A unanimous panel of the United States Court of Appeals for the Fifth Circuit has held that the United States Department of the Interior violated the Outer Continental Shelf Deep Water Royalty Relief Act (“RRA”) by imposing price threshold conditions that require federal lessees to pay royalties when commodity prices rise.  Kerr-McGee Oil & Gas Corp. v. U.S. Dep’t of Interior, __ F.3d __, 2009 WL 57883 (5th Cir. Jan. 12, 2009).  Relying on its 2004 decision in Santa Fe Snyder Corp. v. Norton, 385 F.3d 884 (5th Cir. 2004), the court held that Section 304 of the RRA unambiguously entitled Kerr-McGee to unconditional royalty relief on minimum volumes of production. 

 

Faced with the nation’s increased dependence on foreign oil and the loss of hundreds of thousands of jobs in the domestic oil and gas industry, Congress enacted the RRA in 1995 to spur investment in oil and gas operations in the deep waters of the Gulf of Mexico.  By any measure, the royalty relief incentives of the RRA have been enormously successful.  The RRA resulted in record bidding on deep water leases, payment of billions of dollars in lease bonuses to the United States, more than a thousand new exploratory wells, tens of thousands of new jobs, billions of dollars in new economic activity, and a six-fold increase in deep water oil and gas production.  Since enactment of the RRA, the deep water Gulf of Mexico has become America’s most important new source of oil and gas.

 

Congress fashioned different royalty relief rules for deep water Gulf of Mexico leases, depending on when the leases were granted.  For deep water leases that already existed when the RRA was enacted, Section 302 of the RRA made royalty relief subject to a series of conditions. For example, royalty relief was only applicable to “new production,” and royalty relief was made subject to a statutory pricing condition:  for pre-existing deep water leases, Congress conditioned royalty relief on commodity prices remaining below statutorily-specified amounts.

 

For deep water leases granted during the five-year period after enactment of the RRA (during the years 1996 through 2000), Congress made royalty relief unconditional.  For these leases, which are governed by Section 304 of the RRA, Congress mandated that royalty suspensions “shall be set at a volume of not less than” specified volumes of production.  The royalty suspension volumes for Section 304 leases range from 17.5 MMBOE to 87.5 MMBOE, with the higher volumes applicable to leases in the deepest water depths.  The Kerr-McGee case involved leases granted pursuant to Section 304 of the RRA.

 

When Interior implemented the RRA, it imposed a series of conditions on Section 304 leases that operated to limit or even negate royalty relief altogether.  Interior lifted the “new production” and price threshold conditions that Congress had applied only to pre-existing leases (governed by Section 302) and applied those conditions to Section 304 leases, thereby negating royalty relief for Section 304 leases when those conditions were triggered.  In addition, Interior diluted the volume of royalty relief to which each Section 304 lease is entitled by requiring all Section 304 Leases in a single “field” to share a single royalty suspension volume, rather than allowing each individual lease to enjoy the full royalty suspension volume that Congress mandated in Section 304.  In Santa Fe Snyder v. Norton, the Fifth Circuit held that Interior violated the RRA by imposing the “new production” requirement and field-based method of volume allocation on Section 304 leases.  In Kerr-McGee Oil & Gas Corp. v. Dep’t of the Interior, the Fifth Circuit held that Interior also violated the RRA by imposing the price threshold condition on Section 304 leases.

 

Kerr-McGee’s lawsuit arose out of one of dozens of royalty payment orders that Interior issued to federal lessees based on increases in commodity prices above the price thresholds.  Interior ordered such royalty payments even though the leases had not yet produced the minimum royalty suspension volumes guaranteed by Section 304.  Relying on Santa Fe Snyder v. Norton, both the Louisiana federal district court and the Fifth Circuit concluded that Interior exceeded its statutory authority when it inserted the price threshold provisions into Kerr-McGee’s Section 304 leases.  According to the Fifth Circuit, Kerr-McGee’s challenge to Interior’s price threshold requirement was “the logical and inevitable extension of Santa Fe Snyder, as the district court correctly reasoned.”

 

Comparing Section 302 of the RRA, in which Congress had included price threshold provisions for pre-existing leases, and Section 304, in which Congress had not, the court rejected Interior’s attempt to extend Section 302’s price-based limitation to Section 304 leases.  The court observed that, if Congress had wanted to impose price thresholds on Section 304 leases, “it certainly knew how to do so.”  Ultimately, the court concluded that Interior’s interpretation of the RRA would make Section 304’s guarantee of minimum royalty suspension volumes meaningless: “if price thresholds trigger royalty payments before § 304’s production volumes are exceeded, then the royalty payment suspension is being set at a volume less that § 304’s specified production levels.”  (Emphasis in the opinion.)  Accordingly, the court held that the price threshold conditions in Kerr-McGee’s Section 304 leases are unlawful and unenforceable.

 

For more information, please contact Jonathan A. Hunter at jahunter@liskow.com, or  Jason R. Johanson at jrjohanson@liskow.com or go to www.liskow.com.