1. Unbundling – What’s A Producer To Do?
Judith M. Matlock, Partner Davis Graham & Stubbs LLP Denver, Colorado
Judy Matlock, Davis Graham & Stubbs LLP,

2. 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.

3. 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

4. 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

5. 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

6. 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

7. 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.

8. 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

9. 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?

10. 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

11. 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 (b)
Allowed services:
Products extraction
And associated fuel
Fuel – allocate between allowed and disallowed services

12. 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

13. Cryogenic Compression

14. 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.

15. 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.

16. Unbundling Methodology at ONRR.Gov
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

17. Problems Industry is Having with the Unbundling Methodology at ONRR
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.

18. 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.

19. 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?

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. Step 2 – Draw a Simplified Schematic

27. Step 3 – Obtain Mainline Specs
Gas quality specifications for CO2, H2S, water, total inerts, nitrogen, etc. can be found in pipeline tariffs.
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).

28. 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 the transportation system operator

29. Step 5 – Update Schematic

30. 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

31. 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

32. Step 8 – Update Schematic Again

33. 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?

34. 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.

35. 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.

36. Estimation Method #2 Cont’d
What information can you find from publicly available resources about:
Costs of compression
Pipeline construction costs
Other nondeductible costs

37. 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.”

38. Example - Pipeline Costs
INGA Foundation – “Jobs & Economic Benefits of Midstream Infrastructure Development – US Economic Impacts Through 2035” by Black & Veatch – Feb 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

39. 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.

40. 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

41. 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

42. 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

43. 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

44. 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.

45. 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.

46. 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?

47. 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.

48. 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.

49. 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.

50. 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.

51. 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.

52. 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.

53. 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.

54. 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).”

55. 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?

56. 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?

57. 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?

58. 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.