Tax Gouging

Journal of Commerce
Guest Opinion
July 28, 1998
Gouging for oil bucks

Sometimes it seems that government agencies will try anything to increase their funding, even if that means violating contracts. Such is the case with a recent edict from a government agency called the Minerals Management Service.

In January 1997, the U.S. Department of the Interior’s Minerals Management Service proposed a regulation that would change oil valuation procedures. The MMS collects oil royalties, and has proposed to value oil production based on an index of prices instead of on market prices.

The federal government owns more than 50% of Western lands and has negotiated royalty interest of 12% to 17% of gross revenue in oil leases on these lands. Contracts mandate what royalty percentage from these leases goes to government coffers.

The problem, according to the MMS, is that some oil is produced and purchased by the same oil company. In such cases, royalty payments are based on the purchaser’s posted price, the price that it offers to pay for oil in that area. The MMS charges that such transactions are not at “arm’s length,” and therefore companies may post a price for oil that is below the market price in order to reduce their royalty burden. The posted prices do not reflect the true value of the oil, says the MMS.

The MMS further charges that valuing crude oil based on posted prices undervalues the price of oil and results in the underpayment of royalties to the U.S. federal government. Basing the oil value on an index of prices will solve this problem and increase government revenue.

The oil industry immediately challenged this proposed rule, fortunately preventing it from taking effect. The industry then proposed an alternative solution to the problem: The government could take payment in kind. If an oil interest owner takes his percentage of proceeds, not in dollars but in actual barrels of oil, that is termed payment in kind.

If the government owns 15% of the proceeds from a lease, then it can take its payment by having 15% of the oil produced from the lease. It can then sell the oil to any purchaser or it can keep it, say to add to the Strategic Petroleum Reserve.

Leases already give the government the right to demand payment in kind from any lease in which it owns royalties, if it’s not satisfied with the price at which the oil is being sold. One purpose for having the option of taking payment in kind is to solve such potential disputes. Any time a royalty owner suspects that he is not getting fair value for his oil, he is allowed to take his share of the oil in actual barrels of oil.

The oil industry’s proposal has resulted in bills in both houses of Congress mandating that the MMS take royalty payments in kind. The MMS has strongly objected to these bills, arguing that it already has the payment-in-kind option.

On July 17, the MMS published a new proposal. It no longer demands that the oil be valued by a price index. It now proposes to base the royalties on the price of oil, but it wants to use a downstream price, not the wellhead price of oil. By contract, royalties are to be based on the first point of sale -- the wellhead price. Downstream prices are higher due to transportation and storage costs and quality control.

The MMS refusal to take payment in kind shows that this argument is not about the government getting the market value for oil; it is about increasing government revenue. If some buyer is willing to pay a higher price for the oil than is currently being paid, the MMS could sell to this buyer. This would ensure that the MMS gets fair value for the oil. However, the MMS does not want market value, it wants higher royalty payments.

Federal oil leases are contracts. They stipulate how royalties will be calculated and what the government’s options are if it believes that the oil is undervalued. The MMS decree is simply a violation of contract. It would set a disturbing precedent: government agencies unilaterally altering contract terms. Given this precedent, no private firm could be certain that a government contract would be upheld.

Calculating royalties based on an index introduces another problem. The index chosen may be manipulated by the government itself. Any time the government needs more revenue, it can “adjust” the index to generate a higher value for the oil. Just as adjusting the consumer price index increases government revenue, adjusting the oil index could increase oil royalties.

If royalties were not based on the price of oil, this would have other implications. Nongovernment royalty owners would also want their royalties based on the proposed index, increasing their payments. Taxes could also be affected. Severance taxes are imposed on all U.S. oil and are based on the market price for oil. If royalties are no longer based on the oil price, then it may also be possible to change the valuation of severance taxes to this same oil price index. Taxes would increase.

Why stop there? There would be no need to base other taxes on the market price of the good being taxed. Consider sales taxes. Suppose that the government declared that the sales tax on food should not be based on your actual grocery bill. The amount you pay for food may not reflect the actual value of the food.

The public would not stand for such a move. The tax-gouging plans of the MMS should be opposed for these same reasons.