In a split decision for natural gas producers, the U.S. Court of Appeals for the District of Columbia Circuit has upheld the federal government’s right to include downstream marketing costs when computing royalties owed by individual producers. But, it said producers’ firm transportation demand charges for unused capacity were not subject to the same royalty consideration.

In what lawyers called an extremely complex decision, the appellate court overturned a producer-favorable ruling that was handed down by the federal court in DC in 2000. That decision declared illegal a controversial portion of the Interior Department’s 1997 royalty valuation rule for natural gas, which required marketing costs to be included in the “gross proceeds” amount upon which royalties are assessed on federal lands.

“On the deductibility of marketing costs, we find no legal error in Interior’s rule and, therefore, reverse the [DC] district court,” the appellate panel said. “We find nothing unreasonable in Interior’s refusal to allow [producer] deductions for so-called ‘downstream’ marketing costs.” The department permits producers to disallow only two costs — processing and transportation — when calculating royalties.

The Independent Petroleum Association of America (IPAA) and the American Petroleum Institute (API) on behalf of gas producers challenged Interior’s decision to bar producers from deducting their marketing costs and unused transportation capacity costs from the royalty-bearing proceeds amount, claiming that the agency’s action was “arbitrary and capricious.”

The appellate court upheld the portion of the DC District Court’s decision that allows producers to deduct reservation charges for pipeline capacity that they don’t use, and are unable to resell. “While some reason may lurk behind the government’s position [to disallow this deduction], it has offered none, and we have no basis for sustaining its conclusion,” the court opined in its decision.

“What is hard to tell is the real reason why” the court decided the way it did, said Washington DC attorney L. Poe Leggette, who represented the IPAA in the case. “A fair portion of the opinion is pretty difficult to grasp,” he told NGI.

“Independent producers are certainly troubled by some of the court’s observations on marketing [costs],” Leggette noted. But he refused to call the decision a defeat for producers. Instead, he agreed that it was a ‘good news, bad news’ ruling.

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