Royalty Relief for U.S. Deepwater Oil and Gas Leases

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

The most common incentives for offshore oil and gas development include various forms of
royalty relief. The Outer Continental Shelf Lands Act (OCSLA) authorizes the Secretary of the
Interior to grant royalty relief to promote increased oil and gas production (43 U.S.C. 1337). The
Deep Water Royalty Relief Act of 1995 (DWRRA) expanded the Secretary’s royalty relief
authority in the Gulf of Mexico outer continental shelf (OCS).
Controversy over royalty relief currently focuses on the lack of price thresholds in Minerals
Management Service (MMS) OCS lease sales held in 1998 and 1999. Without the price
thresholds, deepwater producers continued to benefit from royalty relief, even as oil prices hit
record levels. In an unresolved issue over the Secretary of the Interior’s authority and discretion
to impose price thresholds, the Department of the Interior asserts that the Secretary of the Interior
is not required to impose price thresholds in each lease (but has the discretion to do so). All lease
sales held since the enactment of DWRRA included price thresholds, except those held in 1998
and 1999. According to the MMS and the Government Accountability Office (GAO), omitting
price thresholds for those two years could cost the federal government as much as $10 billion.
This situation has prompted efforts to amend the 1998 and 1999 leases to include price
thresholds. A recent court decision, however, ruled that the Secretary of the Interior does not have
authority to impose price thresholds in those DWRRA leases. On September 16, 2008, the House
passed H.R. 6899. Under Title I, this bill would, among other things, deny new Gulf of Mexico
oil and gas leases to lessees holding leases without price thresholds or payment of or agreement to
pay the proposed “conservation of resources” fees. An earlier bill (H.R. 6) with similar language
passed the House in January 2007 by a vote of 264-123. However, on December 6, 2007, the
House approved the Senate-passed version of energy policy legislation (H.R. 6) without the
royalty relief provisions discussed above. The royalty relief provisions were not enacted into law.

Introduc tion ..................................................................................................................................... 1
OCS Leasing System.......................................................................................................................1
Royalty Relief...........................................................................................................................1
Deepwater Development...........................................................................................................3
Congressional Concerns..................................................................................................................4
Legislative Actions....................................................................................................................5
Table 1. Minimum Royalty Suspension Volumes Per Lease...........................................................3
Table 2. Deepwater Proved Reserves and Resources......................................................................4
Author Contact Information............................................................................................................5

As oil and gas prices hit record levels during 2006, allegations arose about missteps at the
Minerals Management Service (MMS) regarding the collection of royalties for oil and gas
production on the outer continental shelf (OCS). Of particular concern to Congress is that price
thresholds for royalty relief in deepwater leases were omitted from deepwater lease sales held in
1998 and 1999. Such thresholds establish a maximum price per barrel of oil or million Btu of
natural gas where producers may receive royalty relief; above the threshold price, royalties must
be paid. Except for the 1998 and 1999 lease sales, the thresholds are included in all leases eligible
for automatic royalty relief under the Deepwater Royalty Relief Act of 1995 (DWRRA, P.L. 104-
58). Without the price thresholds, oil and gas can be produced from a lease up to a specified
volume without being subject to royalties, no matter how high the price goes.

The Outer Continental Shelf Lands Act of 1953 (OCSLA), as amended, provides for the leasing
of OCS lands in a manner that protects the environment and returns to the federal government
revenues in the way of bonus bids, rents, and royalties. Lease sales are conducted through a
competitive, sealed bonus-bidding process, and leases are awarded to the highest bidder.
Successful bidders make an up-front cash payment, called a bonus bid, to secure a lease. A
minimum bonus bid is determined for each tract offered.
Bidding on deepwater tracts in the mid-1990s led to a surge in bonus revenue (e.g., $1.4 billion in ¹
FY1997). Bonus bids totaled $902.6 million in FY2007. In addition to the cash bonus bid, a
royalty rate of 12.5% or 16.66%, has been imposed on the value of production, with royalties ²
sometimes paid “in-kind.” More recently, the MMS imposed an 18.75% royalty rate on its
offshore leases. Annual rents range from $5 to $9.50, with lease sizes generally ranging from
2,500 to 5,760 acres. Initial lease terms of 5-10 years are standard, and leases are continued as
long as commercial quantities are being produced. The MMS, in the Department of the Interior,
administers the offshore leasing program.
OCSLA authorizes the Secretary of the Interior to grant royalty relief to promote increased oil
and gas production. There are generally four royalty relief categories in the Gulf of Mexico
(GOM): Deepwater (more than 200 meters), Shallow Water Deep Gas, End-of-Life, and Special
Case. Royalty relief under the End-of-Life and Special Case categories was already in place
under OCSLA before the Deep Water Royalty Relief Act of 1995 (DWRRA) and is not involved
in the current controversy. DWRRA expanded the Secretary’s authority to grant royalty relief to
deepwater leases in the Gulf of Mexico OCS. Under DWRRA, the Secretary may reduce royalties ³
if production would otherwise be uneconomic.

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In an unresolved matter over price thresholds, the Department of the Interior interprets the
DWRRA (P.L. 104-58) to provide the Secretary of the Interior with the authority and discretion to
establish thresholds, above which the relief is discontinued. Another interpretation of the law ⁴
concludes that thresholds are mandatory, not discretionary. In addition, the authority of the ⁵
Secretary to impose price thresholds has come into question in a lawsuit filed by Kerr-McGee.
The U.S. District Court, Western District of Louisiana issued a ruling on October 18, 2007, in ⁶
favor of Kerr-McGee, meaning that the Secretary of the Interior did not have authority to impose
price threshold levels in leases issued under DWRRA (1996-2000). The ruling could apply to
potentially $23-$31 billion in future OCS royalties according to the MMS, but may not affect
congressional efforts to impose new fees or establish new lease eligibility criteria discussed ⁷
below. Threshold levels were established in 1995 for eligible deepwater leases and are adjusted ⁸
annually for inflation. The market price for oil in late 2006 was above the threshold, so leases
with thresholds were paying royalties on oil production. Some gas lease thresholds were below ⁹
the late-2006 market price and others slightly above.
DWRRA provides for “fields”¹⁰ with eligible leases to receive royalty suspensions for specific
volumes of production at specified depths (Table 1). The royalty relief was contingent on the ¹¹
lease being part of a non-producing field before DWRRA was enacted. Eligible leases are those
issued in the GOM between 1996 and 2000 at depths greater than 200 meters located wholly west
of 87 degrees, 30 minutes West longitude. The lease is offered subject to a lease suspension
volume—the amount of oil and gas that can be produced royalty-free. Eligible leases do not
require an economic evaluation to be granted royalty relief. Also within the Deepwater category
are “Pre-Act” leases (lease sales held before November 1995), Post-2000 leases (lease sales held
after November 2000), and leases classified as Expansion Projects, all of which can qualify for
royalty relief under DWRRA with an application demonstrating economic need. In addition,
“Post 2000” leases or “royalty suspension leases” may be offered with an automatic royalty
suspension volume on a “lease,” rather than field, basis. The Energy Policy Act of 2005 (EPACT-
05, P.L. 109-58) expanded the “post-Act” royalty relief program by providing automatic
minimum suspension volumes at specified depths in each lease.

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A shallow-water, deep-gas incentive became effective March 1, 2004.¹² The rule suspends the
royalty on gas from wells with at least 15,000 feet “true vertical depth” located in waters less than
200 meters deep in the central and western GOM. It also provides a royalty suspension
supplement for drilling “certain” unsuccessful deep wells in that region. The gas price threshold
for discontinuing this royalty relief was $9.91 per million Btu in late 2006 for 2004-2005 lease ¹³
sales. The shallow-water, deep-gas incentive was expanded by EPACT-05 to require royalty
suspension volumes of at least 35 billion cubic feet of natural gas produced in waters less than
400 meters deep from ultra-deep wells (20,000 feet true vertical depth), leases that have
previously produced from wells at 15,000 feet deep, or “sidetrack wells.”
Table 1. Minimum Royalty Suspension Volumes Per Lease
^{DWRRA 1995 (P.L. 10}^4-5⁸⁾^{Energy Policy A}^{ct 2005 (P.L}^{. 109-}⁵⁸⁾
^Depth^{Barrels of Oil E}^quivalent^{(in millions)}^Depth^{Barrels of Oil E}^quivalent^{(in millions)}
^200-⁴⁰^{0 mete}^rs^17.5^—^—
^400-⁸⁰^{0 mete}^rs^52.5^400-⁸⁰^{0 mete}^rs^5.0
^{> 80}^{0 mete}^rs^87.5^800-^1,60^{0 mete}^rs^9.0
^{— — 1,60}^0-2,00⁰^mete^rs^12.0
^{> 2,00}^{0 mete}^rs^16.0
^Source:^{P.L. 104-}^{58 a}^{nd P.L. 10}⁹^-58.
Proponents of these royalty relief measures contend that without incentives, little GOM
deepwater or shallow-water, deep-gas drilling would have taken place, because these areas would
not have been competitive with foreign offshore prospects (e.g., Brazil and West Africa).
Increased GOM drilling enhances U.S. energy security, proponents contend. Critics, during the
debate on royalty relief that preceded passage of EPACT-05, charged that the government would
forfeit millions of dollars through the subsidy and that drilling costs were already coming down
as a result of advances in technology, thus making many deepwater lease tracts economical.
According to MMS, deepwater drilling in the Gulf of Mexico has benefitted from a combination ¹⁴
of improved technology, higher prices, and royalty reductions.
A significant amount of activity is taking place in deepwater GOM. Out of 8,221 active offshore
oil and gas leases, 54% are in deep water. Interest surged after enactment of DWRRA, with 3,000 ¹⁵
deepwater leases bid between 1996 and 1999. Deepwater oil production rose from 42 million
barrels in 1994 to 348 million barrels in 2004. Natural gas production increased from 159 billion
cubic feet in 1994 to 1.4 trillion cubic feet in 2004. Within the past two years, there was a 37%
increase in the number of producing projects. Deepwater development, however, is facing major

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challenges. Currently, about 8% of the DWRRA-eligible leases issued between 1996 and 2000
have been drilled, and only a few are in production (because of rig constraints and large lease
inventories). In 2004, of the 1,667 leases producing in the GOM, 30 qualified as eligible leases
under DWRRA. Since 2004, oil and gas prices rose above the price thresholds, and full payment
of royalties became due on 10 of those leases that were issued in 1996, 1997, and 2000. The other

20 were issued in 1998 and 1999 without price thresholds.

MMS maintains that the future of deepwater production looks bright. Proved oil and gas reserve
and resource estimates have more than doubled since 2000 (Table 2), discoveries are taking place
in much deeper waters since 2000, and development time decreased from 10 years in the mid-
1990s to seven years in 2006. Although DWRRA spurred a surge of interest in deepwater oil and
gas development, major production directly related to the act’s incentives has yet to be realized.
For leases containing price thresholds, relatively little royalty relief has been granted.
Table 2. Deepwater Proved Reserves and Resources
^{(in million barre}^{ls of oil equi}^v^a^lent)
^{Year Proved}^Reserves^{Proved and}^Unpr^{oved Resou}^rces^{and Ind}^{ustry Discoveries}
²⁰⁰^{0 4,01}⁵^8,62²
²⁰⁰^{2 4,38}⁵^12,8⁷¹
²⁰⁰^{4 6,70}²^15,5⁷³
²⁰⁰^{6 9,43}⁵^18,5³¹
^Source:^{DOI, M}^{MS, OCS Report MMS 2}⁰⁰^6-0^2.

Controversy over royalty relief currently focuses on the lack of price thresholds in OCS lease
sales held in 1998 and 1999. Without the price thresholds, deepwater producers continued to
benefit from royalty relief even as oil prices hit record levels. How these price thresholds were
omitted is the subject of ongoing congressional and administrative investigations. According to
the Minerals Management Service, although the Secretary of the Interior is not required to impose
price thresholds in each lease (but has the discretion to do so), all lease sales held since the
enactment of DWRRA included price thresholds except those held in 1998 and 1999. The MMS
and the Government Accountability Office (GAO), estimate that this error could cost the federal
government as much as $10 billion. The MMS estimated that about $956 million in royalty
revenue was foregone through FY2006. Annually, the MMS collects about $10 billion in
revenues from oil and gas leases on federal lands.
The policy concern for some is whether, and if so how, to amend the 1998 and 1999 leases to
include price thresholds. Some argue that modifications to the leases should be retroactive to
capture past as well as future revenues from deepwater oil and gas production. Others in Congress
argue that any mandatory modification of the leases might be a breach of contract or
unconstitutional, and would be contested in court. Another legislative possibility is to enact
incentives, such as prohibiting lessees from bidding on future leases to induce holders of 1998-
1999 leases to accept price thresholds. MMS has initiated efforts to have lessees voluntarily
modify their leases to include price thresholds going forward from October 2006. In December

2006, five companies holding about 25% of the leases have agreed to the MMS initiative.¹⁶ Of the
1,032 deepwater leases issued in 1998 and 1999, 526 are active (under exploration or
development) and 19 are currently producing. While prices remain at the current level, the only
volumes subject to royalty relief will come from deepwater leases that were awarded in 1998 and

1999 without price thresholds and from shallow-water, deep-gas leases.

On September 16, 2008, the House passed H.R. 6899, the Comprehensive American Energy
Security and Consumer Protection Act. Under Title I, this legislation would, among other things,
require the Secretary of the Interior accept a lessee’s request to modify those leases without price
thresholds (“covered leases”) to include price thresholds. The bill would not made available to
lessees holding “covered leases” new oil and gas leases in the Gulf of Mexico unless current
leases include price thresholds or the lessee agree to pay the proposed “conservation of resources ¹⁷
fee” or an agreement to pay such fees. The bill would also reaffirm the Secretary’s authority to ^th
impose a price threshold in certain leases. Earlier in the 110 Congress, on January 18, 2007, the
House passed H.R. 6, with similar language on royalty relief, by a vote of 264-123. However, the
provisions discussed above were not included in the House-passed version (December 6, 2007) of
the Senate-passed energy policy bill (H.R. 6, P.L. 110-140). The royalty relief provisions were not
enacted into law.
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