Royalties Collection: Ongoing Problems with Interior's Efforts to Ensure A Fair Return for Taxpayers Require Attention
Published: 2007-03-28T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Department of the Interior's Minerals Management Service (MMS) is charged with collecting and administering royalties paid by companies developing fossil and renewable energy resources on federal lands and within federal waters. To promote development of oil and natural gas, fossil resources vital to meeting the nation's energy needs, the federal government at times has provided "royalty relief" waiving or reducing the royalties that companies must pay. In these cases, relief is typically applicable only if prices remain below certain threshold levels. Oil and gas royalties can be taken at MMS's discretion either "in value" as cash or "in kind" as a share of the product itself. Additionally, MMS also collects royalties on the development of geothermal energy resources--a renewable source of heat and electricity--on federal lands. This statement provides (1) an update of our work regarding the fiscal impacts of royalty relief for leases issued under the Deep Water Royalty Relief Act of 1995; (2) a description of our recent work on the administration of the royalties in kind program, as well as ongoing work on related issues; and (3) information on the challenges to collecting geothermal royalties identified in our recent work. To address these issues we relied on recent GAO reports on oil, gas, and geothermal royalty collection systems. We are also reviewing key MMS estimates and data.
section_title: What GAO Found
paragraphs: The absence of price thresholds in oil and gas leases issued by MMS in 1998 and 1999 has already cost the government about $1 billion and the agency has recently estimated that future foregone royalties would be $6.4 billion to $9.8 billion over the lives of the leases. Precise estimates of the actual foregone royalties, however, are not possible at this time because future projections are sensitive to price and production levels, both of which are subject to change. MMS is currently negotiating with oil and gas companies to apply price thresholds to future production from these leases, with mixed results--only 6 of the 45 companies involved have agreed to terms. Moreover, a pending legal challenge to Interior's authority to include price thresholds on any leases issued under the Deep Water Royalty Relief Act could, if successful, cost the government billions more in refunded and foregone revenue. In our most recent review of the royalty in kind (RIK) program, conducted in 2004, we found that MMS was unable to determine whether the revenues received from its sales of oil taken in kind were equivalent to receiving royalties in value, largely because it had not developed systems to rapidly and efficiently collect this information. We made recommendations that the agency has implemented that have improved the administration of the program as it existed at the time of our report. However, the continued expansion of the program raises a new question about the adequacy of the agency's overall management practices and internal controls to meet the increasing demands placed on the RIK program. Accordingly, we are undertaking follow-on reviews assessing, among other things, the agency's ability to quantify and compare administrative costs and revenues of the RIK and royalties in value programs and the extent to which the revenues collected under the RIK program are equal to or greater than what would have been received had they been taken in value. In a 2006 report on geothermal royalties, we found that missing and erroneous historical data, as well as insufficient data on electricity sales, meant that MMS is unable to accurately determine whether it was collecting royalties as directed by statute. The Energy Policy Act of 2005 included provisions that significantly changed how geothermal royalties are calculated but also directed Interior to maintain the same level of royalties over the next ten years that would have been collected prior to the Act's passage. We found that making this determination requires historical data on sales of electricity produced from geothermal resources as well as accurate royalty data. However, MMS did not have sufficient historical gross revenue data with which to establish a baseline for past royalties paid as a percentage of electricity revenues. Further, about 40 percent of MMS's royalty data was either missing or erroneous for the projects we reviewed. We recommended that MMS correct these deficiencies and the agency agreed. We are continuing to monitor the agency's efforts.

section_title: Letter
paragraphs: We are pleased to be here today to discuss our recent work on the  administration of revenues collected from the production of fossil and  renewable energy resources on federal lands and within federal waters.  Companies that develop these resources do so under leases which  generally require the payment of royalties on the resources extracted and  produced. These leases are administered by the Minerals Management  Service (MMS), an agency within the Department of the Interior (Interior).  These resources include geothermal, coal, and, most notably, oil and  natural gas (hereafter oil and gas).
In particular, fossil energy resources from federal lands and waters are a  critical component of the nation’s energy portfolio, supplying more than a  third of all the oil and nearly a quarter of all the natural gas produced in  the United States in fiscal year 2005. Oil and gas companies received over  $77 billion from the sale of oil and gas produced from federal lands and  waters in fiscal year 2006, and these companies paid the federal  government about $10 billion in royalties.
In order to promote oil and gas production, the federal government has at  times and in specific cases provided “royalty relief”—the waiver or  reduction of royalties that companies would otherwise be obligated to pay.  When the government grants royalty relief, it typically specifies the  amounts of oil and gas production that will be exempt from royalties and  may also specify that royalty relief is applicable only if oil and gas prices  remain below certain levels, known as “price thresholds.” For example,  the Outer Continental Shelf Deep Water Royalty Relief Act of 1995, also  known as the Deep Water Royalty Relief Act (DWRRA), mandated royalty  relief for oil and gas leases issued in the deep waters of the Gulf of Mexico  from 1996 to 2000. These deep water regions are particularly costly to  explore and develop. However, as production from these leases has  grown, and as oil and gas prices have risen dramatically in recent years,  serious questions have been raised about the extent to which royalty relief  has been in the interest of taxpayers. These concerns were brought into  stark relief when it was learned that MMS issued leases in 1998 and 1999  that failed to include the price thresholds above which royalty relief would  no longer be applicable, making large volumes of oil and natural gas  exempt from royalties and significantly affecting the amount of royalty  revenues collected by the federal government. Further royalty relief is  currently available under other legislation and programs, raising the  prospect that the federal government may be forgoing additional royalty  revenues. Recently, congressional committees, Interior’s Inspector  General, public interest groups, and the press have questioned whether  our nation’s oil and gas royalties are being properly managed and whether  the oil and gas industry is paying a fair share of revenue to the public  resource owners, especially in light of high oil and gas prices, record  industry profits, and the daunting current and long-range fiscal challenges  facing our nation. GAO has expressed similar concerns, and the U.S.  Comptroller General has highlighted royalty relief as an area needing  additional oversight by the 110th Congress.
The MMS is authorized by Congress to collect royalties “in value,” as a  fraction of the revenues companies receive from sale of oil and gas  produced on federal leases, or “in kind,” as a fraction of the oil and gas  that the MMS then sells to recover the government’s share of oil and gas  revenue. With regard to oil, while MMS has long received relatively small  amounts of oil in kind for specific purposes, such as in a past program that  provided royalty oil to small refiners at subsidized prices, the bulk of  royalties have historically been collected in value. In recent years,  however, MMS has taken a growing proportion of oil royalties in kind.  Much of this oil was then exchanged for other oil that was put into the  nation’s Strategic Petroleum Reserve, over 700 million barrels of publicly  held crude oil that is stored to ensure emergency supplies in the event of a  significant disruption in the normal oil supply. Under the Energy Policy  Act of 2005, MMS is charged with ensuring that the revenues it receives  when it sells oil taken in kind are at least as great as the revenues it would  have received had it taken the royalties in value. The recent expansion of  the royalties in kind (RIK) program has raised the obvious question of  whether or not this condition is being met.
While fossil energy resources are significant, the federal government also  manages royalties from renewable sources such as geothermal energy.  Geothermal energy is a unique renewable energy resource in that it can  provide a consistent and uninterrupted supply of heat and electricity.  Companies drill wells to bring the geothermal fluids and steam to the  surface, separate the steam from the fluids as their pressure drops, and  use the steam to spin the blades of a turbine that generates electricity. The  electricity is then sold to utilities in a manner similar to sales of electricity  generated by hydroelectric, coal-fired, and gas-fired power plants, and the  companies pay royalties based on the electricity sold.
Due, in part, to increasing demand for electricity, interest is increasing in  developing geothermal energy resources as an alternative form of  generation. Because many areas that have the potential to produce  additional geothermal energy are located on federal lands, the federal  government will continue to be a major participant in the future  development of geothermal energy. MMS collects the federal geothermal  royalties and disburses to the state and local governments its share of  these royalties. In 2005, the most recent year for which data are available,  MMS collected $12.3 million in geothermal royalties, almost all of which  was derived from the production of electricity.
You asked us to provide information from our recent work on the  administration of federal royalty revenues at MMS. My testimony today   (1) updates our work regarding the fiscal impacts of royalty relief for  leases issued under the Deep Water Royalty Relief Act of 1995;   (2) describes our recent work regarding the administration of the royalties  in kind program, as well as ongoing work on this and related issues we  have undertaken for congressional requesters; and (3) provides  information on the challenges to collecting and managing geothermal  royalties that we identified in recent work.
To address these issues, we relied on recent GAO reports related to MMS’s  royalty collection systems for oil, gas, and geothermal resources. As part  of our ongoing work, we also reviewed the methodology and assumptions  used by MMS to produce their February 2007 estimate of foregone oil and  gas royalties. Our work follows the issuance of our report last year  explaining why oil and gas royalties have not risen at the same pace as  rising oil and gas prices. Our work was conducted in accordance with  generally accepted government auditing standards.
In summary we found:    The absence of price thresholds in leases issued in 1998 and 1999 has  already cost the government about $1 billion and MMS’s most recent  estimate indicates a range of future foregone royalties of between   $6.4 billion and $9.8 billion over the lifetime of the leases. However,  because there is considerable uncertainty about future oil and natural gas  prices and production levels, actual foregone royalties could end up being  higher or lower than MMS’s estimates. MMS is currently negotiating with  oil and gas companies to apply price thresholds to future production from  the 1998 and 1999 leases. To date, the results of these negotiations have  been mixed—only 6 of the 45 companies involved have agreed to terms.  Moreover, a pending legal challenge to Interior’s authority to include price  thresholds on any leases issued under the DWRRA could, if successful,  cost the government billions more in refunded and foregone revenue.
In our most recent audit of the RIK program, conducted in 2004, we found  that MMS had not collected the necessary information to determine  whether or not the revenues received from its sales of royalty oil were  equivalent to receiving royalties in value, largely because it had not  developed information systems to rapidly and efficiently collect this  information. We made recommendations to the Secretary of the Interior  that the agency has implemented and that have improved the  administration of the program as it existed at the time. However, the  continued expansion of the program raises additional questions about the  adequacy of the agency’s overall management practices and internal  controls to meet the increasing demands of the program. Accordingly, at  the request of Congress, we are undertaking a follow-on review assessing,  among other things, the agency’s ability to quantify and compare  administrative costs and revenues of the RIK and royalties in value  programs and the extent to which the revenues collected under the RIK  program are equal to or greater than what would have been received had  they been taken in value.
In a 2006 report on geothermal royalties, we found that MMS had  erroneous and missing historical geothermal royalty data and did not  collect sufficient data from royalty payors to accurately asses whether  MMS was collecting the amount of royalties required by statute. The  Energy Policy Act of 2005 included provisions that significantly changed  how geothermal royalties are calculated but also instructed the Secretary  of the Interior to seek to maintain the same aggregate level of royalties  over the next ten years that would have been collected prior to the Act’s  passage. We found that in order to compare royalties collected under the  provisions of the Act with what would have been collected under the old  system would require historical data on gross revenues from geothermal  electricity sales as well as accurate royalty data. However, we found that  MMS did not have sufficient historical gross revenue data with which to  establish a baseline for past royalties paid as a percentage of electricity  revenues. Further, about 40 percent of MMS’s royalty data was either  missing or erroneous for the projects we reviewed. In our report we  recommended that the Secretary of the Interior direct MMS to correct  these deficiencies and the agency agreed with our findings and  recommendations. We are continuing to monitor the agency’s efforts to  address these shortcomings.
subsections: section_title: Background
paragraphs: Interior oversees and manages the nation’s publicly owned natural  resources, including parks, wildlife habitat, and crude oil and natural gas  resources on over 500 million acres onshore and in the waters of the Outer  Continental Shelf (OCS). In this capacity, Interior is authorized to lease  federal fossil and renewable energy resources and to collect the royalties  associated with their production. These substantial revenues are disbursed  to 38 States, 41 Indian Tribes, Interior’s Office of Trust Funds Management  on behalf of some 30,000 individual Indian royalty owners, and to U.S.  Treasury accounts.
Royalties paid for fossil and renewable resources extracted from leased  lands represent the principal source of the $12.6 billion in revenues  managed by MMS—$10.7 billion, more than 85 percent of revenues  received in fiscal year 2006. Of these, oil and natural gas leases are the  most significant component of royalties, composing on average nearly   90 percent of the royalties received over the past five years. For oil and  gas, production royalties are paid either in value or in kind. The OCS  Lands Act of 1953, as amended, and the Mineral Leasing Act of 1920, as  amended, authorize the collection of production royalties either in value  or in kind for federal lands leased for development onshore and on the  OCS. Furthermore, according to MMS, the terms of virtually all federal oil  and gas leases provide for royalties to be paid in value or in kind at the  discretion of the lessor. The Energy Policy Act of 2005 provides additional  statutory requirements to support the operation and funding of a program  for managing federal oil and gas royalties in kind.
Additionally, MMS also collects revenue generated by exploration and  development of geothermal energy resources commonly used to generate  electricity. Until recently, the Geothermal Steam Act of 1970, as amended,  directed MMS to disburse royalties collected from geothermal energy  development such that 50 percent of geothermal royalties be retained by  the federal government and the other 50 percent be disbursed to the states  in which the federal leases are located. A provision of the Energy Policy  Act of 2005 changed the distribution of the royalties collected from  geothermal resources. While 50 percent of federal geothermal royalties  must still be disbursed to the states in which the federal leases are located,  an additional 25 percent must be disbursed to the counties in which the  leases are located, leaving only 25 percent to the federal government.
section_title: Billions of Dollars of Royalty Revenue Will be Foregone Because of Problems Associated with Royalty Relief
paragraphs: As Assistant Secretary Allred of Interior recently testified before the  Congress, the absence of price thresholds in leases issued in 1998 and 1999  has already cost the government almost $1 billion and MMS has estimated  a range of potential future foregone revenue for these leases of between  $6.4 billion and $9.8 billion. MMS calculated these estimates under a range  of assumptions about oil and natural gas prices and future production  levels. We reviewed MMS’s assumptions and methodology for estimating  the potential foregone revenue from 1998 and 1999 leases and found them  to be reasonable. However, because there is considerable uncertainty  about future oil and natural gas prices and production levels, actual  foregone royalties could end up being higher or lower than MMS’s  estimates.
MMS is currently negotiating with oil and gas companies to apply price  thresholds to future production from the 1998 and 1999 leases. If  successful, this approach would partially undo the omission of price  thresholds for future production, thereby implementing the royalty relief  as though price thresholds had been included in the leases. However, the  results of the negotiation have been mixed so far—as of late February  2007, only 6 of 45 companies have agreed to terms, and a current legal  challenge to Interior’s authority to set price thresholds on any DWRRA  leases may further deter or complicate a negotiated settlement.
In addition to forgone royalty revenues from leases issued in 1998 and  1999, royalty revenues on leases issued under DWRRA in 1996, 1997, and  2000 are also threatened pending the outcome of a legal challenge  regarding price thresholds. Specifically, Kerr-McGee filed suit against the  Department of the Interior in early 2006, challenging its authority to place  price thresholds on any of the leases issued under the DWRRA. In effect,  this suit seeks to remove price thresholds from the leases in question. In  June 2006, Kerr-McGee agreed to enter into mediation with Interior in an  attempt to resolve the issue; however, the mediation was unsuccessful and  litigation has resumed. As of March 2007, the leases in question have  generated approximately $1 billion in royalties. If the government loses  this legal challenge, it may be required to refund these royalties—perhaps  with interest penalties—and to forego any future royalties on these leases,  and perhaps any lease issued during 1996, 1997, and 2000. As a result, the  government could stand to lose billions of additional dollars.
section_title: The RIK Program Has Been Unable to Demonstrate Its Effectiveness Due to Data Limitations
paragraphs: We reviewed the RIK pilot program for this committee in two separate  reports in 2003 and 2004 and found that MMS did not collect the necessary  information to effectively monitor and evaluate the program. This  information includes the administrative costs of the RIK program and the  revenue impacts of all sales. We found that MMS lacked this information  largely because it had not developed information systems to rapidly and  efficiently collect this information.
We made several recommendations in our 2003 and 2004 reports to  address the shortcomings we identified. Specifically, to further the  development of management controls for MMS’s RIK program, we  recommended that the Secretary of the Interior instruct the appropriate  managers within MMS to identify and acquire key information needed to  monitor and evaluate performance prior to expanding the RIK program.  We specified that such information should include the revenue impacts of  all RIK sales, administrative costs of the RIK program, and expected  savings in auditing revenues. We also recommended that MMS clarify the  RIK program’s strategic objectives to explicitly state that the goals of RIK  include obtaining fair market value and collecting at least as much revenue  as MMS would have collected in cash royalty payments. MMS agreed with  both recommendations and has taken several steps to address these  shortcomings.
We acknowledge the agency’s efforts and, within the context of the  program’s scope at the time of our report, consider our recommendations  implemented by the agency. However, the expansion of use of RIK since  our last review raises an additional concern. The RIK program has actively  expanded the scope of its operations as MMS has increasingly opted to  take royalties in kind rather than in cash. As MMS reported in its  September 2006 Report to Congress, today’s RIK operation manages a  significant portfolio of the nation’s oil and gas royalty assets collected  primarily from federal leases in the Gulf of Mexico. This portfolio has  expanded more than three-fold from 1999 to present—some 82 million  barrels of oil equivalent were exchanged in kind in fiscal year 2005—and is  expected to continue to grow for the foreseeable future. The Energy  Policy Act of 2005 permanently established an RIK operation with  administrative and business costs to be paid from royalty revenues  generated by RIK sales, effectively transitioning the program from pilot  status to a steady-state business operation and potentially enabling a  further expansion of the RIK program. The Act restricts the use of RIK to  those situations where the benefit is determined to equal or exceed the  benefit from royalties in value prior to the sale. However, the larger scale  of the RIK program at present makes it unclear that MMS can effectively  and accurately make this determination going forward.
Noting this issue, we are undertaking work for the Congress. Specifically,  we have several ongoing reviews assessing, among other things, MMS’s  ability to quantify and compare administrative costs and revenues of the  RIK and royalties in value programs; the effectiveness of the systems used  to collect, account for, and disburse royalties; and the accuracy of royalty  revenue collection, including evaluating whether the value of RIK  payments equal or exceed the value of royalties that would have been  received in value for oil and gas as required by statute.
section_title: MMS Does Not Collect the Data Necessary to Assess Whether Geothermal Royalties Remain Constant as Required by Law
paragraphs: In a 2006 report on geothermal royalties, we found that MMS had  erroneous and missing historical geothermal electricity revenue data and  did not collect sufficient data from royalty payors to accurately asses  whether MMS was collecting the amount of royalties required by statute.  Specifically, about 40 percent of the royalty revenue data for royalty  payors was either missing or erroneous in the projects we reviewed. In  addition, MMS did not have sufficient historical gross revenue data for  geothermal electricity sales.
MMS is charged with collecting and distributing royalties collected from  the development of geothermal resources used to generate electricity. The  Energy Policy Act of 2005 included provisions that significantly changed  how geothermal royalties are calculated but also instructed the Secretary  of the Interior to seek to maintain the same level of royalties over the next  ten years that would have been collected prior to the Act’s passage. We  found that to meet the statutory requirements, MMS will need to calculate  the percentage of gross sales revenues that lessees will pay in future  royalties from electricity sales and compare this to what lessees would  have paid prior to the Act. In order to compare royalties collected under  the provisions of the Act with what would have been collected under the  old system would require historical data on gross revenues from  geothermal electricity sales as well as accurate royalty data on those sales.
As a result of the insufficient gross revenue data and missing or erroneous  royalty revenue data, MMS is unable to determine if it is collecting the  amount of royalties on geothermal electricity production as required in  statute. In our report we recommended that the Secretary of the Interior  direct MMS to correct these deficiencies and the agency agreed with our  findings and recommendations. We will continue to monitor the agency’s  efforts to address these shortcomings.
section_title: Conclusions
paragraphs: As seen by all the attention royalties management has received in the  Congress and the media, Interior’s performance in managing this effort is a  cause for concern. Billions of dollars have been lost already and  potentially billions more are at risk. In a time of dire long-term national  fiscal challenges it is urgent that this problem be fixed and the confidence  of the American public that the sale of its national resources is generating  a fair return be restored. Our work on this issue is continuing on multiple  levels, including comparing the value of royalties taken in kind to the value  of royalties taken as cash, reviewing the diligence of resource  development, and evaluating the accuracy of the agency’s cost, revenue,  and production data.
We look forward to this continued work, and to helping this committee  and the Congress as a whole exercise oversight of this important issue. Mr.  Chairman, this concludes my prepared statement. I would be pleased to  respond to any questions that you or other members of the Committee  may have at this time.
section_title: GAO Contact and Staff Acknowledgments
paragraphs: For further information about this testimony, please contact me, Mark  Gaffigan, at 202-512-3841 or gaffiganm@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on the  last page of this statement. Contributors to this testimony include Frank  Rusco, Assistant Director; Robert Baney; Ron Belak; Philip Farah; Doreen  Feldman; Glenn Fischer; Dan Haas; Chase Huntley; Dawn Shorey; Barbara  Timmerman; Maria Vargas; and Jacqueline Wade.
section_title: Related GAO Products
paragraphs: Oil and Gas Royalties: Royalty Relief Will Likely Cost the Government  Billions, but the Final Costs Have Yet to Be Determined, GAO-07-369T  (Washington, D.C.: Jan. 18, 2007).
Suggested Areas for Oversight for the 110th Congress, GAO-07-235R  (Washington, D.C.: Nov. 17, 2006).
Department of Interior: Royalty-in-Kind Oil and Gas Preferences,   B-307767 (Washington, D.C.: Nov. 13, 2006).
Royalty Revenues: Total Revenues Have Not Increased at the Same Pace  as Rising Natural Gas Prices due to Decreasing Production Sold,   GAO-06-786BR (Washington, D.C.: June 21, 2006).
Renewable Energy: Increased Geothermal Development Will Depend on  Overcoming Many Challenges, GAO-06-629 (Washington, D.C.: May 24,  2006).
Mineral Revenues: Cost and Revenue Information Needed to Compare  Different Approaches for Collecting Federal Oil and Gas Royalties,   GAO-04-448 (Washington, D.C.: Apr. 16, 2004).
Mineral Revenues: A More Systematic Evaluation of the Royalty-in-Kind  Pilots is Needed, GAO-03-296 (Washington, D.C.: Jan. 9, 2003).
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