Natural gas royalties should be valued on the first sale between producers and their “owned or controlled” marketers, not on the downstream resale, if the marketers also purchase “at least some” gas from sources other than their owner-producers, a federal appeals court in Washington, DC ruled late last month. The ruling was a significant victory for gas producers.

The case before the U.S. Court of Appeals for the District of Columbia focused on a valuation dispute involving gas that was sold twice: first by a producer to a gas marketing firm that it controls, and then by the controlled marketing firm to end-users. The court rejected the Interior Department’s claim that royalties should be paid on the higher resale value of the gas sold by a marketer to an end-user, which would include transportation and marketing costs, and accepted the position of Final Oil and Chemical Co. Fina argued in favor of royalties being based on the lower contract price of the initial sale.

In 1993, Fina was unsuccessful in its appeal of the agency’s gas royalty valuation decision before the Interior Board of Land Appeals. Fina then challenged the board’s ruling in the U.S. District Court in DC, which also upheld Interior’s ruling.

But the three-judge appeals court sided with Fina, finding that royalties on the gas it sold to Fina Natural Gas Co. (FNGC) should have been valued on the initial sale since FNGC purchases gas from both Fina and other gas producers. While FNGC is owned by the producer, Fina argued that FNGC was not a “marketing affiliate” because it bought gas from other producers, and the court agreed.

“Gas sold to non-marketing affiliates [such as FNGC]…is valued through the benchmarks of the initial sales price and not the subsequent resale value,” the court opined. In contrast, royalties on gas sold directly to marketing affiliates, which buy gas exclusively from their owner-producers, would be valued on the higher, subsequent resale price, it noted.

“Although the [Interior] secretary does not expressly say so, her primary concern seems to be [that] valuing the gas based on the initial sale would allow Fina and other lessees to pay royalties on gas before its value increases through transportation and marketing services provided by affiliates like FNGC,” the court said. If the secretary wants to change this, “she should amend regulations through notice-and-comment rulemaking, not under the guise of interpretation,” the judges said.

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