Unbundling – What’s A Producer To Do?

Judith M. Matlock, PartnerDavis Graham & Stubbs LLP

Denver, Colorado

Judy Matlock, Davis Graham & Stubbs LLP, 303-892-7380 judith.matlock@dgslaw.com

Preliminary Matters• For Federal and Indian royalty purposes:

– “Gathering” is the movement of lease production to the BLM/BSEE approved point of measurement. The cost of this gathering is non-deductible.

– “Transportation” is the movement of lease production from the BLM/BSEE approved point of measurement to a processing plant or downstream pipeline. Producers and pipeline owners typically call these lines gathering lines to mean that they are not subject to federal regulation under the Natural Gas Act. The contracts for service on these lines are called gathering agreements.

Preliminary Matters• If a Federal or Indian lessee sells its production

before it is in marketable condition, the gross proceeds must be increased to the extent that the gross proceeds have been reduced because the purchaser, or any other person, is providing certain services the cost of which ordinarily is the responsibility of the lessee to place the gas/oil in marketable condition or to market the gas/oil.

• Exception – Indian leases in an index zone

Preliminary Matters• Whether the unprocessed gas valuation regulations

apply and, therefore, the reporting is by Product Codes 04 (conventional gas) or 39 (coalbed methane) and, in some cases, Product Code 15, or

• The processed gas valuation regulations apply and, therefore, the reporting is by Product Codes 03, 07 and 15,

• The marketable condition rule applies and the same amount of royalties will be owed; only the reporting is different

The Marketable Condition Rule – ONRR’s Position

• Gas is not in marketable condition until it is of the quality and at the pressure acceptable to the primary market into which the gas from a field or area is sold

• Gas destined for the interstate market must meet interstate pipeline quality and pressure requirements

• The point where gas is in marketable condition may be downstream of the point of sale

The Marketable Condition Unbundling Problem

• Costs to put production into marketable condition (including associated fuel) cannot be deducted directly or indirectly

• Under most existing gathering (transportation) and processing contracts, costs to put gas into marketable condition are not separately stated; they are “bundled” in the gathering and processing fees

• Lessees who deduct 100% of their costs (or the costs their purchaser incurs) are likely to be deducting some marketable condition costs and could be subject to penalties by ONRR

What is Unbundling?• If a lessee pays a rate that includes both allowed

and disallowed costs or if the lessee’s purchaser deducts gathering or processing fees that include both allowed and disallowed costs, the rate or fees must be “unbundled” or separated into the allowed and disallowed components and only the allowed components.

• Royalties must also be paid on fuel associated with disallowed costs.

Example• Suppose gas produced from a federal lease is

transported and processed for a fee of $0.45/MMBtu

• Fee must be unbundled between transportation and processing because those are separate allowances and subject to separate caps

• Transportation and processing components must further be unbundled into allowed and disallowed components under the marketable condition rule

What Is the Unbundling Question?

• What portion of the costs incurred under a specific transportation or processing contract is for the purpose of putting the lessee’s production into marketable condition?

• Focus is on:– The bundled costs under the contract, and– The marketable condition services included in those bundled

costs.• Another way to phrase the question - if the lessee could

have negotiated a fully unbundled contract, what would the separate charges have been?

Unbundling Gas Transportation Charges –ONRR Current Position

• Disallowed services:– Dehydration to mainline specs– Compression up to the pressure of the mainline– Treating to mainline specs

• Allowed services:– Delivery service for the gas and impurities up to the

pipeline specs (such as 3% CO2) – Dehydration and treating below mainline specs– Compression after gas has reached the mainline pressure

• Fuel – allocate between allowed and disallowed services

Unbundling Gas Processing Charges –ONRR Current Position

• Disallowed services:– Inlet compression– Dehydration to mainline specs– Treating to mainline specs– Boosting of residue gas - in the regs at 30 CFR 202.151(b)

• Allowed services:– Products extraction– And associated fuel

• Fuel – allocate between allowed and disallowed services

Gray Areas

• Compression performed at the plant solely for the cryogenic (liquids extraction) process

• Additional dehydration or treating below mainline specs for the cryogenic process

• Other pending questions (such as those raised by COPAS)

• Stay current on reported decisions

Cryogenic CompressionPsig: Cryogenic Plant

1000950900850800750700650600550500450400350300250200150100

50

ONRR’s Original Unbundling Approach

• An estimation methodology. • Focuses on a particular transportation system or

processing plant.• Determine the allowed to total ratio of the

depreciated capital costs to determine the Unbundling Cost Allocations or UCA’s. To be updated annually.

• Lessees multiply their contract rate or purchaser’s deduct by the applicable ONRR UCA.

ONRR’s Engineering Solution

• ONRR is working on an Engineering Solution which involves using – Industry accepted engineering practices and data, and– Sophisticated industry standard modeling tools– To calculate the allowed to total ratio of the facility

replacement costs for a theoretical plant to determine the UCA’s. To be updated annually.

• Lessees multiply their contract rate or purchaser’s deduct by the applicable ONRR UCA.

Unbundling Methodology at ONRR.Gov

• http://www.onrr.gov/Unbundling/methodology.htmReferences• Unbundling Methodology for calculating Transportation UCAs• Unbundling Methodology for calculating Processing UCAs• List of Engineering Data Needs• List of Accounting and Cost Data Needs• Reporting Questions

Problems Industry is Having with the Unbundling Methodology at ONRR.Gov

• Requires lessees to obtain confidential and proprietary information which the owners of gathering and processing facilities are not willing to provide to lessees.

• Some owners will provide some information (such as a high level process flow diagram).

• Most owners will provide no information (even information arguably not confidential or proprietary).

• No owners will provide depreciated capital cost information.

What’s a Producer To Do?

• ONRR Expects Lessees to:– Calculate their own UCAs using a reasonable method– Alternative 1 – Use ONRR UCAs if available– Alternative 2 – Take no transportation or processing

allowances(From Doug Ginley Slides)

• Failure to do one of these may result in penalties.

The Dilemma• If you need to unbundle a charge,• And you don’t have the type of data ONRR used for

its unbundling project or the type of data and models needed for ONRR’s engineering solution,

• And an ONRR unbundled rate is not available or you believe your contract or your production are different from the norm on which ONRR’s UCA’s may have been based,

• How do you avoid a penalty?

Alternative Unbundling Methodologies Are Allowed

• These are not the only methods by which the UCAs may be calculated. Other methods may be used provided they are in accordance with appropriate regulations. Regardless of the method used to Unbundle, you are still subject to audit.

http://www.onrr.gov/Unbundling/methodology.htm

Unbundling Methodology

• Remember the question: What portion of the costs incurred under a specific transportation or processing contract are for the purposes of putting the lessee’s production into marketable condition?

• ONRR’s methodologies and lessee alternative reasonable unbundling methodologies are all merely ways of estimating the answer to the question – none provide an exact answer.

• Appropriate unbundling estimates may be deemed to be reasonable “actual” transportation and processing costs under the regulations.

Unbundling - Expectations• Avoid the Penalty Box - yes

– A reasonable unbundling estimate is necessary to avoid the penalty box.

• Avoid Future Adjustments - unknown– A reasonable unbundling estimate will not

necessarily avoid having an auditor require further adjustments.

– Reasonable people can still disagree.

Alternative Unbundling Ideas

• The accounting group does not have all of the information necessary to make an unbundling estimate.

• Unbundling requires a team.• Information needed from:

– Operations– Marketing– Legal

• With strong support from management.

Alternative Unbundling Ideas

• Start by following ONRR’s instructions on its website for unbundling.

• Use a proxy (i.e., alternative methodology) for depreciated capital costs and any other the steps you cannot do.

Step 1 - Identify Flowpath and Facilities

• Determine the physical flow path of the gas from the wellhead to the point of sale or to the point where the gas is in marketable condition, whichever last occurs.

• Identify all facilities through which the product passes - gathering, compression, dehydration, transportation, and processing facilities.

Step 2 – Draw a Simplified Schematic

Simplified Schematic

Compressor Plant

Interstate, Intrastate,Receipt or Public Utility PipelinePoints

Liquids Pipeline or Trucking

Legend:

BLM Point of Delivery - on lease, CA, or PA unless prior approval for downstream commingling and meaasurement

Compression or other facilities used to put gas into marketable condition

Gas Plant

Transportation System

Step 3 – Obtain Mainline Specs• Gas quality specifications for CO2, H2S, water, total

inerts, nitrogen, etc. can be found in pipeline tariffs.www.FERC.gov Documents and Filings eTariff Tariff Viewer

• Interstate gas pipeline pressure harder to find.– Check tariff, processing contract, or pipeline’s electronic

bulletin board; check with plant owner or interstate pipeline tariff contact; try googling it (may be mentioned in press releases for example).

Step 4 – Determine Quality of the Production

• Obtain gas composition data for the production as delivered at the BLM Point of Measurement– Look at transporter gas volume statement– Check with your operations folks

• Find out what you can about the quality and pressure of the gas at each compressor station on the transportation system and at any dehydrator or treating facilities on the transportation system– Check with your operations folks– Check with the transportation system operator

Step 5 – Update Schematic

CO2 3 Mole % CO2 Not more than 2.0% by volume H2O 10 lbs/MMcf H2O Not more than 7lbs/MMcfH2S 0 Compressor Plant H2S Not more than 1/4 grain per 100 cfPressure 150 psig Pressure 1000 psig

XYZ Interstate Pipeline CompanyReceiptPoints

ABC Liquids Pipeline Company

Step 6 – Information in Between

• Find out what you can about the quality and pressure of the gas:– At each compressor station on the transportation

system – At any dehydrator or treating facilities on the

transportation system– At the inlet of the plant

• Check with your operations folks and the transportation system operator; look for publicly available information

Step 7 - Review Contracts

• Review all contracts related to the marketing of the product – gathering, processing, and sales contracts

• Review statements and invoices• Identify all fees or other charges and determine

which ones need to be unbundled• Identify all volume reductions or increases –

gathering fuel, plant fuel, lost and unaccounted for volumes, drip, imbalances

Step 8 – Update Schematic Again

CO2 3 Mole % CO2 Not more than 2.0% by volume H2O 10 lbs/MMcf H2O Not more than 7lbs/MMcfH2S 0 Compressor Plant H2S Not more than 1/4 grain per 100 cfPressure 150 psig Pressure 1000 psig

XYZ Interstate Pipeline CompanyReceiptPoints

ABC Liquids Pipeline Company

Gathering and Processing Agreement with Gatherer/Processor:Dehydration Fee $0.02 per receipt Mcf Not deductibleGathering Fee $0.24 per receipt MMBtu UnbundleProcessing Fee Plant retains 10% of the liquids Unbundle

Step 9 – Identify Marketable Condition Services Received

• Based on a comparison of your gas to the mainline specs, what marketable condition services are being provided on the transportation system and at the plant?

• Are any of these services separately priced under the contracts?

• What charges need to be unbundled?• What fuel needs to be unbundled?

Step 10 – Alternative Unbundling Estimation Method #1

• Can your company answer this question: If you provided the service yourself, how much would it cost on a per Mcf or MMBtu basis?

• Companies can often answer this question as a way to unbundle transportation costs between disallowed dehydration and compression costs and allowed delivery of gas to a gas plant.

• Use the ratio of the estimated costs to allocate the transportation charges between allowed and disallowed components.

Step 10 – Alternative Unbundling Estimation Method #2

• Can your company answer this question: If you had negotiated an unbundled contract, what would the standalone costs for the various services have been?

• Companies can often answer this question as a way to unbundle transportation costs between disallowed dehydration and compression costs and allowed delivery of gas to a gas plant.

• Use the ratio of the estimated standalone costs to allocate the transportation charges between allowed and disallowed components.

Estimation Method #2 Cont’d

• What information can you find from publicly available resources about:– Costs of compression– Pipeline construction costs– Other nondeductible costs

Example – Estimating Pipeline Costs

• Underground Construction Magazine – 2012 Pipeline Construction Report“After analyzing costs of 120 pipelines from the past decade, Ziff Energy Group’s results show the average estimated shale gas pipeline rose in 2011 to almost $200,000/inch-mile (the cost per pipeline diameter inch per mile), three times higher than 2004.”

Example - Pipeline Costs

• INGA Foundation – “Jobs & Economic Benefits of Midstream Infrastructure Development – US Economic Impacts Through 2035” by Black & Veatch – Feb. 2012 - all-in average installed cost:– Large diameter (20”-42”) – $2.8 million/mile– Small diameter (0.5” to 6”) gathering pipeline -

$100,000/mile– Lateral pipelines (6”-24”) - $2.2 million/mile

Step 10 – Associated Fuel • Use ratio of horsepower of gas-fired equipment to allocate

gathering fuel between allowed and disallowed transportation services. Value under benchmark 2 – residue price will work.

• If electricity is separately charged under the contract, do not include the horsepower of the electric compressors when allocating gathering fuel.

• Note – on many systems, 100% of gathering fuel is for disallowed compression services.

Processing Contracts• More complex facts• Same approach

– What do you know– What can you find out– Make a reasonable estimate

• Work through each service being provided by the plant –may need to use a different estimation methodology than the one used for the transportation system

• Allocate plant fuel and value under benchmark 2

Processing Contracts• See what the plant owner will tell you• Check the website of the plant owner for

equipment and process flow descriptions• Check the Risk Management Plan for facility

information• Look for press releases or technical articles about

the plant or components

Summary - Estimation Methodologies• Apply what you know or can find from publicly

available resources• To the facility information you are able to assemble• And make a reasonable good faith estimate of the

allocation of unbundled costs – Between transportation and processing– Between allowed and disallowed components

Internal Evaluation Example

• Ten miles of six inch pipeline• Four stages of compression from 5 psig to

1100 psig• Bundled “gathering” charge• Allocation proposed by one company

engineer:– 1/4 for deductible delivery component– 3/4 for nondeductible compression component

Other Considerations• Are the results reasonable?• Consider using more than one approach and

compare results.• Be conservative.

– Not necessary to go after every last penny.– Largest components of disallowed costs are for

compression costs and associated fuel.– Dehydration and treating are usually a small component

of disallowed costs.

Impact of Marketable Condition Rule and Unbundling

• Based on unbundling experience to date, applying the marketable condition rule results in an effective federal royalty rate of approximately 15% of net proceeds.

• Varies based upon residue gas and liquids prices, GPM of gas, contract terms, degree of unbundling already in the contracts, and other factors.

The No Deduct Option

• If you can’t unbundle,• Or you want more certainty than just

avoiding the penalty box, • Or you don’t want to possibly have to

reverse and rebook in the future after an audit or when ONRR unbundles the facility,

• What will the no deduct option cost?

The No Deduct Alternative• Do the math first before deciding – can result in an

effective federal royalty rate of 16% of net proceeds (in a $3.00 gas market) at a minimum.

• Much higher impact during periods of high residue prices (such as over the last six years)– Residue gas price is used to value the gathering and plant

fuel on which royalties are owed under the no deduct alternative.

The No Deduct Alternative• Does not just apply to the obvious charges such as

a stated gathering fee.• Make sure you don’t miss any deductions:

– Value at residue price of all gathering and plant fuel and lost and unaccounted for volumes.

– All gathering and processing fees including fees in the form of the value of all residue gas and liquids retained by the plant.

– All separately charged costs for marketable condition services.

Advantages of Calculating Your Own UCA

• Just because a transportation system or plant has the capability to provide a particular service, does not mean that service is being provided for your production.– Lisbon Plant in Utah – removes H2S from gas streams

that are 40% H2S or more– But some users of the plant deliver gas with no H2S.

Their own UCA should have a lower disallowed % than an ONRR-determined UCA for the Lisbon Plant.

Advantages of Calculating Your Own UCA – cont’d

• A particular lessee may be providing some of its own marketable condition services – such as dehydration and compression.

• At some gas plants, while most of the gas goes through inlet compression, there may be a high pressure pipeline that bypasses plant inlet compression.

• Calculating your own UCA using a reasonable approach allows you to reflect your specific facts.

Document Everything

• You won’t remember what you did and why.• Keep all documents used to make your unbundling

estimates.• Make sure the documentation is user friendly for

future users so they don’t have to guess what you did and why.

• Make sure documentation can be found when needed.

Going Forward – Try to Negotiate Unbundled Contracts

• Identify all marketable condition services for which a separate rate is needed.

• Consider information needed to comply with all royalty obligations – not just federal.

• Try to negotiate separate charges for each component. – Harder than you think – facility owners don’t think about

all costs in an unbundled way and producers cannot force facility owners to unbundle.

Going Forward – Try to Negotiate Unbundled Contracts – cont’d

• Try to include a provision that owner will provide any information needed to comply with royalty reporting requirements.

Unbundling – Harder Than It Needs To Be

• “Even when speech is not at issue, the void for vagueness doctrine addresses at least two connected but discrete due process concerns: first, that regulated parties should know what is required of them so they may act accordingly; second, precision and guidance are necessary so that those enforcing the law do not act in an arbitrary or discrimina tory way. See Grayned v. City of Rockford, 408 U.S. 104, 108–109 (1972).”

Unbundling – Harder Than It Needs To Be

• Given the difficulties and time involved in unbundling for both ONRR and lessees,

• And the time and cost to lessees of reversing and rebooking as UCA’s change or if an auditor disagrees with a lessee’s estimate,

• And the fact that all methodologies are estimates,• And the one size fits all nature of the existing UCAs and

UCAs based on replacement costs,• Are we headed for litigation on implementation or can we

find a better way?

Unbundling – Harder Than It Needs To Be

• Could there be safe harbors for marketable condition costs based upon standard costs?– Unbundled CO2 treating costs are 1.5 cents per each ½

mole% over specs (sometimes written as 3 cents per each 1 mole% over specs) in contracts in all producing states. This is also a common rate in tariffs.

– Can we agree that a transportation or processing fee that includes CO2 treating services can be reduced by that rate applied to a particular lessee’s gas production?

Unbundling – Harder Than It Needs To Be

• Could there be an alternative valuation methodology that avoids the need to apply the marketable condition rule as there is with Indian leases in an Index Zone (Index minus 10% capped at 30 cents – no allowances)?

• Could there be an adjustment factor alternative that avoids the need to apply the marketable condition rule – just as there is alternative dual accounting for those who do not want to do actual dual accounting?

Unbundling Conclusions• Lessees must comply with the marketable condition rule.• Unbundling is required unless a lessee elects the no deduct

alternative.• Failure to take action to comply with the marketable

condition rule may result in significant penalties.• Unbundling is time consuming and expensive for both ONRR

and Industry and both sides have litigation exposure.• Let’s try to work together to simplify the process and

provide certainty particularly in this period of low prices where money can be better spent than on trying to unbundle with limited access to information.