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Kerr-McGee Files Against Interior Over Royalties; Government Has $500M at Stake

Kerr-McGee Oil and Gas Corp. has asked a federal court for a declaratory judgment and an injunction against the Interior Department and Johnnie Burton, Interior's acting assistant secretary for Land and Minerals Management, saying the government is illegally attempting to force Kerr-McGee to pay royalties on deepwater Gulf of Mexico production exempted by law from royalties.

The action filed March 17 in the U.S. District Court for the Western District of Louisiana, Lake Charles Division, points out the Deepwater Royalty Relief Act (DWRRA) of 1995, passed by the Congress and signed by the president, exempted from royalties volumes produced from the high-risk, high-cost wells up to a minimum production level, which varied depending on the water depth. After companies had produced the minimum volumes, royalties on further production would be collected at the full rate.

The "unconditional" exemption for minimum volumes was in effect for deepwater leases issued from 1996 through 2000. Kerr McGee says its eight wells on which the government is trying to collect "are well short of the minimum" production level of 87.5 million barrels of oil equivalent per lease, effective for wells drilled in water deeper than 800 meters, and therefore should not be subject to royalties.

Even if the law had stated that Interior had discretion in applying the exemptions, Interior's own regulations "denied MMS the discretionary authority to impose price thresholds. These regulations grant lessees the statutory minimum volumes of production free of royalty without any limitation based on price thresholds," Kerr-McGee said.

In addition, the company notes that one of its challenged wells was among those involved in a similar court case with Interior which the producers won (Santa Fe Snyder Corp. v. Norton) and which was affirmed in the Fifth Circuit Court of Appeals. That case decided that the minimum volumes applied per lease and not per field, thus expanding the minimum volumes since one field can include several leases.

The company points out the policy was set to encourage companies to undertake the large expense of exploring and extracting oil and gas from the deep water at a time when the nation's production was declining. In addition, Kerr-McGee said, companies paid the government extra bonuses for the leases, and it has expended billions of dollars in developing its deepwater GOM production.

The legislation to encourage deepwater production worked. Kerr-McGee's court document quoted an MMS official as saying deepwater development "has succeeded probably beyond the most optimistic dreams of most of us and shows no sign of diminishment[.] Production from the deepwater frontier grew to an estimated 959,000 bbl/d by the end of 2002. This was a rise of 535% and 620% for oil and gas, respectively, since 1995."

The Interior Department refused to comment last week on Kerr-McGee's legal action, but released twos memorandums sent to Burton in early February by Walter D. Cruickshank, deputy director of the Minerals Management Service (MMS), which said the government could lose over $500 million in past and future royalties if it lost the court case. The bulk of that money already has been paid by other companies, but would have to be refunded if the government loses its case.

Cruickshank said with such a large sum at stake, MMS has taken longer than usual to build its case. He noted that Kerr-McGee had offered a compromise to settle the issue, but "the compromise would have required us to change the way we apply price thresholds on all deepwater leases. This offer was rejected."

Kerr-McGee's suit claims there were 10 sales of mandatory relief leases between November 1995 and November 2000. On five of the sales Interior included clauses in the leases purporting to impose price thresholds on the royalty suspensions, "contrary to the clear text of the DWRRA," while five other sales did not include price threshold clauses. "Nothing in the administrative record explains why the department included price threshold clauses in the first five sales."

Burton issued the order to pay to Kerr-McGee on Jan. 6, 2006, setting out the price thresholds for 2002, 2003 and 2004 and noting that the price of natural gas on the New York Mercantile Exchange exceeded those thresholds in 2003 and 2004, while oil exceeded the threshold in 2004.

A Kerr-McGee spokesman said the company was not taking a confrontational stance. "We have had a long-standing relationship with MMS. Now we have a disagreement. We tried in good faith to settle it," but were unsuccessful. "Now we are asking the court to resolve it."

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