Amoco Production Co. v. Watson, 04-5006

• Citation: 410 F.3d 722
• Decision Date: 10 June 2005
• Docket Number: 04-5007.,No. 04-5006,04-5006
• Parties: AMOCO PRODUCTION COMPANY, Appellant v. Rebecca W. WATSON, Assistant Secretary for Land and Mineral Management, et al., Appellees.
• Court: United States Courts of Appeals. United States Court of Appeals (District of Columbia)

410 F.3d 722

AMOCO PRODUCTION COMPANY, Appellant v. Rebecca W. WATSON, Assistant Secretary for Land and Mineral Management, et al., Appellees.

Nos. 04-5006, 04-5007.

United States Court of Appeals, District of Columbia Circuit.

Argued February 14, 2005.

Decided June 10, 2005.

COPYRIGHT MATERIAL OMITTED

Steven R. Hunsicker argued the cause for appellants. With him on the briefs was Melissa E. Maxwell.

Craig L. Stahl was on the brief for amicus curiae Burlington Resources, Inc. in support of appellant. John T. Boese and Laura B. Rowe entered appearances.

John A. Bryson, Attorney, U.S. Department of Justice, argued the cause and filed the brief for appellees. Ellen J. Durkee, Attorney, U.S. Department of Justice, entered an appearance.

Patricia A Madrid, Attorney General, Attorney General's Office of the State of New Mexico, Christopher D. Coppin, Assistant Attorney General, Thomas H. Shipps, Ken Salazar, Attorney General, Attorney General's Office of the State of Colorado, Alan J. Gilbert, Solicitor General, Lee Ellen Helfrich, Martin Lobel, Jill Elise Grant, Harry R. Sachse, and James E. Glaze were on the brief for amici curiae in support of appellees.

Before: EDWARDS, SENTELLE, and ROBERTS, Circuit Judges.

Opinion for the Court filed by Circuit Judge ROBERTS.

ROBERTS, Circuit Judge.

The San Juan Basin covers 7500 square miles in northwest New Mexico and southwest Colorado. Since the end of World War II, it has been a prolific source of natural gas, connected by pipeline to southern California and literally helping to fuel the dramatic growth of that region. Beginning in the 1980s, large-scale extraction of the variety of natural gas known as coalbed methane began to supplement the supply of conventional gas from the region. Coalbed methane contains upwards often percent carbon dioxide, which is largely absent from conventional natural gas. Because carbon dioxide does not produce energy, mainline natural gas pipelines will not accept gas with a carbon dioxide component of more than two to three percent of volume. A high carbon dioxide content does not render the natural gas useless for consumers, but if producers in the San Juan Basin want to sell their gas to markets beyond that sparsely populated region, they must use the mainline and meet its more stringent carbon dioxide standard.

The federal government is a large landowner in the San Juan Basin and, like many other owners of property rich in natural gas, it leases rights to extract the gas in exchange for a percentage of the proceeds. Unlike the case with other landowners, however, the relationship between the government and those who extract gas from the government's land is regulated pursuant to an elaborate array of statutes and rules. The present case involves several disputes between the government and gas producers over how the need to remove the excess carbon dioxide from coalbed methane, to make it palatable to the mainline pipelines, affects the royalty payment the producers owe the government under those statutes and regulations. For the reasons that follow, we affirm the district court's decision and uphold the government's determination that the producers owe additional royalties.

I. Background

Statutory and Regulatory Framework. The Department of the Interior (DOI), through its Minerals Management Service (MMS), issues and administers leases authorizing the extraction of natural gas from government land. The Mineral Leasing Act (MLA), 30 U.S.C. §§ 181 et seq. (2000), requires producer-lessees to pay the government-lessor "a royalty at a rate of not less than 12.5 percent in amount or value of the production removed or sold from the lease." Id. § 226(b)(1)(a). To ensure the government gets its due in royalties, the Secretary of the Interior is directed by statute to establish a comprehensive inspection, auditing, and collection system. See id. § 1711.

In 1988, pursuant to these statutes, MMS "amended and clarified" the rules "governing valuation of gas for royalty computation purposes." Revision of Gas Royalty Valuation Regulations and Related Topics, 53 Fed.Reg. 1230 (Jan. 15, 1988). Under these new regulations, MMS specified that the "value of the production" referred to in 30 U.S.C. § 226(b)(1)(A) must be no less than "the gross proceeds accruing to the lessee for lease production," minus certain allowable deductions. 30 C.F.R. § 206.152(h) (1988). A factor in calculating these "gross proceeds" is a longstanding interpretation of the MLA that obligates lessees to put the gas they extract in "marketable condition at no cost to" the federal lessor. Id. § 206.152(i); see California Co. v. Udall, 296 F.2d 384, 387-88 (D.C.Cir.1961) (upholding marketable condition requirement). Under the 1988 regulations, lease products are considered in marketable condition if they "are sufficiently free from impurities and otherwise in a condition that they will be accepted by a purchaser under a sales contract typical for the field or area." 30 C.F.R. § 206.151. If a lessee sells "unmarketable" gas at a lower cost, the gross proceeds for purposes of royalty calculation must be "increased to the extent that gross proceeds have been reduced because the purchaser, or any other person, is providing certain services" to place the gas in marketable condition. Id. § 206.152(i). To take a simple example, if it costs $20 to put gas in marketable condition by removing impurities, and the purified gas is sold for $100, "gross proceeds" for purposes of royalty calculations is $100, regardless of whether the producer removes the impurities and sells the gas for $100, or instead sells the gas for $80 to a purchaser who then removes the impurities.

The regulations allow lessees to deduct from gross proceeds costs directly related to transporting gas from the wellhead for sale at markets remote from the lease. See id. § 206.157(a)-(b). The government's generosity with respect to this deduction, however, goes only so far — absent approval from MMS, a lessee is not allowed to deduct the costs of transporting non-royalty bearing products. See id. § 206.157(a)(2)(i), (b)(3)(i). In other words, to the extent the government is not going to share in the proceeds of the producers' distant sale, because some of the product is non-royalty bearing, the government does not in effect share in the cost of transporting that portion of the product by having that cost deducted from "gross proceeds." There is an exception to this logic: a portion of the product may fall into a category known as "waste products which have no value." Id. § 206.157(a)(2)(i), (b)(3)(i). Although it may at first seem counterintuitive, the government allows a deduction for the cost of transporting such waste products, because such transport is considered part of the cost of transporting the royalty-bearing product with which the waste products are associated.

Facts and Rulings Below. Producers Amoco Production Company (Amoco) and Atlantic Richfield Company and Vastar Resources, Inc. (ARCO/Vastar) produce coalbed methane on public land in the San Juan Basin pursuant to leases with the federal government. To make the coalbed methane suitable for transportation over mainline pipelines, the producers arranged for the removal of excess carbon dioxide from most of the gas they extracted. Between 1989 and 1996, the producers sold untreated gas at the wellhead to purchasers who would pipe the gas to treatment centers, remove the excess carbon dioxide, and then put the treated gas on the mainline system for transport and sale to end-users throughout the country. The producers' sales arrangements differed; Amoco would sell untreated gas primarily to a wholly-owned trading subsidiary and ARCO/Vastar would contract arms-length sales with unaffiliated purchasers. Nevertheless, the economics of the transactions were the same, with the price of untreated gas at the wellhead reflecting the fact that the purchaser would have to transport the gas to treatment plants and remove the excess carbon dioxide before sending the gas into the mainline.

On April 22, 1996, MMS issued a letter to lease operators and royalty payors in the San Juan Basin laying out the Service's "guidelines" for calculating royalties on coalbed methane. Payor Letter, at 1. The Payor Letter informed the producers that removing excess carbon dioxide was considered a cost of placing the gas in marketable condition. Consequently, producers who removed the gas themselves could not deduct the cost of doing so from gross proceeds, and those selling untreated gas at a lower price nevertheless needed to add back to gross proceeds the cost of removal services performed by the purchaser. See id. at 1-2. The letter also addressed transportation allowances, specifying that producers could deduct the costs of piping the methane and the allowable two to three percent portion of carbon dioxide to the treatment center, but not the cost of transporting the excess carbon dioxide to be removed at the center. In the government's view, that excess constituted a non-royalty bearing product under the regulations. See id. at 2-3.

On the heels of the Payor Letter, MMS issued separate orders finding Amoco and ARCO/Vastar deficient in their royalty payments for the period between 1989 and 1996. This shortfall stemmed from the producers' accounting for sales of raw coalbed methane that was later treated and marketed on the mainline by its purchasers. In calculating gross proceeds, the producers did not add back the costs incurred by the purchasers in moving the excess carbon dioxide to the treatment plant and removing it once there. Instead, they calculated gross proceeds the same way they did for sales of coalbed methane used in untreated form by local purchasers. MMS thus concluded that Amoco and ARCO/Vastar owed the government additional royalties totaling $4,117,607 and $782,373, respectively. The producers did not have to add back to gross proceeds the cost of...