Oil and Gas Law Alert

January 2003

The Future of California Oil and Gas Taxation

On January 15, 2003, the California Supreme Court shocked many in the oil and gas industry by denying review of the Fifth District Court of Appeals’ controversial decision in Maples v. Kern County Assessment Appeals Board (2002) 103 Cal.App.4th 172. The Supreme Court let stand a decision that significantly changes the established method for assessing taxes on oil and gas properties in California. The new method could potentially cost the oil and gas industry billions of dollars by requiring an assessment of the entire mineral property, rather than only those oil reserves which have proven reserves beneath the ground.

The case originated when, in 1998, Occidental of Elk Hills purchased the federal Naval Petroleum Reserve located in Kern County and consisting of approximately 37,000 acres (the “Reserve”). Occidental bought the Reserve for $3.65 billion through a sealed bid auction. The Kern County Assessor, James Maple, then assessed taxes against Occidental based on a fair market value of $3.65 billion, reasoning that the full purchase price represented the Reserve’s base-year fair market value for purposes of assessment under the California Revenue and Taxation Code.

On appeal at the local level, the Kern County Assessment Appeals Board (“AAB”) agreed with Occidental’s position that the purchase price did not establish a prima facie value for the Reserve. Based on an interpretation of the State Board of Equalization’s (“SBE’s”) Rule 468, the AAB concluded that the correct assessment value did not include any estimate for the “unproved reserves” and determined that the mineral interest had a fair market value instead of $1.921 billion. Subsequently, the Superior Court of California, Kern County concurred with the AAB’s ultimate decision in establishing the reduced value of the mineral interest for tax purposes.

The Assessor then appealed to the Court of Appeals. The Court first determined that there is a presumption that the purchase price for the Reserve is the fair market value for purposes of tax assessments. The Court then held that Occidental had the burden of proving that the Reserve’s fair market value was different than the purchase price, using the valuation method contained in SBE Rule 468.

Rule 468 directs the Assessor “to make a determination of the fair market value of reserves using the criteria that would be used by knowledgeable buyers and sellers of properties bearing such reserves.” In determining what criteria should be used, Rule 468 uses the term “proved reserves.” Occidental argued that the term is necessarily defined by industry standards, which limit “proved reserves” to those reserves which “can be estimated with reasonable certainty to be commercially recoverable. . . from known reservoirs and under current economic conditions, operating methods, and government regulations.” An appraisal of mineral property, therefore, should be restricted to those reserves which are determined to be currently recoverable.

The Court, however, disagreed. The Court analyzed the history of Rule 468 and determined that the term “proved reserves” is used in an entirely different context in Rule 468 than in the oil and gas industry. Industry standards, it explained, focus on the “here and now” and require proved reserves to be recoverable under existing economic and operating conditions. In contrast, Rule 468, as amended, defines “proved reserves” as those which are recoverable under “present and expected technological and economic circumstances.” Accordingly, considerations of expected future changes in the economics and technology of petroleum production could be taken into account in determining the appropriate assessment value.

Ultimately, the Court concluded that Occidental failed to overcome the presumption that the purchase price was the fair market value of the Reserve. Because Occidental only presented evidence of value as established by the industry definition of “proved reserves” and not Rule 468’s meaning of the term, the Court held that there ultimately was insufficient evidence to refute that the purchase price for the entire mineral interest was the fair market value. Accordingly, Occidental was assessed taxes on the Reserve based on the full purchase price.

It remains to be seen what future ramifications this decision will have on the California oil and gas industry. Although the Supreme Court’s refusal to hear the case limits the decision’s precedence to the Fifth District, the decision opens the door for other county assessors to follow the new interpretation.

Lessee Must Give Notice of First Entry

In California, it is well settled that when property has been severed so as to create separately owned surface and mineral estates, the surface estate is servient to the dominant mineral estate. Thus, absent an express provision to the contrary in the instrument creating the separate estates or other agreement, the mineral owner (or the mineral owner’s lessee) may possess and occupy as much of the surface as is reasonably necessary to explore, develop, and possess the underlying minerals. Notwithstanding that the mineral owner is not required to obtain permission for entry onto the property, California law requires that notice be given to the surface owner prior to the mineral owner’s first entry onto the property for the purpose of conducting any operations thereon.

Section 848 of the California Civil Code requires that the mineral owner provide the surface owner with written notice before conducting any prospecting, mining, or other operations on the property. This necessarily includes geophysical seismic operations. The notice must be given to the “owner or owner’s representative of the real property who is listed as the assessee on the current local assessment roll or lessee,. . . and to any public utility which has a recorded interest in the property. . ..” The notice must be given either by certified mail or acknowledged personal delivery and provide information regarding the extent and location of the operations and the approximate time or times of entry upon the property.