A federal court in western Louisiana last week ruled in favor of Anadarko Petroleum Corp. in its dispute with the Interior Department over royalties on oil and natural gas production in the deepwater Gulf of Mexico in 2003 and 2004, a decision that was a blow to the federal government but may be a boon to other producers that are challenging the government's efforts to collect more royalties.

Anadarko subsidiary Kerr-McGee Oil and Gas challenged a January 2006 Interior order, which directed the producer to pay royalties on natural gas it produced in 2003, and on both oil and gas produced in 2004, for eight leases that the company operated under the Deepwater Royalty Relief Act of 1995 (DWRRA). Under the royalty-relief law, Congress suspended royalty payments for specific volumes of production in certain water depths.

Interior argued that the royalty relief available to the eight Kerr-McGee leases ended when the market price for oil and gas exceeded the thresholds in the terms of the leases. Kerr-McGee, however, countered that its leases were not subject to price thresholds because they had not reached the minimum volume of royalty-free production afforded by the DWRRA.

"The crux of this case is whether Section 304 [of the DWRRA], which requires mandatory royalty relief for specified volumes, also stripped the Interior of its discretion to set price thresholds that would apply before a mandatory relief lease produced the minimum volume of royalty-free production. Kerr-McGee contends that mandatory relief leases are not subject to price thresholds below the minimum volume of royalty-free production, whereas the department argues it retained the discretion to set price thresholds," said the U.S. District Judge Patricia Minaldi for the Western District of Louisiana in Lake Charles, LA.

"The price threshold requirement found in Kerr-McGee's mandatory royalty-relief leases is...unlawful under the plain text of the DWRRA because DWRRA's Section 304, applying to new leases, clearly requires minimum royalty relief. The Interior has no discretion to enact a price threshold requirement that applies to volumes below the minimum volume of royalty-free production," the court concluded.

"Because the Interior imposed price threshold requirements on Kerr-McGee's eight deepwater leases that would require Kerr-McGee to pay millions of dollars in royalties before it had even produced the minimum volume of royalty-free production, the Interior exceeded its congressional authority...Interior's action is unlawful because it contradicts the plain, unambiguous text of the [DWRRA] statute." Interior is said to be considering an appeal of the court's decision.

Minaldi, in short, ruled that Congress' action under the 1995 royalty-relief act trumped Interior's discretion to impose price thresholds in Kerr-McGee's oil and gas leases.

Interior said that even if its action was contrary to law, several affirmative contractual defenses apply that nonetheless would require Kerr-McGee to pay royalties based on the price thresholds, but the court didn't buy that argument. "Because contractual defenses are not available when the government makes a contract contrary to law, the Interior's affirmative defenses are unavailing...Interior's affirmative defenses will be dismissed as a matter of law," the court said.

The court ruling was a huge victory for Anadarko, which said "the court upheld what we believe was the intent of Congress to assure that companies were afforded the royalty treatment it granted as an incentive to make huge investments in the deepwater Gulf of Mexico frontier." It noted that none of its leases were 'royalty free,' but rather required the payment of royalties on production after volume thresholds were exceeded.

The favorable decision also may give a shot in the arm to other offshore producers, which are fighting the efforts of the federal government to collect billions in royalties on 1998-1999 deepwater leases that, due to a mistake on the part of Interior, failed to include price thresholds. The price thresholds were intended to cut off royalty relief to producers when the market prices for oil and natural gas soared above certain levels. As a result of this oversight, producers have been able to forego royalty payments on certain volumes of production.

Rep. Edward Markey (D-MA), who has been at the forefront of Congress's effort to collect back royalties, said the decision has the "potential to set a dangerous precedent that could lead to American taxpayers losing up to $60 billion" in royalties that are owed the federal government.

He called on the Department of Justice to "vigorously defend the interest of the American people in this case," and urged Congress to "move forward to approve the House-passed language that would force the oil companies to renegotiate the 1998-1999 leases so that royalty-free drilling is not allowed."

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