Watson Millican & Company’s technical experts were retained by several natural producers to provide midstream unbundling services for their natural gas production and processing costs in multiple basins. Unbundling means determining and assigning the costs to the discrete services involved with natural gas and natural gas liquids production. Watson Millican unbundled the transportation and processing services provided by several midstream companies. The capital and operational costs for these services were estimated and their respective allowable producer deductions from royalty payments with respect to the marketable condition requirement were determined.

The Issue

For the right to extract natural gas from public lands and offshore development, Exploration and Production (E&P) companies pay royalties to the federal government, state governments, and tribal governments.  The Office of Natural Resources Revenue (ONRR) manages the revenue from leases of federal and Native American land. Each month, companies must report on the resources they produced, including the amount produced, the value of their production, and the amount of royalties they owe.

In accordance with 30 CFR 1206.156 and 30 CFR 1206.158, a lessee may deduct from federal royalty payments the reasonable actual costs for transporting and processing, respectively, natural gas and its associated products.  ONRR’s current interpretation does not necessarily allow all processing and transportation costs to be deducted from royalty payments. The main criterion for determining if these costs are deductible is whether the relevant product is in marketable condition, defined in 30 CFR 1206.151 (2016), as

“Marketable condition means lease products which are sufficiently free from impurities and otherwise in a condition that they will be accepted by a purchaser under a sales contract typical for the field or area.”

Once the lease products achieve the ONRR’s view of marketable condition, costs incurred by the lessee to increase the value of the product can be deducted from royalty payments.  The process of allocating costs to specific processing and transportation functions is referred to as “unbundling.”

Watson Millican & Company Scope

The E&P companies engaged Watson Millican to provide technical expertise to unbundle the transportation and processing costs incurred by the E&P companies for services provided by the midstream companies.  These costs can be in the form of fees per unit of production, residue gas and/or natural gas liquid retention by the midstream company, or a combination thereof. 

The midstream companies provide multiple transportation and processing services, depending on the natural gas production conditions and the needs of the E&P company.  These services include transportation, compression, dehydration, treating, natural gas liquids extraction, and condensate stabilization.

Watson Millican performed their unbundling analyses as follows:

          1. Identified the various functions performed by midstream companies.

          2. Estimated annual capital costs and the operations and maintenance costs for each function.

          3. Determined the percentage for each function that can be allocated to transportation and to processing.

          4. Determined the allowable percentage of each function that can be deducted based on the marketable condition rule.

Midstream companies provide incomplete, if any, technical data about their assets. Therefore, Watson Millican used publicly available and proprietary information to determine the services performed by the midstream companies and estimate the annual capital costs and operations and maintenance costs.

Watson Millican unbundled transportation and processing costs for small, intermediate, and large natural gas “super systems” located in the Permian Basin, the Powder River Basin, the Bakken Shale, the San Juan Basin, the Uinta Basin, and the Gulf of Mexico.

Watson Millican used the results of the unbundling analyses to develop an allowable percentage for each cost incurred by the E&P companies.  The E&P companies applied these allowable percentages to determine the costs that can be deducted from their royalty payments.

Project Scope:

  • Value: Several million for each system

  • Services:  Unbundling of Natural Gas Transportation and Processing Costs

  • Sectors: Natural gas and NGLs; Natural gas processing