Unbundling –
What’s A Producer To Do?
Judith M. Matlock, Partner
Davis 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 Compression
Psig:
Cryogenic Plant
1000
950
900
850
800
750
700
650
600
550
500
450
400
350
300
250
200
150
100
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.htm
References
• 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,
or Public Utility Pipeline
Receipt
Points
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
H2O
H2S
Pressure
3 Mole %
10 lbs/MMcf
0
150 psig
Compressor
Plant
CO2
Not more than 2.0% by volume
H2O
Not more than 7lbs/MMcf
H2S
Not more than 1/4 grain per 100 cf
Pressure 1000 psig
XYZ Interstate Pipeline Company
Receipt
Points
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
H2O
H2S
Pressure
3 Mole %
10 lbs/MMcf
0
150 psig
Compressor
Plant
CO2
Not more than 2.0% by volume
H2O
Not more than 7lbs/MMcf
H2S
Not more than 1/4 grain per 100 cf
Pressure 1000 psig
XYZ Interstate Pipeline Company
Receipt
Points
ABC Liquids Pipeline Company
Gathering and Processing Agreement with Gatherer/Processor:
Dehydration Fee
$0.02 per receipt Mcf
Not deductible
Gathering Fee
$0.24 per receipt MMBtu Unbundle
Processing 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 discriminatory 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.