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Fifth Circuit Affirms Royalty Relief for Offshore Oil and Gas Leases

Beveridge & Diamond, P.C., January 15, 2009

In a major victory for the oil and gas industry, the U.S. Court of Appeals for the Fifth Circuit ruled that the U.S. Department of the Interior’s Minerals Management Service (“MMS”) cannot require the payment of royalties from certain production on deepwater oil and gas leases issued between 1996 and 2000 in the Gulf of Mexico.  See Kerr-McGee Oil and Gas Corp. v. Allred, Slip. Op. No. 08-30069 (5th Cir. Jan. 12, 2009). 

The Outer Continental Shelf Deep Water Royalty Relief Act of 1995 (“DWRRA”) incentivized the development of oil and gas from deepwater leases on the Outer Continental Shelf (“OCS”) through relief from paying royalties, i.e., a percentage of revenue, to MMS.  Under Section 304 of the DWRRA, certain Gulf of Mexico lessees are entitled to royalty relief up to statutorily-prescribed production volumes of between 17.5 and 87.5 million barrels of oil equivalent per lease, varying by water depth.  The DWRRA has been a remarkable success.  With the passage of the DWRRA, Congress achieved its goals of spurred development, generated jobs, economic growth, and income for the government, while increasing domestic energy supply.

MMS sought to limit the statutory royalty relief by including a so-called “price threshold” in the leases, such that if commodity prices exceeded certain levels set by MMS, the royalty relief would be terminated.  When oil and gas prices increased beyond the threshold, MMS demanded royalty payments on the royalty relief volumes from a number of Section 304 leases.  Kerr-McGee sued, claiming that the statutorily-prescribed royalty relief volumes could not be conditioned by the agency and no royalty was owed.  The Court agreed with Kerr-McGee and rejected MMS’s attempts to collect royalties, holding that the DWRRA granted MMS no authority to limit Congress’ clearly established volume-based royalty relief in favor of administratively established price thresholds.  The Court analogized the case to Sante Fe Snyder v. Norton, 385 F.3d 884 (5th Cir. 2004), where it similarly held that Interior could not restrict Section 304’s royalty relief by limiting relief to leases located in fields without existing production or by calculating relief by field rather than by individual leases.

While the decision directly concerns the eight leases obtained by Kerr-McGee, it also affects dozens of other deepwater leases issued to other companies between 1996 and 2000.  The Federal Government has offered several different assessments of potentially foregone royalties under the DWRRA; these estimates, ranging from approximately $15 to $53 billion, also tend to rely on projected production that MMS has since deemed optimistic as well as oil and gas prices much higher than used today for Federal budgeting purposes.  The Congress already had been engaged in efforts to “recoup” some of the foregone DWRRA royalties as a result of MMS having omitted any price thresholds in the DWRRA leases issued in 1998 and 1999.  In an effort to compel those lessees to “renegotiate” their leases and include a price threshold that effectively would have limited the royalty relief, the House passed a measure in early 2007 that would have imposed monetary penalties or barred those lessees from participating in future OCS lease sales.  The Senate also considered measures imposing taxes on the affected companies to regain some revenues.  The debate in Congress centered on the contractual, constitutional and other legal issues that such legislation presented.  None of these proposed measures has been passed by Congress.

Now that the Kerr-McGee decision has expanded the debate to all five years of leases issued under the DWRRA, and in light of Congress’ continuing oversight of many Interior programs, it is expected that the new Congress may again focus attention on this issue.

For further information on royalties and related oil and gas issues, please contact Fred Wagner (202) 789-6041, Bill Sinclair (410) 230-1354, or James Auslander (202) 789-6009.

To read the full court opinion, click here.