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Producers Split on Willingness to Renegotiate Royalty-Free Leases

Executives from Shell Oil, ConocoPhillips and Chevron last Wednesday said they were willing to meet with the Department of Interior to discuss resolving the dispute over the missing price ceilings in the 1998 and 1999 deepwater oil and natural gas leases, but ExxonMobil, which has had no production from the leases, and Kerr-McGee Corp. signaled that renegotiating the leases with the federal government was not on their agenda.

"Any change in prior year lease terms and conditions would indicate the United States' government does not place a high value on contract sanctity," said Tim Cejka, president of ExxonMobil Exploration Co., during a second hearing of a House Government Reform subcommittee that is investigating why the price thresholds were omitted from the 1998 and 1999 leases for drilling on the Outer Continental Shelf (OCS).

"While the federal government, of course, certainly has the right to change the terms on future leases...we expect that terms of the existing leases to be honored," he told the Energy and Resources Subcommittee. "Any attempt to revoke or retroactively renegotiate leases previously granted by the federal government, we think sets a bad example."

Cejka noted that Exxon and Mobil, when bidding as separate companies, were the high bidders on 145 deepwater leases that were awarded by Interior in 1998 and 1999. Since then, ExxonMobil has traded all or some of the original leases or formed ventures to elevate its ownership position to 159 leases that were issued during the two-year period. From those leases, the producer has drilled three wildcat wells -- all dry -- and plans to drill two more, he said. Because there has been no production, "we have not taken any royalty relief from these leases," Cejka said.

The critical price ceilings serve as a benchmark to determine when oil and gas production becomes subject to federal royalties. Without them, producers who negotiated leases in 1998 and 1999 have been able to escape paying royalties on production up to a specific volume limit. The price caps were included in leases that were negotiated in 1996, 1997 and 2000, but not in the 1998 and 1999 leases -- which only compounds the mystery. The Government Accountability Office (GAO) has estimated that these royalty-free leases will cost the federal government upwards of $10 billion in lost revenue, according to the subcommittee.

The subcommittee has concluded that "a trail of irresponsibility and gross mismanagement" by Interior led to the omissions of the price triggers in the leases, and that an apparent "cover-up" by the agency served to only worsen the problem.

Gregory F. Pilcher, senior vice president and general counsel of Kerr-McGee, said the 104th Congress, which passed a 1995 law offering producers relief from royalties for specific volumes of production, did not give Interior the authority to include price triggers in any leases sold during the five-year period after the passage of the law.

"The absence of price triggers from the leases awarded in 1998 and 1999 does not appear to be a mistake; to the contrary, the absence of price triggers was necessary in order for those leases to be consistent with the law," he noted. Kerr-McGee is challenging in court Interior's authority to include price ceilings in oil and gas leases during that period.

"We hope that Congress will permit the judicial system to do its work and...permit the underlying dispute to be resolved according to the rule of law," Pilcher told the subcommittee.

Shell Oil sent a letter to Johnnie Burton, director of Interior's Minerals Management Service (MMS), on June 15 "expressing our willingness to 'make a change' in our 1998 and 1999 leases by considering the addition of price thresholds," said company President John Hofmeister. "Shell stands ready to work with MMS and Congress to address this issue," he noted.

"Where an obvious error has occurred, and both parties are willing to review the contract and consider possible modifications to correct the error, we believe such discussions are appropriate. Therefore, Shell is interested in meeting with you on this matter," the company said in its letter to Burton.

However, Hofmeister and other energy executives said their companies strongly believed in the sanctity of contracts and would oppose unilateral modification of legally binding contracts. He reported that Shell holds 73 deepwater leases that were acquired in 1998 and 1999 leases sales, four of which are currently producing.

Subcommittee Chairman Darrell Issa (R-CA) said that oil and gas producers had to have known that the price thresholds were missing from the 1998 and 1999 leases, and should have brought this to the attention of MMS.

Issa came close to accusing the producers of theft by failing to notify the MMS of its oversight. "I'm sure that at least some oil and gas producers noticed that price thresholds were missing from the final notice of sale and the first leases executed in 1998," he observed. Issa said he had one question for the producers: "If there is a bank error in your favor...do you bring it to the bank's attention or do you take funds and hope that no one finds the error?"

But Hofmeister responded that the lease process does not allow for give-and-take between the MMS and producers. "OCS leases are not negotiated by lessees. MMS drafts and publishes a standardized lease form to be used in the OCS. A lessee must either accept the lease as drafted or forfeit the lease and deposit...There is no negotiation, but only an award of a lease to the highest qualified bidder. Shell's policy is to pay royalties due by lease and regulation," he said.

Randy L. Limbacher, executive vice president of ConocoPhillips, indicated that his company "[was] willing to enter into a dialogue with MMS regarding leases" that were issued in 1998 and 1999. He noted that ConocoPhillips presently holds interests in 34 leases awarded during the two-year period that do not include price thresholds.

Limbacher further said that none of the 34 leases "are producing oil or gas and, as a consequence, no deepwater royalty relief is presently being taken by ConocoPhillips. As a result, "this has not been a significant issue" for the company.

"If requested, Chevron will meet with MMS to discuss the 1998 and 1999 leases, and Chevron will seriously consider any proposals the agency may offer to resolve the current royalty incentive debate," said Paul K. Siegele, vice president of deepwater exploration projects for Chevron North America Exploration and Production Co.

He noted that someone from Chevron did question MMS' regional office in New Orleans, LA, in 1998 about the lack of price thresholds in the leases. "It was [at] a meeting," but Siegele could not recall the name of the MMS official who attended.

At the start of the year, Chevron had interests in approximately 750 leases in the Gulf of Mexico in water depths of 1,000 feet or greater that could be eligible for some category of royalty relief, he said. "Most of the leases will never produce oil or gas. In fact, only 10 of these 750 deepwater leases have produced in the past five years. Three of the 10 have already stopped producing, and one is currently shut-in because of damage from Hurricane Rita. Additionally, since the beginning of the year, Chevron has relinquished approximately 50 of the 750 leases back to the MMS."

Interior's inspector general is conducting a parallel investigation into the missing price thresholds, and expects to release a report within six to eight weeks, according to the House subcommittee. The GAO also is carrying out a probe of the absent price ceilings, at the request of Sen. Jeff Bingaman of New Mexico, the ranking Democrat on the Senate Energy and Natural Resources Committee.

Since March, the House Energy and Resources Subcommittee "has reviewed the documentation surrounding nearly every aspect of the lease creation process...The subcommittee has interviewed individuals intimately familiar with all levels of the lease sale process. What has surfaced is a trail of irresponsibility and gross mismanagement," the House panel reported (see NGI, March 6).

"This investigation has revealed that the problem began in 1995 when the Interior Department promulgated inadequate regulations" that excluded the price thresholds in some deepwater leases.

"Instead of correcting those regulations, the department applied a series of 'Band-Aids' that never stopped the bleeding. This irresponsible behavior may have culminated in a cover-up by the department that only perpetuated the problem," the subcommittee said. "At best, the Interior Department suffers from a poor management culture. At worst, there is a persisting cover-up with regard to the missing price thresholds," subcommittee staff wrote in a briefing memorandum.

"The department testified, under oath, that nobody noticed the lack of price thresholds until early 2000. The subcommittee staff believes that this is inaccurate. The documents suggest that someone noticed the problem and unsuccessfully attempted to fix it," the briefing memo further said.

The absence of the price thresholds in the 1998 and 1999 leases "was brought to my attention sometime in '99," testified Milo Mason, an Interior Department attorney, at last Wednesday's hearing. He said he believed the price triggers were being included in the leases until he received a telephone call in 1999 informing him otherwise.

Mason told the subcommittee that he did not write a departmental memo informing others of the lapse, but rather he said he phoned other Interior attorneys. "I was looking into what [to do] to fix it." Given that oil prices had flat-lined at the time, "it didn't seem like a big deal as it is now," he conceded.

Other Interior attorneys admitted that they gave only a cursory review of the 1998 and 1999 lease sale agreements, with one noting that the documents were "literally close to a foot tall."

It's estimated that producers are holding 576 leases that do not contain price caps, and thus are not paying any royalties on certain volumes of oil and production from those deepwater leases.

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