MMS'S ROYALTY-IN-KIND PILOT PROGRAM 

OVERSIGHT HEARING 

BEFORE THE 

SUBCOMMITTEE ON ENERGY 

AND MINERAL RESOURCES 

OF THE 

COMMITTEE ON RESOURCES 

HOUSE OF REPRESENTATIVES 

ONE HUNDRED FOURTH CONGRESS 

SECOND SESSION 

ON 

THE MINERAL MANAGEMENT SERVICE'S NATURAL GAS ROYALTY-INKIND PILOT PROJECT CONDUCTED ON THE GULF OF MEXICO 

LEASES IN 1995, THINGS LEARNED, INSIGHTS GAINED FROM 

TEXAS PROGRAM, AND POSSIBILITY OF SECOND PROGRAM 

26-584cc 

JUNE 27, 1996--WASHINGTON, DC 

Serial No. 104-82 

Printed for the use of the Committee on Resources 

U.S. GOVERNMENT PRINTING OFFICE 

WASHINGTON : 1996 

For sale by the U.S. Government Printing Office 

Superintendent of Documents. Congressional Sales Office. Washington. DC 20402 

ISBN 0-16 -053446-1 
COMMITTEE ON RESOURCES 

DON YOUNG, Alaska, Chairman 

W.J. (BILLY) TAUZIN, Louisiana 

JAMES V. HANSEN, Utah 

JIM SAXTON, New Jersey 

I;LTON GALLEGLY, California 

JOHN J. DUNCAN, JR., Tennessee 

JOEL HEFLEY, Colorado 

JOHN T. DOOLITTLE, California 

WAYNE ALLARD, Colorado 

WAYNE T. GILCHREST, Maryland 

KEN CALVERT, California 

RICHARD W. POMBO, California 

PETER G. TORKILDSEN, Massachusetts 

J.D. HAYWORTH, Arizona 

FRANK A. CREMEANS, Ohio 

BARBARA CUBIN, Wyoming 

WES COOLEY, Oregon 

HELEN CHENOWETH, Idaho 

LINDA SMITH, Washington 

GEORGE P. RADANOVICH, California 

WALTER B. JONES, JR., North Carolina 

WILLIAM M. (MAC) THORNBERRY, Texas 

RICHARD (DOC) HASTINGS, Washington 

JACK METCALF, Washington 

JAMES B. LONGLEY, JR., Maine 

JOHN B. SHADEGG, Arizona 

JOHN E. ENSIGN, Nevada 

GEORGE MILLER, California 

EDWARD J. MARKEY, Massachusetts 

NICK J. RAHALL II, West Virginia 

BRUCE F. VENTO, Minnesota 

DALE E. KILDEE, Michigan 

PAT WILLIAMS, Montana 

SAM GEJDENSON, Connecticut 

BILL RICHARDSON, New Mexico 

PETER A. DEFAZIO, Oregon 

ENI F.H. FALEOMAVAEGA, Amt"~ican 

Samoa 

TIM JOHNSON, South Dakota 

NEIL ABERCROMBIE, Hawaii 

GERRY E. STUDDS, Massachusetts 

SOLOMON P. ORTIZ, Texas 

OWEN B. PICKETT, Virginia 

FRANK PALLONE, JR., New Jersey 

CALVIN M. DOOLEY, California 

CARLOS A. ROMERO-BARCELO, Puerto 

Rico 

MAURICE D. HINCHEY, New York 

ROBERT A. UNDERWOOD, Guam 

SAM FARR, California 

PATRICK J. KENNEDY, Rhode Island 

DANIEL VAL KISH, Chief of Staff 

DAVID G. DYE, Chief Counsel 

CHRISTINE A.KENNEDY, Chief Clerk/Administrator 

JOHN LAWRENCE, Democratic Staff Director 

SUBCOMMITTEE ON ENERGY AND MINERAL RESOURCES 

KEN CALVERT, California, Chairman 

W.J. (BILLY) TAUZIN, Louisiana NEIL ABERCROMBIE, Hawaii 

JOHN J. DUNCAN, JR., Tennessee EDWARD J. MARKEY, Massachusetts 

JOEL HEFLEY, Colorado NICK J. RAHALL II, West Virginia 

J.D. HAYWORTH, Arizona CALVIN M. DOOLEY, California 

FRANK A. CREMEANS, Ohio SOLOMON P. ORTIZ, Texas 

BARBARA CUBIN, Wyoming 

HELEN CHENOWETH, Idaho 

WILLIAM M. (MAC) THORNBERRY, Texas 

WILLIAM CONDIT, Professional Staff 

SHARLA BICKLEY, Professional Staff 

LIZ BIRNBAUM, Democratic Counsel 

(II) 
CONTENTS 

Page 

Hearing held June 27, 1996 .................................................................................... 1 

Statements of Members: Calvert, Hon. Ken, a U.S. Representative from California; and Chairman, Subcommittee on Energy and Mineral Resources ...................................... 1 

Thornberry, Hon. William, a U.S. Representative from Texas ..................... 2 

Statements of witnesses: Hoyle, Andrew N., Vice President, Marketing, Enron Oil and Gas Com- pany .................................................. .............................................................. 11 

Kelley, Stroud C., Special Counsel for Energy Policy, Texas General Land 

Office ..... ................................................ .......... ................. ............... ............... 4 

Nichols, Larry, President, Devon Energy Corporation .................................. 14 

Prepared statement .............................. ....... .... .... .... ... .............. ... .... .... .... .. 32 

Patterson, G.S., Manager, Gas Plant Supply and Property Management, 

Amerada Hess Corporation .... ...... ... .... ...... ... .... .... .... ....... .. .. .. .... .. . .... .... ..... ... 13 

Quarterman, Cynthia, Director, Minerals Management Service .. .... .. .... ..... 2 

Prepared statement ..................... ................ ...... ........................................ 26 

(III) 

MMS'S ROYALTY-IN-KIND PILOT PROGRAM 

THURSDAY, JUNE 27, 1996 

HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON ENERGY 

AND MINERAL RESOURCES, COMMITTEE ON RESOURCES, Washington, DC. 

The Subcommittee met, pursuant to call, at 2:11 p.m., in room 

1324, Longworth House Office Building, Hon. Ken Calvert (Chairman of the Subcommittee) presiding. 

STATEMENT OF HON. KEN CALVERT, A U.S. REPRESENTATIVE 

FROM CALIFORNIA; AND CHAIRMAN, SUBCOMMITTEE ON 

ENERGY AND MINERAL RESOURCES 

Mr. CALVERT. The Subcommittee will come to order. The Subcommittee meets to continue our oversight of Federal oil and gas 

resource programs in an effort to improve efficiency and enhance 

revenues to the Federal and State treasuries. 

Today's hearing will review the Mineral Management Service's 

natural gas royalty-in-kind pilot project conducted on Gulf of Mexico leases during 1995, what the agency and the gas producing and 

marketing industry have learned from the pilot, what insights we 

might gain from a royalty-in-kind program in the State of Texas, 

and what plans exist to expand a second pilot to onshore lease, as 

well as on the OCS. 

On Federal lands, including the Outer Continental Shelf, OCS, lessees must pay a portion of their production value, usually 1/8 

onshore or 116 offshore, in the form of a royalty to the Federal Government. Valuation of production is a complex and burdensome 

process for lessee and lessor alike, which has resulted in years of 

costly litigation. A seemingly obvious way to avoid the valuation 

quagmire is for the royalty owners to take their fraction "in-kind" 

rather than "in-value." 

On a small scale, this conjures up images ofa West Texas rancher taking his or her natural gas directly into a sod house for domestic heating and cooking use and maybe warming the stock watering 

tanks in the winter to keep them from freezing. At the other end 

of the spectrum, recognizing that the Federal Government is the 

largest royalty owner in the country, would be a quasi-governmental corporation marketing the Feds royalty-in-kind product. 

Of course, it· is not too realistic to believe a Federal Government 

oil or gas company will be created by this or any future Congress 

I can foresee, so the question remains what is to be gained by the 

MMS taking gas in-kind. Because the Treasury still needs dollars, 

not BTUs, there has to be a point at which the royalty-in-kind 

(1) 
2 

product, be it natural gas, or oil, or any other Federal mineral, is 

converted to cash. 

A possible exception would be to heat and generate electricity for 

Federal facilities from royalty gas or oil. A small-scale example of 

this is going on in Alaska today where a small natural gas field in 

the NPR serves a military installation and the village of Barrow. 

Our witnesses today will give us their insights so that Congress 

might direct further efforts to expand the RIK programs, or redirect their focus if necessary, in order to achieve a net gain for the 

taxpayers. By net I mean, receipts flowing into the Treasury minus 

the Federal Government's costs associated with producing those 

revenues, including auditing and the enormous legal costs to argue 

valuation decisions through administrative and judicial Courts. 

I understand the ranking member, Mr. Abercrombie, is going to 

be here shortly, and so I am sure he will have an opening statement. But in the interim, I would like to welcome our witnesses. 

And, first, I would like to introduce Cynthia Quarterman, Director 

of the Minerals Management Service, and Stroud C. Kelly, Special 

Counsel for Energy Policy, Texas General Land Office. If you would 

like to come up to the table and take your seats. 

Before you testify, I am sorry. I didn't see my colleague, Mr. 

Thornberry, arrive so I would like to recognize Mr. Thornberry for 

any opening statement. 

STATEMENT OF HON. WILLIAM THORNBERRY, A U.S. 

REPRESENTATIVE FROM TEXAS 

Mr. THORNBERRY. Thank you, Mr. Chairman. This · seems to me 

to be one of those issues that makes so much sense that Washington has a hard time getting it done. And I realize that getting into 

the details of some of this is where the rub is, but it does seem to 

me that allowing royalty-in-kind to exist makes a lot of sense, and 

I think this is an area where we have a lot to learn from what 

some of the States have done. And I am particularly pleased that 

we can learn something about the Texas example here. And I look 

forward to hearing from the witnesses and hearing their comments 

about what we need to be doing. 

Mr. CALVERT. Thank you, Mr. Thornberry. First, I would like to 

introduce Cynthia Quarterman, the Director of Minerals Management Service. I hope you will have more fun on this panel than the 

last group you were at earlier this week. Ms. Quarterman. 

STATEMENT OF CYNTHIA QUARTERMAN, DIRECTOR, 

MINERALS MANAGEMENT SERVICE 

Ms. QUARTERMAN. Good afternoon. Thank you, Mr. Chairman, 

Mr. Thornberry. I hope I have as much fun at least, if not more. 

I appreciate the opportunity to appear today to present testimony 

on the royalty gas marketing pilot which was implemented by the 

Minerals Management Service during 1995. The pilot was one of 

the National Performance Review laboratories implemented by the 

Department of the Interior and represents one of our many efforts 

to provide better service to the public at reduced cost. The MMS gas pilot was conducted from January 1 through December 31 of 1995 and tested the concept of the Minerals Management Service taking the Federal Government's royalty share of gas 
3 

production in-kind from offshore Federal leases and selling the gas 

at or near the leases to competitively chosen gas marketing companies. The royalty gas was provided by 14 lessees on 79 leases who 

volunteered to participate and helped us to design the pilot. 

The MMS had two objectives in conducting this pilot. The first 

was to find processes for streamlining royalty collections in a manner that reflects changes that have occurred in the gas market; and 

the second was to test the process for royalty collection that promises increased efficiency and greater certainty in valuation. We are 

pleased with the results of the pilot. It has provided the information that we required to evaluate the potential for using in-kind 

royalty gas for collection. 

During the pilot, MMS took, in kind, approximately 45.6 billion 

cubic feet of gas, totaling over six percent of the Federal Government's royalty share in the Gulf of Mexico and sold it to gas marketing companies. The marketers were responsible for all costs 

downstream of the points of delivery. They also retained all the 

proceeds from selling the gas to their customers in a free market 

environment. 

The MMS plans to issue a report on the pilot results later this 

summer. My testimony today will address only the main conclusions from the report. We will provide the committee with a copy 

of the report as soon as it is completed. Based on the results of the 

pilot, MMS is considering whether to pursue additional royalty-inkind pilot efforts and, if so, how and where to conduct them. We 

will keep the Congress informed of our progress as we go along. 

Again, in general, we are pleased with the results of the gas 

pilot. The pilot was an operational success. The fact that MMS designed and evaluated the pilot in collaboration with its customers 

was a critical factor, I believe, in the pilot's success. We are still 

working on the revenue impact analysis for the pilot. Our preliminary estimates indicate that there was some revenue loss from the 

pilot. 

We are also conducting an analysis to estimate the internal MMS 

administrative cost savings that can be achieved through implementation of the pilot on a more global basis. We expect that participating lessees would also realize savings through reductions in 

reporting requirements, audit interface, and litigation if the pilot 

were expanded. 

MMS learned several lessons from the pilot, including the necessity to allow more lead time before proceeding, both on our part 

and on the part of those who participated in the pilot with us; to 

provide additional information to bidders during the bidding process; and to start well before the winter season begins if a future 

pilot goes forward. 

In conclusion, I would like to emphasize that the pilot presented 

the true spirit of MMS's efforts to find ways to make our royalty 

management efforts more efficient and less burdensome for the industry. We worked with industry to design an efficient program 

that reflects procedures that have evolved in the industry and 

serve both their needs and ours. 

We have also been encouraged by industry's willingness to work 

with us in evaluating the results of our combined efforts. At the 

same time, however, we have sought to structure the pilot in such 
4 

a way as to ensure a fair return to the public from production of 

its resources. And that is something that we have to keep in mind 

as we move forward with any future royalty-in-kind efforts. 

We are evaluating the results of the pilot carefully to see how we 

can best move forward to reduce costs, both for government and for 

industry, without compromising royalty collections. Those conclude 

my prepared remarks. I would be happy to answer any questions 

any of the members might have. Thank you. 

[Statement of Ms. Quarterman may be found at end of hearing.] 

Mr. CALVERT. Thank you, Director Quarterman. Next, Stroud 

Kelley, Special Counsel for Energy Policy, Texas General Land Office. Mr. Kelley. 

STATEMENT OF STROUD C. KELLEY, SPECIAL COUNSEL FOR 

ENERGY POLICY, TEXAS GENERAL LAND OFFICE 

Mr. KELLEY. Mr. Chairman and members, Texas Land Commissioner Garry Mauro appreciates the invitation to appear before you 

to discuss the Texas royalty-in-kind program, and he regrets that 

he is unable to be here. He asked me to speak on his behalf. 

The Land Office has been pleased with the results of our in-kind 

gas program. We are glad to share that information with you. 

While royalty in-kind may not cure all of the disputes that arise 

between royalty owners and producers, our experience in Texas is 

that the in-kind program provides a means to substantially reduce 

royalty disputes, reduce costs to both the State and the lessees, and 

provide the State an opportunity to obtain an enhanced return by 

actively participating in the natural gas marketplace. 

For those of you who are not familiar with the General Land Office, please allow me to explain briefly our role. The Land Commissioner, who heads our agency, is an elected official. One of his main 

duties is to manage the more than 20 million acres of public lands 

and minerals owned by various Texas government departments, 

most prominently, the Permanent School Fund, a trust fund that 

supports public education in Texas. 

Annual mineral revenue from the fund is some $150 million, and 

although that is not large by Federal standards, it has nonetheless 

allowed Texas to create a public school endowment worth over $11 

billion. The approximately 33 billion cubic feet of natural gas that 

represents our annual royalty share would rank the school fund as 

the 43rd largest producer of natural gas in the United States. 

Over the past 10 years, the Texas gas in-kind program has enhanced royalty income for our Permanent School Fund by over $9.8 

million, saved State agencies over $85 million in gas utility bills, 

and saved untold thousands of dollars for the General Land Office 

and gas producers by eliminating the need for royalty accounting 

for those volumes of gas taken in-kind. The program's past success 

has led us to expand the program through a new public-private alliance that I will describe for you in a few minutes. 

The Texas in-kind program began in the early 1970's and has expanded to its present form. Since '85, the program has concentrated 

on sales to State agencies, universities, and other public facilities. 

The goals of the program are twofold: first, to enhance income from 

the school fund, and, second, to reduce gas costs to State facilities 
5 

by providing State gas at prices below those charged by gas utilities. 

The Texas Legislature has consistently supported the program 

and, in recent years, has enacted laws that assure its smooth operation. One such statute requires all State agencies that consume 

more than 100 Mcf of gas per day to submit all of their gas acquisition contracts to the Land Office for review. 

If the Land Office is able to provide gas at the same or lower 

cost, it may require the agency to purchase gas from us. Another 

supportive statute requires all regulated gas utilities to provide 

transportation of State gas if capacity is available. Transportation 

rights are generally competitive with those provided to private parties. 

At present, the Texas program sells approximately 8. 7 billion 

cubic feet of gas per year to State agencies and another 3.6 billion 

cubic feet on the spot market. Gas is currently being taken in-kind 

from 105 leases, most of them on the upper Texas coast. End-user 

sales contracts are in place with 101 State facilities, 27 State colleges and universities, and 7 other government bodies, including 

school districts and small municipalities. 

Transportation contracts are currently maintained with 27 different pipelines and local gas distributing companies. And we also 

maintain a contract for up to one billion cubic feet of natural gas 

storage at a facility near Houston. Sales of gas on the spot market are made through monthly solicitations of interest from prequalified gas marketers of whom there 

are currently 12. In order to qualify, marketers must show financial stability. But in addition to that, to encourage small business 

participation, theLand Office maintains credit risk insurance. 

Since 1973, all State leases have provided for in-kind takes, and 

we have negotiated in-kind rights for some older State leases. Once 

we have exercised our right to take in-kind for a particular lease, 

we make every effort to continue to take gas from that lease in 

order not to burden the lessee by alternately going in and out of 

the take. We generally take possession of the gas at the point at 

which it has been made ready for sale or commercial use at the 

producer's cost. 

In our end-user program costs of transportation and other costs, 

together with a markup for enhancement, a set administrative fee 

is charged to the gas purchasers. In all but a few cases, prices to 

the end-user agencies are significantly below those available from 

private sources and are lower than local utility costs in almost 

every instance. ' 

Gas producers on State lands have been almost uniformly supportive of our program. Although I do not have specific figures, the 

administrative savings and other benefits to both producers and 

the Land Office are clear. It is far easier to account for volumes of 

oil or gas physically delivered than it is to account for both the volumes delivered and the market value of those volumes. The in-kind programs have been successful, and we are now, as 

I have mentioned, starting the process of revising and more than 

doubling our gas program. The changes in the natural gas marketplace-may I extend my remarks? 

Mr. CALVERT. Without objection, so ordered. 
6 

Mr. KELLEY. Thank you. We believe we can form a public/private 

alliance with a gas marketing firm that will bring together the very 

specialized expertise of gas marketers together with gas supply and 

markets that our office can provide to the benefit of both the State 

and the private marketer. 

We have invited over 60 gas marketing firms to submit proposals 

by July the 8th covering management of our end-user program, creation of a natural gas liquids program, and the purchase of the balance of our natural gas supply at an index plus basis. 

It is in the context of proposed expansion of our in-kind gas program that the State is seeking a way to obtain royalty provided 

for-royalty in-kind as provided-that we now provide for in cash 

under the Outer Continental Shelf Lands Act. We estimate that 

should that be able to be done, the 8(g) volumes would increase our 

available volumes by approximately 10 to 15 percent. 

There apparently are some legal questions about the authority of 

the Secretary to deliver this gas in-kind, and we are eager to work 

with you to see if these questions can be removed and the authority 

of the Secretary to do so clarified. 

We believe that the additional pilot programs that include State 

participation are a very valuable step in this direction. Mr. Chairman, we appreciate your efforts to include in the Interior appropriations process language that would establish a cooperative inkind pilot program with a coastal State. 

In conclusion, I would say that in-kind royalty is worth the consideration of any royalty owner that has the opportunity to take 

marketable volumes of oil or gas or has the opportunity to join with 

others in doing so. We look forward to working with you to encourage such programs. 

Mr. CALVERT. Thank you, Mr. Kelley. First, I would like to direct 

a question to Director Quarterman. I appreciate your assessment 

about MMS needing to find ways to remove itself from the complex 

issue of valuation of oil and gas produced from Federal leases, and 

I think most of us would agree. 

Back in what some may view as the good old days of regulated 

wellhead prices and pipeline purchases of natural gas, the audit job 

was relatively easy. But we all know that deregulation is here to 

stay and rightly so as competition in the marketplace is essential 

to bring about more competitive prices. 

Many predict that the electricity business will follow next, and 

several energy companies are posed to enter that market when it 

is open. So it seems that gas valuation for royalty purposes will 

probably even get more complex unless such steps as RIK are 

taken. Do you agree that that would occur? 

Ms. QUARTERMAN. Well, I think the valuation of gas has already 

proved to be quite complex in the past and with deregulation has 

become even more complex. That is why we have come forth with 

the RIK pilot. It is also why we put together the Federal gas valuation negotiated rulemaking team to try to reach some sort of consensus about the way the gas should be valued going into the future. So, yes, I do agree that valuation has become extremely complex. However, I don't think we should rush to any one conclusion 

in how to proceed in the future . 
7 

Mr. CALVERT. Your testimony mentioned the preliminary estimates indicate some relative loss, and you also mentioned that because of the complexity of valuation that it may be impossible to 

know, but, more importantly, does the estimate include a factor for 

the diminished cost of auditing and legal costs that the permanent 

RIK program would engender. You mentioned that briefly. Is there 

a percentage now that you know what your accounting costs, your 

legal costs are in association with your total costs? 

Ms. QUARTERMAN. That is one of the things that we have been 

working on, trying to determine what the administrative costs are 

that MMS has. We had an early estimate that, frankly, was not 

quite credible. That is why we have r~determined when the report 

would come out. 

We had expected it to come out on Monday. It will probably come 

out later in the summer as we analyze that a little bit more thoroughly. I can't give you an estimate for how much money would be 

saved based on administrative costs. But, in any event, it would 

not be enough to offset the losses that we have seen thus far in the 

pilot program. 

Mr. CALVERT. It will be interesting to see the results of that as 

soon as they are available. Mr. Kelley has sung the praises of RIK 

for Texas leases, but then they had a fully operational program for 

well over a decade. And Texas is a value-added business, as well 

as aggregating value and was using it at State government facilities and doing its own marketing gas access to those needs. Has 

there been any discussion with the Interior Department or with the 

National Performance Review staff to consider such additional 

functions for MMS? 

Mr. KELLEY. Mr. Chairman, as you know, our former Land Commissioner is Assistant Secretary, and his assistant formerly ran our 

gas program as well. We have not had formal discussions. We have 

had some informal discussions and are certainly willing to offer 

any assistance if we can. 

Mr. CALVERT. Ms. Quarterman, do you have any comments on 

that? 

Ms. QUARTERMAN. I should add before we started the pilot, some 

folks from MMS's staff did meet with Texas because we realized 

that they were doing something very similar to determine whether 

we should pattern our program precisely after theirs or do a variation of that. So we have talked to them. I don't think we have 

talked to them since the program has been completed, but it is 

something that we certainly should do. 

It seems that they are going on a different direction that might 

be closer to what we have done in the past and might be interested 

in doing in the future. So we plan to continue discussing with them 

the RIK program. 

Mr. CALVERT. Thank you. Mr. Kelley, what legislative changes, 

if any, are needed in order for a State to take its portion of royaltyin-kind gas from leases in the 8(g) zone? 

Mr. KELLEY. Mr. Chairman, the Outer Continental Shelf Lands 

Act is not terribly clear on the point. Our view, of course, is that 

the delivery of in-kind gas would be the equivalent of a delivery of 

revenue. However, we think it would be very helpful to have express authority for the Secretary to authorize 8(g) producers to de-
8 

liver the State royalties' fraction in-kind certainly under arrangements that would need to be worked out with producers and with 

MMS. Mr. CALVERT. Your interpretation of fair market value, in other 

words, is the value that Texas receives for its portion of royalty 

gas? 

Mr. KELLEY. Yes, sir. Under our view, that the delivery of the 

correct royalty fraction is equivalent to the~fully satisfies the royalty obligation, obviously, subject only to audit for volumes and not 

for value. · 

Mr. CALVERT. So Texas does not look beyond its volumetric portion of in-kind gas for the royalty obligation? 

Mr. KELLEY. No, sir. When we receive our volumes, we consider 

the royalty obligation satisfied. 

Mr. CALVERT. Thank you. Mr. Thornberry. 

Mr. THORNBERRY. Mr. Kelley, did I understand from your testimony that in the past 10 years this royalty-in-kind in Texas has 

significantly increased the royalties that the State has :eceived as 

far as the oil and the gas, as well as saving utility bills? 

Mr. KELLEY. We have an oil in-kind program as well. Both programs we feel have enhanced our royalty values beyond what we 

would have received had we been made simply a cash royalty, as 

well as saved considerable administrative overhead. 

Mr. THORNBERRY. Have you made any attempt to quantify the 

administrative and legal fee savings? Do you have any estimates 

for us on that? 

Mr. KELLEY. We have not reduced that to dollars. I can tell you 

that I personally am involved in, as counsel, to the audit program, 

and we spend-we have approximately 20 auditors. We have several lawyers dedicated solely to that function that we could put to 

doing other tasks if we were to go entirely to an in-kind program. 

So the savings would be considerable. 

Mr. THORNBERRY. We talked a little bit about cooperation with 

the Federal pilot program. Have you examined the Federal pilot 

program, and do you have comments on what they did right or suggestions on how they can improve things? 

Mr. KELLEY. We have not, but we look forward to seeing thereport because as the Director said, we are moving more in that direction into a public/private alliance with a marketer. And we are 

very pleased that that model is there that we can look to. Mr. THORNBERRY. But you haven't looked at it yet? 

Mr. KELLEY. Have not. 

Mr. THORNBERRY. Would the State be willing to accept responsibility for the gas at the wellhead? 

Mr. KELLEY. We would have to look at that. Under our present 

scheme, as I testified, under our leases, the lessees are obligated 

to take the gas generally to a point post-processing. But, again, we 

view the gas takes as almost on a lease-by-lease basis and what is 

appropriate and what would work and turn a profit for us in our 

program. 

Mr. THORNBERRY. In answer to one of the Chairman's questions, 

you were talking about your view is the royalty requirement is met 

regardless of the value as long as the volume of gas is delivered. 

Is that correct? 
9 

Mr. KELLEY. Yes, sir. 

Mr. THORNBERRY. And so do you have some difference of opinion 

as to where it is delivered or does that matter? 

Mr. KELLEY. Well, it does matter clearly in terms of cost. Mr. THORNBERRY. Sure, but I am talking about as far as where 

the obligations are. Mr. KELLEY. We construe our State leases to require the producer to put the gas in marketable condition before delivery as royalty. That is a parallel obligation we view in terms of cash royalty 

as well, that those are nondeductible costs. Clearly, if we were to 

participate on Federal leases, that would be something that would 

have to be worked out under Federal requirements. And, generally 

speaking, if we felt the gas could be profitably taken into our system into our program at the wellhead, I am sure we would be willing to do so. 

Mr. THORNBERRY. But you have not looked at that at this point? 

Mr. KELLEY. We have not studied that. We have mostly been 

spending our effort getting our expanded program ready under our 

regulations and our scenario. 

Mr. THORNBERRY. OK. But you are not ruling it out either? You 

don't rule it out, do you? 

Mr. KELLEY. No, sir. We would not rule that out. 

Mr. THORNBERRY. OK. Ms. Quarterman, we heard Mr. Kelley 

mention he believes there ought to be a clearer provision in the law 

to provide for a royalty-in-kind. Tell me, in the 8(g) zone what is 

your view as to what the law allows now and what would be required to make it clearer, if we need to do that, to permit a State 

such as Texas to receive our gas in that zone and in-kind? 

Ms. QUARTERMAN. My understanding of what 8(g) provides right 

now is that States can share 27 percent of the revenues. Our solicitor has looked at that and determined that he believes that it 

would require a change in that language so that the State could 

take it in-kind. I believe that we have worked with the State to 

come up with language that is acceptable to us to achieve the goal 

that the State wants to have happen. 

Mr. THORNBERRY. Well, is this something that you and the Department supports, or are you somewhat reluctant to allow Texas 

and perhaps other States to take their royalties-in-kind? 

Ms. QUARTERMAN. Well, since there hasn't been any legislation 

that came forward, officially, I cannot give you an official Administration or Department position. I think as a practical matter we 

like the idea as we have piloted ourselves of States having the opportunity to do things more flexibly. 

The only caveat that I would put there is that in doing so, the 

Secretary and the Department be given some flexibility so that we 

aren't put in an awkward position with our lessees, and we don't 

get in a situation that might administratively not be workable. But 

I don't foresee that as being a problem. 

Mr. THORNBERRY. But you are not here to testify that because 

the current Federal pilot program has not made as much money as 

we would like that that was run perfectly? As a matter of fact, you 

have listed in· your testimony a number of lessons that were 

learned where improvements could be made. You still think there 

are problems, in other words, to take this approach? 
10 

Ms. QUARTERMAN. Absolutely. I think we learned quite a few 

things that we would do things differently, and that is precisely 

why we did it as a pilot to see what we could learn. I think there 

are ways that the pilot could be improved. Whether or not we 

would ever reach the point where we were revenue-neutral is something that I think I and my staff have to sit down and thresh 

through for a while. 

There are some concerns that we have about the extra burden 

that would be placed on the government in marketing the gas that 

it does not have now. Right now, the producer markets that gas, 

and any value associated with that is given to us in dollar terms. 

If we take it in kind, we do take some of that responsibility. Either we can do it, which would offset the administrative savings, 

or we could hire someone else to do it, which is what we did in this 

instance and I think is reflective of lower values that we got. 

Mr. THORNBERRY. Mr. Chairman, if I might ask one more question? In listening to what has happened in Texas, is there anything 

so fundamentally different in the Federal structure that would 

change necessarily the results that they have received? Because 

Mr. Kelley has testified that they feel like they have had enhanced 

royalties and savings, you know, under the Texas system utility 

bills, plus the administrative and legal costs. Is there anything that 

is so fundamentally different in the Federal system that would preclude us from getting those results as well? 

Ms. QUARTERMAN. Well, I haven't studied the Texas lease terms 

or statutes in any detail so I hesitate to respond. I would say that 

I think there may be some differences in the transportation terms 

between the Federal and State leases wherein in the Federal leases 

we may not be able to require or have not so far at least required 

companies to take gas or oil at a point further without then allowing them a transportation allowance. 

And I am not sure the State may have the ability to do that, as 

well as a little bit more ability in terms of marketable-putting 

things in marketable condition. So there may be a few differences. 

Mr. THORNBERRY. Well, that is exactly the sort of thing that I 

think is helpful for us to know because that could affect the cost, 

of course, if you have got to pay an allowance to take it on further 

down the line. I appreciate that. Mr. Chairman, I may have some 

other questions that I would like to submit along that line, and if 

I may do so for the record, I would appreciate it. 

Mr. CALVERT. Certainly. I have just a question following up with 

Mr. Thornberry for Mr. Kelley. Do you have any suggestions that 

could assist the MMS in an in-kind program which would increase 

revenue? 

Mr. KELLEY. We would certainly welcome the opportunity, and I 

am sure we will have the opportunity to look at theirs and offer 

any suggestions we might have and also learn from their experience in a program that looks a whole lot more like the one we are 

moving toward. Without studying their experience in more detail, 

I don't think I would have anything specific at this time. 

Mr. CALVERT. Thank you. Mr. Thornberry, any questions right 

now, or would you like to submit your questions later in writing? 

Mr. THORNBERRY. I would like to submit my questions. But let 

me be a little clearer about this. Who is moving toward whom? It 
11 

seems to me if you all are making money and you all haven't yet, 

you need to move that? Am I missing something? 

Mr. KELLEY. Well, we are, as I said, moving toward that kind of 

program in terms of using a private marketer in a public/private 

alliance. We have been very fortunate in that we have had an enduser enhanced value market for most of the gas that we have 

taken. And we are hopeful that, of course, that part of the program 

will continue. 

It is the additional volumes of which at this point we do not have 

a clear market and which we intend to sell in the open market on 

an index basis-hopefully an index plus basis that we hope will 

make progress. We will have one provision that I think will give 

us some assurances on premium priced gas where our marketer 

will not be entitled to a take on that gas, but they would have to 

match the price if there is a high price contract in place for a particular well. 

Mr. THORNBERRY. But as I understood your testimony, you all 

are already marketing what?-a fourth of the gas on the spot market now? 

Mr. KELLEY. Yes, sir. 

Mr. THORNBERRY. OK. Thank you. 

Mr. CALVERT. Thank you. I would like to thank this panel for 

your testimony and for your answers. And you may receive some 

more questions that ask for your written replies which will be 

made part of the record. 

Next, I would like to ask the next panel from the industry to 

come forward; Mr. Andrew N. Hoyle, the Vice President of Marketing, Enron Oil and Gas Company; G.S. Patt~rson, Manager, Gas 

Plant & Property Management, Amerada Hess Corporation; and 

Larry Nichols, President of Devon Energy. Please come forward 

and take your seats at the witness table. I would first ask Mr. 

Hoyle from Enron to go ahead and begin your testimony. 

STATEMENT OF ANDREW N. HOYLE, VICE PRESIDENT, 

MARKETING, ENRON OIL AND GAS COMPANY 

Mr. HOYLE. Good afternoon, Mr. Chairman. I am Andy Hoyle, 

Vice President, Marketing, Enron Oil & Gas Company. Enron Oil 

& Gas Company is owned approximately 60 percent by Enron Corp, 

and is one of the largest independent nonintegrated oil and gas 

companies in the United States in terms of domestic proved reserves. In addition, it is the operator of substantial reserves in 

Canada, India, and Trinidad. The company's year-end 1995 reserve 

base was 88 percent in North America and 92 percent natural gas. 

I thank you for the opportunity to testify on the role of Enron 

Oil & Gas as a participant in the royalty-in-kind pilot program conducted by the Minerals Management Service in 1995. I will discuss 

the program from the point of view of Enron Oil & Gas as a producer of natural gas from MMS leases. 

I will also include comments on behalf of Enron Oil & Gas Marketing, Inc., a marketer which buys and resells natural gas and 

was the willing bidder for the MMS's royalty gas from the Enron 

Oil & Gas company's leases. 

Enron Oil & Gas volunteered for the RIK pilot program five 

leases offshore the Gulf Coast of Texas in the Matagorda Island 
12 

area. Enron Oil & Gas's ownership in these leases vary from 61 

percent as a low to 89 percent as a high. And also Enron Oil & Gas 

is the operator of the producing facilities serving those blocks. 

As far as the volumes produced and marketed in 1995, we have 

summarized those volumes into two groups; one group of 

Matagorda 500 blocks, if you will, with their share of the gas average for 1995 4,380 MMBTU s per day, and on the Matagorda 620 

and 638 blocks, MMS volumes averaged 7,450 MMBTU s per day. 

You add that up, and you come up with something shy of profiles 

of MMBTUs per day. 

What are the benefits of the program? We believe the major administrative benefit of the pilot program should be to reduce the 

MMS audit requirements, mainly involving valuation issues. We 

have found that resolving valuation issues during an audit takes 

a significant amount of administrative time and effort. 

Another potential benefit of the program we identified was the 

MMS's waiver of the onerous requirements of Section 10 of the 

Outer Continental Shelf Lands Act for refunding overpayments by 

the producers to the MMS. 

The program would seem to provide yet another benefit to the 

producer because the administrative responsibility for filing MMS 

2014 forms was, on paper, shifted from the producer to the marketer. Unfortunately, marketers at this time were typically unfamiliar with these forms and the reporting requirements. Thus, the producer was still involved in the process and was required to provide the marketer with information involving detailed 

volume allocations. This negated the producer's benefit of not filing 

MMS 2014 forms, but, perhaps over time, the marketers' familiarity with these forms could ease the producers' input into the 

overall process. 

Unfortunately, the pilot program also required additional reports 

from the producer that would offset some, if not all, of the administrative benefits previously discussed. For example, the MMS required the producer to complete a Royalty Gas Imbalance report 

which was required to be submitted to the MMS and the market. 

The producer was further required to provide the MMS a monthly report which included detailed volume and pricing information 

so that the MMS could evaluate the revenue neutrality of the program. 

As far as the marketing contract goes, it was unlike most industry contracts in that certain provisions were very one-sided in favor 

of the Minerals Management Service. The majority of the industry 

agreements between Enron Oil & Gas and the marketers have provisions that are reciprocal in nature, meaning the penalties will affect either party if nonperformance occurs. 

If the marketing contract offered under this program had been 

submitted by an industry entity instead of the MMS, neither Enron 

Oil & Gas nor Enron Oil & Gas Marketing would have executed 

the agreements because of its strong bias for the other party. Generally, the provisions where this bias was most prevalent were, 

first, penalties for the marketer's failure to take 100 percent of the 

gas volume; secondly, indemnification of the MMS for any penalties 

due to gas pipeline imbalances; and, finally, the right of the MMS 

to terminate the contract anytime without liability. 
13 

How can the 1995 pilot program be improved? One thing would 

be to mandate that all producers or owners in the blocks participate in the program. This will allow the operator to handle MMS 

volumes similar to the volumes of other owners. And in my written 

testimony, I have one more suggestion involving the gas contract, 

but I would like to go to the final paragraph if I could please. One 

more comment. 

As a producer and marketer, I can only support expansion of the 

pilot program if the expansion includes elimination of administrative burdens imposed by the MMS during the pilot program. I fully 

support the idea of reduced MMS audit requirements which could 

virtually eliminate valuation issues. 

However, if the MMS continues to require producers and marketers to prepare reports outlined in this presentation, I fear that both 

the industry and the MMS would incur significantly higher costs. 

If the pilot program is expanded, MMS would need to increase its 

gas marketing expertise. 

In today's unregulated environment, the MMS needs to develop 

competent expertise in all producing and marketing issues from the 

wellhead through the pipeline delivery point. If the MMS does not 

want to invest in gaining more expertise, but would prefer to expand the program utilizing basically the same concepts and onerous agreements as the pilot program, I believe the current program 

would be difficult for both producers and marketers to accept. 

Not only would it increase the producers' and marketers' costs of 

operations, but I believe it would be grossly unfair for the MMS to 

mandate such requirements in order to shield the agency from the 

realities of a pipeline and marketing environment largely created 

by its sister agency, the Federal Energy and Regulatory Commission. Thank you, Mr. Chairman. 

Mr. CALVERT. Thank you for your testimony. Mr. Patterson, 

Manager, Gas Plant Supply & Property Management, Amerada 

Hess Corporation? 

Mr. PATTERSON. That is correct. 

Mr. CALVERT. You may begin your testimony. 

STATEMENT OF G.S. PATTERSON, MANAGER, GAS PLANT SUPPLY & PROPERTY MANAGEMENT, AMERADAHESS CORPORATION 

Mr. PATTERSON. Well, in June 1994, the .MMS approached 

Amerada Hess and asked us, among others, to participate in the 

gas pilot in the Gulf of Mexico. We participated by pumping, to 

some extent, with the contracts on both sides. They asked for our 

comments, and we gave them there. We also participated by offering three offshore leases for the pilot, two of which were accepted. 

As a marketer, Amerada Hess bid on 23 groups of leases, and we 

were a successful bidder on one. 

Overall, I would say the MMS did an excellent job in designing 

and implementing the pilot. By getting input from the industry to 

start with, they avoided a lot of problems. It got off to a very good 

start. I really don't know if it was successful or not because I 

haven't seen any of the results yet. 

With respect to the two leases that Amerada Hess had in the 

pilot, the economic results were not favorable. The MMS lost about 

26-584 - 96 - 2 
14 

14 cents per MCF on the gas that was provided in-kind versus the 

revenue they would have received under the conventional method. 

And I, once again, have no idea of what the offsetting administrative savings might have been. 

There are a couple of specific things that could be improved. During the bidding process, information really was not available to the 

marketers with respect to the lateral lines. Those are the lines that 

go from the wellhead to the nearest large pipelines. And without 

that information, bidders were bidding in the dark. And I was 

working on this-the bids-the properties we put up, people did 

call me and ask me what the pipeline arrangements were, and it 

was a fatal mistake for some of them. 

Another area, if after a marketer has bid on a property and the 

rules change; for example, if the FERC allows certain interstate 

pipelines to spin down their gathering assets and the marketers 

see higher fees, they can be in a situation where they will be forced 

into a breach situation, which wouldn't because they really 

weren't--

And, finally, if the MMS wants to go ahead with their extended 

pilot-second pilot or perhaps go on to putting all the offshore gas 

under something like this, I would suggest they do it over a period 

of time. Because overnight if they did it, it would be like 116th of 

the gas, which is pumping 2/BCF a day, would, in effect, disappear 

from the market in one respect, and the producers wouldn't have 

that gas to sell so the market companies would have it. To the extent the producers had entered into long-term contracts 

for transportation or perhaps warranty contracts for the downstream, they would have to scramble to replace that gas. So certainly if we can do this, we want to do it over time, which gives 

the industry time to adjust. 

A solution to that would be to allow the producer to have a last 

look at that marketer's bid and match it. That would be revenue 

neutral to the MMS, and it would give that producer a chance to 

keep his gas and continue to sell it. Those are my comments. 

Mr. CALVERT. Thank you, Mr. Patterson. Larry Nichols, President of Devon Energy. 

STATEMENT OF LARRY NICHOLS, PRESIDENT, DEVON ENERGY 

Mr. NICHOLS. Thank you, Mr. Chairman. I am Larry Nichols, 

President of Devon Energy Corporation, an independent producer 

who has Federal production. I am here today on behalf of Devon 

and the Independent Petroleum Association of America, a national 

trade association with over 5,500 independent oil and gas producers. I will summarize my comments but request that the full written comments be made part of the record. 

Mr. CALVERT. Without objection, so ordered. 

Mr. NICHOLS. Mr. Chairman, we always appreciate the opportunity to work with you in the pursuit of a more efficient and cost 

efficient way of managing the payment of royalties. In June of last 

year, I testified before you on the need to reform the Federal royalty collection system. We personally want to thank you and the 

committee for responding by expeditiously moving the Royalty 

Fairness bill, and we appreciate your continued efforts on behalf of 

that bill. 
15 

Today, we are discussing another important initiative-reducing 

uncertainty associated with the payment of Federal royalties in today's natural gas market. We applaud the Minerals Management 

Service's recognition that alternative approaches need to be pursued to develop a more certain and a more predictable method of 

determining gas royalty payments. 

Gas production is important to this country and is important to 

independents who produce 65 percent of domestic natural gas. We 

need to develop a Federal royalty system that encourages natural 

gas from Federal onshore and offshore leases and, as required by 

law, always looks to the free and competitive market between a 

willing buyer and willing seller as the basis for all royalty payments. 

The gas market has changed radically in recent years. Historically, gas was sold at the wellhead by the producer at a regulated 

price. Payment of royalties, the calculation of royalties was very 

simple. A lot has changed over the last few years. Producers may 

now sell directly to industrial customers, to end-users, to local distribution companies, and other former interstate pipeline companies. 

Producers must now also either build, in many cases, transportation lines to transport gas away from their wells or pay third 

parties to transport gas away from the wellhead for shipment to 

different markets. 

We agree with a March 1996 MMS report which stated that in 

today's gas market, tracing proceeds from a point of sale back to 

a particular lease is very difficult, and determining the royalty 

value of gas produced from Federal leases has become increasingly 

complex and burdensome. 

Additionally, we believe uncertainty increases costs once considered deductible as a cost for merchant services provided by a pipeline. Those are now being questioned and traced to distant markets 

for royalty purposes. 

In response to the changes in the gas marketplace, the MMS has 

initiated two important efforts: one, a negotiating committee to update the rules for paying gas royalties and, two, a royalty-in-kind 

pilot. With regard to the rulemaking effort, IP AA supports finding 

an alternate valuation method for gas that does not increase ad- ministrative costs and eliminates the burdensome accounting now 

associated with gas processing. With regard to the royalty-in-kind program, Devon volunteered 

one offshore lease. During that pilot, Devon was required to notify 

the government's purchaser of the volume of the gas that it was required to take. This additional communication and the new relationship with the MMS's purchaser appears to somewhat offset the 

administrative cost savings that occur by eliminating the current 

royalty calculation method. 

On the other hand, a mutual benefit to both the government and 

the producer under any in-kind-type scenario is the certainty that 

is associated with delivering volumes in lieu of royalty payments. 

Once delivered, the royalty obligation under a lease is satisfied. One question that is always asked is what is the market value? 

When taken in-kind, the market value is the price that the MMS 
16 

receives from the willing purchaser. This eliminates the audit burden, both on producer and on the government. 

We compliment and encourage the MMS to continue to work cooperatively with the industry and the States to develop these alternatives to restore certainty and create simplicity for paying royalties on natural gas production. We strongly encourage the MMS to 

allow pilot participants an opportunity to comment on its draft to 

the report so that both producer and market reviews can be incorporated into that final report. To encourage additional pilots, my 

own company has volunteered gas for an in-kind onshore pilot. 

Mr. Chairman, we support the legislative language that you submitted to the Chairman of the Subcommittee on Interior Appropriations authorizing the MMS to conduct additional in-kind pilots. 

If these pilots are conducted in a manner similar to your language, 

then all concerned parties will be able to make informed decisions 

about the future of such a program. 

I want to inform the committee about a separate effort we have 

initiated to develop alternatives to the current system. As chairman of an advisory subcommittee for the MMS entitled 

Nonconventional Alternatives, we will attempt to develop payment 

options to reduce the royalty regulative burdens that are now associated with gas production. 

As this committee's works are concluded, we will report back to 

you and the MMS on our efforts. We are available to work with 

this committee in pursuit of its attempts to simplify domestic natural gas production. Mr. Chairman, this concludes my prepared comments. Thank you. 

[Statement of Mr. Nichols may be found at end of hearing.] 

Mr. CALVERT. Thank you, Mr. Nichols. Mr. Hoyle, as a marketer, 

put yourself in the shoes of MMS for a second, and tell us what 

you could do with in-kind gas to increase revenue to the Federal 

and State treasuries. 

Mr. HOYLE. I think if I were in the MMS's shoes, I believe that 

it is tough to market gas when you are a passive working-interest 

owner, in effect, at a block platform or a well. A company that operates has some advantages in marketing its gas because it knows 

what the volumes are. But I think overall, a general comment, if I was the MMS, I 

would look and see where I have strengths or I have volumes concentrated on certain pipelines-large volumes-! would say in excess of 5,000 MMBTUs per day. The closer to 10,000 MMBTUs per 

day or greater, I think, would be better. 

And that is just simply because you get to the lower volumes. If 

you think you get a higher price for the gas, it doesn't really have 

that much impact on the higher the volumes generally. You use a 

little more market clout in here. So I would, again, look in detail 

at the areas where I do have strengths-larger volumes-so I could 

aggregate those sources and be a bigger player in the marketplace 

on that pipeline system. 

Mr. CALVERT. Mr. Patterson, regarding valuation, Director 

Quarterman testified that revenue loss on the pilot was not really 

known. You indicated that there was a 14 cents per MCF. Is this 

figure derived from your company's production-volunteered for 

RIK versus the price you sold the other 5/6th at? 
17 

Mr. PATTERSON. Yes. That was just restricted to the two leases 

that Amerada Hess had with the program. 

Mr. CALVERT. So, obviously, this is your particular company, and, 

if so, you can't comment on MMS's loss throughout the entire pilot 

program, but certainly in your particular instance it was 14 cents? 

Mr. PATTERSON. I have no idea whether there was a loss or gain 

on the rest of it. 

Mr. CALVERT. What is that, sir? 

Mr. PATTERSON. I said I have no idea if there was a loss or gain 

on the rest of the pilot. 

Mr. CALVERT. OK. When various companies are bidding for business with MCF, do you think there is fear dealing with the Feds 

somewhat because of the bureaucracy or whatever the reason, and 

that translates into discounting as far as what they bid on as far 

as the gas that they are buying from the MMS? 

Mr. PATTERSON. Well, from our perspective, it was something entirely new. We had never done anything like that so there was a 

little fear that we were getting into something we weren't familiar 

with-the bidding with a Federal agency. And also the contract 

that, you know, a marketer had to sign was pretty draconian. It 

was tough. You had to give a lot of thought to whether to bid or 

not, and then build in some extra money just in case you got in 

trouble. 

Mr. CALVERT. Mr. Nichols, please tell us how expanding the royalty-in-kind program could benefit an independent operator such as 

Devon? 

Mr. NICHOLS. Well, the primary benefit from any in-kind program is to create certainty so that you know what your role to obligation is and how it can be satisfied. By giving the government its 

share of royalty at the wellhead, you know with certainty on a 

timely basis that you have totally fulfilled your obligation. On the 

other hand, the current system has great uncertainty with it because of the valuation methodology and the complications that the 

MMS follows in determining the value. 

Secondly is the cost benefit. The current system is very costly to 

the industry and very costly to the government because of all of the 

reporting and all of the auditing that needs to go on. A royalty-inkind program holds out the promise to eliminate those costs or substantially reduce those costs and to add certainty. So I would say 

the establishment of certainty and the substantial reduction in cost 

holds out great promise to both the government and to the independent producer. 

Mr. CALVERT. I think this question would be both for Mr. Hoyle 

and for Mr. Patterson. What are your suggestions to MMS for future pilots, would it be increase competitive bidding for the royalty 

gas? A similar question that I asked Mr. Patterson earlier. How do 

we get that number up? 

Mr. PATTERSON. Better information. I think given more time to 

put your bid together, more time to contact the producer, find out 

how the wells are connected, and what pipelines they flow through, 

and not doing it starting in the winter would be a good idea. Those 

are a couple of items the MMS mentioned. Those would be the 

major ones I would suggest. 
18 

Mr. HOYLE. Mr. Chairman, I guess I would agree with what Mr. 

Patterson said, but I would also add that if MMS would want higher value or more bang for the buck or whatever you want to call 

it, that they might be willing to take some more risk in the marketing efforts with the marketers. Because marketers are basically in 

the business to make money, and they don't particularly care for 

risk either. 

And the way the contracts are structured, the marketers really 

bore the brunt of the risk in marketing this gas, whether it was 

a pipeline imbalance or whatever. I think if MMS would maybe accept a little bit of that risk themselves and not try to push it off 

on other parties, that may enhance the prices that they could receive at the wellhead for their profit. 

Mr. CALVERT. Again, for both of you, from your experience with 

the '95 pilot, are your companies willing to participate in future 

programs? 

Mr. PATTERSON. We would participate again I think. 

Mr. CALVERT. How about Enron? 

Mr. HOYLE. Yes, sir, Mr. Chairman. We would participate in the 

program, but I would like to also add, if I may, that Enron Oil & 

Gas would like to work with representatives of the MMS at, you 

now, really a very early stage in designing the pilot and identifying 

the producing areas where they have strength, and then we can 

make the program really more reciprocal or beneficial for both parties. So we would like to be very much a part of that process. 

Mr. CALVERT. Mr. Hoyle, Enron, of course, is certainly a very 

large company, and what are you?-the largest marketer of natural 

gas now in the world or right up there from what I understand. 

And Mr. Kelley testified as to the State of Texas's RIK program 

possibly being expanded to a public/private partnership for adding 

further value to their royalty gas. 

That sounds like an invitation Enron certainly would-a company such as yours or probably Mr. Patterson's company also 

would certainly-be interested in. But your testimony with respect 

to MMS can be described as a little negative. Basically, what do 

you think that Texas has learned and the Feds haven't? 

Mr. HOYLE. Mr. Chairman, I am not familiar with the Texas program. We don't have any leases or properties that participate in 

that effort so I really have no direct knowledge about really how 

the program is structured or designed and how it is implemented. 

I am sorry I can't help you there. 

Mr. CALVERT. OK. Well, maybe you can put some thought into 

it. Maybe later on you can get back to us on that. Mr. Nichols, lastly, given that many independents continue to sell their production 

at or near the lease, what benefits and drawbacks do you envision 

under an in-kind scenario? 

Mr. NICHOLS. Well, I think the benefits are demonstrated by the 

Texas program. If Texas has devised a program that is satisfactory 

with the industry down there and satisfactory with government 

and doing it in a cost-effective and adding certainty to the system, 

t};len one would certainly hope that the same principles could be applied on Federal lands. 

Mr. CALVERT. Thank you for your answers, and now the ranking 

member, Mr. Abercrombie, has arrived. And so I would like to 
19 

allow him to make a statement and ask a few questions if he would 

like. 

Mr . .ABERCROMBIE. I have no statement, Mr. Chairman, other 

than to thank you for having the hearing and getting some of the 

information that has come forward since the experimental program 

went into existence to be put on the record .. The only question I have~me or two questions-maybe are more in the way of observations. And you may have gone into this previously but perhaps 

could be amplified on. . Am I correct that essentially what happens if everything works 

out in the experimentation is that the uncertainties that are associ- ated with trying to deduce exactly what costs can be legitimately 

assessed with respect to transportation processing, marketing, et 

cetera, those costs can essentially be eliminated-not the costs 

eliminated, but trying to assess the costs be eliminated, and you 

essentially get down to production in volume being, if not the singular, the essential element against which costs are assessed? Correct? 

Mr. PATTERSON. Correct. 

Mr. ABERCROMBIE. And you have had this experience now for is 

it a year? Is it a whole year already or approximately a year? '95 

but I am not quite certain when it started-'95-'96. How long is 

the experience right now? 

Mr. PATTERSON. The pilot was for 12 months. 

Mr. ABERCROMBIE. OK. So it has been about 12 months now. OK. 

Four quarters. Now, inasmuch as there were, let us see, what?-

about a quarter of the eligible companies participated in the experiment so far? Am I right? 

Mr. PATTERSON. I don't know. Mr. CALVERT. About six percent of the MMS production. Mr. ABERCROMBIE. I am not sure of the total production. But, I 

mean, the number of companies. I think there are what?-150 or 

plus companies that might have participated in about 40 some companies. But let us say for all intents and purposes, other companies 

are watching you. Have you shared your experience so far with 

other companies? Have there been any other inquiries? I am speaking in industry exchanges of one kind or another. 

Mr. PATTERSON. I have not. 

Mr. NICHOLS. There certainly has not been any formal exchange. 

There is certainly a lot of informal exchange-anecdotal exchange. Mr. ABERCROMBIE. Right. So has there been-and, again, I may 

have missed this-has there been a formal time in which there will 

be an assessment where everybody will sit down and try to offer 

their formal-aside from this hearing, has there been a formal 

presentation by the companies, say sponsored by MMS, where they 

come out and say, "Here is our evaluation"? 

Mr. NICHOLS. Mr. Abercrombie, one of the points I made in my 

remarks was that the MMS is currently preparing a report, and I 

suggested that the MMS share a draft of that with the industry 

participants so that our own views could be expressed in that, and 

that that might provide a forum for--

Mr. ABERCROMBIE. No, I understand that. Right, and I agree 

with that. But there has not been done, say, a formal conference 
20 

or anything in which evaluations are presented for public consumption. Right? Unless I am mishearing? 

Mr. NICHOLS. That is right. 

Mr. ABERCROMBIE. OK. Do you think such a thing would be a 

good idea? 

Mr. NICHOLS. Yes. 

Mr. ABERCROMBIE. I don't think-you know, I am quite the opposite on the fence from Mr. Calvert, but I give him credit for having 

the hearing today. I am pleased we have had it, but I don't think 

a congressional hearing is the proper forum for a kind of roundtable-! guess is really what I am talking about-in which those 

of you who have been participating could perhaps present your various perspectives as to what has happened. Because I think that 

would be perhaps the most effective way for the other companies 

to get the benefit of your experience. Does that strike you as something that would be useful? 

Mr. NICHOLS. I would agree with that and for the MMS to exchange its views on that subject too. 

Mr. ABERCROMBIE. I am sorry. I missed the last--

Mr. NICHOLS. And for the MMS to exchange its observations. 

Mr. ABERCROMBIE. Yes. In other words, a roundtable and then do 

some kind of report, and I don't really see the efficacy necessarily 

of having a report based on extraction rather than-you know, no 

pun intended-trying to extract a viewpoint as opposed to simply 

having people analyze what they have gone through, what they see 

the pluses and minuses, and try and go. 

And if it is OK with the Chairman, I would like to suggest perhaps that we suggest, in turn, to the MMS and to the companies 

that have been involved in this that perhaps a roundtable discussion or something of that nature prior to reports being issued and 

all that be undertaken, and then that be made available, not just 

to us, but to the industry as a whole. 

Mr. CALVERT. I don't oppose that idea. I understand that they 

are at the last ebbs and flow of putting together this report so it 

would have to be pretty quick. 

Mr. ABERCROMBIE. OK. Well, then let me alter it. How about 

this, that once this report becomes available, how about sharing it 

with all the companies involved, get responses, and then perhaps 

hold a roundtable discussion on the papers that thus evolve, and 

then before you get to a final conclusion, that it comes, say, back 

to us? 

Mr. CALVERT. Certainly. We will share that with Director 

Quarterman and see if we can't get some kind of--

Mr. ABERCROMBIE. Is there any disagreement among you folks as 

to that, generally? I am not saying that is definitive but something 

along those lines. You at least ought to be able to get a chance to 

respond or to comment or observe on such a report, don't you 

think? 

Mr. NICHOLS. Absolutely. 

Mr. ABERCROMBIE. And then perhaps the combination could be 

put forward in a general industry conference or roundtable or 

something of that nature. Because that is the best way I think, Mr. 

Chairman, in conclusion, that we can get the kind of feedback we 

need to make legislative activity useful and focused. Thank you. 
21 

Mr. CALVERT. Right. Certainly. And I think information is useful, 

but certainly through this hearing today we found out it has been 

very successful in Mr. Thornberry's State of Texas. And I think we 

can share that and hopefully move this program along. With that, 

I will introduce Mr. Thornberry to ask questions of the industry 

panel. 

Mr. THORNBERRY. Thank you, Mr. Chairman. And I want to 

thank each of the witnesses on this panel for participating in the 

hearing today. Following along Mr. Abercrombie's line, it is kind of 

interesting, as I have tried to work on this issue, that some folks 

don't mind talking about it quietly, but they have some concerns 

even talking about the subject in a public way, which I have yet 

to figure out, but probably not the only thing. Enron answered this question from the Chairman, but let me 

just check with the other two of you. Have you all had any experience with the State of Texas's program so that we can compare one 

program versus another? 

Mr. NICHOLS. No. Our company has not. 

Mr. PATTERSON. Nor has ours. 

Mr. THORNBERRY. Do any of you have concerns and, if so, what 

are they, to a program that would be a mandatory royalty-in-kind 

gas program for, say, the 8(g) zone where you have to take your 

royalty-in-kind at the wellhead? Does anybody have any problems? 

Mr. NICHOLS. Well, I think, you know, if the royalty-in-kind program can be developed to correct some of the problems and it 

works--

Mr. THORNBERRY. Yes, so we have got to deal with the administrative problems that Mr. Hoyle talked about, for example, and I 

think you talked about it as well. But if, say, we can reduce those 

administrative problems that maybe offset some of the advantages 

of a royalty-in-kind, is there any other reason that you can see or 

objections that you would have to that sort of approach? 

Mr. HoYLE. Mr. Thornberry, if I could ask a question? Would 

that just be-when you say mandate, that would be like blanket? 

Mr. THORNBERRY. It would apply to everybody. 

Mr. HOYLE. It would apply to everybody? 

Mr. THORNBERRY. It would apply to everybody. 

Mr. HOYLE. EveryWhere? The thing that concerns me a little bit 

about that is that every producing area has its own distinct, unique 

type of characteristics. It is not something that you can kind of put 

into squares and circles or whatever. It is every area, again, is kind 

of distinct and unique as far as the number of wells that are 

drilled, the operators and owners that are involved in these leasing 

areas. And just in my opinion, I think there would have to be an evaluation of the producers and operators in an area, say, working together with the MMS to see what the pluses and minuses are of 

doing that in specific areas. I really believe you have to look at 

overall areas for these types of programs and situations just because it is just the way things are, quite frankly. 

Smaller volumes to me don't make any sense to mess with. I 

think that the larger volumes-that is where you have the opportunities to try to capture better margin or premium in the market-

! mean, if you can do that. In today's market environment and pric-
22 

ing the way it is, you know, these premiums are hard to come by, 

at least it has been over the last few years because of the supply 

situation. 

But at any rate, I think you have to look at the measure-producing areas, and, again, I would volunteer Enron Oil & Gas as a participant with the MMS to undertake-that in here as we write. 

Mr. THORNBERRY. Well, would it be specific enough to say to 

have a mandatory program in the 8(g) waters off the coast of 

Texas? Is that a zone that is specific enough that you could make 

a determination whether it would work or not, or do you have to 

divide that up further? 

Mr. HoYLE. I am embarrassed to admit that the 8(g) waters-you 

are talking about the State waters of Texas-just the State waters 

or--

Mr. THORNBERRY. Yes, or the Federal. Yes, the Federal. All right. Because in Texas it goes further than in other States. 

Mr. HOYLE. Right. Well, as far as the OCS waters go, the way 

the transportation networks and systems are set out, they are very 

complex and many. So, again, I am sorry I can't get off this broken 

record of looking at individual areas, but that is kind of where I 

am headed once again. 

Mr. THORNBERRY: OK. Well, let me ask you this. Would there be 

any complications that would arise, say, if the State took production in-kind but MMS did not in those waters, if you have two governmental entities that are operating under two different systems? 

Mr. HOYLE. If it would be set up where the State would participate like a nonoperating working interest owner and go through 

the same operating conditions that a working interest owner does 

to try to market that gas, that it would just add just another owner 

to the situation that you are already in. It doesn't seem like just 

offhand that that could be too burdensome, but, again, I would like 

to look at it in some more detail just to make sure. 

Mr. THORNBERRY. Sure. Mr. Nichols, several times today anumber of us have talked about how a royalty-in-kind program would 

help in dealing with problems of valuation and administrative expenses-the lawsuits that you get into from all of that. But I don't 

think we have addressed yet how big a deal that is. You can say 

administrative expenses and problems of valuation, but can you address how important is it to basically solve disputes over valuation? 

How big a burden is that on producers, and how much advantage 

is there to getting that sort of program? 

Mr. NICHOLS. Well, that is a significant burden, and it is a burden that is growing. That is attested to by the burgeoning number 

of lawsuits on that very issue. Litigation is, of course, an extremely 

expensive way to resolve disputes. And just the sheer burgeoning 

number of lawsuits on royalty questions is ample evidence that 

there has got to be a better way to provide simplicity and fairness 

to both sides. 

One would like to hope that these pilot programs would lead to 

a royalty-in-kind program that both the government and the industry would be both enthusiastic about so that a mandatory program 

would be welcomed. It is perhaps premature to answer that question now because we haven't determined whether we can solve the 

problems that would allow us to all embrace a mandatory program. 
23 

Mr. THORNBERRY. So you are going to need to, for example, look 

at the contracts and the administrative burdens and that sort of 

stuff that would go with the mandatory program for you to know 

for sure whether you want to put your arms around it or not? 

Mr. NICHOLS. Right. Precisely. 

Mr. THORNBERRY. OK. I don't blame you a bit. Mr. Patterson, I 

thought you made an interesting point that if you move to, say, a 

total royalty-in-kind program that you have to take into account 

existing contracts. Because if you take away a certain volume from 

existing producers, they have to make it up some way. How long 

or for what time period are typical contracts now? In other words, 

what sort of contracting timeframe do we need to be concerned 

about? 

Mr. PATTERSON. Well, generally, they can be long-term contracts, 

say, five, ten years....:....things like that. Or on a gathering system, 

you might have to commit to a firm transportation in order to 

save-to get a discount from the gathering company. And you 

would have to commit a volume. Say, 100 BCF over time would get 

you a 2 cent discount off of a rate. And then if you don't move 100 

BCF, you have to pay or you don't get the discount. And that could 

be several million dollars to the producer, and that would be the 

life of the lease. So it is not an insignificant problem. 

Mr. THORNBERRY. Is it common to have 10-year contracts, for example? · Mr. PATTERSON. I don't know. When you say common--

Mr. THORNBERRY. I am just trying to get a feel for how widespread that sort of long-term contract is. Mr. Hoyle, can you shed 

any light on that question? 

Mr. HOYLE. Mr. Thornberry, 10-year agreements at least in the 

areas that we produce the market gas are really uncommon. In the 

marketplace nowadays, in our opinion, there is not much value 

added to a really long term type of agreement. There is some, but 

it is not great enough to tie down your production for an extended 

period of time. . As far as a range of contract terms, I would say the most that 

we do as far as term type of a commitment right now would be like 

four years. Maybe we will do a wintertime five-month deal-something like that. But most of the stuff that we do is sold on the spot 

market-type basis. 

Mr. THORNBERRY. So what do you think about this phased-in 

deal? Do you think it needs to be phased in over a period of time, 

and, if so, what sort of time? 

Mr. HOYLE. I would say that sounds like a reasonable and a good 

idea to phase it in over time. I think that would allow you to evaluate the producing areas and design a program that will be most 

beneficial and reciprocal for the MMS, States, and the industry. 

And, Mr. Thornberry, as far as what time period, I really couldn't 

hazard a guess on that. Maybe over like a three-year period, some• 

thing like that. 

Mr. PATTERSON. Mr. Thornberry, may I clear something up? 

Mr. THORNBERRY. Certainly. 

Mr. PATTERSON. With respect to when I was referring to contracts, there are certainly some warranty contracts out there where 

a producer has agreed to sell gas to an end-user for a period of 
24 

time. Those tend to be longer term. Then there are the transportation contracts, which can be for a lot, so those are distinct, and 

both are still being entered into today, I believe. 

Mr. THORNBERRY. OK. Thank you. Mr. Hoyle, you mentioned 

something about market clout that comes with the greater volumes-having control over greater volumes. It would just seem to 

me that that would certainly apply to this situation with MMS, 

would it not, that this pilot program-let me ask you this way. 

Would it be true that the pilot program may underestimate 

somewhat the ability to market the gas because we are dealing 

with a small quantity, and if we are dealing with a larger quantity 

that they might be able to get a better deal? Is that true or not? 

Mr. HOYLE. Well, . I would just say from a market clout standpoint, if you have a large volume of gas, say, in excess of 10,000 

MMBTUs per day, one of the things that you can do is split that 

volume up and sell it to the other purchasers. 

Like you can take two 5 million-a-day segments and bid it out 

and see if you couldn't get better pricing in doing something like 

that. Or you could take that 10 million-a-day package and do some 

kind of a warranty-type transaction or longer term commitment for 

just a piece of it. 

Because, again, the way the market works nowadays, what the 

purchasers are looking for is a volume delivered at a point, and 

they want that volume to show up every day, every hour. But, see, 

you have to warrant that that volume will show up. 

Well, if you have a 10,000 MMBTU segment of gas so you could 

warrant 4,000-5,000 MMBTUs per day of that, that would give 

you some excess gas above that to allow for some downtime or natural depletion of the reservoirs so you can ma.ke sure that that gas 

volume did show up. 

And typically with a warranty-type situation, you probably could 

get a little bit better price, but within the last couple of years with 

the supply situation being pretty strong, we have not seen any real 

benefit in doing those kinds of things. Now, it appears to us that 

the supply-and-demand situation is changing, and you could maybe 

capture more of a premium by doing that. It hasn't happened here 

just recently, at least in our experience. 

Mr. THORNBERRY. Until this winter at least, we had plenty of 

supply, didn't we? Mr. Chairman, if I may add just finally, Mr. 

Nichols followed up on Mr. Abercrombie's point. Do you think lots 

of other folks are interested in the idea? 

One of you talked about that you haven't had any formal conferences talking about it but informal discussion. And among the 

people that you deal with and talk with, do you think that there 

is interest in this sort of approach among those people who are in 

the business? 

Mr. NICHOLS. Oh, yes, I definitely think there is interest. There 

is concern as there always is with change, with new ideas. There 

is concern about how it might work and wanting to make sure it 

does work more properly. But there certainly is interest in the idea 

because we all recognize the difficulties that both we and the government have with the current system. 

Mr. THORNBERRY. Thank you. 
25 

Mr. CALVERT. Thank you, Mr. Thornberry. And I want to thank 

this panel for your excellent testimony and coming forward today. 

We had some trouble with some of the major oil industry's reluctance to come out and testify today so we are grateful to you that 

you came out this long distance to give us some valuable information. Thank you very much. This Subcommittee is adjourned. 

[Whereupon, at 3:36 p.m., the Subcommittee was adjourned; and 

the following was submitted for the record:] 
26 

Testimony of 

Cynthia L. Quarterman, Director 

Minerals Management Service 

U.S. Department of the Interior 

Before the 

Subcommittee on Energy and Mineral Resources 

Resources Committee 

House of Representatives 

June 27, 1996 

Mr. Chairman and Members of the Subcommittee, I appreciate the opportunity to 

appear today to present testimony on the Royalty Gas Marketing Pilot (pilot), which 

was implemented by the Minerals Management Service (MMS) in 1995. The pilot was 

one of the National Performance Review (NPR) labs implemented by the Department 

of the Interior and represents one of our many efforts to provide better service to the 

public at reduced cost. 

The MMS gas pilot was conducted from January 1, 1995, to December 31, 1995, and 

tested the concept of MMS taking the Federal Government's royalty share of gas 

production in-kind from offshore federal leases and selling the gas at or near the leases 

to competitively chosen gas marketing companies. The royalty gas was provided by 

14lessees on 79leases who volunteered to participate in, and helped MMS design, the 

pilot. 

The MMS had two objectives in conducting this pilot: 1) to find processes for 

streamlining royalty collections in a manner that reflects changes that have occurred in 

the gas market; and 2) to test a process of royalty collection that promises increased 

efficiency and greater certainty in valuation. We are pleased with the results of the 

pilot. It has provided the information required by the Federal government to evaluate 

the potential of using in-kind royalty collection for gas. 
27 

2 

During the pilot, MMS took, in kind, approximately 45.6 billion cubic feet of gas, 

totaling over 6 percent of the Federal government's royalty share in the Gulf of Mexico 

and sold it to gas marketing companies. The marketers were responsible for all costs 

downstream of the points of delivery. They also retained all proceeds from selling the 

gas to their customers in a free market environment. 

The MMS plans to issue a report on the pilot results later this summer. My testimony 

today will address only the main conclusions from the report. We will provide the 

Committee with a copy of the report as soon as it is completed. Based on the results 

of this pilot, MMS is considering whether to pursue additional royalty-in-kind efforts, 

and if so how and where to conduct them. We will keep the Congress informed of our 

progress in deciding whether to proceed and where. 

Background 

The pilot was a dramatic effort by MMS to do business in a different manner in 

response to recent changes in the gas marketplace (post FERC-Order 636). The MMS 

is testing the concept of removing itself from the complex practice of determining the 

appropriate value of production and auditing whether companies have paid royalties 

based on an appropriate value. In traditional gas valuation, much of the complexity 

arises from the difficulty in determining whether a non-arm's-length transaction 

represents the true value of the gas. We face additional complexity because of the 

problems inherent with calculating whether and to what extent certain costs incurred 

after production (e.g., transportation, processing, marketing) are deductible from the 

royalty value. 

In the pilot, the valuation procedure is simplified dramatically. The producer is 

responsible for reporting only the total gas production from the lease and the royalty 

share of that gas delivered to the marketer. The marketer reports and pays MMS on 

the basis of the volume taken and the price! MMBtu at the lease, which is the price the 

marketer bid for the gas in the competitive selection. Thus, production volumes 

become the sole focus of any audits. 

The MMS designed, and has evaluated, this project in collaboration with its customers. 

This is an experimental effort to develop a regulatory approach that complements 

industry practices instead of adding burdens. 
28 

Some of the key features of the pilot include the following: 

• The leases included in the pilot were volunteered by the participating 

lessees. 

• The agreement establishing the procedure for taking of royalty gas was 

negotiated by the MMS and the lessees who volunteered to participate in 

the pilot. 

• The MMS competitively selected marketing companies by issuing an 

open Invitation for Bids (IFB) on October 21, 1994. MMS opened the 

bids on November 21, 1994. 

• The IFB instructed bidders to submit bids for each lease or group of 

leases identified by MMS. The bids were to be stated in terms of a 

published index price e.g., plus or minus a differential. 

• Bids were based on the value of the gas at the Point of Delivery with the 

marketer responsible for costs incurred downstream of that point. 

• The MMS received 23 bids from 22 companies, and ultimately awarded 

13 contracts. 

Royalty gas valuation, determination, and collection procedures have been subject to 

debate and litigation for years. Recently, MMS has undertaken several initiatives to 

attempt to find ways to streamline these processes without sacrificing royalty revenues. 

One of the attempts was gas pilot. 

The procedures employed in the pilot were made possible by recent deregulation of the 

gas industry. Since the Natural Gas Policy Act of 1978, the gas industry has 

experienced several phases of deregulation including the decontrol of wellhead prices, 

the open access regulations for pipelines contained in Federal Energy Regulatory 

Commission (FERC) Order 436 and the formal separation of pipeline company sales 

and transportation services accomplished in 1993 by FERC Order 636. 
29 

4 

This deregulation has transformed the U.S. gas market in at least two important ways. 

First, wellhead prices for gas are now determined by competitive forces to a much 

greater degree. Second, marketing companies have emerged that provide the services 

required by buyers and sellers in today's gas market. These changes have improved t4e 

efficiency with which gas is marketed and allow the MMS to take advantage of the 

competition between marketing companies for in-kind royalty gas offered at or near the 

lease. 

Results of the Pilot 

Ill general, we are pleased with the gas pilot. We acquired information and experience 

that will be invaluable in deciding how to proceed with any future gas royalty in-kind 

efforts. In particular, I would note the following results: 

• The pilot was an operational success, proving that the concept is feasible. 

Our experience demonstrated to us that the procedures employed in the 

pilot can function smoothly once producers and marketers have a clear 

understanding of their respective responsibilities. 

• The fuct that MMS designed and evaluated the pilot in collaboration With 

its customers must be considered a critical factor in the pilot's operational 

success. For example, MMS negotiated directly with lessees on the terms 

and conditions for accepting the in-kind gas. This cooperative 

atmosphere also facilitated learning and flexibility. 

• We are still working on our revenue impact analysis for the pilot. Our 

preliminary estimates indicate some royalty revenue loss for the gas 

production covered by the pilot. However, this is not entirely unexpected 

or unreasonable because we built in a 5 percent tolerance.. The most 

important aspect of this pilot was to gain information and experience on 

taking royalty in-kind. · 

• MMS learned several lessons from the pilot that we feel will be useful in 

raising revenues in future royalty in-kind efforts. 

I. We know that all of the participants in this pilot needed 

considerably more lead time than what was allowed. This need 
30 

5 

was particularly evident for gas marketers bidding for the Federal 

royalty gas. Also, MMS needs additional time to verify physical 

gas flow and to determine appropriate gas price indices. 

It We have learned that additional information must be. included in 

the IFB. For example, future IFB's should include all gas analysis 

information (including Btu content) and the names of producer 

contacts who can provide information on transportation costs and 

gas flow. 

III. . Because of time constraints, we started this pilot in the middle of 

the winter season. We have learned that an auction of royalty gas 

should be conducted well before the start of the winter season so 

that gas marketing companies can integrate the availability of the 

gas into their winter gas contracts. By addressing each of these 

lessons in future royalty in-kind efforts, we feel that we can reduce 

the uncertainties faced by bidders and raise the level of bids so that 

revenue losses are reduced. 

However, even in light of what we have learned, it is unlikely that 

the revenue losses can be completely eliminated. The reason is 

that the bids for the in-kind royalty gas reflect the fact that 

marketing companies must incur certain costs for marketing gas 

that was normally borne by lessees. Also, the marketing 

companies must also pay for the use of producer owned pipelines 

at rates that may be higher than the transportation allowance that 

lessees are able to deduct when paying gas royalties on an in-value 

basis. 

• The MMS is also conducting an analysis to estimate the internal (MMS) 

administrative cost savings that can be achieved through the use of gas 

royalty in-kind procedures instead of conventional royalty valuation. 

• Participating lessees indicated that they anticipated administrative savings 

ifMMS were to institute a Gulf-wide gas royalty in-kind program. These 

savings would be realized through reductions in reporting requirements, 

audit interface, and litigation. 
31 

6 

While MMS intends to consider conducting additional pilot projects, there is one 

statutory constraint that could limit MMS' ability to conduct such projects on a 

significant scale on the Outer Continental Shelf (OCS). The problem for MMS arises 

because of the way in that the OCS Lands Act (OCSLA) defines and uses the term "fair 

market value." The Act appears to stipulate that in the selling of royalty gas taken in 

kind, MMS must obtain a price no less than that obtained by the lessee for its share of 

the production. Based on results of the pilot, it appears that MMS would encounter 

difficulty meeting this standard for each lease, each month. The MMS would be 

pleased to work with .the Subcommittee to develop clearer legislative language that 

allows greater flexibility in defining the fair market value standard. 

Conclusion 

In conclusion I would like to emphasize that this pilot represented the true spirit of 

MMS's efforts to find ways to make our royalty management efforts more efficient and 

less burdensome for the industry. We worked with industry to design an efficient 

program that reflects procedures that have evolved in the industry and serve both their 

needs and ours. We have also been encouraged by industry's wiilingness to work with 

us in evaluating the results of our combined efforts. At the same time, we sought to 

structure the pilot in such a way as to ensure a fair return to the public from production 

of its resources. 

We are evaluating the results of the pilot carefully to see how we can best move 

forward to reduce costs, both for government and industry, without compromising 

royalty collections. Please be assured that we will keep the Subcommittee apprised of 

our progress in evaluating the pilot and in considering whether to conduct future gas 

royalty in-kind efforts. 

Mr. Chairman, this concludes my prepared remarks. However, I would be pleased to 

answer any questions you or other members of the. Subcommittee may have. 
32 

Written Statement by 

Larry Nichols 

President and Chief Executive Officer 

Devon Energy Corporation 

representing 

Independent Petroleum Association of America (IPAA) 

before the 

Committee on Resources 

Subcommittee on Energy and Mineral Resources 

U.S. House of Representatives 

June 27, 1996 

Mr. Chairman and Members of the Committee: 

I am Larry Nichols, president of Devon Energy Corporation ("Devon"), an 

independent producer who has federal production. I am here today on behalf of Devon 

and the Independent Petroleum Association of America ("IPAA"), a national trade 

association representing more than 5,500 independent oil and natural gas producers. 

Mr. Chairman, members of the Committee, we always appreciate the 

opportunity to work with you in the pursuit of more efficient and cost-effective ways of 

managing the payment of federal royalties. In June of last year, I testified before you 

about the need to reform the federal royalty collection system. I personally want to 

thank you and the committee for responding by expeditiously moving your Royalty 

Fairness Bill. 

Today, we are discussing another important initiative-- reducing uncertainty 

associated with the payment of federal royalties in today's natural gas market. We 

applaud the Minerals Management Service's (MMS) recognition that alternative 

approaches need to be pursued to develop a more certain and predictable method of 

determining gas royalty payments. Independents have participated in two of MMS' 

efforts to change the way they conduct business in the new gas marketplace. Gas 

production is important to this country and is important to independents, who produce 

65% of domestic natural gas. We need to develop a federal royalty system that 

encourages gas production from federal onshore and offshore leases and, as required by 

law, always looks to the free and competitive market between a willing buyer and a 

willing seller as the basis for all royalty payments. 

One of the two efforts initiated by MMS, which is not the subject of today's 

hearing, is the Federal Gas Valuation Negotiated Rulemaking Committee. This 

Negotiated Rulemaking Committee explored alternative valuation methodologies that 

would reduce the need to trace federal gas molecules through a myriad of complex 

marketing transactions in an attempt to determine market value at or near the lease. The 

IPAA participated in the last official meeting of the Negotiated Rulemaking Committee 
33 

in an attempt to find common ground among large and small producers. The IPAA 

supports an alternative valuation method for gas production and an option to eliminate 

the burdensome accounting associated with gas processing by allowing payment on a 

wellhead heating value. This proposal addresses in an equitable manner MMS' 

concerns about administrative burden, state concerns about revenue neutrality, 

independent concerns about audit burden and cash flow, and everyone's need for a 

simplified valuation methodology. 

The MMS' second effort, to reengineer and increase certainty of gas royalty 

payments, is the topic of today's hearing. The effort is called the Gas Royalty-In-Kind 

Pilot Program (pilot). The MMS asked volunteers with production in the Gulf of 

Mexico to offer royalty gas for participation in a test in-kind program. Devon 

participated in the test in-kind program with one federal lease. We appreciated MMS' 

cooperative spirit of bringing different types of lease forms into the pilot. 

For our volunteered lease on the volumes that were attributable to royalty inkind, Devon replaced the accounting burdens associated with a monthly royalty 

payment with additional gas control responsibilities. Under the pilot, we were required 

to notify the government's purchaser of the volume of gas that it was required to take. 

This additional communication and new relationship with MMS' purchaser appears to 

replace the administrative costs associated with reporting royalty in value. 

Royalty Payments in today's new gas marketplace 

Between the late 1940s and the 1970s, when a new well was drilled , a producer 

would negotiate and execute a gas sales agreement with an interstate or intrastate 

pipeline for the purchase and sale of gas at each new well. The pipeline would then 

construct a transportation (gathering) line to the new well for receipt of the gas into its 

pipeline system. Gas was sold and flowed directly into the interstate or intrastate 

pipeline "at the welL" The pipeline moved the gas through its transportation system to 

its processing plant, if necessary. The pipelines purchased the gas at each well and 

transported it away from the well to local distribution companies, who sold it to 

localized industrial, commercial, and residential customers. Because the pipelines 

bought and resold gas, they functioned as gas merchants and were referred to as 

"merchant pipelines. " 

Gas was sold at the well to the pipelines at a price which represented the value 

of gas in its naturally occurring state at the point of production. For royalty purposes, it 

has been recognized for over 50 years that the price paid to the producers by the 

pipelines constituted the "market value at the well" for the royalty gas produced under 

the lease contracts. 

Beginning in the mid-1980s, gas marketing changed dramatically as a result of 

the Federal Energy Regulatory Commission's ("FERC") initiatives to inject more 

competition into interstate gas markets. In 1985, FERC issued Order No. 436 which 

2 
34 

.required interstate pipelines to provide "open access transportation" to all producer 

shippers on a nondiscriminatory basis. Order No. 436 completely restructured the 

national gas industry and began changing the role of pipelines, from that of gas 

"merchants" to that of gas transporters. In obtaining "open access" to pipeline 

transportation, producers could now transport on pipelines and sell directly to 

prospective customers throughout the nation. 

Subsequently, FERC Order No. 636 mandated the "unbundling" of the 

pipeline's various Sales and transportation functions and other services, and further 

implemented the open access transportation policies initiated by Order No. 436. As a 

result of these regulatory changes, interstate pipelines have virtually ceased to be 

purchasers of gas and instead now function almost solely as transporters of gas owned 

by others. 

As a result of these sweeping changes, potential markets for the sale of gas were 

greatly expanded. Producers may now sell directly to industrial customers, end-users, 

local distribution companies, and other former interstate pipeline customers. Rather 

than sales occurring at the wellhead, as was historically and customarily done during 

the first 50 years of gas production, producers now must either build transportation 

lines to transport gas away from their wells or pay third parties to transport gas away 

from the wellhead for shipment to distant markets. When a producer sells gas away 

from the well, the producer must incur the cost and expense of getting its gas to that 

distant point of sale. The "wellhead" price for "any away from the well" sale can be 

calculated by using a "net back to the well" method, which results in a price that is net 

of the costs incurred to get gas to the market. A producer taking advantage of today's 

marketing flexibility by selling downstream of the well, directly incurs charges for such 

functions as transportation, compression, and processing that were previously reflected 

in an interstate pipeline wellhead sales price. Prior to this regulatory restructuring of 

the industry, these functions were generally performed by interstate pipeline purchasers 

as part of their "bundled" merchant service. 

The changing marketing arrangements did not easily conform to the current 

regulatory structure. As companies sell away from the well, "netting back to the well" 

to determine value can be administratively complex and increase uncertainty as costs 

once considered deductible as a cost for "bundled" merchant services are now being 

tracked and reviewed for royalty purposes. The need for regulatory change for gas 

production was recognized by MMS in a report it issued in March 1995 entitled "Final 

Report Federal Gas Valuation Negotiated Rulemaking Committee," which states that 

"tracing proceeds from sales of gas back to a particular lease is very difficult, and 

determining the royalty value of gas produced from federal leases has become 

increasingly complex and burdensome." 
35 

Why MMS and producers nursued a gas royalty in-kind project 

As stated above, the MMS has acknowledged that the current royalty payment 

system for gas does not compliment the gas marketplace. When MMS takes its royalty 

gas in-kind at the wellhead, it relieves the government and lessee of the uncertainties 

and complexities associated with gas sales occurring at locations remote from the lease. 

The MMS stated in a press release that the pilot "evolved out of discussions with our 

customer and typified doing more with less. It is a true example of reinventing 

government, MMS trying new business practices and procedures to work better and 

smarter." 

A mutual benefit to the government and the producer is the certainty associated 

with delivering volumes in lieu of royalty payments. Once delivered, the royalty 

obligation under the lease is satisfied. One question always asked is what is market 

value? When taken in-kind, market value is the price that the MMS receives from the 

willing purchasers. In-kind provides flexibility for both the MMS and the natural gas 

producer in an ever changing and evolving gas market in North America. 

While my comments today have been general in nature, we have attached 

additional background with regard to a royalty in-kind program. The attachment 

highlights factors that need to be considered that could affect the outcome of an in-kind 

program. To facilitate continued cooperation between MMS and industry for 

experiments, such as in-kind, we suggest that MMS allow volunteers and purchasers 

involved in the pilot to comment on its draft of the report about the in-kind project. 

Much of the data and information being used by MMS in its report was supplied by 

participants in the pilot. 

For an official analysis of the MMS pilot, we refer you to a paper prepared for 

the Rocky Mountain Mineral Law Foundation's 41st annual institute. This paper is 

entitled "Testing the Water: A Cooperative Effort to Design the MMS' Royalty In-kind 

Pilot Program for Natural Gas." 

Conclusion 

We compliment and encourage MMS to continue to work cooperatively with the 

industry and states to develop alternatives that restore certainty and create simplicity for 

paying royalties on natural gas production. In this regard, Devon has volunteered gas 

for an in-kind onshore pilot. A second pilot will serve as a learning experience as we 

move forward. 

Mr. Chairman, we support the legislative language you submitted to the 

Chairman of the Subcommittee on Interior Appropriations authorizing MMS to conduct 

additional in-kind pilots. If these pilots are conducted in a manner similar to your 

language -- "at or near the lease on a volunteer basis in an onshore area with active gas 

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markets" --then all concerned parties would be better able to make informed decisions 

about the future of such a program. 

I want to inform the Committee about a separate effort that we have initiated to 

develop alternatives to the current royalty payment system to better compliment today's 

gas market. As chair of an advisory subcommittee for the MMS entitled 

"Nonconventional Alternatives," we will develop payment options to reduce royalty 

regulatory burdens associated with gas production. Potential alternatives include an 

extended period for reporting gas transactions to accommodate the thousands of 

adjustments associated with tracing gas sales back to the well, taking gas in-kind, and 

buying out royalty streams. This subcommittee is comprised of industry, state, and 

Native American representatives. When this subcommittee develops recommendations 

we will submit them to the committee for its review. 

As the demand for natural gas increases from domestic sources, we must reverse 

the trend of independents not increasing their development of gas resources from public 

lands, an important source of undiscovered gas. Devon and IPAA encourage the 

Committee to continue with its oversight of activities to improve the state of natural gas 

production from federal lands. To encourage additional development, independents 

cannot be required to pay royalties on values which exceed the proceeds received for 

the sale of gas at or near the lease. 

Thank you for this opportunity to testify. There are a number of options, such 

as royalty in-kind, that need to be pursued as ways to reduce costs and streamline the 

royalty payment process for gas production. There is much to be learned about a 

royalty in-kind program from a federal and state government and industry standpoint. 

We are available to work with the committee as the process for developing alternatives 

for paying royalties on gas production moves forward. 
37 

Attachment 1 

What primary factors affect the outcome of an in-kind program? 

The Mineral Leasing Act and the Outer Continental Shelf Lands Act require that the 

amount of royalties due the government be paid in full the month following the month 

of production. To ensure proceeds were deposited with the Treasury within the required 

timeframe, the MMS chose to immediately transfer, or "flip," title of the gas delivered 

by the producer. The MMS chose not to expend any costs and/or take any risks 

associated with downstream value-added gas sales activities. 

The MMS felt that this payment requirement contained within the law prevented them 

from entering into any sort of gas balancing or storage situation. These restrictions 

were passed onto the competitively selected purchaser of the gas which prevented 

purchasers from entering into traditional balancing arrangements thereby affecting the 

price received for the gas. The requirement for the purchaser to take all produced 

volumes may require the purchaser to obtain firm transportation in lieu of interruptible 

transportation, which could be a more costly proposition. 

Other factors affecting the success of an in-kind program: 

I. To achieve maximum efficiency, reporting and auditing should be limited to 

production reports and communication regarding available volumes, including 

imbalances. 

2. Gas balancing should be designed to minimize impacts on the producers and the 

government. Once production occurs, which is under the sole discretion of the 

lessee/producer, the lease requires royalties to be paid. The producer cannot segregate 

the royalty share of production to be left in the ground. 

3. An in-kind program cannot interrupt a lessees existing processing and marketing 

arrangements. When gas is taken in-kind, there should be sufficient notice as not to 

disrupt existing marketing arrangements. 

4. For every federal lease, the MMS or the Bureau of Land Management approves 

a royalty settlement point as the point of measurement consistent with the terms of the 

lease. It is imperative that under any in-kind program, production be delivered at this 

point. 

5. States need to be consulted in all future in-kind efforts. If states begin marketing 

their share of the royalty stream, the entire royalty stream must be taken in-kind to 

prevent the additional administrative costs of multiple collection systems. 

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6. .Potential purchasers need to have more timely access to information affecting 

the bids. This includes mapping of actual flow, a longer time before purchasers have to 

submit bids to understand supply source, cost data regarding non-regulated lateral lines 

owned by the producer, and the quality of gas being purchased. 

7. An in-kind program should not be unnecessarily burdened by an examination of 

other sales occurring in the area to determine if an in-kind sale received market value. 

A sale of in-kind volumes by MMS is market value because it is the agreed-to price 

between a willing buyer and seller at the time of the sale. To clarify this important 

point, a legislative change may be required. 

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