or dehydrate the gas to meet the requirements of the pipelines that serve its purchasers before any supplemental compression or dehydration is allowed, or can “marketable condition” be reached in segments? For processed gas, ONRR disallows all compression until gas first reaches marketable condition, then disallows booster compression as well. It also requires gas to be dehydrated to marketable condition before any dehydration costs are allowed. Did ONRR require marketable condition to be reached “first” when creating all its Unbundling Cost Allocations (UCAs)? The next ONRR presenters, Karl Wunderlich and Linda Shishido-Sheahan, will address all questions on ONRR’s UCAs, use of which is optional. In the Devon Energy Corp Valuation Determination, upheld in Devon v. Kempthorne in 2008, the agency stated “where – and in how many phases or steps a lessee chooses to compress the gas to the necessary pressure is up to the lessee.” Do ONNR’s UCAs and agency-issued guidance documents on the “marketable condition rule” follow the holding in Devon and permit the lessee to place the gas in “marketable condition” in segments of the lessees choosing? Devon was decided: 1) at a time when ONRR did not have a method for allocating the costs of a compressor, and 2) under the unprocessed gas regulations, which are inapplicable when a processing plant’s booster compressor is at play. For processed gas, ONRR’s regulation limiting deduction of the costs of a booster compressor complicates the issue. Whether a lessee can choose to use a booster compressor to meet marketable condition while deducting the costs of an upstream compressor is currently the subject of litigation.

Industry Proposal for Allowable Compression

ONRR-Allowed Compression

Updates on The Marketable Condition Rule and its application

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