Independent Petroleum Ass'n of Amer. v. Armstrong, Civ. 98-00531 RCL.

• Decision Date: 28 March 2000
• Docket Number: No. Civ. 98-00531 RCL.,No. Civ. 98-00631 RCL.,Civ. 98-00531 RCL.,Civ. 98-00631 RCL.
• Citation: 91 F.Supp.2d 117
• Parties: INDEPENDENT PETROLEUM ASSOCIATION OF AMERICA, Plaintiff, v. Robert L. ARMSTRONG, et al., Defendant. American Petroleum Institute, Plaintiff, v. Bruce Babbitt, et al., Defendants.
• Court: U.S. District Court — District of Columbia

91 F.Supp.2d 117

INDEPENDENT PETROLEUM ASSOCIATION OF AMERICA, Plaintiff, v. Robert L. ARMSTRONG, et al., Defendant.

American Petroleum Institute, Plaintiff, v. Bruce Babbitt, et al., Defendants.

No. Civ. 98-00531 RCL.

No. Civ. 98-00631 RCL.

United States District Court, District of Columbia.

March 28, 2000.

L. Poe Leggette, Nancy L. Pell, Glenn S. Benson, Fulbright & Jaworski, LLP, Washington, DC, for IPAA.

David T. Deal, American Petroleum Institute, Washington, DC, Thomas Eastment, Lois McKenna Henry, Baker & Botts, L.L.P., Washington, DC, for API.

Lois J. Schiffer, Ann D. Navarro, United States Department of Justice, Environment & Natural Resources Division, General Litigation Section, Washington, DC, Geoffrey Heath, Christopher P. Salotti, United States Department of the Interioras, for defendant.

MEMORANDUM OPINION

LAMBERTH, District Judge.

Plaintiffs, two gas industry trade associations whose members hold federal and Indian gas leases, challenge as arbitrary, capricious and not in accordance with law amended Department of the Interior ("Interior") regulations ("Rule") that impose royalties on costs incurred when lessees sell gas in downstream markets. Plaintiffs contend that the royalty obligations imposed by the Rule exceed Interior's statutory authority under the applicable statutes and have no basis in prior regulations or the gas leases themselves. Additionally, plaintiffs advance that the new Rule draws arbitrary distinctions between similar costs and impairs the obligations of leases executed prior to the enactment of the amendments. Defendants cross-move for summary judgment, asserting that the Rule was properly enacted after notice and comment and constitutes a reasonable interpretation of the regulations that Interior administers and the implied covenant of the gas leases. Upon consideration of the parties' cross-motions for summary judgment, the oppositions thereto, the record, oral argument, the applicable law, and for the reasons set forth below, the court GRANTS plaintiffs' motions for summary judgment and DENIES defendants' motion for summary judgment.

I. BACKGROUND

A. The Natural Gas Industry and Royalties on Federal and Indian Leases

The Department of the Interior issues and administers oil and gas leases for federal and Indian lands pursuant to the Mineral Leasing Act, 30 U.S.C. §§ 181-287, the Mineral Leasing Act for Acquired Lands, 30 U.S.C. §§ 351-359, Indian leasing statutes, 25 U.S.C. §§ 396a-396g, 25 U.S.C. § 396, and the Outer Continental Shelf Lands Act, 43 U.S.C. §§ 1331-1356. The leasing statutes and regulations administered by Interior require lessees to pay royalties on gas production from federal and Indian leases. These statutes provide that royalties are established by a specified percentage of the value of the gas saved, removed, or sold from the lease. See 43 U.S.C. § 1337(a)(1); 30 U.S.C. § 226; 25 C.F.R. § 211.13; 25 U.S.C. § 212.16. Interior has the sole authority to "prescribe such rules and regulations as may be necessary to carry out" the leasing provisions. 43 U.S.C. § 1334(a); 30 U.S.C. § 189; 25 U.S.C. §§ 396 and 396(d). The Minerals Management Service ("MMS"), a bureau within Interior, collects, verifies and distributes revenues from the gas leases issued under these authorities.

The American Petroleum Institute ("API") is a nationwide trade association representing over 400 corporate members engaged in all aspects of petroleum exploration, production, refining, distribution, and marketing. API members hold oil and gas leases on federal and Indian lands. The Independent Petroleum Association of America ("IPAA") is a trade association representing more than 5,500 producers of oil and natural gas within the United States. Many IPAA members also hold leases on federal or Indian lands.

The present controversy grows out of the re-structuring of the gas pipeline industry brought about by Federal Energy Regulatory Commission Order No. 636. Pipeline Service Obligations and Revisions to Regulations Governing Self-Implementing Transportation; and Regulation of Natural Gas Pipelines After Partial Statutes and Regulations, Order No. 636, 57 Fed.Reg. 13267 (April 16, 1992), FERC STATUTES AND REGULATIONS (CCH) ¶ 30, 950 (August 3, 1992); order on reh'g, Order No. 636-B, 57 Fed.Reg. 57911 (December 8, 1992), 61 F.E.R.C. (CCH) ¶ 61,272 (November 27, 1992). Accordingly, to appreciate the instant dispute, it is necessary to highlight lessees' obligations as they existed prior to the amended Rule and FERC Order 636.

In the pre-FERC 636 gas market, lessees sold gas to pipelines at or near the lease. Thus, the essential bargain embodied in federal and Indian leases entitled the lessor to a royalty based upon the value of production at the lease when the lessee produced gas from the leased premises. Consistent with this practice of selling gas at the lease, royalties on federal gas leases were typically "calculated at values at the wells, not at the pipe line destination...." Continental Oil Co. v. United States, 184 F.2d 802, 820 (9th Cir. 1950). The basic rule on royalties, known as the "gross proceeds rule," provides that "under no circumstances shall the value of production for royalty purposes be less than the gross proceeds accruing to the lessee for the lease production." 30 C.F.R. § 206.152.(h) (1995). Gross proceeds are "the total monies and other consideration accruing to an oil and gas lessee for the disposition of [gas]," minus allowances or deductions. 30 C.F.R. § 206.151 (1995).

Under the pre-existing regulations and the leases, lessees also have an express duty to place gas in marketable condition, which means that production costs are borne solely by the lessee. The marketable condition rule requires lessees to produce "lease products which 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 (1997).

In addition to the duty to place production in marketable condition, lessees have an express obligation to avoid waste. This duty can be satisfied by marketing and selling the gas at the lease or wellhead, or by beneficially consuming the production. See, e.g., California Co. v. Udall, 296 F.2d 384, 387 (D.C.Cir.1961) (construing 30 C.F.R. § 221.35 (now covered by 30 C.F.R. § 202.150(c)), which provided that a "lessee is obligated to prevent the waste of oil or gas and to avoid physical waste of the gas ...").

Prior to FERC Order 636, producers generally did not need to incur transportation costs to locate a market for the gas, as pipelines were the primary purchasers. Accordingly, allowances for transportation costs were largely irrelevant. But when a lessee did transport gas, the lessee was required to pay a pipeline rate or tariff to transport the gas and Interior permitted the lessee to deduct the entire rate or tariff from the value it received downstream from the lease.

A producer likely sells gas away from the wellhead because it can demand a higher price in that market. Moving gas away from the wellhead to downstream markets, however, entails costs that are not incurred when gas is marketed at the lease. Thus, from an economic standpoint, the higher sale prices obtained in a downstream market are, in part, a reflection of the costs and risks involved. For example, a lessee transporting gas to a market downstream of the well will typically need to pay for the aggregation or storage of gas produced by multiple leases, in addition to the cost of getting the gas to the hub or sales point. Other fees involve the necessary costs of intermediaries such as market hub operators or for the management of market or environmental risks, or for scheduling delivery.

In the pre-FERC Order 636 gas market, all costs associated with moving gas to downstream markets were treated collectively as transportation costs and, hence, were deductible from royalty value when the point of sale was downstream from the lease. That is, when downstream sales occurred, MMS would collect a royalty based on the enhanced value of production obtained in the downstream sale. Yet at the same time, MMS shared in the costs incurred by the lessee to transport the gas to the downstream market by tracing the value of production back to the lease or wellhead by deducting those costs associated with moving the gas downstream. Thus, while reaping the benefits of a higher value downstream sale through a higher royalty, MMS did not simply free-ride on the lessees' efforts to obtain value for the gas.

FERC Order 636 was designed to increase competition in the gas sales market by the mandatory unbundling of pipeline sales services. To that end, Order 636's unbundling mandate was directed at gas sales by pipelines, not producers, in order to facilitate gas purchases by suppliers other than the pipelines. It was thought that this unbundling would enable the development of more competitive markets for gas at the wellhead and downstream. FERC determined that without Order 636's unbundling, interstate pipelines would retain a substantial market advantage over alternative suppliers because pipelines included firm transportation service in their sales price and this more desirable capacity was reserved exclusively for pipelines' own sales customers. Firm transportation capacity was, therefore, unavailable to accommodate transactions between purchasers and alternative suppliers, and such sales were relegated to spot sales using interruptible transportation. In short, pipelines' bundling of sales and transportation precluded alternative suppliers from competing effectively in the premium firm, long-term sales market because such suppliers were unable to offer transportation service on par with that offered by pipelines.

To correct this market imbalance, Order 636 required pipelines to convert their existing bundled sales contracts into contracts for an equivalent...