Mineral Revenues: Data Management Problems and Reliance on Self-Reported Data for Compliance Efforts Put MMS Royalty Collections at Risk
Published: 2008-03-11T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Companies that develop and produce federal oil and gas resources do so under leases administered by the Department of the Interior (Interior). Interior's Bureau of Land Management (BLM) and Offshore Minerals Management (OMM) are responsible for overseeing oil and gas operations on federal leases. Companies are required to self- report their production volumes and other data to Interior's Minerals Management Service (MMS) and to pay royalties either "in value" (payments made in cash), or "in kind" (payments made in oil or gas). GAO's testimony will focus on whether (1) Interior has adequate assurance that it is receiving full compensation for oil and gas produced from federal lands and waters, (2) MMS's compliance efforts provide a check on industry's self-reported data, (3) MMS has reasonable assurance that it is collecting the right amounts of royalty-in-kind oil and gas, and (4) the benefits of the royalty-in-kind program that MMS has reported are reliable. This testimony is based on ongoing work. When this work is complete, we expect to make recommendations to address these and other findings. To address these issues GAO analyzed MMS data, reviewed MMS, and other agency policies and procedures, and interviewed officials at Interior. In commenting on a draft of this testimony, Interior provided GAO technical comments which were incorporated where appropriate.
section_title: What GAO Found
paragraphs: Interior lacks adequate assurance that it is receiving full compensation for oil and gas produced from federal lands and waters because Interior's Bureau of Land Management (BLM) and Offshore Minerals Management (OMM) are not fully conducting production inspections as required by law and agency policies and because MMS's financial management systems are inadequate and lack key internal controls. Officials at BLM told us that only 8 of the 23 field offices in five key states we sampled completed their required production inspections in fiscal year 2007. Similarly, officials at OMM told us that they completed about half of the required production inspections in calendar year 2007 in the Gulf of Mexico. In addition, MMS's financial management system lacks an automated process for routinely and systematically reconciling production data with royalty payments. MMS's compliance efforts do not consistently examine third-party source documents to verify whether self-reported industry royalty-in-value payment data are complete and accurate, putting full collection of royalties at risk. In 2001, to help meet its annual performance goals, MMS moved from conducting audits, which compare self-reported data against source documents, toward compliance reviews, which provide a more limited check of a company's self-reported data and do not include systematic comparison to source documentation. MMS could not tell us what percentage of its annual performance goal was achieved through audits as opposed to compliance reviews. Because the production verification processes MMS uses for royalty-in-kind gas are not as rigorous as those applied to royalty-in-kind oil, MMS cannot be certain it is collecting the gas royalties it is due. MMS compares companies' self-reported oil production data with pipeline meter data from OMM's oil verification system, which records oil volumes flowing through metering points. While analogous data are available from OMM's gas verification system, MMS has not chosen to use these third-party data to verify the company-reported production numbers. The financial benefits of the royalty-in-kind program are uncertain due to questions and uncertainties surrounding the underlying assumptions and methods MMS used to compare the revenues it collected in kind with what it would have collected in cash. Specifically, questions and uncertainties exist regarding MMS's methods to calculate the net revenues from in-kind oil and gas sales, interest payments, and administrative cost savings.

section_title: Letter
paragraphs: We are pleased to participate in the subcommittee’s hearing to discuss the  Department of the Interior’s (Interior) oversight of the collection of  royalties paid on the production of oil and natural gas (hereafter oil and  gas) from federal lands and waters. In fiscal year 2007, Interior’s Minerals  Management Service (MMS) collected over $9 billion in oil and gas  royalties and disbursed these funds to federal, state, and tribal accounts.  The federal portion of these royalties, which totaled $6.7 billion in fiscal  year 2007, represents one of the country’s largest nontax sources of  revenue. At the same time, oil and gas production on federal lands and  waters represents a critical component of the nation’s energy portfolio,  supplying roughly 35 percent of all the oil and 30 percent of all the gas  produced in the United States in 2006. The Department of Energy’s (DOE)  Energy Information Administration projects that over the next 10 years the  portion of U.S. production from federal lands and waters will increase to  47 percent for oil and 37 percent for gas. In fiscal year 2007, MMS also  transferred $322 million worth of oil to DOE as part of its efforts to fill the  nation’s Strategic Petroleum Reserve (SPR). The SPR currently holds  nearly 700 million barrels of oil—equivalent to about 58 days of net oil  imports—that can be released at the discretion of the President in the  event of an oil supply disruption. Recently, both oil prices and the demand  to drill for oil and gas on federal lands have increased dramatically. For  example, the price of West Texas Intermediate—a commonly used  benchmark crude oil—now exceeds $100 per barrel, a price that, when  adjusted for inflation, is the highest price since 1980. Moreover, Interior’s  Bureau of Land Management (BLM) is projecting substantially increased  numbers of drilling permit applications. It received 8,351 in 2005 and  anticipates receiving 12,500 in 2008.
Companies that develop and produce federal oil and gas resources from  federal lands and waters do so under leases obtained and administered by  Interior—BLM for onshore leases and MMS’s Offshore Minerals  Management (OMM) for offshore leases. Together, BLM and OMM are  responsible for overseeing oil and gas operations on more than 28,000  producing leases to help ensure that oil and gas companies comply with  applicable laws, regulations, and agency policies. Among other things,  BLM and OMM staff inspect producing leases to verify whether oil and gas  are accounted for as required by both the Federal Oil and Gas Royalty  Management Act of 1982 and agency policies. As a condition of producing  oil and gas under federal leases, companies are required to self-report  monthly production volumes to MMS (as part of their monthly production  reports). In some situations, several companies may be jointly involved in  developing oil and gas from a lease or a number of adjacent leases, in  which case the companies designate one of the companies to be the  “operator.” The operator has sole responsibility for submitting production  reports for all oil and gas produced from the leases.
Companies, or lessees, compensate the government for producing federal  oil and gas resources either “in value” (royalty payments made in cash), or  “in kind” (royalty payments made in oil or gas). In fiscal year 2006, 58  percent of the $9.74 billion in oil and gas royalty payments were made in  value, while 42 percent were made in kind. Under the royalty-in-value  program, lessees responsible for paying cash royalties, also called  “payors,” calculate the royalty payment they owe to the federal  government using the key variables illustrated in the following equation:  Royalty payment = (sales volume x sales price - deductions) x royalty  Cash royalty payors are required to submit monthly royalty reports to  MMS specifying the royalty amount they owe the federal government for  the production and sale of oil and gas, and generally make the cash  payment via an electronic fund transfer to an account at the Department of  the Treasury (Treasury). In many instances, because leases are co-owned  by multiple companies, multiple payors submit individual royalty reports  for a single lease. However, in these situations a single company is  designated the “operator” and is responsible for submitting the production  report for that entire lease. As a result, MMS will often receive multiple  royalty reports corresponding to a single production report. Royalty  reports include the sales volume (amount sold), the sales revenue (the  amount of revenue received from the sale), and the royalty payment due to  MMS (royalty value less allowances taken for transportation and  processing the gas into a marketable condition), prorated based on the  share owned by each payor. Some of these data, as well as some of the  deductible transportation costs, are also available from third-party  sources. For example, individual royalty payor data on production and  some transportation costs can be acquired from pipeline statements,  which are essentially receipts from pipeline companies for shipping oil  and gas. In contrast, documentation of sales revenue data, as well as data  supporting allowable deductions, are generally available only from oil and  gas company records. Royalty payors submit their monthly royalty reports  through a Web-based portal. Once MMS reconciles the self-reported  royalty payment data from the monthly royalty reports with the payments  submitted to Treasury, MMS disburses the royalties from the Treasury  account to the appropriate federal, state, and tribal accounts. The  transaction information is recorded in MMS’s financial management  system.
As a check on the accuracy of the self-reported data the payors use when  determining cash royalty payments, among MMS’s internal controls are  audits and compliance reviews. Audits are an assessment of the accuracy  and completeness of the self-reported production and royalty data  compared against source documents, such as sales contracts and oil and  gas sales receipts from pipeline companies. By contrast, compliance  reviews deal with reasonableness—a quicker, more limited check of the  accuracy and completeness of a company’s self-reported data—and they  do not include systematic examination of underlying source  documentation. In addition, some states and tribes that receive a share of  royalties collected by MMS have agreements with MMS authorizing them  to conduct both audits and compliance reviews on federal and Indian  producing leases within their jurisdictions. MMS has an annual  performance goal whereby it evaluates the compliance group’s  performance on the basis of whether the group has conducted compliance  activities—either full audits or compliance reviews—on a predetermined  percentage of royalty payments.
In contrast to royalties in value, when paying royalties in kind, a payor  delivers a volume of oil or gas to MMS as determined by the following  equation:  Royalty volume = total production volume x royalty rate  Once it receives the oil or gas, MMS may either sell it and disburse the  revenues received from the sales, or transfer it to federal agencies for  them to use. For example, MMS can transfer oil to DOE and DOE, in turn,  can trade this oil for other oil of specific quality to fill the SPR. Under the  Energy Policy Act of 2005, MMS is charged with ensuring that the  revenues it receives when it sells oil and gas taken in-kind are at least as  great as the revenues it would have received had it taken the royalties in  value. Furthermore, MMS cannot sell oil and gas it takes in-kind for less  than market value. As required, MMS routinely compares the estimated  benefits of the in-kind program to the estimated benefits MMS would have  received if the royalties had been taken in cash and annually reports these  benefits to the Congress.
MMS estimates that from fiscal years 2004 through 2006 the royalty-in-kind  program generated about $87 million more in net value to the government  than MMS would have collected had it received royalties in cash. Of this  $87 million, MMS estimates that (1) $74 million came from selling royalty- in-kind oil and gas for more than it would have received in cash royalty  payments, (2) $5 million came from interest from receiving revenues from  in-kind sales earlier than cash payments are due, and (3) $8 million came  from savings because the royalty-in-kind program costs less to administer  than the in-value program.
Our testimony today is based on two ongoing efforts. The first focuses on  MMS’s royalty-in-value program and addresses (1) whether Interior has  adequate assurance that it is receiving full compensation for oil and gas  produced from federal lands and waters and (2) the extent to which  MMS’s compliance efforts provide an adequate check on industry’s self- reported data. The second, relating to MMS’s royalty-in-kind program,  addresses (1) the extent to which MMS has reasonable assurance that it is  collecting the right amounts of royalty-in-kind oil and gas and (2) the  reliability of the benefits of the royalty-in-kind program that MMS has  reported.
In addressing these issues, we reviewed documentation on MMS policies  and procedures for collecting royalties; collected and assessed  information on the sales of royalty oil and gas; and reviewed MMS  procedures for preparing the administrative cost comparison between the  royalty-in-value and royalty-in-kind programs. We also interviewed  officials at offices selected from a nonprobability sample of five BLM field  offices and the associated BLM state offices—the offices were selected  based on the numbers of violations, oil and gas volume errors identified,  and geographic location. In addition, we interviewed officials at MMS;  toured oil and gas production facilities in Wyoming, Colorado, and the  Gulf of Mexico; sent questionnaires addressing production and royalty  data issues to the 11 state and 7 tribal members of the State and Tribal  Royalty Audit Committee, of which 9 states and 5 tribes responded. We  assessed the reliability of the royalty-in-kind sales and performance data  by (1) reviewing the systems that MMS has in place to help ensure that the  data were entered and calculated correctly, and (2) comparing the data to  aggregate performance results that MMS reported to the Congress for  fiscal years 2004 through 2006. We determined that the data were  sufficiently reliable for the purposes of this testimony. Our work is  ongoing and we are continuing to assess information related to the  objectives and findings presented in this testimony. We conducted this  work from April 2007 to February 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.
In summary, regarding the royalty-in-value program, our work to date has  revealed the following:  Interior lacks adequate assurance that it is receiving full compensation for  oil and gas produced from federal lands and waters. For example, neither  BLM nor OMM is meeting statutory obligations or agency targets for  conducting inspections of meters and other equipment used to measure oil  and gas production, which raises questions about the accuracy of oil and  gas measurement. Further, MMS’s systems and processes for collecting  and verifying royalty data are inadequate and lack key internal controls.  Specifically, MMS lacks an automated process to routinely and  systematically reconcile all production data filed by payors (those  responsible for paying the royalties) with production data filed by  operators (those responsible for reporting production volumes).
MMS’s compliance efforts do not consistently examine data from third  parties to verify whether self-reported industry payment data are complete  and accurate. Combined with the inadequacy of MMS’s systems and  processes for collecting and verifying royalty data and the lack of key  internal controls, the absence of a consistent check on self-reported data  using third-party data raises further questions about the accuracy of  royalty payments.
Regarding the royalty-in-kind program, our work to date has revealed the  following:    MMS does not consistently check the accuracy of self-reported gas  collection data against available third-party data, putting the accuracy of  gas royalty collections at risk. MMS’s ability to detect gas production  discrepancies is weaker than for oil because, unlike in the case of oil, MMS  does not use third-party gas metering data to verify the operator-reported  production numbers.
The methods and assumptions MMS uses to compare the revenues it  collects in kind with what it would have collected in cash do not account  for all costs and do not sufficiently deal with uncertainties, raising  significant questions about the reported financial benefits of the in-kind  program.
subsections: section_title: Interior’s Oversight Does Not Provide Adequate Assurance That the Government Is Being Fully Compensated for Oil and Gas Production on Federal Lands and Waters
paragraphs: Interior lacks adequate assurance that it is receiving the full royalties it is  owed because (1) neither BLM nor OMM is fully inspecting leases and  meters as required by law and agency policies, and (2) MMS lacks  adequate management systems and sufficient internal controls for  verifying that royalty payment data are accurate and complete. With  regard to inspecting oil and gas production, BLM is charged with  inspecting approximately 20,000 producing onshore leases annually to  ensure that oil and gas volumes are accurately measured. However, BLM’s  state Inspection and Enforcement Coordinators from Colorado, Montana,  New Mexico, Utah, and Wyoming told us that only 8 of the 23 field offices  in the 5 states completed both their (1) required annual inspections of  wells and leases that are high-producing and those that have a history of  violations and (2) inspections every third year on all remaining leases.  According to the BLM state Inspection and Enforcement Coordinators, the  number of completed production inspections varied greatly by field office.  For example, while BLM inspectors were able to complete all of the  production inspections in the Kemmerer, Wyoming, field office, inspectors  in the Glenwood Springs, Colorado, field office were able to complete only  about one-quarter of the required inspections. Officials in 3 of the 5 field  offices in which we held detailed discussions with inspection staff told us  that they had not been able to complete the production inspections  because of competing priorities, including their focus on completing a  growing number of drilling inspections for new oil and gas wells, and high  inspection staff turnover. However, BLM officials from all 5 field offices  told us that when they have conducted production inspections they have  identified a number of violations. For example, BLM staff in 4 of the 5 field  offices identified errors in the amounts of oil and gas production volumes  reported by operators to MMS by comparing production reports with  third-party source documents. Additionally, BLM staff from 1 field office  we visited showed us a bypass built around a gas meter, allowing gas to  flow around the meter without being measured. BLM staff ordered the  company to remove the bypass. Staff from another field office told us of a  case in which individuals illegally tapped into a gas line and routed gas to  private residences. Finally, in one of the field offices we visited, BLM  officials told us of an instance in which a company maintained two sets of  conflicting production data—one used by the company and another  reported to MMS.
Moreover, OMM, which is responsible for inspecting offshore production  facilities that include oil and gas meters, did not inspect all oil and gas  royalty meters, as required by its policy, in 2007. For example, OMM  officials responsible for meter inspections in the Gulf of Mexico told us  that they completed about half of the required 2,700 inspections, but that  they met OMM’s goal for witnessing oil and gas meter calibrations. OMM  officials told us that one reason they were unable to complete all the meter  inspections was their focus on the remaining cleanup work from  hurricanes Katrina and Rita. Meter inspections are an important aspect of  the offshore production verification process because, according to  officials, one of the most common violations identified during inspections  is missing or broken meter seals. Meter seals are meant to prevent  tampering with measurement equipment. When seals are missing or  broken, it is not possible without closer inspection to determine whether  the meter is correctly measuring oil or gas production.
With regard to MMS’s assurance that royalty data are being accurately  reported by companies, MMS’s systems and processes for collecting and  verifying these data lack both capabilities and key internal controls,  including those focused on data accuracy, integrity, and completeness. For  example, MMS lacks an automated process to routinely and systematically  reconcile all production data filed by payors (those responsible for paying  the royalties) with production data filed by operators (those responsible  for reporting production volumes). MMS officials told us that before they  transitioned to the current financial management system in 2001, their  system included an automated process that reconciled the production and  royalty data on all transactions within approximately 6 months of the  initial entry date. However, MMS’s new system does not have that  capability. As a result, such comparisons are not performed on all  properties. Comparisons are made, if at all, 3 years or more after the initial  entry date by the MMS compliance group for those properties selected for  a compliance review or audit.
In addition, MMS lacks a process to routinely and systematically reconcile  all production data included by payors on their royalty reports or by  operators on their production reports with production data available from  third-party sources. OMM does compare a large part of the offshore  operator-reported production data with third-party data from pipeline  operators through both its oil and gas verification programs, but BLM  compares only a relatively small percentage of reported onshore oil and  gas production data with third-party pipeline data. When BLM and OMM  do make comparisons and find discrepancies, they forward the  information to MMS, which then takes steps to reconcile and correct these  discrepancies by talking to operators. However, even when discrepancies  are corrected and the operator-reported data and pipeline data have been  reconciled, these newly reconciled data are not automatically and  systematically compared with the reported sales volume in the royalty  report, previously entered into the financial management database, to  ensure the accuracy of the royalty payment. Such comparisons occur only  if a royalty payor’s property has been selected for an audit or compliance  review.
Furthermore, MMS’s financial management system lacks internal controls  over the integrity and accuracy of production and royalty-in-value data  entered by companies. Companies may legally make changes to both  royalty and production data in MMS’s financial management system for up  to 6 years after the reporting month, and these changes may necessitate  changes in the royalty payment. However, when companies retroactively  change the data they previously entered, these changes do not require  prior approval by, or notification of, MMS. As a result of the companies’  ability to unilaterally make these retroactive changes, the production data  and required royalty payments can change over time, further complicating  efforts by agency officials to reconcile production data and ensure that the  proper amount of royalties was paid. Compounding this data reliability  concern, changes made to the data do not necessarily trigger a review to  determine their reasonableness or whether additional royalties are due.  According to agency officials, these changes are not subject to review at  the time a change is made and would be evaluated only if selected for an  audit or compliance review. This is also problematic because companies  may change production and royalty data after an audit or compliance  review has been done, making it unclear whether these audited royalty  payments remain accurate after they have been reviewed. Further, MMS  officials recently examined data from September 2002 through July 2007  and identified over 81,000 adjustments made to data outside the allowable  6-year time frame. MMS is working to modify the system to automatically  identify adjustments that have been made to data outside of the allowable  6-year time frame, but this effort does not address the need to identify  adjustments made within the allowable time that might necessitate further  adjustments to production data and royalty payments due.
Finally, MMS’s financial management system could not reliably detect  when production data reports were missing until late 2004, and the system  continues to lack the ability to automatically detect missing royalty  reports. In 2004, MMS modified its financial management system to  automatically detect missing production reports. As a result, MMS has  identified a backlog of approximately 300,000 missing production reports  that must be investigated and resolved. It is important that MMS have a  complete set of accurate production reports so that BLM can prioritize  production inspections, and its compliance group can easily reconcile  royalty payments with production information. Importantly, MMS’s  financial management system continues to lack the ability to automatically  detect cases in which an expected royalty report has not been filed. While  not filing a royalty report may be justifiable under certain circumstances,  such as when a company sells its lease, MMS’s inability to detect missing  royalty reports presents the risk that MMS will not identify instances in  which it is owed royalties that are simply not being paid. Officials told us  they are currently able to identify missing royalty reports in instances  when they have no royalty report to match with funds deposited to  Treasury. However, cases in which a company stops filing royalty reports  and stops paying royalties would not be detected unless the payor or lease  was selected for an audit or compliance review.
section_title: MMS’s Compliance Efforts Do Not Consistently Use Third-Party Data to Check Self-Reported Royalty-in-Value Payment Data
paragraphs: MMS’s increasing use of compliance reviews, which are more limited in  scope than audits, has led to an inconsistent use of third-party data to  verify that self-reported royalty data are correct, thereby placing accurate  royalty collections at risk. Since 2001, MMS has increasingly used  compliance reviews to achieve its performance goals of completing  compliance activities—either full audits or compliance reviews—on a  predetermined percentage of royalty payments. According to MMS,  compliance reviews can be conducted much more quickly and require  fewer resources than audits, largely because they represent a quicker,  more limited reasonableness check of the accuracy and completeness of a  company’s self-reported data, and do not include a systematic examination  of underlying source documentation. Audits, on the other hand, are more  time- and resource-intensive, and they include the review of original  source documents, such as sales revenue data, transportation and gas  processing costs, and production volumes, to verify whether company- reported data are accurate and complete. When third-party data are readily  available from OMM, MMS may use them when conducting a compliance  review. For example, MMS may use available third-party data on oil and  gas production volumes collected by OMM in its compliance reviews for  offshore properties. In contrast, because BLM collects only a limited  amount of third-party data for onshore production, and MMS does not  request these data from the companies, MMS does not systematically use  third-party data when conducting onshore compliance reviews. Despite  conducting thousands of compliance reviews since 2001, MMS has only  recently evaluated their effectiveness. For calendar year 2002, MMS  compared the results of 100 of about 700 compliance reviews of offshore  leases and companies with the results of audits conducted on those same  leases or companies. However, while the compliance reviews covered,  among other things, 12 months of production volumes on all products— oil, gas, and retrograde, a liquid product that condenses out of gas under  certain conditions—the audits covered only 1 month and one product. As  a result of this evaluation comparing the results of compliance reviews  with those of audits, MMS now plans to improve its compliance review  process by, for example, ensuring that it includes a step to check that  royalties are paid on all royalty-bearing products, including retrograde.
To achieve its annual performance goals, MMS began using the  compliance reviews along with audits. One of MMS’s performance goals is  to complete compliance activities—either audits or compliance reviews— on a specified percentage of royalty payments within 3 years of the initial  royalty payment. For example, in 2006 MMS reported that it had achieved  this goal by confirming reasonable compliance on 72.5 percent of all  calendar year 2003 royalties. To help meet this goal, MMS continues to rely  heavily on compliance reviews, yet it is unable to state the extent to which  this performance goal is accomplished through audits as opposed to  compliance reviews. As a result, MMS does not have information available  to determine the percentage of the goal that was achieved using third- party data and the percentage that did not systematically rely on third- party data. Moreover, to help meet its performance goal, MMS has  historically conducted compliance reviews or audits on leases and  companies that have generated the most royalties, with the result that the  same leases and companies are reviewed year after year. Accordingly,  many leases and companies have gone for years without ever having been  reviewed or audited.
In 2006, Interior’s Inspector General (IG) reviewed MMS’s compliance  process and made a number of recommendations aimed at strengthening  it. The IG recommended, among other things, that MMS examine 1 month  of third-party source documentation as part of each compliance review to  provide greater assurance that both the production and allowance data are  accurate. The IG also recommended that MMS track the percentage of the  annual performance goal that was accomplished through audits versus  through compliance reviews, and that MMS move toward a risk-based  compliance program and away from reviewing or auditing the same leases  and companies each year. To address the IG’s recommendations, MMS has  recently revised its compliance review guidance to include suggested steps  for reviewing third-party source production data when available for both  offshore and onshore oil and gas, though the guidance falls short of  making these steps a requirement. MMS has also agreed to start tracking  compliance activity data in 2007 that will allow it to report the percentage  of the performance goal that was achieved through audits versus through  compliance reviews. Finally, MMS has initiated a risk-based compliance  pilot project, whereby leases and companies are selected for compliance  work according to MMS-defined risk criteria that include factors other  than whether the leases or companies generate high royalty payments.  According to MMS, during fiscal year 2008 it will further evaluate and  refine the pilot as it moves toward fuller implementation.
Finally, representatives from the states and tribes who are responsible for  conducting compliance work under agreements with MMS have expressed  concerns about the quality of self-reported production and royalty data  they use in their reviews. As part our work, we sent questionnaires to all  11 states and seven tribes that conducted compliance work for MMS in  fiscal year 2007. Of the nine state and five tribal representatives who  responded, seven reported that they lack confidence in the accuracy of the  royalty data. For example, several representatives reported that because  of concerns with MMS’s production and royalty data, they routinely look  to other sources of corroborating data, such as production data from state  oil and gas agencies and tax agencies. Finally, several respondents noted  that companies frequently report production volumes to the wrong leases  and that they must then devote their limited resources to correcting these  reporting problems before beginning their compliance reviews and audits.
section_title: The MMS Royalty-in- Kind Program Is at Risk of Inaccurate Collection of Natural Gas Royalties because of Inconsistent Oversight
paragraphs: Because MMS’s royalty-in-kind program does not extend the same  production verification processes used by its oil program to its gas  program, it does not have adequate assurance that it is collecting the gas  royalties it is owed. As noted, under the royalty-in-kind program, MMS  collects royalties in the form of oil and gas and then sells these  commodities in competitive sales. To ensure that the government obtains  the fair value of these sales, MMS must make sure that it receives the  volumes to which it is entitled. Because prices of these commodities  fluctuate over time, it is also important that MMS receive the oil and gas at  the time it is entitled to them. As part of its royalty-in-kind oversight effort,  MMS identifies imbalances between the volume operators owe the federal  government in royalties and the volume delivered and resolves these  imbalances by adjusting future delivery requirements or cash payments.  The methods that MMS uses to identify these imbalances differ for oil and  gas.
For oil, MMS obtains pipeline meter data from OMM’s liquid verification  system, which records oil volumes flowing through numerous metering  points in the Gulf of Mexico region. MMS calculates its royalty share of oil  by multiplying the total production volumes provided in these pipeline  statements by the royalty rates for a given lease. MMS compares this  calculation with the volume of royalty oil that the operators delivered as  reported by pipeline operators. When the value of an imbalance  cumulatively reaches $100,000, MMS conducts further research to resolve  the discrepancy. Using pipeline statements to verify production volumes is  a good check against companies’ self-reporting of royalties due the federal  government because companies have an incentive to not underreport their  share of oil going into the pipeline because that is the amount they will  have to sell at the other end of the pipeline.
For gas, MMS relies on information contained in two operator-provided  documents—monthly imbalance statements and production reports.  Imbalance statements include the operator’s total gas production for the  month, the share of that production that the government is entitled to, and  any differences between what the operator delivered and the government’s  royalty share. Production reports contain a large number of data elements,  including production volumes for each gas well. MMS compares the  production volumes contained in the imbalance statements with those in  the production reports to verify production levels. MMS then calculates its  royalty share based on these production figures and compares its royalty  share with gas volumes the operators delivered as reported by pipeline  operators. When the value of an imbalance cumulatively reaches $100,000,  MMS conducts further research to resolve the discrepancy.
MMS’s ability to detect gas imbalances is weaker than for oil because it  does not use third-party metering data to verify the operator-reported  production numbers. Since 2004, OMM has collected data from gas  pipeline companies through its gas verification system, which is similar to  its liquid verification system in that the system records information from  pipeline company-provided source documents. Our review of data from  this program shows that these data could be a useful tool in verifying  offshore gas production volumes. Specifically, our analysis of these  pipeline data showed that for the months of January 2004, May 2005, July  2005, and June 2006, 25 percent of the pipeline metering points had an  outstanding discrepancy between self-reported and pipeline data. These  discrepancies are both positive and negative—that is, production volumes  submitted to MMS by operators are at times either under- or overreported.
Data from the gas verification system could be useful in validating  production volumes and reducing discrepancies. However, to fully benefit  from this opportunity, MMS needs to improve the timeliness and reliability  of these data. After examining this issue, in December 2007, the  Subcommittee on Royalty Management, a panel appointed by the  Secretary of the Interior to examine MMS’s royalty program, reported that  OMM is not adequately staffed to conduct sufficient review of data from  the gas verification system. We have not yet, nor has MMS, determined  the net impact of these discrepancies on royalties owed the federal  government.
section_title: Significant Questions and Uncertainties Exist Regarding the Reported Financial Benefits of the Royalty-in-Kind Program
paragraphs: The methods and underlying assumptions MMS uses to compare the  revenues it collects in kind with what it would have collected in cash do  not account for all costs and do not sufficiently deal with uncertainties,  raising doubts about the claimed financial benefits of the royalty-in-kind  program. Specifically, MMS’s calculation showing that MMS sold the  royalty oil and gas for $74 million more than MMS would have received in  cash payments did not appropriately account for uncertainty in estimates  of cash payments. In addition, MMS’s calculation that early royalty-in-kind  payments yielded $5 million in interest was based on assumptions about  payment dates and interest rates that could misstate the estimated interest  benefit. Finally, MMS’s calculation that the royalty-in-kind program cost  about $8 million less to administer than an in-value program did not  include significant costs that, if included, could change MMS’s  conclusions.
subsections: section_title: Sales Revenue
paragraphs: MMS sold the oil and gas it collected during the 3 fiscal years 2004 through  2006 for $8.15 billion and calculated that this amount exceeded what MMS  would have received in cash royalties by about $74 million—a net benefit  of approximately 0.9 percent. MMS has recognized that its estimates of  what it would have received in cash payments are subject to some degree  of error but has not appropriately evaluated or reported how sensitive the  net benefit calculations are to this error. This is important because even a  1 percent error in the estimates of cash payments would change the  estimated benefit of the royalty-in-kind program from $74 million to  anywhere from a loss of $6 million to a benefit of $155 million.
Moreover, MMS’s annual reports to the Congress present oil sales data in  aggregate and therefore do not reflect the fact that, in many individual  sales, MMS sold the oil it collected in kind for less than it estimates it  would have collected in cash. Specifically, MMS estimates that, in fiscal  year 2006, it sold 28 million barrels of oil, or 64 percent of all the oil it  collected in kind, for less than it would have collected in cash. The  government would have received an additional $6 million in revenue if it  had taken these royalties in cash instead. These sales indicate that MMS  has not always been able to achieve one of its central goals: to select,  based on systematic economic analysis, which royalties to take in cash  and which to take in kind in a way that maximizes revenues to the  government.
According to a senior MMS official, the federal government has several  advantages when selling gas that it does not have when selling oil, a fact  that helps to explain why MMS’s gas sales have performed better than its  oil sales. For example, MMS can bundle the natural gas production in the  Gulf of Mexico from many different leases into large volumes that MMS  can use to negotiate discounts for transporting gas from production sites  to market centers. Because purchasers receive these discounts when they  buy gas from MMS, they may be willing to pay more for gas from MMS  than from the original owners. Opportunities for bundling are less  prevalent in the oil market. Because MMS generally does not have this, or  other, advantages when selling oil, purchasers often pay MMS about what  they would pay other producers for oil, and sometimes less. Indeed, MMS’s  policies allow it to sell oil for up to 7.7 cents less per barrel than MMS  estimates it would collect if it took the royalties in cash. MMS told us that  the other financial benefits of the royalty-in-kind program, including  interest payments and reduced administrative costs, justify selling oil for  less than the estimated cash payments because once these additional  revenues are factored in, the net benefit to the government is still positive.  However, as discussed below, we have found that there are significant  questions and uncertainties about the other financial benefits as well.
section_title: Interest
paragraphs: Revenues from the sale of royalty-in-kind oil are due 10 days earlier than  cash payments, and revenues from the sale of in-kind gas are due 5 days  earlier. MMS calculates that the government earned about $5 million in  interest from fiscal years 2004 through 2006 from these early payments  that it would not have received had it taken royalties in cash. We found  two weaknesses in the way MMS calculates this interest. First, the  payment dates used to calculate the interest revenue have the potential to  over- or underestimate its value. MMS calculates the interest on the basis  of the time between the actual date that Treasury received a royalty-in- kind payment and the theoretical latest date that Treasury would have  received a cash payment under the royalty-in-value program. However,  MMS officials told us that cash payments can, and sometimes do, arrive  before their due date. As a result, MMS might be overstating the value of  the early royalty-in-kind payments. Second, the interest rate used to  calculate the interest revenue may either over- or understate its value  because the rate is not linked to any market rate. From fiscal year 2004  through 2007, MMS used a 3 percent interest rate to calculate the time  value of these early payments. However, during this time, actual market  interest rates at which the federal government borrowed fluctuated. For  example, 4-week Treasury bill rates ranged from a low of 0.72 percent to a  high of 5.18 percent during this same period. Therefore, during some fiscal  years, MMS likely overstated or understated the value of these early  payments.
section_title: Administrative Cost Savings
paragraphs: MMS has developed procedures to capture the administrative costs of the  royalty-in-kind and cash royalty programs and includes in its  administrative cost comparison primarily the variable costs for the federal  offshore oil and gas activities—that is, costs that fluctuate based on the  volume of oil or gas received by MMS, such as labor costs. Although MMS  also includes some department-level fixed costs, it excludes some fixed  costs that it does not incur on a predictable basis (largely information  technology  costs). According to MMS, if it included these IT and other  such costs, there would be a high potential of skewing the unit price used  to determine the administrative cost savings. However, by excluding such  fixed costs from the administrative cost comparison, MMS is not including  all the necessary cost information to evaluate the efficacy of the royalty-in- kind program.
MMS’s administrative cost analysis compares a bundle of royalty-in-kind  program administrative costs divided by the number of barrels of oil  equivalent realized by the royalty-in-kind program during a year, with a  bundle of cash royalty program administrative costs divided by the  number of barrels of oil equivalent realized by that program. The  difference between these amounts represents the difference in cost to  administer a barrel of oil equivalent under each program.
MMS then multiplies the difference in cost to administer a barrel of oil  equivalent under the two programs by the number of barrels of oil  equivalent realized by the royalty-in-kind program to determine the  administrative cost savings. However, MMS’s calculations excluded some  fixed costs that are not incurred on a regular or predictable basis from the  analysis. For example, in fiscal year 2006, royalty-in-kind IT costs of $3.4  million were excluded from the comparison. Moreover, additional IT costs  of approximately $29.4 million—some of which may have been incurred  for either the royalty-in-kind or the cash royalty program—were also  excluded. Including and assigning these IT costs to the programs  supported by those costs would provide a more complete accounting of  the respective costs of the royalty-in-kind and royalty-in-value programs,  and would likely impact the results of MMS’s administrative cost analysis.
section_title: Conclusions
paragraphs: Ultimately the system used by Interior to ensure taxpayers receive  appropriate value for oil and gas produced from federal lands and waters  is more of an honor system than we are comfortable with. Despite the  heavy scrutiny that Interior has faced in its oversight of royalty  management, we and others continue to identify persistent weaknesses in  royalty collections. Given both the long-term fiscal challenges the  government faces and the increased demand for the nation’s oil and gas  resources, it is imperative that we have a royalty collection system going  forward that can assure the American public that the government is  receiving proper royalty payments. Our work on this issue is continuing  along several avenues, including comparing the royalties taken in kind  with the value of royalties taken in cash, assessing the rate of oil and gas  development on federal lands, comparing the amount of money the U.S.  government receives with what foreign countries receive for allowing  companies to develop and produce oil and gas, and examining further the  accuracy of MMS’s production and royalty data. We plan to make  recommendations to address the weaknesses we identified in our final  reports on these issues.
We look forward to further work and to helping this subcommittee and the  Congress as a whole to exercise oversight on this important issue. Mr.  Chairman, this concludes our prepared statement. We would be pleased to  respond to any questions that you or other members of the subcommittee  may have at this time.
section_title: GAO Contact and Staff Acknowledgments
paragraphs: For further information about this testimony, please contact either Frank  Rusco, at 202-512-3841, or ruscof@gao.gov, or Jeanette Franzel, at 202-512- 9406, or franzelj@gao.gov. Contact points for our Congressional Relations  and Public Affairs may be found on the last page of this statement.  Contributors to this testimony include Ron Belak, Ben Bolitzer, Lisa  Brownson, Melinda Cordero, Nancy Crothers, Glenn C. Fischer, Cindy  Gilbert, Tom Hackney, Chase Huntley, Heather Hill, Barbara Kelly, Sandra  Kerr, Paul Kinney, Jennifer Leone, Jon Ludwigson, Tim Minelli, Michelle  Munn, G. Greg Peterson, Barbara Timmerman, and Mary Welch.
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