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

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

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˜¢Š•?¢ȱŽ•’Ž?ȱ?˜›ȱǯǯȱŽŽ™ Š?Ž›ȱ’•ȱŠ—?ȱ
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epared for Members and Committees of Congress

˜¢Š•?¢ȱŽ•’Ž?ȱ?˜›ȱǯǯȱŽŽ™ Š?Ž›ȱ’•ȱŠ—?ȱ ŠœȱŽŠœŽœȱ
ȱ
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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).
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 was 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
(leases issued between 1996-2000) 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. A recent U.S. District Court decision, however, which was upheld by a 3-
member panel in the U.S. Court of Appeals, ruled that the Secretary of the Interior had no
authority to impose price thresholds for oil and gas leases held under the DWRRA . Based on the
court ruling, the lessees, therefore, should have the right to produce up to the specified volume of
oil and gas in the lease, regardless of the price. This ruling could cost the federal treasury as much
as $1.8 billion in refunds according to the MMS and between $21-$53 billion over 25 years
according to the Government Accountability Office (GAO).
The policy concern for some is not only to amend the 1998 and 1999 leases to include price
thresholds but also address the Secretary’s authority to impose price thresholds in any of the
DWRRA leases issued from 1996-2000.
There are discussions underway in the 111th Congress on how to address the royalty relief issue
involving price thresholds and DWRRA leases. In the 110th Congress, the House passed H.R.
6899, the Comprehensive American Energy Security and Consumer Protection Act. Under Title I,
this legislation would have, among other things, required the Secretary of the Interior to accept a
lessee’s request to modify those leases without price thresholds (“covered leases”) to include
price thresholds. The bill would not have made new oil and gas leases in the Gulf of Mexico
available to lessees holding “covered leases” unless current leases included price thresholds or the
lessee agreed to pay the proposed “conservation of resources fee.” The bill also would have
affirmed the Secretary’s authority to impose a price threshold in certain leases. The royalty relief
provisions were not enacted into law.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

˜¢Š•?¢ȱŽ•’Ž?ȱ?˜›ȱǯǯȱŽŽ™ Š?Ž›ȱ’•ȱŠ—?ȱ ŠœȱŽŠœŽœȱ
ȱ
˜—?Ž—?œȱ
Introduction ..................................................................................................................................... 1
OCS Leasing System....................................................................................................................... 1
Royalty Relief ........................................................................................................................... 2
Deepwater Development ........................................................................................................... 4
Congressional Concerns .................................................................................................................. 5
Legislative Actions.................................................................................................................... 5

Š‹•Žœȱ
Table 1. Minimum Royalty Suspension Volumes Per Lease ........................................................... 3
Table 2. Deepwater Proved Reserves and Resources ...................................................................... 4

˜—?ŠŒ?œȱ
Author Contact Information ............................................................................................................ 6

˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ

˜¢Š•?¢ȱŽ•’Ž?ȱ?˜›ȱǯǯȱŽŽ™ Š?Ž›ȱ’•ȱŠ—?ȱ ŠœȱŽŠœŽœȱ
ȱ
—?›˜?žŒ?’˜—ȱ
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 was 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
(leases issued between 1996-2000) 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. A recent U.S. District Court decision1, however, which was upheld by a 3-
member panel in the U.S. Court of Appeals, ruled2 that the Secretary of the Interior had no
authority to impose price thresholds for oil and gas leases held under the DWRRA . Based on the
court ruling, the lessees, therefore, should have the right to produce up to the specified volume of
oil and gas in the lease, regardless of the price. This ruling could cost the federal treasury as much
as $1.8 billion in refunds according to the MMS3 and between $21-$53 billion over 25 years
according to the Government Accountability Office (GAO).4
ȱŽŠœ’—?ȱ¢œ?Ž–ȱ
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
FY1997).5 Bonus bids totaled $9.5 billion in FY2008 up from $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 sometimes paid “in-kind.”6 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.

1 Kerr-McGee Oil and Gas Corp. v. Allred, No. 2:06-CV-0439 (W.D. La. October 30, 2007).
2 U.S. Court of Appeals for the 5th Circuit, No. 08-30069, January 12, 2009.
3 Personal communication with MMS Office of Congressional Affairs, Lyn Herdt, February 4, 2008.
4 U.S. Government Accountability Office, Oil and Gas Royalties: Litigation over Royalty Relief Could Cost the
Federal Government Billions of Dollars, June 8, 2008.
5 Department of the Interior, FY2002 Budget Justifications, p. 63.
6 A royalty-in-kind payment would be in the form of barrels of oil or cubic feet of natural gas.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
ŗȱ

˜¢Š•?¢ȱŽ•’Ž?ȱ?˜›ȱǯǯȱŽŽ™ Š?Ž›ȱ’•ȱŠ—?ȱ ŠœȱŽŠœŽœȱ
ȱ
˜¢Š•?¢ȱŽ•’Ž?ȱ
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
if production would otherwise be uneconomic.7
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
concludes that thresholds are mandatory, not discretionary.8 In addition, the authority of the
Secretary to impose price thresholds has come into question in a lawsuit filed by Kerr-McGee
(purchased by Anadarko Petroleum Corporation in 2006).9 The U.S. District Court, Western
District of Louisiana issued a ruling on October 18, 2007, in favor of Kerr-McGee,10 meaning that
the Secretary of the Interior did not have authority to impose price threshold levels in leases
issued under DWRRA (1996-2000). The Department of the Interior appealed the District Court
ruling. On January 12, 2009, a three-judge panel of the 5th U.S. Circuit Court of Appeals in New
Orleans upheld the District Court decision.11 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 below.12 The GAO estimates the
range of royalty revenue loss to the federal treasury at between $30-$53 billion over 25 years.
The range of estimated losses are based on a number of assumptions including future prices and
production rates. Threshold levels were established in 1995 for eligible deepwater leases and are
adjusted annually for inflation.13 On average, the market price for oil and gas throughout 2008
was above the threshold (with the exception of shallow water deep gas leases), so leases with
thresholds were paying royalties on oil production.

7 A description of MMS royalty relief programs is available at http://www.gomr.mms.gov/homepg/offshore/
royrelef.html. A more detailed analysis of the royalty relief programs is contained in a Department of the Interior,
MMS, report: Guidelines for the Application, Review, Approval, and Administration of the Deepwater Royalty Relief
Program for Pre-Act Leases and Post-2000 Leases, Appendix 1 to NTL No. 2002-No. 2, February 2002.
8 Letter to House Committee on Government Reform, by Stephen Lowey of Lowey Dannenberg Bemporad & Selinger,
P.C., Re: Gulf of Mexico defective deep water drilling leases, October 31, 2006.
9 For more details on this case, see CRS Report RL33404, Offshore Oil and Gas Development: Legal Framework, by
Adam Vann.
10 Kerr-McGee Oil & Gas Corp. v. Allred.
11 U.S. Court of Appeals for the 5th Circuit.
12 See CRS Report RL33974, Legal Issues Raised by Provision in House Energy Bill (H.R. 6) Creating Incentives for
Certain OCS Leaseholders to Accept Price Thresholds, by Robert Meltz and Adam Vann and CRS General
Distribution Memorandum: Impact of the Kerr-McGee Oil and Gas Corp. v. Allred Ruling on the Proposed Royalty
Relief for America Consumers Act of 2007, by Adam Vann.
13 Price threshold levels for deepwater oil and gas can be found on the MMS website at http://www.gomr.mms.gov/
homepg/offshore/royrelef.html.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
Řȱ

˜¢Š•?¢ȱŽ•’Ž?ȱ?˜›ȱǯǯȱŽŽ™ Š?Ž›ȱ’•ȱŠ—?ȱ ŠœȱŽŠœŽœȱ
ȱ
DWRRA provides for “fields”14 with eligible leases to receive royalty suspensions for specific
volumes of production at specified depths (Table 1). The royalty relief was contingent on the
lease being part of a non-producing field before DWRRA was enacted.15 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. For five years after enactment of
EPACT-05, the Secretary of the Interior is granted authority to place limits on royalty relief based
on the market price of oil and natural gas.
A shallow-water, deep-gas incentive became effective March 1, 2004.16 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 estimated by MMS at $10.37 per million Btu in 2008 for
lease sales beyond 2003.17 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. 104-58)
Energy Policy Act 2005 (P.L. 109-58)
Depth
Barrels of Oil Equivalent
(in millions)
Depth
Barrels of Oil Equivalent
(in millions)
200-400 meters
17.5
—
—
400-800 meters
52.5
400-800 meters
5.0
> 800 meters
87.5
800-1,600 meters
9.0
— — 1,600-2,000
meters
12.0

> 2,000 meters
16.0
Source: P.L. 104-58 and P.L. 109-58.

14 A field is defined as an area consisting of a single reservoir or multiple reservoirs with the same geological structure
or stratigraphic trapping condition and may contain more than one lease.
15 The MMS rule pertaining to royalty relief for each field as opposed to each lease was challenged in district court in
Louisiana in 2003. The court ruled in favor of the lessees (and was upheld by the Court of Appeals), allowing royalty
relief to apply to individual leases rather than fields (reported at 385 F. 3rd 884, 5th Circuit Court).
16 69 Federal Register 3492, January 26, 2004.
17 See the MMS website at http://www.mms.gov/econ/PDFs/currentkick-outsNOV-2008.pdf.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
řȱ

˜¢Š•?¢ȱŽ•’Ž?ȱ?˜›ȱǯǯȱŽŽ™ Š?Ž›ȱ’•ȱŠ—?ȱ ŠœȱŽŠœŽœȱ
ȱ
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
of improved technology, higher prices, and royalty reductions.18
ŽŽ™ Š?Ž›ȱŽŸŽ•˜™–Ž—?ȱ
A significant amount of activity is taking place in deepwater GOM. Out of 8,221 active offshore
oil and gas leases, about 54% are in deep water Gulf of Mexico. Interest surged after enactment of
DWRRA, with 3,000 deepwater leases bid between 1996 and 1999.19 Annual deepwater oil
production rose from 108 million barrels in 1997 (26% of total GOM) to 343 million barrels in
2006 (72% of total GOM). Deepwater natural gas production increased from 382 billion cubic
feet in 1997 (7% of total GOM) to 1.1 trillion cubic feet in 2006 (38% of total GOM). Deepwater
development, however, is facing major 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 2007, of more than1,600 leases
producing in the GOM, 19 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 barrels of oil equivalent)
Year Proved
Reserves
Proved and Unproved Resources
and Industry Discoveries
2000 4,015
8,622
2002 4,385
12,871
2004 6,702
15,573
2006 9,435
18,531
Source: DOI, MMS, OCS Report MMS 2006-02.

18 Deepwater Gulf of Mexico 2006: America’s Expanding Frontier, OCS Report MMS 2006-022, U.S. Department of
the Interior, May 2006.
19Ibid., Fig. 52.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
Śȱ

˜¢Š•?¢ȱŽ•’Ž?ȱ?˜›ȱǯǯȱŽŽ™ Š?Ž›ȱ’•ȱŠ—?ȱ ŠœȱŽŠœŽœȱ
ȱ
˜—?›Žœœ’˜—Š•ȱ˜—ŒŽ›—œȱ
Controversy over royalty relief had focused on the lack of price thresholds in OCS lease sales
held in 1998 and 1999, but because of a recent U.S. District Court ruling, upheld by the Circuit
Court of Appeals (discussed above), the authority of the Secretary of the Interior to impose price
thresholds may be at issue in all of the DWRRA leases issued from 1996-2000. All lease sales
held under the DWRRA (1996-2000) included price thresholds except those held in 1998 and
1999. Without the price thresholds, deepwater producers continue to benefit from royalty relief
regardless of the price. The DOI continues to argue that the Secretary of the Interior has the
authority and discretion to impose price thresholds in the DWRRA leases and may appeal the
ruling further. The MMS and the Government Accountability Office (GAO) estimate that the
error in the 1998-99 leases alone could cost the federal government as much as $14.7 billion. The
MMS estimated that about $1.2 billion in royalty revenue was foregone through April 2007. In
FY2008 the MMS collected about $18 billion in revenues from oil and gas leases on federal
lands.
The policy concern for some is not only to amend the 1998 and 1999 leases to include price
thresholds but also address the Secretary’s authority to impose price thresholds in any of the
DWRRA leases issued from 1996-2000.
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. 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.20 Of the 1,032 deepwater
leases issued in 1998 and 1999, 526 are active (under exploration or development) and 19 are
currently producing.
Ž?’œ•Š?’ŸŽȱŒ?’˜—œȱ
There are discussions underway in the 111th Congress on how to address the royalty relief issue
involving price thresholds and DWRRA leases. In the 110th Congress, the House passed H.R.
6899, the Comprehensive American Energy Security and Consumer Protection Act. Under Title I,
this legislation would have, among other things, required the Secretary of the Interior to accept a
lessee’s request to modify those leases without price thresholds (“covered leases”) to include
price thresholds. The bill would not have made new oil and gas leases in the Gulf of Mexico
available to lessees holding “covered leases” unless current leases included price thresholds or the
lessee agreed to pay the proposed “conservation of resources fee.”21 The bill also would have
affirmed the Secretary’s authority to impose a price threshold in certain leases. The royalty relief
provisions were not enacted into law.

20Companies include BP Plc, ConocoPhillips, Marathon Oil, Royal Dutch Shell, and Walter Oil and Gas Corp.
21The fee would be $9/barrel oil and $1.25/million Btu natural gas on covered producing leases and$3.75/acre annually
on non-producing leases.
˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
śȱ

˜¢Š•?¢ȱŽ•’Ž?ȱ?˜›ȱǯǯȱŽŽ™ Š?Ž›ȱ’•ȱŠ—?ȱ ŠœȱŽŠœŽœȱ
ȱ
ž?‘˜›ȱ˜—?ŠŒ?ȱ —?˜›–Š?’˜—ȱ

Marc Humphries

Analyst in Energy Policy
mhumphries@crs.loc.gov, 7-7264

˜—?›Žœœ’˜—Š•ȱŽœŽŠ›Œ‘ȱŽ›Ÿ’ŒŽȱ
Ŝȱ