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Appeals Court Upholds Ruling on Royalty Cost Deductions

A federal appeals court in Washington, DC, has affirmed a lower court's decision upholding the Department of Interior's (DOI) interpretation of which costs can be deducted when producers calculate royalties owed for the production of natural gas on federal lands.

The case involves a dispute between Devon Energy Corp. and Interior over the extent of the deductions that the independent producer could take for calculating royalties on coalbed methane production in the Powder River Basin in Wyoming. Oklahoma City, OK-based Devon interpreted the allowable deductions to include the costs for dehydrating and compressing coalbed methane as part of its transportation costs.

Interior convened a royalty policy board in November 1995 to settle the matter, but it only intensified the dispute. Devon said the board's guidance permitted it to deduct the costs of dehydration and compression, provided that they were incurred after the gas reached the central delivery point and were necessary for transportation. Interior countered that the board's conclusions were ambiguous and, if interpreted as Devon viewed them, erroneous. The ruling, which required Devon to retroactively recalculate royalties owed to the government, was upheld by Interior in 2003 and prompted Devon to seek relief in the courts.

In 2007, the U.S. District Court in Washington upheld Interior's interpretation (see NGI, Sept. 3, 2007). The U.S. Court of Appeals for the District of Columbia Circuit in late December echoed the lower court's ruling, holding that the "marketable condition rule" precluded Devon from deducting costs associated with compression and dehydration when calculating the "gross proceeds" upon which royalties are owed. The marketable condition rules requires producers to put their natural gas into a marketable condition for purchasers at no cost to the federal government.

"It is true that the DOI marketable condition rule is ambiguous, and Devon's preferred interpretation of the rule is not unreasonable. In other words, we assume that the costs of dehydration and compression can reasonably be interpreted to fall within the compass of 'transportation costs.' However, we are obliged to afford 'substantial deference ' to an agency's interpretation of its own regulations...We find that DOI's contested construction of the marketable condition rule is reasonable," said the three-judge panel.

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