Where the Minerals Management Service has so far failed inobtaining more gas royalties through changes in its valuationmethods, the Justice Department hopes to succeed through thecourts, producers say.

Many of the so called violations of gas royalty rules cited inthe recent Qui Tam, or whistle-blower, cases in the U.S. DistrictCourt for the Eastern District of Texas in Lufkin, TX, involveissues that MMS attempted but failed recently to include in itsregulations. A federal court threw them out in March, and nowJustice has taken up the flag with hopes of winning big settlementpayments like those it has won on the oil side, which have run intothe billions of dollars.

“My view is that the government is trying to impose those newregulations ex post facto, and that’s what these lawsuits are allabout,” said one producer attorney. “They want to try to use thelitigation process and the False Claims Act process to try toextract from these companies the money the government wants tocollect from us under these new regulations. The fact that theregulations have been thrown out won’t have a direct impact on thelitigation.

The United States District Court for the District of Columbiastruck down the controversial part of the Interior Department’s1997 royalty valuation rule for natural gas in March. The MMS wasattempting to change the rules to incorporate marketing and certaintransportation charges in royalty values (Civ. No. 98-00531). Ingranting a summary judgment requested by the Independent PetroleumAssociation of America and the American Petroleum Institute, JudgeRoyce C. Lamberth found no basis for the Interior Department’sMinerals Management Service (MMS) to claim producers had an”implied duty to market” at no cost to the government. “The endresult of the rule is that lessees must now pay a royalty in excessof the value of production they received from the sale,” Lamberthsaid in declaring that part of the rule invalid.

What is well recognized is that “the government’s royaltyinterest is limited to the value of production at the lease orwellhead, not in value enhancements resulting from downstreamactivities,” the court said.

However, now the Justice Department is bringing up many of thesame issues in its complaints against producers. After a two-monthinvestigation, the DOJ filed a lawsuit two weeks ago againstaffiliates of ExxonMobil and Burlington Resources for “knowinglyunderpaying” natural gas royalties for production from federal andIndian lands. Justice also requested more time to decide whether tosue Shell Oil and Meridian Oil for similar violations. There aremore than 130 producer defendants involved in the Harrold E. “Gene”Wright civil suit in which Justice intervened. Wright claims thedefendants underpaid royalties by about $25 billion. There’scertainly the potential for Justice to significantly broaden itsinvestigation.

Besides the Wright case, there are two other publicly known gascases going on in Lufkin, including one filed by Victor Murrayagainst Mobil and one by Glenn Osterhoudt III against eight otherproducers. There may be a fourth case in Lufkin against justBurlington, according to a Justice Department spokesman, andpossibly many others in other parts of the country that are sealed.

In its complaint against Mobil, Justice said that beginning in1991 for offshore production and in 1993 for onshore production theMobil affiliates (now ExxonMobil) changed the pricing methodologyused in royalty calculations and came up with a “transfer price”using an adjusted index that was based on prices that were “too lowand did not constitute a reasonable value for Mobil’s natural gasunder any of the applicable benchmarks.”

In calculating the adjusted indexes, Justice claims, Mobilincluded indexes to potential markets that Mobil did not actuallyserve. Although its gas went to the most profitable markets,Mobil’s transfer price, which is used in calculating royalties, wasbased on prices at less profitable markets. Justice also claimsMobil consistently received above-index prices for its gas butfailed to use those prices in its royalty calculations. Inaddition, it claims that Mobil artificially increased certaintransportation deductions, using maximum transportation rates whenit actually paid discounts, in order to come up with a lowertransfer price on which to calculate its royalties.

Mobil claims it merely switched to the widely accepted practiceof index pricing from a far less accurate regional pricingmethodology. The regional prices often were higher than the indexesused because the indexes were for points upstream that were asclose to the actual lease as possible. “There’s not much mysteryabout how we value gas. Most companies over the last five to 10years have been using index prices,” noted the producer attorney.

In Burlington’s case, Justice said between 1988 and 1998 theproducer used “sham intermediate transactions to avoid payingroyalties on the full sales price received from third parties underarms-length contracts. Rather than sell directly to third parties,Burlington’s production subsidiaries first sold the gas toBurlington Trading at the Burlington transfer price.” The actual”arms-length” sales to a third party by its affiliate drew muchhigher prices.

In addition, the transfer price that was used was based on”estimated” index prices, indexes that were “biased downward” orindexes that did not reflect Burlington’s actual disposition ofgas.

The producer affiliates all deny they underpaid royalties ontheir gas production. “It’s our position that we have paid allthese royalties in a fair and proper manner and in completeaccordance with the federal regulations and the provisions of thecompany contracts with the federal government,” said ExxonMobilspokesman Bob Davis. “It’s also our position that the government’sclaims in these cases are simply an attempt to unilaterally changethe terms of the contracts and usurp the administrative process setup by the [Minerals Management Service] and the agreements thathave been entered into by the MMS and ExxonMobil.

“A federal court in the District of Columbia rejected the theorythat’s being set forth by the federal government in these cases,”said Davis. “And we expect it to be rejected here as well. “Wefeel that ultimately when this case is reviewed, [the IPAA vs.Armstrong case] will work certainly to ultimately reject the DOJ’stheory,” said Davis.

Davis also noted that Mobil recently won a landmark oil royaltydecision in the Long Beach case in which the city of Long Beachaccused the producer of underpaying royalties using methods similarto those in the current case. The Long Beach case had gone on for10 years.

There are “hundreds” of these “Qui Tam” cases, in whichwhistle-blowers, usually disgruntled former employees, drum upcharges against producers in the hopes of winning a sizablepercentage of the damages if the case is won, noted one producerofficial, who asked to remain anonymous.

Qui tam, which is Latin for “he who sues on behalf of the kingas well as for himself,” is a provision of the Federal Civil FalseClaims Act that allows a private citizen to file a suit in the nameof the U.S. Government charging fraud by government contractors andother entities who receive or use government funds, and share inany money recovered. Before a 1986 amendment, the court couldarbitrarily set the percentage of award for the Qui Tam relator.The 1986 amendment guaranteed a minimum of 15% of the recovery anda maximum of 30% for the relator to aid in paying an attorney andspending the time and money on the case.

“For a lot of these people it’s like an attempt to win thelottery,” the producer said. “Having the government on their sidehelps a lot.”

For example the two whistle-blowers who won a settlement inApril with BP and Amoco after filing a complaint under the FalseClaims Act will share more than $5.4 million of the settlementproceeds. Earlier this year, Mobil, BP Amoco and others shelled outbig bucks to settle whistle-blower claims for underpayment ofroyalties on oil production. BP Amoco agreed to pay a total of $32million as part of the settlement with Justice and thewhistle-blower. Mobil paid $45 million, Oxy USA Inc. paid $7.3million, Chevron shelled out $95 million and Conoco added $26million.

Producers are actively lobbying on Capitol Hill for changes tothe Qui Tam statute. Whistle-blowers have been an effective weaponfor the federal government. Since 1986, when the False Claims Actwas amended, the Justice Department has recovered more than $3.5billion in civil fraud cases brought by whistle-blowers, who werepaid in excess of $550 million.

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