Washington Eyes Oil Industry
Royalty Relief and Price Thresholds
This royalty relief was designed to encourage exploration of deepwater prospects that, at the time, were too high-risk to undertake. By removing the royalties on the first portion of production, the government gave companies a break during the difficult and expensive period of production startup so that they could recover some of the capital expenditures required to bring the field online.
Given the low oil prices that persisted through the 1990s, when this legislation was passed, there was little concern at the time that oil prices would reach levels at which royalty relief would seem unreasonable. At the same time, the government empowered the Department of the Interior to determine the price threshold at which royalty relief would no longer apply. This was initially set at $28.00 per barrel for oil (in 1994 dollars) for leases with mandatory relief. With yearly adjustments for inflation, the royalty relief level was $34.71/bbl of oil in 2005.
This arrangement would have worked well except that for all the leases issued in 1998 and 1999, a total of 1,100 deepwater leases subject to royalty relief, the MMS failed to include language setting the price threshold for those leases. As such, all of these leases are not subject to royalty payments (assuming they have not reached the royalty-free production threshold for their water depth) even with oil prices that have exceeded the price threshold for the last two years. These flawed leases have been the subject of much debate, and they are the target of the new energy bill.
Gulf of Mexico Leasing
However, in 1998, when the average oil price dropped to $11.91, the amount spent on GOM leases still amounted to $1.3 billion, one of the highest sums for any year. Thus, it is clear that the current oil price plays a fairly small factor in operator's lease decisions and that the oil price the year before is a much larger factor. Given that, it is no surprise that the total lease value for 1999 dropped more than 80% to just $249 million, even though oil prices recovered to an average of $16.55 for the year.
Looking specifically at the years of 1998 and 1999, and Gulf of Mexico Lease Sales 169, 171, 172, and 174 which occurred during that time frame, a total of 1,556 blocks were leased, 1,100 of which were classified as deepwater leases in water depths of 200 meters or more. The vast majority of this activity occurred in 1998, when a total of 1,196 leases were purchased.
Putting the Numbers Together
Given the water depths of these discoveries, all but four of them would qualify for the 87.5 million boe royalty relief. This means that the operators would be able to produce 87.5 million boe without being responsible for any taxes, and with no price thresholds in the contracts, that would apply even with oil prices over $50 per barrel as in today's market. In order for these discoveries to be of commercial quality, the fields would have to contain far beyond the royalty relief limit, so there is no questions that these quantities of oil and gas would be produced from these leases.
Just looking at the royalty-free amount that can be produced for each of the 17 fields that qualify for that level of relief, there are 17 leases multiplied by 87.5 mmboe per lease priced at $50/boe for a total value of $74 billion worth of oil and gas production that is royalty-free. Given a 12% royalty rate for these leases, the US government would be missing out on $8.9 billion in royalties on just these deepest fields.
Consider also that of the 1,100 leases purchased during the 1998-99 time frame, only about 7 percent of them have been drilled. With over 900 leases yet to be drilled, the potential for further discoveries is quite large. If only one percent of those leases yielded commercial discoveries, that would be a further nine leases and $39 billion worth of revenue on which the government is trying to begin collecting royalties.
As such it is easy to see why the government is eager to bring these contracts into line and start collecting revenues from them. At the same time, with Kerr McGee already filing suit to contest the government's setting of price thresholds for royalty relief, it may be a long time before this contest comes to an end.
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