Oil and Gas Royalties: The Federal System for Collecting Oil and Gas Revenues Needs Comprehensive Reassessment
Published: 2008-09-03T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In fiscal year 2007, domestic and foreign companies received over $75 billion from the sale of oil and gas produced from federal lands and waters, according to the Department of the Interior (Interior), and these companies paid the federal government about $9 billion in royalties for this oil and gas production. The government also collects other revenues in rents, taxes, and other fees, and the sum of all revenues received is referred to as the "government take." The terms and conditions under which the government collects these revenues are referred to as the "oil and gas fiscal system." This report (1) evaluates government take and the attractiveness for investors of the federal oil and gas fiscal system, (2) evaluates how the absence of flexibility in this system has led to large foregone revenues from oil and gas production on federal lands and waters, and (3) assesses what Interior has done to monitor the performance and appropriateness of the federal oil and gas fiscal system. To address these issues, we reviewed expert studies and interviewed government and industry officials.
section_title: What GAO Found
paragraphs: In addition to having a low government take, the deep water Gulf of Mexico and other U.S. regions are attractive targets for investment because they have large remaining oil and gas reserves and the U.S. is generally a good place to do business compared to many other countries with comparable oil and gas resources. Multiple studies completed as early as 1994 and as recently as June 2007 indicate that the U.S. government take in the Gulf of Mexico is lower than that of most other fiscal systems. For example, data GAO evaluated from a June 2007 industry consulting firm report indicated that the government take in the deep water U.S. Gulf of Mexico ranked 93rd lowest of 104 oil and gas fiscal systems evaluated. Generally, other measures indicate that the United States is an attractive target for oil and gas investment. The lack of price flexibility in royalty rates--automatic adjustment of these rates to changes in oil and gas prices or other market conditions--and the inability to change fiscal terms on existing leases have put pressure on Interior and the Congress to change royalty rates in the past on an ad hoc basis with consequences that could amount to billions of dollars of foregone revenue. For example, royalty relief granted on leases issued in the deep water areas of the Gulf of Mexico between 1996 and 2000--a period when oil and gas prices and industry profits were much lower than they are today--could cost the federal government between $21 billion and $53 billion, depending on the outcome of ongoing litigation challenging the authority of Interior to place price thresholds that would remove the royalty relief offered on certain leases. Further, royalty rate increases in 2007 are expected to generate modest increases in federal revenues from future leases offered in the Gulf of Mexico. However, in choosing to increase royalty rates, Interior did not evaluate the entire oil and gas fiscal system to determine whether or not these increases strike the proper balance between the attractiveness of federal leases for investment and appropriate returns to the federal government for oil and gas resources. Interior does not routinely evaluate the federal oil and gas fiscal system, monitor what other governments or resource owners are receiving for their energy resources, or evaluate and compare the attractiveness of federal lands and waters for oil and gas investment with that of other oil and gas regions. As a result, Interior cannot assess whether or not there is a proper balance between the attractiveness of federal leases for investment and appropriate returns to the federal government for oil and gas resources. Specifically, Interior does not have procedures in place for evaluating the ranking of (1) the federal oil and gas fiscal system or (2) industry rates of return on federal leases against other resource owners. Interior also does not have the authority to alter tax components of the oil and gas fiscal system. All these factors are essential to inform decisions about whether or how to alter the federal oil and gas fiscal system in response to changing market conditions.

section_title: Letter
paragraphs: In fiscal year 2007, domestic and foreign companies received over $75  billion from the sale of oil and gas produced from federal lands and  waters, according to the Department of the Interior’s (Interior) Minerals  Management Service (MMS). The agency further reported that these  companies paid the federal government about $9 billion in royalties for  such oil and gas development. Clearly, such large and financially  significant resources must be carefully developed and managed so that the  nation’s rising energy needs are met while at the same time the American  people are assured of receiving a fair return on publicly owned resources.  In May 2007, we reported that, based on studies by industry experts, the  amount of money that the U.S. government receives from production of oil  and gas on federal lands and waters—the so-called “government take”— was among the lowest in the world. The government take that accrues to  any government resource owner is largely determined by the government’s  oil and gas fiscal system—the precise mix and total amount of payments  made to the government for the rights to explore, develop, and sell oil and  gas resources. We also noted that several factors needed to be considered  to determine whether adjustments to an oil and gas fiscal system are  warranted, including the size and availability of the oil and gas resources  in place; the costs of finding and developing these resources, including  labor costs and the costs of complying with environmental regulations;  and the stability of both the oil and gas fiscal system and the country in  general. Conceptually, a fair government take would strike a balance  between encouraging private companies to invest in the development of  oil and gas resources on federal lands and waters while maintaining the  public’s interest in collecting the appropriate level of revenues from the  sale of the public’s resources.
Governments and companies negotiate the exploration and development of  oil and gas resources under terms of leases or contracts granted by  governments. The terms and conditions of such arrangements are established  by law and policy, or are negotiated on a case-by-case basis. An important  aspect of these arrangements is the oil and gas fiscal system, which defines all  applicable payments from the companies to the government resource  owners. Oil and gas fiscal systems vary widely across different resource  owners, reflecting differences in the mix and weight of the various payments.  U.S. federal oil and gas leases operate under a system in which the  government transfers title to the oil and gas produced to a company for a  period of time, generally in exchange for a lump-sum payment called a bonus  bid. The company is then typically subject to the payment of rental rates,  royalties, and taxes for any oil and gas that is eventually produced on the  lease. In other oil and gas fiscal systems, such as “production sharing” or  “profit sharing” systems, the host country and production company enter into  a contract to apportion the production or profits between them rather than or  in addition to royalty payments.
In recent years, and in response to increasing industry profits and other  changing market conditions, many countries have re-evaluated or are re- evaluating their oil and gas fiscal systems. A number of countries have  significantly increased their overall government take while others— typically those with marginal or less certain levels of oil and gas  resources—have reduced their government take. According to Wood  Mackenzie, an energy consulting firm that recently performed a  comprehensive study of government take and other measures that  determine the attractiveness of different countries to oil and gas investors,  the most prominent trend in changing oil and gas fiscal systems has been  the imposition of windfall profits taxes or other mechanisms to increase  the resource owners’ shares of oil and gas revenues from existing projects.  Wood Mackenzie estimates that these changes will ultimately result in  these countries’ collecting additional oil and gas revenues of between $118  billion and $400 billion, depending on future oil and gas prices. For  example, the state of Alaska recently increased its government take and  changed the terms of contracts to give Alaska larger shares of revenues as  oil and gas prices increase. A second trend in changing oil and gas fiscal  systems has been an increase in governmental control of resources. For  example, Algeria, Russia, and Venezuela have rich resource reserves and  have increased the state control over these resources, while increasing  their government takes. Other trends include increasing variation of fiscal  terms across and within countries to reflect differences in the value of the  resources and other factors that affect the attractiveness of these  resources to investors. For example, Papua New Guinea and Vietnam are  offering terms to encourage production that reflect these countries’ status  as frontier areas for exploration, while Norway has provided incentives for  exploration and continued production on fields with declining production.
A considerable body of legislation governs Interior’s authority and  obligations to manage resources on federal lands and within federal  waters. For example, the Outer Continental Shelf Lands Act (OCSLA) and  the Federal Land Policy and Management Act (FLPMA) direct Interior to  ensure the United States receives fair market value on the development of  its oil and gas resources. In 1976, an Interior report concluded that the  government receives “fair market value” when lessees receive no more  than a “normal” rate of return. In 1982—the last time Interior convened a  task force to comprehensively review its “fair market value” procedures,  the task force indicated that fair market value was not the value of the oil  and gas eventually discovered or produced; instead it is the value of “the  right” to explore and, if there is a discovery, to develop and produce the  energy resource. In general, for offshore, Interior has the authority to  change most components of the federal oil and gas fiscal system so long as  no more than one component is set on automatically adjusting or “flexible”  terms, and so long as the Congress does not disapprove the change—pass  a resolution of disapproval—within 30 days of receiving notice of  Interior’s bidding system. However, only the Congress may change the tax  components of the oil and gas fiscal system.
To provide more information to the Congress about the nature of the  federal oil and gas fiscal system and the attractiveness of the United States  as a place in which to invest in oil and gas development, we agreed to  build on the information in our May 1, 2007, report, which compared the  U.S. government’s take with the government takes of other resource  owners throughout the world, by reviewing new studies on the subject and  adding and updating other information. Specifically, this report (1)  evaluates the government take and the attractiveness for investors in the  federal oil and gas fiscal system for the Gulf of Mexico and the United  States in general, (2) evaluates how the absence of flexibility in this  system has led to large foregone revenues from oil and gas production on  federal lands and waters as oil and gas prices have risen, and (3) assesses  what Interior has done to monitor the performance and appropriateness of  the federal oil and gas fiscal system in light of changing market conditions.
To evaluate the attractiveness of the United States for oil and gas  investment, we reviewed the results of a study we procured from Wood  Mackenzie, a leading industry consultant. In using this study, we reviewed  the methodology and controls used by Wood Mackenzie to ensure the  accuracy of the data used and the study results. We found the study results  and the data that accompanied the study to be sufficiently reliable to meet  the objectives of this report. We also evaluated the results of various  studies conducted by other industry experts and by MMS, the agency  responsible for collecting oil and gas royalties from federal lands and  waters. To evaluate the study results, we interviewed study authors and  other industry experts to determine the studies’ methodologies and the  appropriate interpretation of the results. Based on these interviews and  our review of the results of the studies, we believe the general approaches  taken by the authors of the studies was reasonable and that results of the  studies are credible. However, with the exception of the Wood Mackenzie  study, we did not fully evaluate each study’s methodology or the  underlying data used to make the government take estimates. We also  purchased and evaluated data from a leading financial firm and evaluated  data and information published by the Department of Energy’s Energy  Information Administration (EIA), the American Petroleum Institute, and  other sources. We assessed these data for reliability and deemed them  reliable for the purposes of this report. We reviewed academic and  government studies that investigated the costs and benefits of various oil  and gas fiscal systems, and we interviewed and gathered information from  officials from MMS, other governments, and the oil and gas industry. To  evaluate how the absence of flexibility in the federal oil and gas fiscal  system has led to large foregone revenues from oil and gas production on  federal lands and waters as oil and gas prices have risen, we relied on past  work evaluating changes in federal oil and gas fiscal terms in the deep  water regions of the U.S. Gulf of Mexico. We also evaluated Interior  analyses that accompanied recent increases in royalty rates in the U.S.  Gulf of Mexico. In addition, we reviewed the Wood Mackenzie study and  accompanying data. We also interviewed company officials and industry  experts to obtain information on their preferences regarding oil and gas  fiscal system characteristics. To assess what Interior has done to monitor  the performance and appropriateness of the federal oil and gas fiscal  system in light of changing market conditions, we evaluated the extent to  which Interior had collected the types of information and done the  analysis needed to determine whether or not the oil and gas fiscal system  should be changed in light of the recent changes in oil and gas market  conditions. To do this, we reviewed Interior studies, policies, and guidance  and interviewed officials from MMS; interviewed and collected views from  oil and gas companies and industry groups; and evaluated analyses of oil  and gas fiscal systems. We neither assessed Interior’s overall management  of the federal system, both on and offshore, nor did we attempt to evaluate  the costs and benefits of any of Interior’s specific changes to the system  over time. We conducted this performance audit from May 2007 to  September 2008 in accordance with generally accepted government  auditing standards. Those standards require that we plan and perform the  audit to obtain sufficient, appropriate evidence to provide a reasonable  basis for our findings and conclusions based on our audit objectives. We  believe that the evidence obtained provides a reasonable basis for our  findings and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Interior, created by the Congress in 1849, oversees and manages the  nation’s publicly owned natural resources, including parks, wildlife  habitats, and minerals, including crude oil and natural gas resources, on  over 260 million surface acres and 700 million subsurface acres onshore  and in the waters of the Outer Continental Shelf. In this capacity, Interior  is authorized to lease federal oil and gas resources and to collect the  royalties associated with their production, Interior’s Bureau of Land  Management (BLM) is responsible for leasing federal oil and natural gas  resources on land, whereas offshore—including the U.S. Gulf of Mexico— Minerals Management Service (MMS) has the leasing authority. To lease  U.S. Gulf of Mexico waters for oil and gas exploration, companies  generally must first pay the federal government a sum of money that is  determined through a competitive auction and evaluated by Interior  against departmental economic and geologic models. This money is called  a bonus bid. Companies are required to submit one-fifth of any bid for a  lease tract up front at time of bid, and pay the remaining four-fifths  balance of their bonus payment and their first year rental payment after  acquiring a lease. After the lease is awarded and production begins, the  companies must also pay royalties to MMS based on a percentage of the  cash value of the oil and gas produced and sold or “in kind,” as a  percentage of the actual oil or gas produced. Royalty rates for onshore  leases are generally 12.5 percent. Royalty rates for leases in the U.S. Gulf  of Mexico, prior to 2007, ranged from 12.5 percent for water depths of 400  meters or deeper (referred to as deepwater) to 16-2/3 percent for water  depths less than 400 meters (referred to as shallow). In 2007, the Secretary  of Interior twice increased the royalty rate for future U.S. Gulf of Mexico  leases—in January, the rate for deep water leases was raised to 16-2/3  percent and in October, the rate for all future leases, included those issued  in 2008, was raised to 18-3/4 percent.
A considerable body of legislation has been enacted pertaining to the  management of resources on federal and Indian trust lands and within federal  waters. This legislation includes the Mining Law of 1872, Mineral Lands  Leasing Act of 1920, 1947 Mineral Leasing Act for Acquired Lands, Outer  Continental Shelf Lands Act of 1953, Federal Land Policy and Management  Act of 1976, the Outer Continental Shelf Lands Act Amendments of 1978,  Federal Oil and Gas Royalty Management Act of 1982, as well as the Federal  Onshore Oil and Gas Leasing Reform Act of 1987, the Outer Continental Shelf  Deep Water Royalty Relief Act of 1995, and the Energy Policy Act of 2005. The  Outer Continental Shelf Lands Act, as amended (OCSLA) is, among other  things, intended to ensure the public “a fair and equitable return” on the  resources of the shelf. The law directs the Secretary of Interior to conduct  leasing activities to assure receipt of fair market value for the lands leased  and the rights conveyed by the federal government. In addition, the Federal  Land Policy and Management Act indicated that, unless otherwise provided  by statute, it is the policy of the United States to receive “fair market value”  for the use of the public lands and their resources. In 1982, Interior’s MMS  convened a task force to review its fair market value procedures. Upon  completion of the task force’s work, the Secretary of Interior informed the  Congress by letter in March 1983 that the Department had completed its  analysis and validation of the process by which it will assure a fair return to  the American people. The Secretary indicated in that letter that the process in  place will assure the American people a full and fair return as it pertains to  bonuses, rentals, royalties, and taxes. The 1983 Interior task force report also  provided some clarity regarding a fair return, or fair market value. The report  indicated that the market value of a lease is not the market value of the oil  and gas eventually discovered or produced. Instead, it is the value of the right  to explore and, if there is a discovery, develop and produce the energy  resource.
Currently Interior has the legal authority to change most aspects of the oil  and gas fiscal system. Specifically, Interior is allowed by statute to change  bid terms for offshore leases including the royalty rate, the bonus bid  structure, rental terms, and even the minimum 12.5 percent royalty rate, so  long as there is only one variable or “flexible” term—such as a royalty rate  that adjusts upwards or downwards with oil and gas prices—in the  resulting system, and so long as Congress does not pass a resolution of  disapproval within 30 days of Interior’s changes to the system. With  regard to onshore leases, Interior is generally allowed by statute to change  bid terms including the royalty rate, the bonus bid structure, rental terms,  and the minimum royalty rate so long as the bid structure meets certain  bid terms, but with certain additional limits on flexibility than the offshore  leases. Over the past 25 years, Interior has implemented several programs  that adjusted royalty rates or other system components. Such programs  included the net profit share leases, which were for offshore leases that  based royalties on a percentage of net profits derived from production;  sliding scale royalty rates, which was an onshore royalty rate system based  on changing production levels; and royalty rate reduction for stripper  wells and lower-grade, more viscous crude oil, where onshore oil wells  producing less than 15 barrels of oil per day were eligible for royalty rate  reductions. Interior officials told us they also “experimented” with a  variety of flexible royalty rate and profit sharing systems in the early  1980s, but found them difficult to administer and validate the amount of  payments due to MMS, which in Interior’s estimation more than offset any  enhanced flexibility associated with a variable royalty rate.
section_title: The Gulf of Mexico Has a Relatively Low U.S. Government Take and the United States Is an Attractive Place to Invest in Oil and Gas Development
paragraphs: Multiple studies completed as early as 1994 and as recently as June 2007  all indicate that the U.S. government take in the Gulf of Mexico is lower  than most other oil and gas fiscal systems. Four recent studies by private  consultants or resource owners indicate that the U.S. government take in  the Gulf of Mexico is relatively low. For example, data we evaluated from  a June 2007 report by Wood Mackenzie reported that the government take  in the deep water U.S. Gulf of Mexico ranked as the 93rd lowest out of 104  oil and gas fiscal systems evaluated in the study. Other U.S. oil and gas  regions are also listed in the Wood Mackenzie study and some but not all  other studies. However, these regions are not uniquely under federal  jurisdiction, so a direct comparison of the government take in these other  regions cannot be used to isolate the federal oil and gas fiscal system. The  results of the four studies are summarized below in table 1.
As we reported in May 2007, the results of five other studies completed  between 1994 and 2006 had similar findings. The information reported by  Wood Mackenzie and other such expert studies are used by resource  owners and oil and gas companies alike to aid in making investment or  policy decisions and these studies represent the best data on government  take available. However, we recognize there are limitations with the  government take studies and the relative ranking of government take  alone is not sufficient to determine whether the federal government is  receiving its fair share of oil and gas revenues. A number of other factors  that are not part of the government take determine company decisions of  where and how much to invest and how much to pay for access to oil and  gas resources. These factors include the relative size of oil and gas  resource bases in different regions and the relative costs of developing  these resources. Thus government take is a major, but not sole factor in  determining the attractiveness of a fiscal system for oil and gas  development.
When other factors are taken into consideration, the U.S. Gulf of Mexico is  an attractive target for investment because it has large remaining oil and  gas reserves and the United States is generally a good place to do business  compared to many other countries with comparable oil and gas resources.  For example, once reserves that are entirely owned by governments are  removed from the analysis, of the 104 remaining fiscal regimes ranked by  Wood Mackenzie that allow some participation by international oil  companies and that have remaining oil and gas reserves, the deep water  U.S. Gulf of Mexico ranked 18th highest in terms of remaining oil and gas  reserves. Three other U.S. regions were ranked in the top 18 in terms of  reserves. These were the U.S. Rocky Mountains (8th), Alaska (14th), and  U.S. Gulf Coast (15th), but these regions are not uniquely covered by the  federal fiscal regimes, as state and private resource owners may also exist.
Wood Mackenzie also ranked oil and gas fiscal regimes in terms of their  attractiveness for investment. Wood Mackenzie’s measure of oil and gas  fiscal attractiveness took into account both reward associated with factors  such as resource size; and risk, including the extent to which government  take includes bonuses. With respect to reward, Wood Mackenzie  compared the levels of government take with the size of oil and gas fields  governed by the various oil and gas fiscal systems. The risk ranking  reflected whether or not the system included bonus payments, which  increase the risk to investors because they must be paid whether or not  economic volumes of oil and gas are eventually found on an oil and gas  tract. Risk also included a measure of the extent to which and the way in  which the resource owner held an equity share in the resources being  developed. The impact of the fiscal terms on the rewards and risks  associated with a wide range of hypothetical new investments were  assessed under the terms of each of the 103 oil and gas fiscal systems  included in this section of the study. Based on these assessments, Wood  Mackenzie ranked the deep water U.S. Gulf of Mexico fiscal system as  more attractive for investment than 60 (about 58 percent) of the 103 fiscal  systems ranked.
More broadly, other measures indicate that the United States is an  attractive place to invest in oil and gas production. For example, since  2002 as oil prices have risen and gas prices have remained high by  historical standards, the number of oil and gas drilling rigs operating in the  United States has increased much faster than in the rest of the world,  which indicates companies in recent years have continued to find the  United States a conducive place to invest in oil and gas production.  Specifically, according to data on crude oil rig counts from Baker Hughes,  the number of rigs in use globally excluding the United States increased by  about 18 percent from an annual average in 2002 of 998 to 1,180 through  the first 4 months of 2008, while the number of rigs operating in the United  States increased about 113 percent, from 831 rigs in 2002 to 1,768 rigs in  2007 and 1,829 rigs in April 2008. These increases coincided with the  increase in oil and gas prices over the same period and indicate that the  United States has remained an attractive place to invest in oil and gas as  prices have risen.
While rig counts can reasonably be associated with the attractiveness of a  region for development and production, they do not tell the whole story.  For example, according to Baker Hughes, the Gulf of Mexico rig count  fluctuated over the longer term and has decreased in recent years.  Specifically, from 1973 to 1981, rig counts in the Gulf of Mexico increased,  from 80 to 231, before generally decreasing to 45 in 1992. They then  generally rose again until 2001. From 2001 to April 2008, the annual rig  count in the Gulf of Mexico decreased from 148 to 58. This decline has  occurred despite the Gulf of Mexico being generally considered an  attractive target for investment, both from the perspective of the  government take and because of the potential for significant oil and gas  resources.
Other analyses report the oil and gas industry appears to have performed  favorably in recent years compared with other industries.
The Energy Information Administration reported in December 2007 that  from 2000 through 2006, the return on equity, which compares a  company’s profit with the value of the shares held by the company’s  owners, for the major energy producers, referred to as Financial Reporting  System (FRS) companies, averaged 7 percentage points higher than that of  the U.S. Census Bureau’s “All Manufacturing Companies.” According to  the report, this reversed a trend where the return on equity for the major  energy producers averaged 2 percentage points lower than All  Manufacturing Companies from 1985 to 1999.
The American Petroleum Institute, in a 2007 study, showed that from 2000  to 2005, the average return on investment for oil and gas production was  about 61 percent higher than for the Standard & Poor’s (S&P) industries.  However, the average return on investment for the industry has matched  or exceeded the returns for the S&P industrials only in recent years; over  the 25-year period from 1980 to 2005, the average return on investment for  oil and gas production was about 18 percent lower than for the S&P  industries.
A GAO analysis found that the “upstream,” or exploration and production  segments, of the domestic oil and gas production companies also received  higher rates of return than companies operating in other U.S.  manufacturing industries from 2002 through 2006. We analyzed financial  data from S&P’s Compustat and EIA’s FRS. From 2002 through 2006, the  upstream segments of the domestic oil and gas production companies  have averaged a 17.4 percent return on investment, compared with 15.2  percent for all other manufacturing companies. When both upstream and  “downstream” the refining and marketing segments are included in the  analysis, the oil and gas industry return on investment averaged over 20  percent during this period. This short term picture, however, contrasts  with a longer-term analysis, which shows the oil and gas industry receiving  a return on investment that is comparable, or slightly lower, than that  received by other manufacturing industries over the past 30 years. Our  analysis found that during this period, upstream oil and gas production has  averaged 11.2 percent return on investment with the entire oil and gas  industry receiving an average 13.7 percent return on investment. All other  manufacturing companies have averaged 12.3 percent return on  investment during this period.  This recent improvement in financial  performance from 2000 through 2006 coincided with rising oil and gas  prices. Further, since 2006, oil and gas prices have risen even higher, while  EIA’s most recent projections to 2030 are for oil and gas prices to remain  much higher than they were for most of the period 1985 through 1999.  In addition, the United States is also generally ranked favorably as a place  to conduct business by the World Bank and by business media sources,  including The Economist, and AM Best. For example, the World Bank  ranked the United States as the third most favorable place to conduct  business of 178 countries analyzed in a 2007 study. The Economist in  October 2007 ranked the United States as the ninth highest of 82 countries  analyzed for projected favorability of business environment from 2008 to  2012. Finally, as of February 2008, the United States remained in the top  tier—of five possible tiers—on AM Best’s countries for business risk  index, meaning the United States generally posed the least risk for  investors of the five possible levels assigned.
section_title: The Inflexibility of Royalty Rates to Changing Oil and Gas Prices Has Cost the Federal Government Billions of Dollars in Foregone Revenues
paragraphs: The lack of price flexibility in royalty rates and the inability to change  fiscal terms for existing leases have put pressure on Interior and the  Congress to change royalty rates in the past on future leases on an ad hoc  basis. For example, in 1980, a time when oil prices were comparable in  inflation-adjusted terms to today’s prices, Congress passed a windfall  profit tax, which amounted to an excise tax per barrel of oil produced in  the United States. Congress repealed that tax in 1988 at time when oil  prices had fallen significantly from their 1980 level. The tax attempted to  recoup for the federal government much of the revenue that would have  otherwise gone to the oil industry as a result of the decontrol of oil prices.
Further, in 1995—a period with relatively low oil and gas prices—the federal  government enacted the Outer Continental Shelf Deep Water Royalty Relief  Act (DWRRA). In implementing the DWRRA for leases sold in 1996, 1997, and  2000, MMS specified that royalty relief would be applicable only if oil and gas  prices were below certain levels, known as “price thresholds,” with the  intention of protecting the government’s royalty interests if oil and gas prices  increased significantly. MMS did not include these same price thresholds for  leases it issued in 1998 and 1999. In addition, the Kerr-McGee Corporation— which was active in the Gulf of Mexico and is now owned by Anadarko  Petroleum Corporation—filed suit challenging Interior’s authority to include  price thresholds in DWRRA leases issued from 1996 through 2000. Recently,  the U.S. District Court for the Western District of Louisiana granted summary  judgment in favor of Kerr-McGee concerning the application of price  thresholds to those leases and this ruling is currently under appeal. In our  June 2008 report on the potential foregone revenues at stake in the Kerr- McGee litigation, we found that the value of future forgone royalties is highly  dependent upon oil and gas prices, and on production levels. Assuming that  the District Court’s ruling is upheld, future foregone royalties from all the  DWRRA leases issued from 1996 through 2000 could range widely—from a  low of about $21 billion to a high of $53 billion, depending on the outcome of  ongoing litigation concerning the authority of Interior to place price  thresholds that would remove the royalty relief offered on certain leases. The  $21 billion figure assumes relatively low production levels and oil and gas  prices that average $70 per barrel and $6.50 per thousand cubic feet over the  lives of the leases. The $53 billion figure assumes relatively high production  levels and oil and gas prices that average $100 per barrel and $8 per thousand  cubic feet over the lives of the leases. A royalty relief provision was also  included in the Energy Policy Act of 2005 on leases issued during the 5-year  period beginning on August 8, 2005.
In 2007, the Secretary of the Interior twice increased the royalty rate for  future Gulf of Mexico leases—in January, the rate for deep water leases  was raised to 16-2/3 percent and in October, the rate for all future leases in  the Gulf, including those issued in 2008, was raised to 18-3/4 percent.  Interior estimated these actions will increase federal oil and gas revenues  by $8.8 billion over the next 30 years. The January 2007 increase applied  only to deep water Gulf of Mexico leases; the October 2007 increase  applied to all water depths in the Gulf of Mexico. These royalty rate  increases appear to be a response by Interior to the high prices of oil and  gas that have led to record industry profits and raised questions about  whether the existing federal oil and gas fiscal system gives the public an  appropriate share of revenues from oil and gas produced on federal lands  and waters. However, the royalty rate increases do not address these  record industry profits from existing leases at all and high profits will  likely remain as long as the existing leases produce oil and gas or until oil  and gas prices fall. In addition, in choosing to increase royalty rates,  Interior did not evaluate the entire oil and gas fiscal system to determine  whether or not these increases were sufficient to balance investment  attractiveness and appropriate returns to the federal government for oil  and gas resources. On the other hand, according to Interior, it did consider  factors such as industry costs for outer continental shelf exploration and  development, tax rates, rental rates, and expected bonus bids. Further,  because the new royalty rates are not flexible with respect to oil and gas  prices, Interior and the Congress may again be under pressure from  industry or the public to further change the royalty rates if and when oil  and gas prices either fall or continue rising. Finally, these royalty changes  only affect Gulf of Mexico leases and do not address onshore leases at all,  which should also be considered in light of the increases in oil and gas  prices.
In addition, Wood Mackenzie reports that the deep water U.S. Gulf of  Mexico ranked in the bottom half of countries in terms of oil and gas fiscal  system stability based on repeated changes to fiscal terms for future leases  and on the relative lack of built-in flexibility that would allow the fiscal  terms to adjust to market conditions. Specifically, the Wood Mackenzie  study ranked the deep water U.S. Gulf of Mexico fiscal terms as lower than  71 (about 72 percent) of the 103 oil and gas fiscal systems. In contrast,  among the key trends among governments in recent years has been to  make fiscal terms more responsive to market conditions. By adding such  progressive features to oil and gas fiscal systems including royalty rates  that increase with oil and gas prices, these other entities are making their  systems more stable over time by reducing incentives for industry or the  public to push for ad hoc changes in fiscal terms as future prices change.  Wood Mackenzie’s measure of fiscal stability combines two criteria: recent  history of changes to fiscal terms and built-in flexibility. As discussed  previously in this report, changes to royalty rates occurred in the Gulf of  Mexico three times since 1995, with the royalty relief in the mid 1990s and  the two increases in royalty rates in 2007. However, as noted above, the  study was conducted before the second 2007 increase in royalty rates, so  the government take would likely have increased but the U.S. stability  rating could have fallen in the intervening period. Built-in flexibility  reflects the relative degree to which a fiscal system is regressive or  progressive, with more progressive systems being more flexible. A flexible  system does not mean changing the fiscal terms of existing contracts but  having a system in place that automatically adjusts to changing economic  and market conditions.
Oil and gas companies we communicated with stated a clear preference  for stable fiscal terms, other things being equal. Overall, oil and gas  companies may be more willing to invest in flexible systems, given that  they tend to be inherently more stable and therefore are less likely to be  arbitrarily changed on a recurring basis. Oil and gas companies and  industry trade associations we contacted provided us a range of views on  the advantages and disadvantages of various oil and gas fiscal systems,  and generally indicated that one of the most important features of any  system is its stability and predictability. Stability of fiscal terms is  important because oil and gas companies are making very long-term  investments and uncertainty about whether or not the resource owner will  change the fiscal terms during the lifetime of the investment adds to the  investment risk. The respondents also said that the terms of the oil and gas  fiscal system should consider industry exploration and development costs,  the likelihood of discovery, and political and economic risks. While  companies surely prefer lower government take, all else constant, to the  extent that stability is also preferred, a more stable system may be able to  remain competitive for investment while resulting in a higher government  take than a less stable system. In particular, companies may be willing to  pay a larger average share of oil and gas revenues if they believe that oil  and gas fiscal systems will not change when market conditions change,  such as the windfall profits charges that a number of countries have  recently imposed. Such willingness to accept lower expected profits in  exchange for lower risk is a common feature of investment markets.
In addition to the potential trade-off between oil and gas fiscal system  stability and government take, companies may be willing to pay higher  average shares of revenues if governments bear some of the risk that  companies take on when they purchase the rights to explore for oil and  gas. For example, in the United States as well as for a number of other  governments, leases are awarded through a bidding process that requires  companies to pay bonus bids for the rights to explore and develop leases.  With regard to bonus bids, there are advantages to requiring such bids.  First, when companies have to compete with one another to win a lease,  the lease is more likely to be awarded to a company with the expertise and  resources to properly explore and develop the resources on the lease than  if leases are awarded using some other rationing mechanism that does not  take into account how much companies are willing to pay for the lease. In  addition, it guarantees the public some revenue early on in the exploration  and development process, which can take a number of years to complete.  However, the use of bonus bids pushes a great deal of risk onto oil and gas  companies and requires them to estimate many uncertain factors,  including the amounts of oil and gas that will ultimately be produced on  the lease, the costs of that production, and the prices of gas and oil over  the entire working life of the lease. In general, by increasing the risk that  companies bear, these companies will have to expect to receive a higher  rate of return to be willing to take on the project. In fiscal systems  requiring bonus bids or other up-front payments, the companies bear the  risk that leases will not generate economically significant oil and gas  production. In fact, in the United States, a large proportion of leases that  companies have paid for do not generate economic levels of production  and the companies, after purchasing the lease, and paying rent for the  duration of the initial term of the lease and whatever resources they spent  on exploring for oil and gas, simply let the lease revert back to the  government when the initial term expires.
Some oil and gas fiscal systems mitigate the risk associated with up-front  company expenditures by allowing the companies to recover exploration  and development costs prior to starting higher royalty payments. For  example, Alberta, Canada, has used such fiscal terms. Other fiscal systems  share risk with companies by more strongly linking government take to  company profits. In such oil and gas fiscal systems, government take is  low in early years of a lease, when exploration and early development are  being undertaken, but increases if production increases or if oil and gas  prices increase once production begins. The state of Alaska has recently  changed its fiscal terms to increase its government take and to increase  the linkage between government take and company profits. Both Alberta  and the state of Alaska have higher government takes than the U.S. Gulf of  Mexico according to the Wood Mackenzie study.
section_title: Interior Does Not Have a System in Place to Evaluate Whether the Federal Fiscal System Is in Need of Reassessment
paragraphs: Interior does not routinely evaluate the federal oil and gas fiscal system as  a whole, monitor what other resource owners worldwide are receiving for  their energy resources, or evaluate and compare the attractiveness of the  United States for oil and gas investment with that of other oil and gas  regions. As a result, Interior cannot assess whether or not there is a proper  balance between the attractiveness of federal lands and waters for oil and  gas investment and a reasonable assurance that the public is getting an  appropriate share of revenues from this investment. This is true of the U.S.  Gulf of Mexico as well as other federal oil and gas producing regions.  Interior does not have procedures in place for routinely evaluating the  ranking of (1) the federal oil and gas fiscal system against other resource  owners or (2) industry rates of return on federal leases compared to other  U.S. industries which could factor into any decisions about whether or  how to alter the fiscal systems in response to changing market conditions.  Interior officials told us that they have a “bid adequacy review process” for  offshore leases that determines whether the bonus bid meets criteria  designed to ensure fair market value of the leased tract but that onshore  leases do not have a similar bid adequacy provision. Moreover, Interior  maintains it has been responsive to changes in market conditions through  revisions to lease terms, including changes in minimum bonus bid levels,  fluctuating royalty rates, and price thresholds. However, as we have  discussed previously in this report, bonus bids have both positive and  negative sides with respect to their likely impact on overall government  take. Further, frequent adjustments to fiscal terms are not looked on  favorably by industry, especially when they involve increases in royalty  rates or other charges. Interior indicated, in commenting on the report  draft, that it is in the process of evaluating other fiscal approaches such as  sliding scale royalties for some oil and gas leases.
We did not evaluate the effectiveness of the bid adequacy review process  in terms of its intended goal of ensuring bonus bids on offshore federal  leases are competitive. However, even assuming that these bids are  competitive, we do not think that this is sufficient to ensure that the other  elements of the system are appropriately balancing the interests of  taxpayers and oil and gas companies. In light of the complexity of oil and  gas fiscal systems, the great deal of uncertainty surrounding the volumes  and future prices of oil and gas, and the costs of producing it, oil and gas  companies cannot be expected to accurately forecast all the factors that  will ultimately determine the value of a lease at the time that lease is sold.  As a result, oil and gas company profits have tended to rise and fall over  time with oil and gas prices, putting pressure on Interior to alter fiscal  terms in a reactive rather than a strategic way. Further, the fact that  Interior does not apply the same or a similar bid adequacy process for  onshore leases raises questions about how Interior, overall, is providing  reasonable assurance that even the bonus bids it receives are  competitively determined in all publicly owned oil and gas producing  regions.
While Interior has made many specific changes to components of the  federal oil and gas fiscal system over the years to adjust to changing  market conditions, these changes were generally not done as part of a  comprehensive review of the fiscal system that took into account the  relative ranking of the U.S. government take or other comparisons with  other countries or regions. The last time Interior conducted a  comprehensive evaluation of the oil and gas fiscal system was over 25  years ago. The lack of a recent comprehensive re-evaluation of the U.S.  federal fiscal system stands in contrast to the actions of many other  governments that have recently reevaluated or are currently re-evaluating  their fiscal systems in light of rising oil and gas prices and higher industry  profits and rates of return. For example, as previously discussed in this  report, a number of countries have recently imposed windfall profits taxes  or other mechanisms to increase the resource owners’ shares of oil and  gas revenues from existing projects. Wood Mackenzie estimates that these  changes will ultimately result in these countries’ collecting additional oil  and gas revenues of between $118 billion and $400 billion, depending on  future oil and gas prices.
In evaluating an oil and gas fiscal system, all components of the system,  including bonus bids, land rental rates, royalties, and oil and gas company  taxes, must be considered. However, while Interior has a great deal of  expertise and data from years of administering and collecting revenues  from oil and gas leases on federal lands and waters that would be essential  for any review of the federal oil and gas fiscal system, they do not have the  authority to change taxes and, therefore, cannot fully revise the system  without legislative action by the Congress. Further, it is essential to keep  federal leases competitive with other potential investments governed by  different fiscal systems. Therefore, in addition to input from Interior, oil  and gas industry experts must also be consulted in any comprehensive  review of the federal oil and gas fiscal system. For example, when Alberta  recently reviewed its oil and gas fiscal system, it convened a panel that  included experts from academia, energy research and consulting firms,  and the energy industry and also hired a consultant to evaluate the system  and make specific recommendations. Following this review, Alberta  increased some elements of the oil and gas fiscal system. However, prior  to this review, Canadian government corporate taxes were reduced, which  made Alberta more attractive for investors.  In any comprehensive review  of the U.S. oil and gas fiscal system, taxes may need to be part of the  discussion. Therefore, congressional action may be needed to change the  federal oil and gas fiscal system, if changes are ultimately determined to  be appropriate.
section_title: Conclusions
paragraphs: Oil prices have increased in recent years to levels not seen since the late  1970s and early 1980s when adjusted for inflation. Natural gas prices have  also been high by historical standards in recent years. These high prices  have coincided with rising oil company profits. Moreover, the EIA’s long- term outlook projects these prices to remain much higher than what they  had been for much of the past 25 years. Our work indicates that federal oil  and gas leases in the deep water U.S. Gulf of Mexico and other U.S.  regions are attractive investments and that the government take in the U.S.  Gulf of Mexico ranks among the lowest across a large number of other oil  and gas fiscal systems. Our work further indicates that other measures,  including fiscal attractiveness and rates of return, indicate the U.S. Gulf of  Mexico and other U.S. oil and gas producing regions are attractive places  to invest. However, the regressive nature of the U.S. federal fiscal systems  and other factors have caused these fiscal systems to be unstable over  time and this adds risk to oil and gas investments and may reduce the  amount oil and gas companies are willing to pay in total for the rights to  explore and develop federal leases. Because of these facts and because  Interior has not re-evaluated its oil and gas fiscal system in over 25 years, a  comprehensive re-evaluation is called for. While Interior could collect data  and commission studies to re-evaluate the federal fiscal system, the  agency does not currently have the information to fully compare the  federal fiscal system with those of other governments, including states or  foreign countries. In addition, Interior does not have the authority to make  changes to all elements of federal fiscal system if such changes were found  to be desirable. Finally, because of the complexity of evaluating oil and  gas fiscal systems and the importance of striking a balance between  remaining an attractive place for investment and providing revenue to the  federal government, it is important that independent experts also be  consulted as well as representatives from the oil and gas industry.
section_title: Matter for Congressional Consideration
paragraphs: In the draft report we sent to Interior for comment, we made  recommendations to address these issues.  In its response, Interior stated  that it did not fully concur with our recommendations because it had  already contracted for a study that will address many of the issues we  raise.  However, because Interior’s ongoing study is limited in scope and is  limited to a specific region in the Gulf of Mexico, rather than a review of  the entire federal oil and gas fiscal system as we recommended, we do not  find the agency’s stated rationale for not agreeing fully with our  recommendations to be convincing. Therefore, we believe that Congress  may wish to consider directing the Secretary of the Interior to convene an  independent panel to perform a comprehensive review of the federal oil  and gas fiscal system.
Further, in order to keep abreast of potentially changing market  conditions going forward, the Congress may wish to consider directing the  Secretary of the Interior to direct the Minerals Management Service and  other relevant agencies within Interior to establish procedures for  periodically collecting data and information and conducting analyses to  determine how the federal government take and the attractiveness for oil  and gas investors in each federal oil and gas region compare to those of  other resource owners and report this information to the Congress.
section_title: Agency Comments and Our Evaluation
paragraphs: The Department of the Interior provided us comments on a draft of the  report. Overall, the department agreed that it is important to reassess the  federal oil and gas fiscal system but did not fully concur with either of our  two recommendations to (1) perform a comprehensive review of the  system using an independent panel and (2) adopt policies and procedures  to keep abreast of important changes in the oil and gas market and in  other countries’ efforts to adjust their oil and gas management practices in  light of these changes. We disagree with Interior’s rationale for its lack of  full concurrence with our recommendations and have, therefore, elected  to reframe the recommendations into Matters for Congressional  Consideration in the final report.
In response to our first recommendation, Interior indicated that it would  be premature and duplicative for the department to undertake such a  review because it had recently contracted with an outside party to conduct  a 2-year study of the policies affecting the pace of area-wide leasing and  revenues in the Central and Western Gulf of Mexico. We disagree that our  recommended review is either premature or duplicative with this Interior  study effort. First, a comprehensive review is overdue, given that Interior  has not performed a comprehensive evaluation of the oil and gas fiscal  system in over 25 years and in light of the dramatic increases in oil and gas  prices and industry profits in recent years. Further, as documented in this  report, many other oil and gas owners have been re-evaluating and  changing their oil and gas fiscal systems in response to these recent  market conditions. The Congress and the public are justifiably concerned  about whether the federal government is getting a fair return for its energy  resources as oil and gas company profits have reached record levels. In  addition, our recommended review would not be duplicative with  Interior’s ongoing study, which is geographically limited to only two  sections of the Gulf of Mexico. In contrast, we recommended that Interior  review all its oil and gas fiscal systems, both onshore and offshore. Nor  does Interior’s ongoing study cover the full scope of review that we  recommended, including looking at how other resource owners are  managing their oil and gas fiscal systems. Further, Interior’s ongoing study  does not explicitly look at the stability of the system as we recommended  and this appears to be a critical factor influencing changes to oil and gas  fiscal systems globally. Finally, Interior’s ongoing effort does not utilize an  independent panel. We believe it is essential to empanel an independent  body, representative of major stakeholders, including those representing  the interests of industry and the public, in order to develop  recommendations that strike an appropriate balance between remaining  and attractive place for investment and providing revenue to the federal  government.
In response to our second recommendation, Interior implied that such an  effort was unnecessary because Interior agencies that lease federal  minerals already keep abreast of current literature on fiscal systems of  other resource owners. During our work, we identified only one Interior  study done over the past 25 years that provided information on the U.S.  government take compared to other fiscal systems. While that one Interior  study issued in 2006 showed, similar to our work, that the U.S. government  take was low compared to other fiscal systems, it is also worth noting that  the study itself relied on dated 1994 government-take information.  Therefore, we do not believe that Interior has adequately kept abreast of  important trends in oil and gas management, especially as it relates to how  other resource owners are managing these resources. In addition, our  recommendation went further than simply keeping abreast of current  literature. In particular, our recommendation sought to have Interior  monitor and report on how the federal government’s fiscal terms for oil  and gas development compare with the terms of other resource owners  worldwide.
Interior’s full letter commenting on the draft report is printed as appendix  III, and our detailed response follows. In addition, Interior made technical  comments that we have addressed as appropriate.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  date of this report.  At that time, we will send copies to appropriate  congressional committees, the Secretary of the Interior, the Director of  MMS, the Director of the Office of Management and Budget, and other  interested parties.  We will also make copies available to others upon  request.  In addition, the report will be available at no charge on GAO’s  Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-3841 on ruscof@gao.gov.  Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report.  GAO staff who made major contributions to this report are  listed in appendix IV.
section_title: Appendix I: Scope and Methodology
paragraphs: We performed our work at the Department of Interior’s (Interior), Bureau of  Land Management’s (BLM), and Minerals Management Service’s (MMS)  offices and in Washington, D.C. from May 2007 to September 2008 in  accordance with generally accepted government auditing standards. We  focused our analysis of government take and industry rates of return on the  U.S. Gulf of Mexico because it represents approximately 79 percent of oil  and 50 percent of gas production on federal leases, and because there are  complicating factors for onshore oil and gas leases, such as state and local  taxes or fees that may differ by locality, which the available studies do not  fully address. We did evaluate information that applied more broadly to the  United States, specifically with respect to overall measures of the  attractiveness of the United States for oil and gas investment. However, we  cannot infer from our review of the Gulf of Mexico federal oil and gas leases  how the data on federal government take or industry returns to investment  are applicable to federal onshore leases. In general, the results of this review  can compare the federal system associated with the U.S. Gulf of Mexico to  that of other oil and gas fiscal systems but cannot provide specific  prescriptive recommendations for how to change the federal fiscal system  to achieve a fair return for the public from sale of oil and gas on public lands  and waters. We also compared the federal oil and gas fiscal system to all  types of fiscal systems around the world to encompass the range of choices  that oil and gas companies are faced with when deciding where to invest.
To determine the degree to which the federal government is receiving a  fair return, our work included reviewing various pieces of energy resource  management legislation enacted over the last several decades. This  included, among others, the Outer Continental Shelf Lands Act of 1953  (OCSLA) and its amendments and the Federal Land Policy and  Management Act of 1976 (FLPMA) and its amendments. We also collected  and analyzed various pieces of Interior energy resource policy and  management information. To evaluate how the U.S. government take  compares to those in other countries, we reviewed the results of a study  procured from Wood Mackenzie, a leading industry consultant, and recent  studies conducted by other private consultants or resource owners. We  also collected and analyzed various studies generated by MMS, the agency  responsible for collecting oil and gas royalties from federal lands and  waters and interviewed private consulting firm officials. In evaluating the  study results, we conducted interviews with study authors and an industry  expert to discuss the study methodologies and the appropriate  interpretation of the results. Based on these interviews and our review of  study results, we believe the general approach that these study authors  took was reasonable and that the results of the studies are credible.  However, we did not fully evaluate each study’s methodology or the  underlying data used to make the government take estimates. Overall,  because all the studies came to similar conclusions with regard to the  relative ranking of the U.S. federal government, and because such studies  are used by oil and gas industry companies and governments alike for the  purposes of evaluating the relative competitiveness of specific oil and gas  fiscal systems, we are confident that the broad conclusions of the studies  are valid. To assess the extent to which the United States’ oil and gas fiscal  system is able to remain stable as market conditions change, we relied  heavily on the study and data we obtained from Wood Mackenzie. We  interviewed industry experts and gathered information regarding the types  of fiscal systems and the relative stability offered with each. We  interviewed company officials and industry experts to obtain information  on their preferences regarding fiscal system characteristics.
We also purchased data from Compustat and analyzed that data and data  published by the Energy Information Administration. The financial data  we procured are widely used by private companies and governments for  purposes of comparing company and industry rate of return over time,  because Interior in the past used rate of return as a credible measure to  evaluate the profitability of the Gulf of Mexico for firms conducting oil and  gas exploration there versus the relative profitability of other  manufacturing firms operating in the United States. We also evaluated data  reported by the American Petroleum Institute and other sources. Further,  we reviewed various reports prepared over the last 2 years by private  sources on the profitability of oil and gas companies operating in the U.S.  versus operating elsewhere in the world. We also spoke to industry  officials regarding aspects of the various fiscal systems in which they  operate. Finally, we discussed the issue of a “fair return” with various  Interior, BLM, and MMS officials, as well as members of the oil and gas  industry. To determine what steps Interior takes to get reasonable  assurance that the federal government take provides a fair return to the  public, we reviewed Interior studies and procedures, and interviewed  officials from MMS.
We conducted this performance audit from May 2007 to September 2008,  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix II: Companies Receiving Royalty Relief in the U.S. Gulf of Mexico
paragraphs: According to Interior, companies operating in the U.S. Gulf of Mexico had  received more than $1.3 billion in royalty relief through September 30,  2007. Table 2 lists the companies that have received royalty relief under  DWWRA and the amounts of that relief. Six companies had signed  agreements with Interior, allowing thresholds to be placed for royalties to  be paid in the future. Those companies are BP Exploration and  Production; ConocoPhillips & Burlington Resources Offshore, Inc.;  Marathon; Shell; Walter Hydrocarbons; and Walter Oil and Gas.  According  to Interior information dated February 4, 2008, ConocoPhillips &  Burlington Resources Offshore, Inc., had not received royalty relief.
section_title: Appendix III: Comments from Department of the Interior
paragraphs: The following are GAO’s comments on the Department of the Interior’s  letter dated August 8, 2008.
subsections: section_title: GAO Comments
paragraphs: 1.  Regarding Interior’s statements that (1) the draft report relies heavily  on measures of government take but does not clarify the link between  government take and investment attractiveness, and (2) the draft  report does not relate the significance of the OCSLA and FLPMA laws,  we disagree. The report on page 1 states that several factors need to be  considered, including the size of availability of the oil and gas  resources in place; the cost of finding and developing these resources,  and the stability of other the oil and gas fiscal systems and the country  in general. Also on page 2, we note that a fair government take would  strike a balance between encouraging private companies to invest in  the development of oil and as resources on federal lands and waters  while maintaining the public’s interest in collecting the appropriate  level of revenues from the sale of the public’s resources. Further, we  devote a significant portion of our discussion of objective one to how  the attractiveness of the U.S. oil and gas fiscal system compares with  those of other resource owners, and concludes that U.S Gulf of Mexico  and other U.S. places are attractive places to invest. With regard to the  significance of the OCSLA and FLPMA laws, on page 3 of the report we  discuss the provisions of the OCSLA and FLPMA laws and how they  relate to the management of the federal oil and gas fiscal system.   2.  Interior commented that the report’s conclusion that inflexibility in the  federal oil and gas fiscal system is responsible for significant  reductions in the federal fiscal take is not supported. We maintain that  the inherent inflexibility of the federal fiscal system means that  government receipts from the production of oil and gas on federal  lands and waters have not tracked with the prices of oil and gas. This  lack of flexibility explains, in part, why the Congress enacted the Deep  Water Royalty Relief Act in 1995, a time when oil and gas prices were  much lower than they are today. The lack of flexibility of the royalty  rates for some of the leases issued under this Act, as implemented by  Interior, will end up costing the public billions of dollars in foregone  revenues. Further, the recent increases to royalty rates that Interior  references in its comments do nothing to address the bulk of leases  already held and for which industry profits have increased as high as  they have precisely because neither the royalty rates, nor other  components of the oil and gas fiscal system were sufficiently flexible  to allow federal revenues to increase automatically when oil and gas  prices and industry profits increased. Overall, Interior should strive to  achieve fair market value over time, not simply evaluate market  conditions at the time leases are issued.  3.  With regard to Interior’s comments that although it has not conducted  a comprehensive evaluation of the federal oil and gas fiscal system, it  has evaluated expected resources and conditions on the Outer  Continental Shelf (offshore) tracts, we agree that Interior takes some  steps to evaluate offshore leases but the objective addresses a broader  evaluation of how Interior monitors the performance and  appropriateness of the entire federal oil and gas fiscal system,  including offshore and onshore, and also including assessing  performance over time rather than at the time a lease is sold. Interior  officials told us they evaluate offshore tracts before the issuance of a  lease for prospectivity of the lease and use such measures to  determine an adequate minimum bid for the lease. However, as  Interior makes note in its own comments, Interior officials have not  systematically reviewed the bid outcomes of offshore tracts.    4.  We agree that onshore and offshore leases can be very different and  for the reasons stated in Interior’s comments. That is why we  recommended a comprehensive review of the entire federal oil and gas  fiscal system, including onshore and offshore. We also recommended  that the results of this comprehensive review be presented to the  Congress so that it can act appropriately in the event any existing laws  or regulations that govern the leasing and collection of revenues from  federal oil and gas leases could be improved in light of the  recommendations of the independent panel.  5.  Interior states that the report implies that Interior maximizes  government receipts from oil and gas leases. We disagree that the  report implies this and can find no place in the report where we  believe a reader would make such an inference.   6.  We disagree with Interior’s statement that it “analyzes fiscal terms  before each lease sale and reviews the results of each sale.” Interior’s  analysis of prospective leases is for offshore leases only and, according  to Interior officials, is an analysis of the prospectivity of the offshore  tract, designed to set minimum adequate bids. It is not a review of  “fiscal terms,” as Interior states in its comments. With regard to the  two recent royalty rate increases for future oil and gas leases in the  Gulf of Mexico, these increases do not resolve fair market value for  past leases issued with inflexible fiscal terms and are themselves  inflexible. Therefore, if future oil and gas prices turn out to be different  than what Interior expected when they made the changes, the resulting  outcome will again not reflect a fair return and could be too high or  too low, depending on what happens in the oil and gas markets.  7.  With regard to Interior’s comment that it recently contracted with a  panel of academic oil and gas industry experts to conduct a study of  fiscal arrangements including fixed and sliding royalty terms, please  see our general response to Interior’s comments on page 24.  8.  We agree with the statements Interior makes in this paragraph, and  note that these concepts are also well represented in our report. For  example, we note that investment choices are affected by many  variables, including the fiscal system of rents, royalties, and bonus  bids, as well as the cost of capital, risk, and the attractiveness of  investments; indeed, we designed the job to discuss the first range of  issues in our first objective, and the second range of issues in the  second objective. We conclude, and Interior agrees, that any increases  in federal revenues through higher fiscal terms must be carefully  weighed; however, Interior has not done this “careful weighing” in  making its royalty rate increases. That is why we recommended a  comprehensive review of the federal oil and gas fiscal system.  9.  With regard to Interior’s comment that it operates under a  management and leasing policy defined by the Congress in the OCSLA  and FLPMA, we agree and this is reflected on page 3 of the draft  report. However, Interior cannot effectively conduct the mineral  leasing programs without evaluating federal mineral leasing systems  and assessing industry rates of return and other factors discussed in  this report. Interior must keep abreast of these issues and  developments in fiscal regimes elsewhere, and advise Congress on  developments in the competitiveness of the federal oil and gas fiscal  system versus those employed by other resource owners. Further, our  audit work shows that Interior has responded to oil and gas market  changes in a reactive, rather than strategic and forward-looking  manner, and we believe the Congress needs to be kept abreast of  changes affecting federal oil and gas leasing and revenue generation.  10. Interior comments that the draft report does not mention the royalty  relief mandated by the Congress in the Energy Policy Act of 2005, and  its decision to seek repeal of this provision, and that the impact of the  law should have been taken into consideration. We agree that the draft  report did not discuss the 2005 law explicitly but note that the results  we report do implicitly take this law into consideration. Our results on  the government take and attractiveness of investment in the deep  water Gulf of Mexico derive largely from a 2007 study done by Wood  Mackenzie that took into account the impact of the existing laws at the  time of the study. We have added language to make explicit  acknowledgement of the Energy Policy Act of 2005  11. See our general response to Interior’s comments on page 24-25 of this  report.  12. See our general response to Interior’s comments on page 24-25 of this  report.  13. See our general response to Interior’s comments on page 24-25 of this  report.
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In additional to the individual named above, Jon Ludwigson (Assistant  Director), Robert Baney, Ron Belak, Nancy Crothers, Glenn Fischer,  Michael Kendix, Carol Kolarik, Michelle Munn, Daniel Novillo, Ellery  Scott, Rebecca Shea, Dawn Shorey, Barbara Timmerman, and Maria  Vargas made key contributions to this report.