Opinion ID: 6336934
Heading Depth: 3
Heading Rank: 4

Heading: New Mexico Audit

Text: Pursuant to 30 U.S.C. § 1735, ONRR delegated authority to audit Hess’s royalty reports and payments for the period of January 1, 2002, to November 30, 2010, to New Mexico’s Taxation and Revenue Department (“New Mexico”). On September 22, 2009, New Mexico sent Hess an initial audit issue letter stating that Hess owed an additional $1,458,127.94 for the period of January 2002 through December 2005. Id. at 292–97. The letter suggested that the third regulatory benchmark applied (the net-back method, 30 C.F.R. § 206.152(c)(3)) and valued Hess’s CO2 based on the single arm’s-length Fasken Contract. Id. at 295. New Mexico then corresponded with ONRR regarding Hess’s CO2 valuation and allowable transportation deductions. On January 12, 2011, ONRR sent New 13 Appellate Case: 21-2011 Document: 010110678144 Date Filed: 05/02/2022 Page: 14 Mexico a response letter. Id. at 407–11. In the response letter, ONRR explained that although the Minerals Management Service had in the past directed the Unit’s producers to value their gas based on the Unit Average, “under different market scenarios and dispositions of Bravo Dome production, it does not dictate how value for royalty purposes must be established during later time periods.” Id. at 410. In doing so, ONRR noted that the Unit Average “falls short” because CO2 values determined by other Unit producers, including non-federal lessees, would not necessarily be relevant and ONRR could not easily verify whether such valuations met federal requirements. Id. ONRR went on to explain that “absent lack of significant arm’s-length sales in the Bravo Dome field, royalty value must be determined in the Permian Basin EOR units where there is an established market for CO2”—i.e., where Hess ultimately used the CO2. Id. But ONRR observed that Hess purchased large quantities of CO2 for its own use and on behalf of other working-interest owners in its Permian Basin EOR operations. Id. Hess therefore had “far more incentive to obtain the lowest possible price for CO2 used in its Permian Basin EOR Units than it [did] to obtain a reasonable value for the government’s royalty share of CO2 from the Bravo Dome Unit” and was arguably “able to depress the market price of CO2 in order to obtain the highest possible return on its Permian Basin oil production.” Id. Consequently, ONRR concluded that the Smithson formula was a reasonable valuation under the second regulatory benchmark. Id. (citing 30 C.F.R. § 206.152(c)(2)). 14 Appellate Case: 21-2011 Document: 010110678144 Date Filed: 05/02/2022 Page: 15 Regarding whether Hess’s compression and dehydration costs could be deducted as a transportation allowance, ONRR determined that “since the Permian Basin [where Hess used the CO2 in EOR units] is the market for Bravo Dome CO2, the requirements to place CO2 into marketable condition would be established there.” Id. at 411. This meant that “[a]ny costs incurred to compress the CO2 up to [the required pressure for injection at the Permian Basin EOR units] would not be deductible from royalties as a transportation allowance.” Id. On February 1, 2011, New Mexico sent Hess a revised issue letter that was generally consistent with ONRR’s January 12, 2011 letter. Id. at 285–91. The revised letter acknowledged that although the Unit Average valuation method “may have been acceptable in the past under different market scenarios and dispositions of Bravo Dome production, it does not dictate how value for royalty purposes must be established during the later periods.” Id. at 286. In Hess’s case, the lack of arm’s-length sales of significant volumes in the Bravo Dome field meant that “royalty value must be determined in the Permian Basin EOR units where there is an established market for CO2.” Id. at 286–87. The revised letter further explained that because Hess did not dispose of the majority of its CO2 under arm’s-length contracts, Hess should value its production using the Smithson formula under the second regulatory benchmark. Id. Regarding transportation deductions, the revised letter stated that “[c]ompression and dehydration costs are costs to get the CO2 gas to marketable condition needed for EOR production,” so Hess could not deduct the costs incurred to compress the CO2 up to the pressure requirement for the EOR 15 Appellate Case: 21-2011 Document: 010110678144 Date Filed: 05/02/2022 Page: 16 delivery pipelines as a transportation allowance. Id. at 288. The revised letter also expanded the audit period to run from January 1, 2002, through November 30, 2010. Id. at 285. On March 11, 2011, Hess responded to the revised issue letter and raised arguments regarding valuation and marketable condition. Id. at 276–79. After reviewing Hess’s response, New Mexico reevaluated its proposed valuation method but adhered to its position that the Unit Average was an inappropriate valuation method and that Hess’s claimed compression and dehydration costs were not deductible as a transportation allowance. Id. at 225–26.