Court decision

Petroleum royalties in Queensland - challenges and changes

By Jonathan Fulcher / 26 June 2019

Key issues:

  • APLNG has successfully challenged an aggressive approach to determining petroleum royalties adopted by the Office of State Revenue in Queensland.
  • In Australia Pacific LNG Pty Limited & Ors v The Treasurer & Ors [2019] QSC 132, Justice Bond allowed APLNG’s application for judicial review and set aside the Minister’s royalty determination.
  • Following the decision, the Queensland Government has announced in its 2019-2020 Budget that the State petroleum royalty will increase from 10% to 12.5%. 

Petroleum producers will be interested in this successful challenge to an aggressive approach to determining petroleum royalties which had been adopted by the Office of State Revenue (OSR) in Queensland.

In a further development immediately following this decision, the Queensland Government’s 2019-2020 Budget increased the petroleum royalty rate from 10% to 12.5%, and foreshadowed a review of the “current royalty regime to ensure greater certainty and equity for all parties and identify opportunities to simplify the current regime, while providing an appropriate return to Queenslanders”, as well as “identify further opportunities to strengthen domestic supply”

Much of the gas produced in Queensland is sold by producers to related companies either acting as market aggregators, or engaged in downstream LNG projects. In this context, the Minister has the power to determine the market value of the petroleum sold for the purpose of determining the royalty, rather than accept the stated contract value. In Australia Pacific LNG Pty Limited & Ors v The Treasurer & Ors [2019] QSC 132, APLNG successfully challenged the Minister’s determination; Justice Bond allowing their application for judicial review and setting aside the Minister’s decision.

Key takeaways

In summary:

  • the variables and inputs in a wellhead value formula must be certain and calculable by reference to objective standards; 
  • consideration of the royalty outcomes for the State by the Minister are irrelevant; and 
  • petroleum producers must be given an opportunity to comment on submissions and reports that adversely affect their interests.

Background

APLNG (and four of its wholly-owned subsidiaries) operate a liquefied natural gas (LNG) project in Queensland. One of the project’s operations is the collecting, treating and transporting of processed coal seam gas (CSG or feedstock gas), extracted from reserves in central Queensland through pipelines to a liquefaction facility on the Queensland coast. Different portions of the project are operated by various entities related to APLNG.

Determining the ‘wellhead value’ of petroleum in Queensland 

Under the Petroleum and Gas (Production and Safety) Act 2004 (Qld) (Petroleum Act) and Petroleum and Gas (Production and Safety) Regulation 2004 (Qld) (Petroleum Regulation), a royalty is payable in the amount of 10% of the ‘wellhead value’ of any petroleum disposed of. The Petroleum Regulation states that ‘wellhead value’ means ‘the amount that the petroleum could reasonably be expected to realise if it were sold on a commercial basis’. 

Determining the wellhead value of APLNG’s feedstock gas was complicated by the fact that the petroleum was being disposed of by way of transfers between related parties so that the contract price could not be assumed to be an arm’s length market price. In such cases the legislation provides for the producer to apply to the Minister for a determination on how APLNG should calculate the wellhead value of its feedstock gas.

APLNG royalty determination - netback calculation or residual price valuation?

The Minister, taking advice from the Office of State Revenue (OSR), determined that a netback calculation was the appropriate method of valuing the feedstock gas as if it were sold on a commercial basis.

A netback calculation is a method of valuation where all costs associated with bringing the petroleum to market are deducted from an ascertainable market price, in this case the LNG sale price.

In adopting a netback valuation method, the Minister provided reasons including that it appropriately reflected the greater bargaining position of the hypothetical upstream developer, and could be applied using objectively verifiable data.

The Minister rejected APLNG’s submission that a residual price valuation, a method that adopts an amount halfway between the amount realised by a netback valuation and a cost plus valuation (that is, the production costs plus an appropriate gross-profit mark-up), was the appropriate methodology to adopt. 

Revenue for the State was estimated to be between $143.5m and $232m higher if a netback valuation, rather than a residual price valuation, was adopted.

Successful challenge against APLNG royalty determination - judicial review 

APLNG applied to the Supreme Court of Queensland for judicial review of the decision. APLNG was successful in arguing that the Minister’s decision as to the adoption of the netback method was invalid on the following grounds:

  • uncertainty;
  • taking irrelevant considerations into account; and
  • a failure to afford procedural fairness.

1. Minister’s valuation formula variables were uncertain 

Justice Bond found that the Minister’s decision could be set aside for uncertainty as a number of the variables utilised by the Minister’s valuation methodology could not be determined objectively. 

For example, one part of the Minister’s methodology required the input of the ‘Expected economic life’ of downstream infrastructure. Justice Bond found that the phrase ‘expected economic life’ was uncertain as it was capable of being approached in a number of different ways depending on the context in which it was used. Justice Bond did not accept the Minister’s submission that the phrase could be given meaning by a Court at trial, as the purpose of the Minister’s exercise of power was to promote consistency and certainty.

Similarly, ‘allowable downstream opex’ and ‘downstream capex’ were also determined to be variables that were uncertain. The Minister’s decision prescribed a number of principles that were to be used to determine allowable and non-allowable expenditure. However, Justice Bond found that a number of the principles were lacking objective and identifiable standards against which the expenditure could be determined. One principle provided that ‘Where costs are incurred in relation to both upstream and downstream they are to be allocated between upstream and downstream on a reasonable and equitable basis’. 

Justice Bond found that this guiding principle was uncertain because there was no objectively ascertainable standard for determining what is reasonable and equitable.

2. Minister must not take into account the royalty outcomes for the State 

In addition to the findings above, Justice Bond found that the Minister’s decision could be set aside on the grounds that she had taken into account an irrelevant consideration. This was because the evidence demonstrated that the OSR and the Minister had considered the royalty outcomes for the State when comparing potential methodologies to value the feedstock gas.

Justice Bond held that the test in the legislation was the value expected to be realised for the petroleum on a sale on a commercial basis and the fact the State stood to benefit between $143.5m and $232m if a netback valuation was adopted was an irrelevant consideration that the Minister must not take into account in making the decision.

3. Minister must afford petroleum proponents procedural fairness 

Finally, the decision reaffirms that the Minister must afford procedural fairness to parties affected by their decisions. 

In this case, the Minister considered a number of supplementary reports commissioned by the OSR from a valuation firm without alerting APLNG to the existence of the reports. 

Justice Bond found that a further reason to set aside the Minister’s decision was on the grounds that APLNG was given no opportunity make submissions on the supplementary reports. This was a violation of APLNG’s right to natural justice. 

Court refused to throw out the ‘netback calculation’ entirely 

APLNG sought a declaration that the netback calculation method adopted by the Minister was wrong in law and constituted a misinterpretation of the statutory test under the Petroleum Regulation by the Minister. 

APLNG argued that the netback method did not constitute a ‘commercial basis’ for the calculation of the royalty because it disincentives the hypothetical downstream operator acting in a commercially rational manner.

This highlights the difficulty in determining the best valuation method where parties have not transacted on an arms’ length basis. 

Justice Bond refused to make this declaration on several bases, including that the Minister has a wide discretion on the appropriate formula to adopt, and that APLNG’s arguments did not disclose an error of law but invited the Court to conduct an impermissible merits review of the decision. 

On 21 June 2019, APLNG filed an appeal of part of Justice Bond’s decision in the Queensland Supreme Court. We will continue to watch this space and provide updates as the appeal progresses. 

Conclusions

The decision is indicative of the challenges of arriving at an appropriate valuation in the absence of a clear market value. It confirms that the Minister’s determined calculation must provide for certainty and transparency, and must not take into account irrelevant policy considerations. 

The matter will now be returned to the Minister who must reconsider the determination. However while this decision will remain relevant to APLNG and its historical royalty obligations, its ongoing relevance for petroleum royalties may well be overtaken by the upcoming review. A whole new regime, with new valuation methodologies, may well apply in the future. 

For more information or discussion, please contact HopgoodGanim Lawyers’ Resources and Energy team.

Authors
Jonathan Fulcher
Partner
Jonathan is a Partner and the head of our leading Resources and Energy practice in Brisbane and is also the leader of our Native Title practice.
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