Royalty payments under federal leases are due on production only after it has been placed in “marketable condition.” Thus, a lessee is responsible for placing oil and gas in marketable condition without the typical deduction of post-production costs.[1] The four non-deductible components of marketable condition are: (i) compression; (ii) gathering; (iii) dehydration; and (iv) sweetening or treatment.[2] Oil and gas are generally not considered to be in marketable condition at the wellhead (even if they can be sold untreated).
Although the costs of gathering may not be deducted by a federal lessee, certain costs regarding transportation are deductible.[3] However, questions often arise as to whether a particular activity counts as “gathering” or “transportation.” Under 30 CFR §§ 1206.10, et seq., transportation does not start until after the Central Accumulation Point (“CAP”), and thus gathering prior to the CAP is not a permitted deduction. In other words, gathering activities typically do not fall within an allowable transportation cost.
The Office of Natural Resource Revenue (“ONRR”) defines “gathering” as “the movement of lease production to a central accumulation or treatment point on the lease, unit, or communitized area, or to a central accumulation or treatment point off of the lease, unit, or communitized area that [the Bureau of Land Management] approves for onshore and offshore leases, respectively, including any movement of bulk production from the wellhead to a platform offshore.”[4] If an activity falls within this broad definition of gathering, a transportation allowance will not be available.
In the recent case of DCOR, LLC v. United States DOI,[5] the U.S. District Court for the Northern District of Texas examined certain offshore activities related to the gathering and transportation of oil and gas. Although the DCOR decision involves offshore activities, it provides guidance on the occult practice of deducting post-production costs – and specifically unbundling transportation costs – under federal onshore leases.
DCOR, LLC (“DCOR”) owns and operates oil and gas platforms associated with federal leases off the coast of Southern California. DCOR’s oil and gas production is initially accumulated and treated on several offshore platforms. The production from these platforms is then transmitted to an onshore facility where it reaches “marketable condition” and moves through an approved royalty measurement point.[6] At issue is whether the movement of production from these offshore platforms to the onshore treatment facility is “transportation” (which is deductible) or “gathering” (which is non-deductible).
The controversy arose when DCOR solicited the ONRR for guidance on how to calculate its transportation allowances. This prompted a federal audit under which the ONRR found that DCOR had improperly deducted various transportation allowances.[7] The ONRR contended that “gathering does not end until production is measured for royalty purposes,” and that DCOR was thus “precluded from claiming transportation allowances upstream of its onshore royalty measurement points, regardless of where its production achieves marketable condition.”[8] In other words, as a general rule transportation costs can only be deducted downstream from the royalty measurement point. After the Interior Board of Land Appeals (“IBLA”) determined that it lacked appellate jurisdiction,[9] DCOR sought judicial review of the ONRR’s decision alleging that its decision was arbitrary and capricious.
The District Court began its review of the ONRR’s decision by noting that federal lessees are required to pay royalties on “gross proceeds,” being “the total monies and other consideration accruing for the disposition of oil produced.”[10] Gross proceeds can be measured only on marketable products, and it is incumbent on the lessee to place production in marketable condition at no cost to the government – including the cost of gathering. As noted above, “gathering” is the movement of production from the lease or unit to a CAP off the lease or unit.[11] A “transportation allowance” is deductible from gross proceeds, and is defined as the reasonable, actual costs of moving oil or gas to a point of sale or delivery but specifically excludes gathering costs.[12]
The court agreed with the ONRR that “central accumulation” did not occur until production reached the final onshore treatment facility and the approved royalty measurement point. Thus, the ONRR’s distinction between initial treatment on the offshore platforms and final treatment on the onshore facility was not arbitrary or capricious.[13] The court next explained that there is no general rule that the ONRR must permit transportation allowances for the movement of production from platforms to shore.[14]
The court then addressed DCOR’s assertion that the longstanding interpretation of the regulations supports that transportation begins at offshore platforms. Citing a preamble to a prior version of the regulations, the court observed that when approval has been granted for the removal of production from a lease or unit for the purposes of treatment or accumulation, no allowances should be granted for costs incurred by a lessee in these instances.[15] Thus, the ONRR reasonably concluded that the prior regulations foreclosed transportation allowances prior to production reaching the royalty measurement point.[16]
The DCOR decision highlights that under the CFR, transportation allowances are not applicable to gathering activities. The general rule is that transportation allowances may not be deducted upstream from the royalty measurement point. DCOR also serves as a reminder that: (i) courts give a high level of deference to administrative decisions unless they are arbitrary or capricious (a high threshold of reverence), and (ii) seeking the ONRR’s guidance on transportation allowances may be a helpful exercise, but may also prompt an unwelcome audit!
[1] Post-production costs are those costs related to treating, processing, compressing, gathering, and transporting oil and gas from the wellhead to the point of sale.
[2] 30 CFR §§ 1206.20 & 1206.171.
[3] Calculating these allowables is referred to as “unbundling” and applies to transportation and/or processing fees.
[4] 30 CFR § 1206.20.
[5] 2023 U.S. Dist. LEXIS 127814 (N.D. Texas).
[6] Id. at 4.
[7] To the tune of $19,396,135.38 in allegedly underpaid royalties. Id. at 5.
[8] Id. at 5-6.
[9] DCOR apparently missed the 33-month deadline to appeal under the Federal Oil and Gas Royalty Management Act (“FOGRMA”).
[10] 30 CFR § 1206.101.
[11] Id.
[12] Id.
[13] 2023 U.S. Dist. LEXIS 127814 at 10-11.
[14] Id. at 12.
[15] See 53 Fed. Reg. 1184-01, 1193 & 1230-01, 1240 (Jan. 15, 1988).
[16] 2023 U.S. Dist. LEXIS 127814 at 14.
Brad represents clients in connection with upstream energy transactions, complex mineral titles, pooling issues, lease analysis, joint operating agreements, surface use issues, title curative and general oil and gas business matters.