1. Unbundling – Steps and Strategies
Judith M. Matlock, Partner Davis Graham & Stubbs LLP Denver, Colorado PASO Federal and Indian Royalty Compliance Workshop February 8 and 9, 2017
Judy Matlock, Davis Graham & Stubbs LLP,

2. Learning Objectives
Upon completion of this presentation, the attendee will:
Know that there is a requirement to unbundle gathering and processing costs,
Know how to identify bundled costs under different types of contracts,
Know which costs are considered by ONRR to be disallowed marketable condition costs,
Know the groups in a company’s organization which will be needed for unbundling, and
Have some strategies for how to unbundle costs.
Have some strategies for unbundling T&F for reporting under the new rules.

3. Be Careful of Definitions
For Federal and Indian royalty purposes :
“Gathering” is the movement of lease production to the BLM/BSEE approved point of measurement. The cost of this gathering is a non-deductible marketable condition cost.
“Transportation” is the movement of lease production from the BLM/BSEE approved point of measurement to a processing plant or downstream pipeline.
Industry meaning: Producers and pipeline owners typically call these lines gathering lines to mean that they are not subject to federal regulation under the Natural Gas Act. The contracts for service on these lines are called gathering agreements.

4. Marketable Condition Rule 1988 Valuation Regulations:
The lessee must place oil/gas/residue gas/gas plant products in marketable condition and market the oil/gas/residue gas/plant products for the mutual benefit of the lessee and the lessor at no cost to the Federal Government.
If oil/gas/residue gas/plant products is sold before it is in marketable condition, the lessee must increase its gross proceeds to the extent that the gross proceeds have been reduced because the purchaser, or any other person, provided services necessary to place the oil/gas/residue gas/plant products in marketable condition.

5. Marketable condition Rule 1988 Valuation Regulations:
No transportation or processing allowance for costs to put oil/gas/residue gas/gas plant products into marketable condition.

6. Prior Understanding and Interpretation of “Marketable Condition” For Gas
Regulation Definition - 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 CFR
1996 Compression Guidance by MMS Deputy Director– compression and dehydration downstream of delivery into the first pipeline were deductible.

7. New Interpretation of “Marketable Condition” For Gas
Regulation Definition – No Change – 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 CFR
New Interpretation by Acting Assistant Secretary of Department of Interior in 2003 – production must be of the quality and at the pressure acceptable to the primary market into which the gas from a field or area is sold. In most cases, this is the interstate market.
1996 Compression Guidance reversed as being in error.

8. New Interpretation of “Marketable Condition” For Gas

9. Appeals of the New Interpretation of “Marketable Condition”
2003 Devon Decision – appealed to the IBLA, federal district court, and federal court of appeals for the DC Circuit – all affirmed; U.S. Supreme Court denied certiorari.
Amoco v. Baca – appealed IBLA, federal district court, and federal court of appeals for the Fifth Circuit – all affirmed.

10. Scope of Marketable Condition Requirement
Applies to both federal and Indian production.
Applies to coalbed methane and conventional gas .
Applies even if gas is sold at the wellhead - must gross up for disallowed costs incurred by the purchaser between the wellhead and the “mainline”.
Applies to fixed fee contracts, keepwhole contracts (difference between value of liquids and shrink is a bundled “fee”), and percentage of proceeds contracts (the residue gas and/or liquids retained by the plant is considered the gathering and processing fee).

11. Scope of Marketable Condition Requirement
Applies to gas reported under the unprocessed gas regulations (Product Codes 04 for conventional gas or 39 for coalbed methane.
Applies to gas reported under the processed gas regulations (Product Codes 03, 07 and 15).

12. Defenses Rejected by Courts
Gas met the quality and pressure requirements of the purchaser at the wellhead and has for decades.
Prior audit findings found lessee was in compliance with regs and did not raise marketable condition rule.
Lack of prior enforcement.
Change in position by ONRR from prior guidance requires rulemaking.

13. Marketable Condition Requirement – Exceptions
Indian leases subject to Index Zone pricing (unbundling already in the formula).
Under new rules effective January 2017 production, for non-arm’s length sales, if the formula option is selected, no unbundling is required (it is in the formula already).
For keepwhole contracts under new rules, the liquids value, processing allowance, and T&F are based on the non-arm’s length formula option and, therefore, no unbundling of processing is required.

14. The Marketable Condition Rule – ONRR’s Position
Gas is not in marketable condition until it is of the quality and at the pressure acceptable to the primary market into which the gas from a field or area is sold
Gas destined for the interstate market must meet interstate pipeline quality and pressure requirements
The point where gas is in marketable condition may be downstream of the point of sale

15. The Marketable Condition Unbundling Problem
Costs to put production into marketable condition (including associated fuel) cannot be deducted directly or indirectly
Under most existing gathering (transportation) and processing contracts, costs to put gas into marketable condition are not separately stated; they are “bundled” in the gathering and processing fees
Lessees who deduct 100% of their costs (or the costs their purchaser incurs) are likely to be deducting some marketable condition costs and could be subject to penalties by ONRR

16. What is Unbundling?
Unbundling is the separation of bundled rates or fees and associated fuel into the allowed and disallowed (marketable condition) cost components.

17. Bundled Fee – Fixed Fee Contract
Suppose gas produced from a federal lease is transported and processed for a fee of $0.45/MMBtu.
Fee must be unbundled between transportation and processing because those are separate allowances and subject to separate caps.
Transportation and processing components must further be unbundled into allowed and disallowed components under the marketable condition rule.

18. Bundled Fee - POP Contracts
POP contract – plant retains a % of residue gas and/or liquids as:
Processing fee only (gathering charged separately), or
Gathering and processing fee.
The value of the retained residue gas and liquids is a bundled fee which may include disallowed marketable condition costs.
Through 2016 production, PC04 reporting but Sales Value on Form ONRR-2014 required to include the disallowed portion of the bundled fee.

19. Bundled Fee - POP Contracts
Starting with 2017 production, gas sold under contracts where purchase price is based upon the residue gas and liquids, must be reported under the processed gas valuation regulations (PC03, 07, 15 reporting).
Transportation and processing allowances must be itemized and may only include the allowed portion of the bundled fee (the allowed portion of the value of the retained residue gas and/or liquids).
Allowed transportation must be allocated to all products transported.

20. Bundled Fee – Keepwhole Contracts
See Dear Reporter Letter dated November 21, 2012, regarding keepwhole reporting in general.
Processed gas reporting required (PC03, 07, 15). Report value of residue gas and liquids.
The bundled “fee” ( a processing fee or a gathering and processing fee if gathering is not separately charged) is the difference between the value of the liquids and the value of the shrink MMBtus received at the outlet of the plant to be kept whole.
Unbundling applies to the “fee” through New rules apply to keepwhole contracts starting with January 2017 production.

21. Unbundling Illustration

22. What Is the Unbundling Question?
What portion of the costs incurred under a specific transportation or processing contract is for the purpose of putting the lessee’s production into marketable condition?
Focus is on:
The bundled costs under the contract, and
The marketable condition services included in those bundled costs.
Another way to phrase the question - if the lessee could have negotiated a fully unbundled contract, what would the separate charges have been?

23. Unbundling Gas Transportation Charges – ONRR Current Position
Disallowed services:
Dehydration to mainline specs
Compression up to the pressure of the mainline
Treating to mainline specs
Allowed services:
Delivery service for the gas and impurities up to the pipeline specs (such as 2% CO2)
Dehydration and treating below mainline specs
Compression after gas has reached the mainline pressure
Fuel – allocate between allowed and disallowed services

24. Unbundling Gas Processing Charges – ONRR Current Position
Disallowed services:
Inlet compression to mainline pressure
Dehydration to mainline specs
Treating to mainline specs
Boosting of residue gas - in the regs at 30 CFR (b)
Allowed services:
Compression, dehydration, treating beyond specs
Products extraction
Fuel – allocate between allowed and disallowed services

25. Litigation Areas
Compression performed at the plant for the cryogenic (liquids extraction) process.
Compression of gas used as field fuel or plant fuel (not going to be delivered into the residue pipeline).
Field and plant inlet compression of the liquids portion of the gas stream (also not going to be delivered into the residue pipeline).
Need to stay current on marketable condition decisions.

26. ONRR’s Unbundling Approach
An estimation methodology.
Focuses on a particular transportation system or processing plant.
Original approach - determine the allowed to total ratio of the depreciated capital costs and O&M costs to determine the Unbundling Cost Allocations or UCA’s. To be updated annually.
Lessees multiply their contract rate or purchaser’s deduct by the applicable ONRR UCA.

27. ONRR’s Engineering Solution
ONRR developed an Engineering Solution which involves using
Industry accepted engineering practices and data, and
Sophisticated industry standard modeling tools
To calculate the allowed to total ratio of the facility replacement costs for a theoretical plant to determine the UCA’s. To be updated annually.
Lessees multiply their contract rate or purchaser’s deduct by the applicable ONRR UCA.

28. ONRR’s Streamlined Solution
ONRR is developing a streamlined data request to system and plant owners which will be used to develop allowed and disallowed ratios.
Lessees multiply their contract rate or purchaser’s deduct by the applicable ONRR UCA.

29. Unbundling Methodology at ONRR.Gov
References
Unbundling Methodology for calculating Transportation UCAs
Unbundling Methodology for calculating Processing UCAs
List of Engineering Data Needs
List of Accounting and Cost Data Needs
Reporting Questions

30. Problems Industry is Having with the Unbundling Methodology at ONRR
Problems Industry is Having with the Unbundling Methodology at ONRR.Gov
Requires lessees to obtain confidential and proprietary information which the owners of gathering and processing facilities are not willing to provide to lessees.
Some owners will provide some information (such as a high level process flow diagram).
Most owners will provide no information (even information arguably not confidential or proprietary).
No owners will provide depreciated capital cost information.

31. What’s a Producer To Do? ONRR Expects Lessees to:
Calculate their own UCAs using a reasonable method
Alternative 1 – Use ONRR UCAs if available
Alternative 2 – Take no transportation or processing allowances
Failure to do one of these may result in penalties.

33. The Dilemma If you need to unbundle a charge,
And you don’t have the type of data ONRR used for its unbundling project or the type of data and models needed for ONRR’s engineering solution,
And an ONRR unbundled rate is not available or you believe your contract or your production are different from the norm on which ONRR’s UCA’s may have been based,
How do you avoid a penalty?

34. Alternative Unbundling Methodologies Are Allowed
These are not the only methods by which the UCAs may be calculated. Other methods may be used provided they are in accordance with appropriate regulations. Regardless of the method used to Unbundle, you are still subject to audit.

35. Unbundling Methodology
Remember the question: What portion of the costs incurred under a specific transportation or processing contract are for the purposes of putting the lessee’s production into marketable condition?
ONRR’s methodologies and lessee alternative reasonable unbundling methodologies are all merely ways of estimating the answer to the question – none provide an exact answer.
Appropriate unbundling estimates may be deemed to be reasonable “actual” transportation and processing costs under the regulations.

36. Unbundling - Expectations
Avoid the Penalty Box - yes
A reasonable unbundling estimate is necessary to avoid the penalty box.
Avoid Future Adjustments - unknown
A reasonable unbundling estimate will not necessarily avoid having an auditor require further adjustments.
Reasonable people can still disagree.

37. Alternative Unbundling Team
The accounting group does not have all of the information necessary to make an unbundling estimate.
Unbundling requires a team.
Information needed from:
Operations
Marketing
Legal
With strong support from management.

38. Alternative Unbundling Strategy
Start by following ONRR’s instructions on its website for unbundling.
Use a proxy (i.e., alternative methodology) to determine the allowed and disallowed costs.
Multiply your allowed and disallowed percentages by the bundled fees you are charged.

39. Step 1 - Identify Flowpath and Facilities
Determine the physical flow path of the gas from the wellhead to the point of sale or to the point where the gas is in marketable condition, whichever last occurs.
Identify all facilities through which the product passes - gathering, compression, dehydration, transportation, and processing facilities.

40. Step 2 – Draw a Simplified Schematic

41. Step 3 – Obtain Mainline Specs
Gas quality specifications for CO2, H2S, water, total inerts, nitrogen, etc. can be found in pipeline tariffs.
Documents and Filings eTariff Tariff Viewer
Interstate gas pipeline pressure harder to find.
Check tariff, processing contract, or pipeline’s electronic bulletin board; check with plant owner or interstate pipeline tariff contact; try googling it (may be mentioned in press releases for example).

42. Step 4 – Determine Quality of the Production
Obtain gas composition data for the production as delivered at the BLM Point of Measurement
Look at transporter gas volume statement
Check with your operations folks

43. Step 5 – Update Schematic

44. Step 6 – Information in Between
Find out what you can about the quality and pressure of the gas:
At each compressor station on the transportation system
At any dehydrator or treating facilities on the transportation system
At the inlet of the plant
Check with your operations folks and the transportation system operator; look for publicly available information; if all else fails, make and document reasonable assumptions.

45. Step 7 - Review Contracts
Review all contracts related to the marketing of the product – gathering, processing, and sales contracts.
Review statements and invoices.
Identify all fees or other charges and determine which ones need to be unbundled.
Identify all volume reductions or increases – gathering fuel, plant fuel, lost and unaccounted for volumes, drip, imbalances.

46. Step 8 – Update Schematic Again

47. Step 9 – Identify Marketable Condition Services Received
Based on a comparison of your gas to the mainline specs, what marketable condition services are being provided on the transportation system and at the plant?
Are any of these services separately priced under the contracts?
What charges need to be unbundled?
What fuel needs to be unbundled?

48. Step 10 – Alternative Unbundling Estimation Method #1
Can your company answer this question: If you provided the service yourself, how much would it cost on a per Mcf or MMBtu basis?
Companies can often answer this question as a way to unbundle transportation costs between disallowed dehydration and compression costs and allowed delivery of gas to a gas plant.
Use the ratio of the estimated costs to allocate the transportation charges between allowed and disallowed components.

49. Estimation Method #1 Cont’d
What information can you find from publicly available resources about:
Costs of compression
Pipeline construction costs
Other nondeductible costs

50. Example – Estimating Pipeline Costs
Underground Construction Magazine – 2012 Pipeline Construction Report
“After analyzing costs of 120 pipelines from the past decade, Ziff Energy Group’s results show the average estimated shale gas pipeline rose in 2011 to almost $200,000/inch-mile (the cost per pipeline diameter inch per mile), three times higher than 2004.”

51. Example - Pipeline Costs
INGA Foundation – “Jobs & Economic Benefits of Midstream Infrastructure Development – US Economic Impacts Through 2035” by Black & Veatch – Feb all-in average installed cost:
Large diameter (20”-42”) – $2.8 million/mile
Small diameter (0.5” to 6”) gathering pipeline - $100,000/mile
Lateral pipelines (6”-24”) - $2.2 million/mile

52. Internal Evaluation Example
Ten miles of six inch pipeline
Four stages of compression from 5 psig to 1100 psig
Bundled “gathering” charge
Allocation proposed by one company engineer:
1/4 for deductible delivery component
3/4 for nondeductible compression component

53. Step 10 – Alternative Unbundling Estimation Method #2
Can your company answer this question: If you had negotiated an unbundled contract, what would the negotiated rate for the various services have been?
Companies may be familiar with negotiated rates for at least some services such as dehydration and field compression.
Use the ratio of the estimated negotiated rates to allocate the transportation charges between allowed and disallowed components.

54. Step 10 – Associated Fuel
Use ratio of horsepower of gas-fired equipment to allocate gathering fuel between allowed and disallowed transportation services. Value under benchmark 2 – residue price will work.
If electricity is separately charged under the contract, do not include the horsepower of the electric compressors when allocating gathering fuel.
Note – on many systems, 100% of gathering fuel is for disallowed compression services.

55. Processing Contracts More complex facts Same approach
What do you know
What can you find out
Make a reasonable estimate
Work through each service being provided by the plant –may need to use a different estimation methodology than the one used for the transportation system
Allocate plant fuel and value under benchmark 2

56. Processing Contracts See what the plant owner will tell you
Check the website of the plant owner for equipment and process flow descriptions
Check the Risk Management Plan for facility information
Look for press releases or technical articles about the plant or components

57. Other Methodologies
Based on engineering reports specific to the system in question.
Use modeling systems or cost-estimating software to estimate the cost of each piece of equipment and service within the bundled fee.

58. Other Methodologies
Based on installation quotes, published papers, studies and other educational resources to approximate the cost of equipment and separate the bundled fee into allowable and non-allowable costs.
Based exclusively on the terms of the contract and publicly available marketable condition information.

59. Summary - Estimation Methodologies
Apply what you know or can find from publicly available resources,
To the facility information you are able to assemble,
And make a reasonable good faith estimate of the allocation of unbundled costs:
Between transportation and processing, and
Between allowed and disallowed components.

60. Other Considerations
Are the results reasonable? How do they compare to ONRR UCAs for comparable plants?
Consider using more than one approach and compare results.
Be conservative.
Not necessary to go after every last penny.
Largest components of disallowed costs are for compression costs and associated fuel.
Dehydration and treating are usually a small component of disallowed costs.

61. Impact of Marketable Condition Rule and Unbundling
Based on unbundling experience to date, applying the marketable condition rule results in an effective federal royalty rate in the range of 14.5% to 15.5% for onshore production (2008 – 2016) of net proceeds (cash in your pocket).
Much higher for Indian leases.
Much higher under fixed fee contracts (in a low price environment).
Varies based upon residue gas and liquids prices, GPM of gas, contract terms, degree of unbundling already in the contracts, and other factors.

62. The No Deduct Option If you can’t unbundle,
Or you want more certainty than just avoiding the penalty box,
Or you don’t want to possibly have to reverse and rebook in the future after an audit or when ONRR unbundles the facility,
What will the no deduct option cost?

63. The No Deduct Alternative
Do the math first before deciding – determine the effective royalty rate (percent of net proceeds if no deducts).
Much higher impact during periods of high residue prices.
Residue gas price is used to value the gathering and plant fuel on which royalties are owed under the no deduct alternative.

64. The No Deduct Alternative
Does not just apply to the obvious charges such as a stated gathering fee.
Make sure you don’t miss any deductions:
Value at residue price of all gathering and plant fuel and lost and unaccounted for volumes.
All gathering and processing fees including fees in the form of the value of all residue gas and liquids retained by the plant or under keepwhole contracts.
All separately charged costs for marketable condition services.

65. Advantages of Calculating Your Own UCA
Just because a transportation system or plant has the capability to provide a particular service, does not mean that service is being provided for your production.
Lisbon Plant in Utah – removes H2S from gas streams that are 40% H2S or more
But some users of the plant deliver gas with no H2S. Their own UCA should have a lower disallowed % than an ONRR-determined UCA for the Lisbon Plant.

66. Advantages of Calculating Your Own UCA – cont’d
A particular lessee may be providing some of its own marketable condition services – such as dehydration and compression.
At some gas plants, while most of the gas goes through inlet compression, there may be a high pressure pipeline that bypasses plant inlet compression.
Calculating your own UCA using a reasonable approach allows you to reflect your specific facts.

67. Document Everything You won’t remember what you did and why.
Keep all documents used to make your unbundling estimates.
Make sure the documentation is user friendly for future users so they don’t have to guess what you did and why.
Make sure documentation can be found when needed.

68. Submit Unbundling Proposal to ONRR
Required if you are in a compliance review or an audit.
May be submitted outside a compliance review or an audit.
Include all the background data from steps 1 through 9.
ONRR will evaluate and determine whether to challenge at this time. Will always be subject to future audit and review.

69. Going Forward –Try to Negotiate Unbundled Contracts
Identify all marketable condition services for which a separate rate is needed.
Consider information needed to comply with all royalty obligations – not just federal.

70. Going Forward – Try to Negotiate Unbundled Contracts
Why is it so hard?
Facility owners don’t think about all costs in an unbundled way (a cryogenic unit and residue compressor are not considered separate pieces of equipment).
Facility owners believe that putting out unbundled pricing information will affect their ability to negotiate contracts.
Producers usually do not have the leverage to negotiate fully unbundled rates – not going to be able to disconnect wells from one pipeline and get another to connect.
Even producers who also own plants have not been willing to unbundle for their own customers.

71. Going Forward – Try to Negotiate Unbundled Contracts – cont’d
Try to include a provision that owner will provide any information needed to comply with royalty reporting requirements.
Experience to date – owners will only agree to provide measurement and billing information and will not agree to “any information” type language.
Providing background information to system and plant owners regarding the unbundling requirement has not worked so far.

72. Unbundling – Need for Certainty
“Even when speech is not at issue, the void for vagueness doctrine addresses at least two connected but discrete due process concerns: first, that regulated parties should know what is required of them so they may act accordingly; second, precision and guidance are necessary so that those enforcing the law do not act in an arbitrary or discrimina­tory way. See Grayned v. City of Rockford, 408 U.S. 104, 108–109 (1972).”

73. Unbundling – Harder Than It Needs To Be
Given the difficulties and time involved in unbundling for both ONRR and lessees,
And the time and cost to lessees of reversing and rebooking as UCA’s change or if an auditor disagrees with a lessee’s estimate,
And the fact that all methodologies are estimates,
And the one size fits all nature of the existing UCAs and UCAs based on replacement costs,
Are we headed for litigation on implementation or can we find a better way?

74. Unbundling – Harder Than It Needs To Be (2015 Slide)
Could there be safe harbors for marketable condition costs based upon standard costs?
Unbundled CO2 treating costs are 1.5 cents per each ½ mole% over specs (sometimes written as 3 cents per each 1 mole% over specs) in contracts in all producing states. This is also a common rate in tariffs.
Can we agree that a transportation or processing fee that includes CO2 treating services can be reduced by that rate applied to a particular lessee’s gas production?

75. Unbundling – Standardized UCAs - New
ONRR developing standardized UCAs for gas plants (not transportation systems which have more variability).
Lessee may use a Standardized UCA if:
ONRR has not published a plant-specific UCA for a processing plant; and
The processing contract is arm’s-length only.
Usable until a plant-specific UCA is published by ONRR.

76. Unbundling – Standardized UCAs
Standardized UCAs for Offshore:
Cryogenic Plant – 65% allowed UCA; 25% allowed fuel
Lean Oil Plant – 80% allowed UCA; 80% allowed fuel
The Standardized UCA may not be applicable to leases that fall under Section 6 of the Outer Continental Shelf Leasing Act.

77. Unbundling – When Plant UCAs Can’t Be Used
Standardized UCAs and ONRR plant-specific UCAs (Opal for example) not usable by lessees who have a bundled gathering and processing fee (fixed fee, keepwhole, POP) because the fee must first be split between the transportation system and the plant.

78. Unbundling – When Plant UCAs Can’t Be Used
Can you come up with a reasonable methodology to split the bundled fee so that you can use the ONRR UCA or Standardized UCA?
Do you have another contract with fixed fees for similar gathering and processing services? What is the split under that contract?

79. Other Unbundling - New Rules – Liquids T&F
Purchaser deductions for transportation and fraction of liquids may not be netted out of the liquids price effective with Jan 2017 production.
Liquids transportation may be included in the transportation allowance.
Liquids fractionation may be included in the processing allowance.
Whether other liquids deducts can be taken will depend on what they are for.

80. Common Liquids Pricing Terms
Purchasers pay an OPIS published price for each natural gas liquids component (ethane, propane, etc.) minus T&F.
Liquids prices on the statement are net of the T&F charges. T&F charges are not typically separately identified on the statements.

81. Backing Into T&F
Liquids pricing benchmark – Mt. Belvieu TET, Non-TET or some combination or Conway.
Minus liquids price paid equals T&F.
Minus liquids pipeline tariff rate equals F.

82. Example – Determining Current T & F

83. Unbundling Conclusions
Lessees must comply with the marketable condition rule.
Unbundling is required unless a lessee elects the no deduct alternative.
Failure to take action to comply with the marketable condition rule may result in significant penalties.
Unbundling is time consuming and expensive for both ONRR and Industry and both sides have litigation exposure.
Let’s continue to try to work together to simplify the process and provide certainty particularly in this period of low prices where money can be better spent than on trying to unbundle with limited access to information.