GAO-01-101R Natural Gas Royalty Payments

United States General Accounting Office

Washington, DC 20548

October 24, 2000

The Honorable Carolyn B. Maloney

House of Representatives

Subject: Royalty Payments for Natural Gas From Federal Leases in the OuterContinental Shelf

Dear Ms. Maloney:

As requested, we are providing you with information on how the Minerals

Management Service (MMS) of the Department of the Interior determines and

monitors royalty payments for gas produced from federal Outer-Continental Shelf

leases (OCS). We used the enclosed material to brief your staff on August 25, 2000.

(See enc. I.) A summary of the information follows.

In 1998, the last year that production data were available, about 5.8 trillion cubic feet

of natural gas was produced in the OCS, accounting for about 24 percent of total U.S.

natural gas production in that year. According to MMS, OCS gas production

accounted for about $1.7 billion, or 46 percent, of the total mineral royalties received

by the federal government in 1999. The Energy Information Administration projects

that U.S. gas production will increase steadily from 1998 through 2020, compared

with a slightly declining trend for oil production. Therefore, gas production from

federal OCS leases will undoubtedly continue to account for a significant share of

total federal mineral royalties.

Gas royalty payments are determined by the following calculation: the gross sales

value, or “proceeds,” from the sale of gas—after adjusting the sales value for

allowable transportation and processing costs—is multiplied by the 16.67-percent

royalty rate for gas produced from federal OCS leases. Although this calculation is

straightforward, interpretations of “sales value” and adjustments to it are less clear

and have created disagreement and litigation between MMS and industry.

For royalty purposes, the sales value equals the unit price received for the gas

multiplied by the volume or quantity of gas produced and sold. Determining the sale

price of gas produced and sold from federal OCS leases has become increasingly

complex, as the gas market has evolved from a regulated to a largely unregulated

market. The deregulation of key aspects of the gas industry and the resulting

restructuring of the industry increased the number and complexity of transactions

among end-users, producers, transporters, distributors, and providers of a host of

related services. As such, MMS must determine if the sale of gas by industry involves

an “arm’s length” transaction—that is, a sale between parties that are not affiliated
2 GAO-01-101R Natural Gas Royalty Payments

and have opposing financial interests. When such a transaction is found, MMS

accepts the sale price for royalty calculation purposes. If the sale is “non-arm’s

length” (i.e., where the parties are affiliated and have similar financial interests),

MMS requires the use of benchmarks, such as the prices under comparable arm’slength transactions in the OCS field or area to help establish an “arm’s length” price.

The volume of gas produced is measured through metering, and it is generally not an

issue between MMS and industry.

In addition to price, MMS and industry dispute what allowable costs can be deducted

from gross proceeds before royalties are paid. For example, MMS allows companies

to deduct storage costs for up to 30 days. However, industry generally believes that it

should be allowed to deduct all costs incurred to store gas for future sales. Some of

these disputes have been the subject of litigation.

MMS monitors the accuracy of gas volumes reported by lessees by using its

Production Accounting and Auditing System and monitors the accuracy of royalty

payments through its Auditing and Financial System. Using these systems and its

audit and compliance efforts, the agency has identified and collected about $2.2

billion in underpayments over the period 1982-99.

To help resolve these valuation disagreements and avoid continued litigation, the

industry believes that the government should take its royalty payments in the form of

physical gas, or, as it is commonly called, royalty-in-kind. MMS believes that royaltyin-kind payments can offer a potential solution to the disputes, but MMS and the

industry acknowledge that these payments are not appropriate in all situations. MMS

is currently pilot-testing the royalty-in-kind program by taking about 10 percent of the

royalties for OCS gas in kind. MMS plans to assess these pilot tests for potential

broader application.

To prepare the information in this report, we interviewed officials from MMS and

relevant states, and representatives from the oil and gas industries. We also reviewed

relevant documents and analyzed data from MMS, the oil and gas industries, and the

Energy Information Administration. We did not verify the accuracy of the data, but

we provided MMS officials, including the Chief, Royalty Valuation Division, with a

draft of this report for review and comment. We also discussed the report with MMS

officials, who agreed with the report’s contents. We conducted our work from June

through September 2000 in accordance with generally accepted government auditing

standards.

-----

Unless you publicly announce its contents earlier, we plan no further distribution of

this report until 7 days after the date of this letter. At that time, we will send copies

to interested Members of Congress and make copies available to others on request.
3 GAO-01-101R Natural Gas Royalty Payments

If you have any questions about this report or need additional information, please call

me at (202) 512-3841. Major contributors to this report included Daniel Haas, Godwin

Agbara, Paul Lacey, and Philip Farah.

Sincerely yours,

Jim Wells

Director, Natural Resources

and Environment

Enclosure
Enclosure I

4 GAO-01-101R Natural Gas Royalty Payments

Briefing on Natural Gas

Royalty Payments

Prepared for:

Rep. Carolyn B.

Maloney

August 25, 2000
Enclosure I

5 GAO-01-101R Natural Gas Royalty Payments

Table of Contents

• Objectives, Scope, and

M hdl • Background

• How MMS Determines and Monitors

OCS Gas Royalty Payments

• How the Oil and Gas Companies

(L ) Determine Their Gas Royalty

• Contentious Issues P

• What to Do?
Enclosure I

6 GAO-01-101R Natural Gas Royalty Payments

Objectives, Scope, and

Methodology

• Objectives

• What processes does the Minerals Management

Service (MMS) use to determine and monitor royalty

payments on gas produced from federal leases in the

Outer-Continental Shelf (OCS)?

• What processes are producing companies using in

determining their royalty payments for gas they

produce from federal OCS leases?

• Scope

• Review focuses primarily on federal OCS gas.

• Methodology

• Interviewed officials from MMS, relevant states, and

representatives from the oil and gas industry.

• Reviewed relevant documents and analyzed data

from MMS, oil and gas industries, and the Energy

Information Administration.

• GAO did not verify the accuracy of the data but

discussed the contents of these slides with MMS

officials.
Enclosure I

7 GAO-01-101R Natural Gas Royalty Payments

Background

U.S. Natural Gas Production (1998)

Source: Natural Gas Annual, 1998, EIA.
Enclosure I

8 GAO-01-101R Natural Gas Royalty Payments

Background

Forecast of U.S. Gas and Crude Oil

Production (1998-2020)

Source: Annual Energy Outlook, 2000, EIA’s.
Enclosure I

9 GAO-01-101R Natural Gas Royalty Payments

Background

Gas Producers and Pipeline Operators in

the OCS

• Gas Producers (Operators)

• 126 companies (operators) produced gas

in the OCS (1999)

• Top 5 companies produced 35% of OCS

gas

• Top 10 companies produced 51% of

OCS gas

• Top 20 companies produced 70% of

OCS gas

• Pipeline Operators

• 315 companies operated in the OCS
Enclosure I

10 GAO-01-101R Natural Gas Royalty Payments

Background

Federal offshore royalties (1990-99)

Source: Mineral Revenues, 1998 and 1999, MMS.
Enclosure I

11 GAO-01-101R Natural Gas Royalty Payments

Background

Federal Mineral Royalties (1999)

Source: Mineral Revenues, 1999, MMS.
Enclosure I

12 GAO-01-101R Natural Gas Royalty Payments

How MMS Determines and

Monitors OCS Gas Royalty

Payments

Royalty Formula

Volume x price = gross proceeds

Gross proceeds allowances = net proceeds

Net proceeds x royalty rate = royalty payment

(16.67%)
Enclosure I

13 GAO-01-101R Natural Gas Royalty Payments

Determining Gas Royalties

(continued)

• Gross proceeds are overriding principle

• Volume determined by meter

• Price

• If “arms length,” sales prices generally

accepted for royalty payment purposes

• If “non-arms length,” benchmarks

apply

• Benchmark 1 (gross proceeds based on

comparable arms-length transactions in

the area, plant, or nearby plants)

• Benchmark 2 (any or combination of

gross proceeds, index prices, etc.)

• Benchmark 3 (Net-back or other

reasonable method)
Enclosure I

14 GAO-01-101R Natural Gas Royalty Payments

Determining Gas Royalties

(continued)

• Allowances

• Transportation

• Lessee’s actual costs to transport

production from the lease to the sales

point or point of value determination

• Limitation of 50% of value at each

sales outlet is allowed (exceptions can

be approved by MMS)

• Processing (for gas plant products)

• Lessee’s actual costs, limited to 66.67%

of tailgate value of each gas plant

product (exceptions can be approved by

MMS)
Enclosure I

15 GAO-01-101R Natural Gas Royalty Payments

Monitoring Gas Royalties

• Two systems involved

• Production Accounting and Auditing

System

• Used to monitor the accuracy of gas

volumes reported by companies

• Auditing and Financial System

• Used to monitor the accuracy of royalty

payments reported by companies

• About $2.2 billion in underpayments

collected (1982 through 1999)
Enclosure I

16 GAO-01-101R Natural Gas Royalty Payments

How Oil and Gas Companies

(Lessees) Determine Their Gas

Royalty Payments

• According to industry representatives:

• Basically follow MMS’ royalty formula

• Volume x price = Gross proceeds -

allowances = net proceeds x royalty

rate = royalty payment

• Volume is metered

• Sales price used for “arms length”

• Benchmark for “non-arms length”

• Each company determines its own

“appropriate” benchmark

• Companies may use different

benchmarks even if producing in the

same lease area
Enclosure I

17 GAO-01-101R Natural Gas Royalty Payments

Gas Market Environments

Affecting Royalty Determination

Regulated Market
Enclosure I

18 GAO-01-101R Natural Gas Royalty Payments

Changing Gas Market

Environments Affecting

Royalty Determination

Deregulated Market
Enclosure I

19 GAO-01-101R Natural Gas Royalty Payments

Contentious Issues

• Volume mostly a non-issue

• Valuation

• Price

• Arms length vs. non-arms length

• Allowances

• Marketing costs

• Storage costs

• Litigation
Enclosure I

20 GAO-01-101R Natural Gas Royalty Payments

What to Do?

• Proposed negotiated regulations “REG-NEG”

published in 1995 by MMS

• Based, in part, on indexed pricing

• Included representatives of federal

government, states, Indian tribes, and

industry

• Withdrawn in 1997 (not revenue neutral)

• Reengineering (MMS)

• Will help identify areas of disagreements

more expeditiously but not necessarily

resolve them
Enclosure I

21 GAO-01-101R Natural Gas Royalty Payments

(141473)

What to Do? (continued)

• Industry strongly favors royalty in kind (RIK)

(acknowledges that RIK is not appropriate in

all situations)

• MMS believes RIK has a potential as a

solution but not in all situations

• Currently pilot-testing RIK (About 10%

OCS gas royalties)