Royalty-In-Kind Program: MMS Does Not Provide Reasonable Assurance It Receives Its Share of Gas, Resulting in Millions in Forgone Revenue
Released: 2009-09-14T00:00:00

Letter

Background

The North American Energy Standards Board serves as an industry forum for the development and promotion of standards that will lead to a seamless marketplace for wholesale and retail natural gas and electricity, as recognized by its customers, business community, participants, and regulatory entities. is a way to simplify royalty administration. In addition, MMS concluded that it would not need to audit RIK sales because the agency would sell th gas rather than relying on producers to accurately report their ow prices, as is done in the royalty-in-value program. The collecting, reporting, and auditing of cash royalty payments have been challenging for MMS because of concerns about the accuracy and reliability of productionand pricing data submitted by royalty payors and because there are about 29,000 leases producing oil and gas, many with several companies paying monthly royalties. MMS began a series of pilot sales of royalty oil and gas in 1998 and, based on the results, dramatically expanded its RIK progr am until 2007. In 2008 and 2009, the volumes taken in kind have, and are projected to, decrease as MMS decreases the number of properties tak in kind, in part because it identified and removed prop lower revenues than a fair market value benchmark.

MMS is charged with ensuring that RIK oil and gas are not sold for less than market value and that revenues it receives are at least as great as the revenues it would have received had it taken the royalties in cash. T this requirement, MMS compares the estimated benefits of the RIK program with the estimated benefits it would have received if the ro had been taken in cash and reports this to Congress annually. MMS estimated that from fiscal years 2004 through 2007, the RIK program generated about $150 million more in net value to the government than MMS would have collected had it received royalties in cash. Of this $150 million, MMS estimated that (1) $131 million came from selling RIK oil and 2) gas for more than MMS would have received in cash royalty payments, ( $8 million came from interest that accrued because revenues from RIK sales were received earlier than cash payments would have been rece through the in-value program, and (3) $11 million came from savings accrued because the RIK p royalty-in-value program. rogram costs less to administer than the Through the RIK gas program, companies that produce gas on federal leases owe MMS a royalty, or a percentage, of the daily gas production. To ensure that the government obtains the fair value of RIK sales, MMS must ensure that it receives the percentage of total production volumes to which it is entitled. The volume of gas a company owes to MMS is determined by the following equation: royalty volume = total production volume x royalty percentage The royalty percentage for leases taken in kind varies somewhat b currently in the range of 12.5 percent to 16.67 percent. Measuring ut is production and allocating a percentage of that production is relatively straightforward when one company measures its own output from a federal lease and reports its own production to MMS. However, multip production companies sometimes combine the gas flowing from theirleases at a measurement point in order to share the risks, costs, and benefits of gas production. These companies often elect from among themselves a single company—called the operator—to allocate the gas flowing from each of the companies. Due to the complex nature of the natural gas market, operators cannot always allocate each producti on company or royalty owner its entitled amount of gas, resulting in a situation known as an “imbalance.” Imbalances—both positive and negative—are a common occurrence for MMS and all companies in the industry because, among other reasons, companies must estimate the volume of gas they will produce; in turn operators allocate gas based those estimates rather than actual production. The operator is also responsible for monitoring and reporting gas imbalances––the differen between the volume of gas owed to lease and royalty owners and the volume actually allocated. Currently, there are points and 550 leases in the RIK gas program.

MMS May Be Losing Revenue Because It Does Not Accurately and Promptly Identi and Collect on R IK Gas Imbalances

MMS risks losing millions of dollars in revenue because it does not accurately and promptly identify and collect on RIK gas imbalances. Specifically, MMS (1) estimates it is owed a net of $21 million for gas imbalances, but it lacks the necessary information to determine the exact amounts; (2) does not audit RIK gas operators’ production and allocatio n data, and thus cannot verify that it receives the correct volumes of RIK gas; (3) lacks adequate policies and procedures to reconcile and resolv imbalances; (4) does not have an information system that can provide accurate and timely data for reconciling and resolving imbalances; and (5) has insuffici ent staff and training to administer the program efficiently and effectively.

MMS Lacks Information Necessary to Quantify Revenues Due from Imbalances

We are not reporting the amount of MMS’s extraordinary threshold because the agency believes this will compromise its efforts to collect additional revenues associated with imbalances in a timely manner. Further, MMS determines when imbalances have reached this threshold by applying a fixed rate of $5 per million British thermal units to volume imbalances. MMS officials said they will re-evaluate the fixed rate and the “extraordinary” level in the future. indicate it has completely reconciled almost 99 percent of the imbalances for production occurring in fiscal year 2007, almost 98 percent for fiscal year 2008, and about 94 percent for fiscal year 2009.

However, MMS does not know the exact amount it is owed for imbalances because it lacks at least three types of information. First, it does not verify all gas production data to ensure it receives its entitled percentage of RIK ciled gas from all leases taken in kind. Prior to February 2009, MMS recon gas imbalances through data from two operator-generated reports, imbalance statements and monthly production reports, and online third- party data from pipeline companies on the amount delivered to purchase of RIK gas. This verified whether MMS received the volumes of ga the operator reported, and whether that volume was the correct percentage of reported production according to operator-generated d However, it did not verify through third-party data that the operator correctly reported the total production at each lease in the first place. Therefore, MMS could not use this method to verify that the gas alloca by operators was equal to MMS’s entitled percentage of gas volum Recognizing this, in 2008, we recommended that MMS bolster its verification process for gas volumes owed to the government by using third-party production information, such as the data collected in the Offshore Energy and Minerals Management division’s gas verification system, in addition to the third-party delivery information it had already been using. MMS’s gas imbalance analysts began using the third-party data contained in the gas verification system in February 2009, but because these data only include total production at the measurement po rather than for each lease, analysts cannot use the system to verify that it was allocated the entitled percentage from each lease taken in kind. ata. es.

Second, MMS lacks information on how to price gas imbalances and the point at which the agency should begin applying interest to the imbalanc for leases that have terminated from the program or those leases whe re production has ceased. Since the RIK program first began, MMS has updated its guidance letter to operators. Although MMS’s most recent guidance letter states that MMS will charge monthly interest on imbalances, past guidance letters state that interest will only be charged if the operator pays its imbalance later than 60 days after the final month the imbalance occurred. Interior is required by law to charge interest on late payments and underpayments of royalties. Further, while MMS’s c guidance letter to operators specifies that it will price imbalances according to its own contract price for the gas during the month the imbalance occurred, the previous guidance letters did not contain this language. MMS is not actively trying to collect on the imbalances of those leases that have been terminated from the program or those leases wh ere production has ceased because there have been discussions with the Office of the Solicitor for more than a year about these issues. In a January 2008 memo, MMS asked the Office of the Solicitor for an opinion on when to charge interest and whether its current methodology to price imbalances is consistent with law. In its memo, MMS proposed the following two pricing methods, in addition to its current method: 1. Calculating the price of the imbalances based on the value applicable editing to the month before settling the imbalance in cash and after cr any over-allocations existing since the first imbalance month. the price using the value when the last imbalance occurred.

Recently, the Office of the Solicitor asked RIK program officials to ch the most appropriate pricing and interest methods before issuing an opinion on those methods. However, those methods have not yet been presented to the Solicitor, and MMS is currently not making additional requests for payment of imbalances for leases that have term the program or those leases where production has ceased.

Finally, MMS could be forgoing revenue because it lacks information daily gas imbalances. Section 115 of the Federal Oil and Gas Royalty Management Act, as amended, provides that a lessee’s obligation does not become “due” until the end of the month following the month in which th e gas is produced. In its guidance letter to operators, MMS requests t deliveries be made on a daily basis equal to the royalty percentage. Because the statute authorizes MMS to enforce operator obligations only on a monthly basis, MMS believes it appropriate to calculate and monito r imbalances owed solely on a monthly rather than daily basis. However, this leaves open the possibility that some companies that owe RIK gas could provide less gas to MMS on days when gas prices are relatively high, hat and make up the difference by providing more gas on days when prices are relatively low. Because purchasers of RIK gas bid on two components of the amount of gas produced daily—a minimum volume set at a monthly price and an additional volume, if available, at a fluctuating daily or “spot price—MMS would lose revenue because it would miss the opportunity sell gas on days when spot prices are higher. Because MMS reconciles imbalances on a monthly––rather than daily––basis, such an occurrence could go undetected. MMS guarantees the purchaser of RIK gas the full minimum volume on a daily basis, except in the case of equipment failure or natural disaster. In contrast, industry officials we spoke with said that they monitor imbalances daily to ensure their companies do not lose revenue from daily imbalances.

To investigate the extent to which MMS has been allocated its royalty percentage of RIK gas on a daily basis, we analyzed daily volumes of to production and allocation to MMS at a sample of measurement points. Because measurement points combine the gas from numerous leases may have differing royalty percentages, it is not possible to determine whether MMS received its royalty percentage on a daily basis using data. We therefore restricted our analysis to a random sample of the measurement points that had leases with a common royalty percenta These points account for about 85 percent of those in the RIK gas program. On most days––74 percent of those we examined––the alloca was within 25 percent of MMS’s royalty percentage. However, on 18 percent of the days, the allocation was more than 25 percent less than ntage and on 8 percent of days the allocation was MMS’s royalty perce more than 25 percent greater than MMS’s royalty percentage. On average, MMS received 15.9 percent of total production when its royalty percentag was 16.67 percent. ge.

In addition, we collected daily data on the differential between the base and spot price for our sample of measurement points and identified a small correlation between higher prices and a lower percentage allocated to MMS. We estimated that the correlation we found would result in a loss of about $1,400 for each measurement point during a 6-month time period. Further, the common royalty percentage in the leases at the measurement points we examined—which accounts for about 85 percent of measurement points in the RIK gas program—makes it easier to detect this practice. At measurement points with a mix of different royalty percentages—about 15 percent of measurement points in the RIK gas program—there are no data available to MMS to detect this, which could encourage such behavior and result in higher revenue losses for these measurement points. See appendix II for our complete analysis.

Daily imbalances may also be costing MMS because it does not track transactions called “keepwhole payments.” MMS must make such payments if RIK gas purchasers do not receive their minimum daily volume of gas. This is because purchasers typically enter into advance contracts to resell RIK gas, and if they do not receive their expected volumes they must buy that volume elsewhere in order to fulfill these e triggering keepwhole payments, contracts. Daily gas imbalances may b but MMS does not know the extent to which this occurs because it does n ot adequately track these payments.

MMS Does Not Audit Operators’ Records to Verify RIK Gas Production

MMS also may be forgoing revenue because it does not audit operator d to ensure it has received its entitled royalty percentage. MMS has procedures for reconciling imbalances and uses third-party production data to verify some of the data it receives from operators. However, it has not assessed the risk of forgoing audits at those measurement points where it does not have complete data with which to verify that it has bee allocated its entitled percentage of gas. Although the RIK guidance lett er to operators states MMS’s right to audit operator information related to RIK gas produced and delivered, MMS has not done so because it has considered its verification of operator-generated data to be sufficient . MMS has also claimed that it has saved money as a result of not auditing and that this is a benefit of the RIK program. However, other royalty owners and members of the oil and gas industry regularly audit operator reported data. According to an industry representative, this entails traveling to an operator’s place of business to scrutinize gas production documentation. According to an official from the Texas General Land Office—the agency responsible for administering Texas’s RIK program— state audits often find that the office has not received the gas volu entitled to. Furthermore, the Council of Petroleum Accountants Societies (COPAS), a professional organization of oil and gas accountants, recommends that any royalty or working interest owner initiate an audit an operator’s response is unsatisfactory or if a discrepancy is considered significant. Industry representatives told us that oil and gas companies regularly audit to ensure that they have received the gas they are entitled to. Representatives from one company noted tha approach, auditing operators who allocate large volumes of gas because there is the greatest risk of error in these cases. t they use a risk-based Additionally, there are cases when available third-party production data not give MMS adequate information to determine whether it has rece its royalty percentage. For example, when RIK leases combined at one measurement point have different royalty percentages, MMS cannot ived determine from the available gas verification system data whether it has received its entitled royalty percentage. Figure 1 illustrates this using two hypothetical measurement points. Measurement point one has three leases flowing into it, all with a royalty percentage of 16.67 percent. Regardle whether each lease has different production volumes, MMS can calcula that it is owed 16.67 percent of the total production of 10,000 million ercent of the total production of 10,000 million British thermal units (MMBtu). However, measurement point two has te British thermal units (MMBtu). However, measurement point two has three leases flowing into it, with two leases owing a royalty percentage of three leases flowing into it, with two leases owing a royalty percentage of 16.67 percent and one lease owing a royalty percentage of 12.5 perc 16.67 percent and one lease owing a royalty percentage of 12.5 perc Because each lease will have a different volume of production and third-ent. Because each lease will have a different volume of production and third-ent. party data from the gas verification system only includes the total party data from the gas verification system only includes the total production volume at the measurement point, MM production volume at the measurement point, MMS is unable to verify it was allocated its entitled percentage of RIK gas without examining the S is unable to verify it was allocated its entitled percentage of RIK gas without examining the operator’s production records at the lea operator’s production records at the lease level. se level. se level.

MMS Lacks Adequate Policies and Reconcile and Resolve Imbalances

MMS does not have adequate policies and procedures to ensure it reconciles and resolves RIK gas imbalances efficiently. This shortcoming is apparent in three main areas.

First, MMS policies do not adequately ensure that operators allocate MMS’s percentage of RIK gas. MMS’s guidance letter to operators requests that operators allocate to MMS the royalty percentage of gas on a daily basis, but MMS believes it does not have the authority to enforce this guidance. Further, RIK officials said MMS does not know what method operators use to allocate gas. Indeed, our analysis shows that, contrary to its guidance letter to operators, on many days MMS is not receiving its percentage of RIK gas. This could be happening because the operator’s allocation method ranks other leaseholders before MMS when allocatin g gas and total production is less than expected. In this instance, MMS cou ld receive less than its royalty percentage of gas or no gas at all. According to COPAS, when the output of gas from multiple leases is combined and measured at a single measurement point, it is imperative that all parties agree on the method the operator will use to allocate the gas. We lea from industry representatives that gas companies rely extensively on such agreements to ensure they receive the gas volumes they are owed and to minimize the negative impact of imbalances on company revenues.

Second, MMS does not have adequate policies and procedures to compe operators to report imbalances promptly and in a standard format. Although the RIK gas guidance letter to operators requests that the operator provide an imbalance statement to MMS within 60 days of the month of production, the guidance is not enforceable and MMS cannot impose a penalty for failing to submit imbalance statements within time period. To allow MMS to take enforcement actions, regulations are required. These regulations must (1) go through the public notice and comment process, and thus be transparent to the public, oversight agencies, and Congress; and (2) carry the full force of the law and hold agency implementing the program and program participants accou to the terms specified in the regulations. RIK officials said MMS has operated the RIK program without regulations because of the onerous nature of establishing regulations and because industry had been cooperative. More recently, RIK officials told us they have recognized that it is necessary to implement regulations for the RIK gas program in order for the agency to receive imbalance statements in a timely manner, among other reasons, and have begun drafting these regulations. In contrast, the provincial government of Alberta, Canada, has regulations in place that state a company can be fined a portion of its royalty payment if it submit required production data on time. Similarly, COPAS guidelin the oil and gas industry provide that operators should submit imbalance statements to appropriate parties within 45 days of the month of production, unless other timing requirements have been agreed to. Following this guideline, gas companies we spoke with said they have es for policies in place to compel timely reporting. For example, one industry agreement we obtained states that if an operator fails to submit imbalance statements for four consecutive months, the operator could be subject to auditing.

Our review of MMS’s spreadsheet for tracking imbalance statements shows that, from January 2007 through June 2008, at least 35 percent o expected imbalance statements were received late and about 10 p remain missing. As a result, MMS analysts spend a great deal of time repeatedly calling companies to inquire about missing imbalance statements. RIK officials agreed that this was not an efficient use of resources.

MMS also does not have a policy to require operators to submit imbalanc statements in a standardized or electronic format. Operators submit imbalance statements by e-mail, but the statements commonly arrive in different file formats—even from a single operator. Additionally, some operators report gas volumes in MMBtu, the measurement unit used by MMS, while others use different units of measure, such as thousand feet. In these cases, MMS analysts must manually convert reported g volumes to a uniform measurement unit—increasing the chance of calculation errors—and must spend additional time combining the information from different reports into one format, rather than focusing on balance reconciling imbalances. MMS could require operators to submit im e statements in an MMS-approved standard format. In contrast to MMS, th government of Alberta requires companies to report gas volumes electronically in a standardized format and measurement unit, and these reports must pass data checks. Alberta officials have stated that standardized reporting has improved the efficiency of its RIK operations.

The third area in which MMS does not have adequate policies and procedures is in collecting payment for an imbalance from a compan when a cash-out settlement between MMS and the company has not reached. When there is an extraordinary imbalance, MMS sends the y been operator an initial cash-out memo explaining the amount that MMS believes the company owes. The operator can either pay for the imbalance or dispute it by submitting evidence that the imbalance value is incorrect. To pay for the imbalance, the operator submits to MMS a royalty pa yment form, which indicates the company’s agreement with MMS’s calculation of the imbalance and classifies the imbalance as an open receivable, triggering the debt collection process with the Department of the Treasu (Treasury). The royalty payment form is the only means of triggering collection, but the operator would not submit this form if it disputes an imbalance. With no other bill or invoice to begin the debt collection process for disputed imbalances, MMS’s practice has been to allow the exchange of supporting evidence with the operator regarding the size and value of the imbalance to continue indefinitely. In one instance, MMS se nt an operator a cash-out memo in December 2006 for an imbalance valued at nearly $900,000 and, as of February 2009, was still negotiating with the operator. In such cases, because MMS has not sent a demand letter to a RIK company for payment, it has not referred a company to Treasury. officials stated that the agency has avoided debt collection for imbalances because it is an onerous process and because it is waiting for the Office ofthe Solicitor to issue an opinion on the pricing and interest associated imbalances for leases that hav such debts are not collected within 7 years, the statute of limitations renders them uncollectible. e reached the end of their contract term. If In contrast, MMS has debt collection policies and procedures in place to collect debt from companies that have purchased and received RIK gas from MMS but have not submitted payment for their purchase. Accordingto MMS policy, a company purchasing RIK gas receives an invoice, whic h triggers the debt collection process. If the company does not pay within time frame, MMS issues a demand letter for payment. If the the agreed amount due MMS is still unpaid after 180 days, the issue is referred to Treasury.

n System MMS’s Informatio Does Not Provide Accurate and Timely Data

MMS’s information system does not provide accurate and timely data on RIK gas imbalances, which reduces the agency’s ability to collect on thes imbalances. In 2003, MMS acquired a commercial, off-the-shelf software product and a custom-built database for the RIK program. The purpose e was to integrate all of the program’s information needs in a singl where it could monitor and track gross gas production, imbalance statement data, gas deliveries, and monthly and cumulative gas imbalances. However, the information system is not capable of provid accurate and timely information on RIK gas imbalances. For instance, MMS’s RIK Deputy Program Manager told us that the system cannot provide accurate information on the number and amount of keepwhole payments MMS has made and cannot calculate RIK cash-out imbalances. Therefore, as of June 2009, MMS was entering data manually into a spreadsheet and performing calculations based on the manually entered data. MMS officials further told us that gas imbalance information cannot analyze data from the operator-submitted imbalance statements, operator-submitted monthly production reports, and MMS’s gas verification system to calculate gas imbalances. As a consequence, more than half of MMS’s gas imbalance work, according to the RIK gas imbalance manager, is currently done manually. For example, two employees spend a portion of their time logging information from operator-submitted imbalance statements onto spreadsheets after which gas imbalance analysts manually upload imbalance statement data into MMS’s information system. An RIK manager said the manual processing of RIK gas imbalance data has put a considerable burden on the RIK gas imbalance staff.

According to GAO’s Standards for Internal Control in the Federal Government, transactions from initiation to completion should be promptly recorded to maintain their relevance and value to management in controlling operations and making decisions. Similarly, according to Interior’s Internal Controls Handbook, accurate and timely information is essential for assuring the safeguarding of assets from waste, loss, unauthorized use, or misappropriation, as well as to assure compliance with laws and regulations. In its December 2007 report on mineral revenue collection, MMS’s Royalty Policy Committee recommended the electronic submission of all offshore production records to improve MMS’s compliance and enforcement activities. According to RIK officials, the committee’s recommendation was not specifically directed at, and therefore did not pertain to, the RIK program. Yet RIK program managers also told us that they recognized as early as August 2007 that the system needed improvements. According to the RIK gas imbalance manager, when MMS alerted the software manufacturer to these problems, there was a disagreement as to whether the manufacturer or the support services contractor were responsible. In July 2008, MMS contracted with the software manufacturer for support services, but this system is still n meeting MMS’s needs.

At the time of our review, MMS had planned to enhance the system but was also exploring the possibility of acquiring a new information management system. According to RIK officials, one candidate system was the Petroleum Registry of Alberta (PRA), which the government of Alberta uses to manage its RIK program. PRA differs from MMS’s current system y, in several aspects. PRA was jointly developed by government and industr with the government providing about 73 percent of the $35 million bud , According to Alberta officials and the provincial government Web site th PRA improves compatibility by serving as the system of record for bo government and industry. In addition, companies participating in the Alberta RIK program are responsible for promptly entering accurate production data electronically. If a company does not enter accurate production data into PRA on time, one MMS RIK official told us, PRA w alert Alberta officials regarding the issue and the company can be fined. This official added that an automated system such as the PRA wou to be customized to fit MMS’s needs at some unknown cost, but that it could save RIK gas imbalance analysts’ hours of time currently spen t e- mailing and calling companies to submit their operator imbalance statements. According to MMS officials, they have decided not to PRA in part because customization could cause issues with future upgrades and fixes, regulation would be required for MMS to require online and standardized reporting, and the system would require significant buy-in from ind although they believe that a better information system would immensely improve RIK gas imbalance work, MMS does not have a timeline to acquire a more effective system. get.

Insufficient Staff and Training Remains a Long- Standing Issue

The RIK gas imbalance office, according to various MMS reports, has b een operating without sufficient staff and training to efficiently and effectively carry out its assigned duties. As a result, certain tasks—such as gas balancing work—have not received sufficient attention, leading to the development of a backlog of RIK gas imbalances. Effective managem an organization’s human capital—its employees, as well as their skills training—is essential to achieving results and an important p art of a program’s internal controls. Human capital has been a long-standing problem for the RIK gas program. Specifically, each of the following reports found that RIK human capital needed improvement.

A January 2001 MMS report indicated that the RIK organization would need to evolve to fully support the RIK operational activity. The report also stated that the future RIK activity would require MMS staff training in handling imbalances, as well as several other areas. 2003 report prepared by an MMS contractor noted that, in order to support a permanent RIK program of significant scale, specific personnel requirements should be identified and filled for all RIK personnel.

A May 2004 MMS report noted that enhancements to human resource capabilities would be necessary in order to meet the objectives of MMS’s RIK business plan. Therefore, the report indicated that specific skill sets and expertise should be acquired or developed in-house by March 2006.

These human capital deficiencies continue to be a problem for the RIK gas program. For example, an RIK manager told us that, although mistakes canoccur in gas imbalance calculations, MMS does not have enough staff dedicate someone to review this work. However, beginning in Nove mber 2008, MMS began reviewing a sample of this work. In addition, according to internal MMS e-mails and our discussions with managers, RIK gas imbalance personnel have received training in oil and gas revenue accounting but managers noted that personnel need additional training seven different courses, especially a course on industry standards on gas imbalance calculations and a communication skills course for dealing with in external customers. Our review of employee training records showed, however, that RIK gas imbalance personnel received training in neither of these two courses and only about half of all the training identified. According to the MMS RIK gas imbalance manager, the training employees have received is sufficient given their workload dealing with gas imbalance improvement actions and current duties.

According to GAO’s Standards for Internal Control in the Federal Government, operational success is dependent on assigning the right personnel for the job and providing them with adequate training and tools. Similarly, according to Interior’s Internal Controls Handbook, in order to eliminate or reduce financial reporting risks, an organization should have, among other things, sufficient resources to perform the various job functions and should provide staff with technical and ethical training. appropriate number of employees needed to perform an organization’s work.

MMS has not conducted such an analysis.

As of March 2009, MMS was in the process of entering into a 6-month contract for an assessment of the organization of RIK invoicing and imbalance work, procedures, and processes. Included in the tasks to be performed under this contract is determining whether: (1) staffing levels are sufficient to meet current and anticipated future workloads and (2) staffing levels, skill sets, education, and experience are comparable to industry. As of June 2009, this contracting effort was still ongoing results from that effort were not available to include in our review.

Lastly, at our suggestion during the course of our review, MMS is reviewing the possibility of enrolling some of its employees in training classes offered by oil and gas companies to their employees participating in the RIK gas program. In offering this suggestion, we pointed out that MMS employees could (1) gain first hand knowledge into how industry does its gas imbalance work, (2) make strategic contact with industry gas imbalance employee counterparts, and (3) gain some insight into industry training requirements. With regard to the latter, whereas COPAS requires its oil and gas accounting members to receive 10 hours of continuing education annually, MMS officials told us that its RIK gas revenue specialists are not required to meet any annual education requirements. As of June 2009, MMS had not decided whether to use this industry training.

Conclusions

GAO, A Model of Strategic Human Capital Management, GAO-02-373SP (Washington, D.C.: Mar. 15, 2002).

Recommendations for Executive Action

To improve the Minerals Management Service’s oversight of the RIK gas program and help ensure that the nation receives its fair share of RIK gas, we recommend that the Secretary of the Interior direct the Minerals Management Service to take the following seven actions: Complete establishing policies and procedures to ensure outstanding imbalances are valued appropriately and tha interest is charged. t the correct amount of Monitor daily gas imbalances to determine whether the allocation practices of gas operators are extent that this is occurring, identify and propose specific legislative changes that MMS believes are needed to require operators to deliver MMS’s royalty percentage on a daily basis. resulting in lost revenues to MMS. To the Audit the operators and imbalance data of a sample of leases taken in and, on the basis of the audit findings, establish a risk-based aud program for RIK properties.

Promulgate RIK program regulations that protect the federal govern erators to submit interests. At a minimum, regulations should require op imbalance statements in a standardized format within 60 days following the month of RIK production. They should also require the use of gas allocation methods MMS deems will ensure a fair return to the government.

Establish procedures, with reasonable deadlines, for resolvin collecting all RIK gas imbalances in a timely manner.

Determine the information system enhancements necessary to effectivel identify and resolve gas imbalances and put into practice such a system.

Conduct an RIK staffing and training needs anal corresponding staffing and training program for MMS staff.

Agency Comments and Our Evaluation

We provided a draft of this report to Interior for review and commen Interior generally agreed with our findings and concurred with four of ou r recommendations, partially concurred with two of our recommendations, and did not concur with one recommendation. t.

Specifically, Interior concurred with our recommendations to: (1) complete establishing policies and procedures to ensure outstanding imbalances are valued appropriately and that the correct amount of interest is charged; (2) establish procedures, with reasonable deadlines, for resolving and collecting all RIK gas imbalances in a timely manner; (3) determine the information system enhancements necessary to effectively identify and resolve gas imbalances and put into practice such a system; and (4) conduct an RIK staffing and training needs analysis and put into place a corresponding staffing and training program for MMS staff.

Interior partially concurred with our recommendation to audit operator and imbalance data of a sample of leases taken in kind and, on the basis of these findings, establish a risk-based auditing program. Interior stated that it would conduct an analysis of the benefits of conducting risk-based audits on a step, we continue to believe it is important to conduct audits of a sample of leases taken in kind. Although MMS’s verification processes may uncover some discrepancies between their entitled percentage and the volumes delivered, we have shown that in some instances MMS’s verification processes are not sufficient to uncover discrepancies. Furthe sample of leases. While we believe this is an important first r, industry and other RIK programs audit to ensure they receive the royalties.

Interior also partially concurred with our recommendation to promulgat RIK program regulations that protect the federal government’s interest and, at a minimum, require operators to submit imbalance statements in a standardized format, within 60 days following the month of production, and require the use of gas allocation methods MMS deems will ensure a fair return to the government. Interior stated that the drafting of regulations addressing the operator’s obligation to deliver, report, and account for production and to resolve or mitigate production imbalances is well underway, which we commend. MMS stated that it will evaluate whether it should require operators to submit imbalance statements in a standardized format. We continue to believe that requiring operators to submit standardized imbalance statements would allow MMS’s gas imbalance analysts to devote more time to reconciling imbalances and would reduce the chance of calculation errors. MMS also stated that it will evaluate whether to require operators to use gas allocation methods. W we believe this is a positive first step, we continue to believe that the use of allocation methods will minimize the negative impact of imbalances on revenues by ensuring MMS receives the gas volumes it is owed.

Interior did not concur with our recommendation to monitor daily gas rators imbalances to determine whether the allocation practices of gas opeare resulting in lost revenue to MMS. Interior’s letter states that the agency believes the operator’s obligation to deliver MMS’s royalty percentage should be the same whether royalties are paid in kind or in value. However, the in-kind program is different from the in-value program in ly that MMS has an obligation to provide RIK gas to purchasers on a dai basis. Therefore, in order to provide reasonable assurance that the government is receiving its fair volumes of gas and in turn meeting its obligations to RIK gas purchasers, receipt of RIK gas volumes from operators should be monitored on a daily basis. While we acknowledge our report that the law authorizes MMS to enforce operator obligations only on a mo may provide less to MMS on days when gas prices are relatively high, and make up that difference by providing additional gas when prices ar relatively low. Further, we found that industry monitors imbalances on a daily basis to ensure they do not continue to believe that MMS should begin to monitor imbalances daily a changes requiring operators to deliver MMS the royalty percentage on a daily basis. nthly basis, this leaves open the possibility that operators lose revenue. For these reasons, we nd, to the extent that lost revenues are occurring, propose legislative Interior’s full letter commenting on the draft report is reprinted in appendix III. In addition, Interior made technical comments, which have addressed as appropriate.

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If you or your staffs have any questions about this report, please contact me at (202) 512- 3841 or 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 sta ff who made major contributions to this report are listed in appendix IV.

Appendix I: Scope and Methodology

We were asked to determine the extent to which MMS ensures the accurate and timely identification and collection of royalty-in-kind (RIK) gas imbalances. To address our objective, we reviewed various reports by the Department of the Interior (Interior) and Interior’s Minerals Management Service (MMS) on the history and current status of imbalances associated with the RIK gas program including: (1) a 2002 internal MMS assessment of RIK gas imbalances; (2) a 2002 report by Interior’s Office of Inspector General, which discussed, in part, MMS’s vulnerability to underreporting of gas receipts due to RIK gas imbalances; (3) MMS’s monthly action plan on RIK imbalances and open receivables, first prepared in August 2007; and (4) MMS’s periodic cumulative imbalance, cash-out, and keepwhole summary statements.

We also reviewed various reports prepared on the direction and overall performance of the RIK program, including (1) an examination of a 2001 MMS report which outlined MMS’s future plans for the RIK program; (2) a 2003 MMS contractor report that assessed the RIK program; (3) a 2007 report by the Subcommittee on Royalty Management, part of the Royalty Policy Committee, which reviewed the operations of the RIK program; (4) a 2008 MMS internal review report on RIK processes; and (5) a 2008 interim report by the Royalty in Kind Subcommittee, also part of the Royalty Policy Committee, which examined various issues, including imbalances, associated with the RIK program. We also examined various reports prepared by other governmental entities—including the Alberta, Canada government and the Texas state government—regarding their RIK programs. We further discussed the issue of RIK imbalances with officials from MMS, gas production companies, gas operators, industry experts, and pipelines.

To examine MMS’s management of RIK gas imbalances, we received a detailed walk-through of MMS’s processes for reconciling RIK gas imbalances. We reviewed a variety of MMS documentation including (1) MMS procedures manuals, (2) correspondence between MMS and Interior’s Office of the Solicitor on RIK legal requirements, and (3) MMS’s guidance letters to operators of RIK gas leases. We also reviewed federal and Interior’s internal control and management standards and policies, including: (1) GAO’s Standards for Internal Control in the Federal Government, (2) Interior’s Internal Controls Handbook, (3) MMS’s Training Needs Assessment Process, (4) the Office of Personnel Management’s Training Policy and Training Needs Assessment Handbooks, (5) Office of Management and Budget’s Circular A- 130 on management of federal information resources, (6) Office of Management and Budget’s Circular A-123 on management’s responsibility for internal control in federal agencies, and (7) the Information Technology Resources Board’s 1999 lessons-learned report on acquiring commercial-off- the-shelf software. Further, we reviewed various documents issued by the Council of Petroleum Accountants Societies such as its 1993 report on oil and gas operator and producer roles and responsibilities and its 2001 report on producer gas imbalances, and information generated by the North American Energy Standards Board. In addition to reviewing documentation, we also conducted interviews with MMS officials; gas production companies; purchasers of MMS’s RIK gas; the North American Energy Standards Board; pipeline companies; and industry experts. Lastly, we reviewed legislation pertinent to MMS’s management of the RIK gas program and RIK gas imbalances. This included the Mineral Leasing Act of 1920, as amended; the Outer Continental Shelf Lands Act of 1953, as amended; and the Debt Collection Improvement Act of 1996, as amended.

Appendix II contains information on the scope and methodology we used to analyze the relationship between gas prices and the daily percentage of gas production allocated to MMS and the effect of this relationship on federal revenue.

We conducted this performance audit from June 2008 to August 2009, 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.

Appendix II: Analysis of the Relationship between Price and Percentage of Gas Production Allocated to MMS and the Effect on Federal Revenue

To ensure that the government obtains a fair value for the RIK gas it sells, the Department of the Interior’s Minerals Management Service (MMS) must ensure that it receives the volumes of gas to which it is entitled. The difference between the RIK gas owed––MMS’s entitled percentage of gas–– and the percentage of gas it actually receives is referred to as an “imbalance.” As discussed in the body of this report, MMS attempts to reconcile gas imbalances monthly.

The nature of gas production causes some daily variation in volume. For example, companies must estimate the volume of gas they will produce on any given day and determine allocations based on these estimates. If actual allocation volumes differ from the estimated volumes, MMS may receive either an under-delivery of gas or an over-delivery of gas. Daily imbalances may be resolved through a subsequent day’s under- or over- delivery, resulting in further variation in volume; however, MMS risks losing revenue if that variation is associated with a variance in price. Specifically, if operators allocate less than the royalty percentage of gas to MMS on days when the spot price is high and more than the royalty percentage of gas on days when the spot price is low, they could still meet the royalty percentage across the month. However, if this occurs, MMS may lose revenue because it may miss opportunities to sell the gas at the higher price, even if no long-term imbalances accumulate.

This appendix describes our analysis of the relationship between prices and the percentage of gas allocated to MMS, and how it affects the revenue that MMS receives. Specifically, it (1) explains, in mathematical terms, the potential for lost revenue if the operators allocate less than the royalty percentages of gas when the spot price is high; (2) describes the data that we used to empirically examine the daily variation in percentage of gas allocated to MMS; (3) describes the methodology and results of our analysis of daily variation in percentages of gas allocated to MMS; (4) describes the methodology and results of our analysis of the relationship between the daily variation in percentage of gas allocated to MMS and gas prices; and (5) describes the methodology and results of our analysis of the potential amounts of lost revenue.

Potential for Lost Revenue

To explain, in mathematical terms, the potential for lost revenue if operators allocate less than the royalty percentages of gas when the spot price is high, we examined how this relationship affects the expected, or average, return for an MMS lease.

The royalties that MMS are owed can be expressed as follows: royalty volume = total production volume x royalty percentage On a daily basis, the royalty volume can be expressed by the product of the daily gas production and the daily volume of gas allocated to MMS: (1) RV = Vol x A where RV is the royalty volume at time t, Vol is the volume of gas allocated to MMS at time t, and A is the royalty percentage at time t. In equation (1), and the equations that follow, t stands for any given day. The monetary value of the gas allocated to MMS can then be expressed by multiplying the royalty volume and the gas spot price at the time of delivery. (2) Rev = P x RV Substituting equation (1) into equation (2) results in the following formula: (3) Rev = P x Vol x A where the revenue MMS receives is the product of the price, volume, and royalty percentage at that time.

To determine how different levels of covariance affect the average revenue, we determined the expectation, as shown in equation (4). (4) E(Rev )= E(P x Vol x A)

Because the focus of our analysis was the effect of daily variances in gas allocated to MMS that was associated with variances in the spot price, we assumed that the volume at the time of delivery is independent of the product of price and the royalty percentage, and that the volume is constant over the period. (5) E(Rev ) = E(Vol) x (E(P)E(A)+Cov(P ,A))

If higher prices tend to correspond with higher percentages of gas allocated to MMS, then the covariance term Cov(P ,A) will be positive, and the expected revenue will be higher. However, if high prices correspond with lower percentage of gas allocated to MMS, then the evenue will fall. covariance term will be negative, and the expected r The covariance describes both the relationship between the variables and the absolute variability of each. A substitute for the covariance would be to introduce the correlation coefficient. The correlation coefficient captures only the relationship between the variables and takes a value between negative 1 and 1. A correlation coefficient of zero would indicate that there was no relationship between the variables. A correlation coefficient close to 1 would indicate a strong positive relationship, while a correlation coefficient close to negative 1 would indicate a strong negative relationship. Using the correlation coefficient, an alternate expression for the equation (5) would be the following: (6) E(Rev ) = E(Vol) x (E(P)E(A)+Corr(P,A) x SD(P) x SD(A))

From equation (6), it is apparent that, all things being equal, the more the price and percentage of gas allocated to MMS are negatively correlated, the greater the loss in revenue. However, the size of the effect is scaled by the absolute variability in each, SD(P ) and SD(A).

Data We Used for Our Analyses

) x (E(V )E(A )+ Corr(V ,A ) x SD(V ) x SD(A )). Therefore, if high volumes correspond to lower royalty percentages, then the covariance term will be negative and the expected revenue will fall. the supply of natural gas that is last to be taken and first to be curtailed and absorbs production variations. The spot price varies daily.

Delivery data: We collected delivery data from MMS’s Entegrate database. MMS downloads final delivery volumes from the electronic bulletin boards for regulated pipelines, or it receives delivery volumes from either operator or purchaser pipeline statements, or both. MMS enters the actual volumes into the Entegrate database monthly.

Volume data: We collected volume data from the Offshore Energy and Minerals Management division of MMS, which collects hardcopy pipeline statements. MMS provided copies of the pipeline statements, which a contractor keypunched. We checked the keypunched data, and found no errors. We then matched the daily production volume data to the daily price and delivery data for use in our analyses.

Because pipeline statements do not report production volume at the lease level, we could not analyze allocation percentages at the lease level. For all three sources, we collected data at the level of the measurement point—the metered point at which gas is measured. A measurement point may combine the gas flowing from numerous leases.

In addition, we excluded from our sample measurement points whose leases had differing royalty percentages. For cases in which the measurement points had differing royalty percentages, it would not have been possible to calculate whether MMS was allocated its share of gas. For example, in figure 1, measurement point one has three leases flowing into it, all with the same royalty percentage of 16.67 percent. Therefore, regardless of whether each lease has different production volumes, MMS can calculate that it is owed 16.67 percent of the total production of 10,000 MMBtu. However, measurement point two has three leases flowing into it, with two leases owing a royalty percentage of 16.67 percent and one lease owing a royalty percentage of 12.5 percent. Because each lease will likely have a different volume of production and MMS will only have the total production volume available from third party data, it is unable to determine its entitled volume of RIK gas.

Because of this limitation, we restricted our analysis to a random sample of those measurement points that had leases with a common royalty percentage. Then, for each of the randomly selected 32 measurement points, we obtained 6 months of daily observations––October 2007 through March 2008––resulting in 5,856 daily observations. MMS officials suggested that we use this 6 month time period in order to avoid hurricane season, which typically occurs during the summer months, but gas prices during these months may differ from those included in our time period. However, 677 days had no production, and data for 366 days was missing values for allocation volumes to MMS. Because we could not produce a percentage of gas allocated to MMS in those cases, our ultimate sample contained 4,829 daily observations with values for volume of gas allocated to MMS and the differential between spot and base price and 31 measurement points.

Methodology and Results of Our Analysis of Daily Variation in Percentages of Gas Allocated to MMS

To determine the extent to which the daily percentage of gas allocated to MMS deviated from its royalty percentage of gas for the measurement points in our sample, we calculated the daily percentage of gas allocated to MMS by dividing the volume of gas allocated to MMS from that measurement point on a given day by the volume of gas produced at the measurement point. We then counted the days that the percentage of gas allocated to MMS differed from the prescribed amount of 16.67 percent by a substantial amount, which we defined as more than 25 percentage points.

Our analysis of daily data found variation in the percentage of gas allocated to MMS; however, on the majority of days, the allocation did not substantially differ from MMS’s royalty allocation, as shown in Figure 2. Specifically, 3,573 of the 4,829 days––about 74 percent––had an allocation that was between 75 and 125 percent of the entitled royalty percentage of one-sixth or 0.167. But on many days, the royalty percentage of gas allocated to MMS was much less or much greater. For example, on 883 days––about 18 percent of the total, shown as the sum of the bottom three bars on figure 2––the royalty percentage of gas allocated to MMS was less than 75 percent of the prescribed amount. On the other hand, on 373 days—about 8 percent of the total, shown in the top two bars—more than 125 percent of the royalty percentage of gas allocated to MMS. On average MMS received 15.9 percent.

Methodology and Results of Our Analysis of the Relationship between the Daily Variation in the Percentage of Gas Allocated to MMS and Gas Prices

While there may be inherent daily variation in the percentage of gas allocated to MMS, the loss of revenue is determined by the extent to which that variation is associated with price. To analyze whether the percentage of gas allocated to MMS varies with price, we used the daily data on the differential between the base and spot price for our sample of measurement points and measured the correlation between these two variables for each measurement point. We found a small negative average and median correlation between higher prices and a lower percentage of gas allocated to MMS. Specifically, the average correlation was negative 0.014, while the median was negative 0.038.

Although the average was slightly negative, we found that correlations had a wide range. Figure 3 presents the frequency of the correlations of the differential between spot price and base price and percentage of gas allocated to MMS for the 31 measurement points in our sample. The maximum, or the most positive, correlation in our sample was 0.645. The minimum, or most negative, was negative 0.560. As figure 3 shows, the vast majority of measurement points had a correlation between negative 0.25 and 0.25.

Methodology and Results of Our Analysis of Potential Amount of Lost Revenue

The potential amount of lost revenue depends on the size and variability of the percentage of gas allocated to MMS, gas produced, and the spot-minus- base differential. To estimate the revenue loss that would be associated with a certain correlation, we used an hypothetical measurement point that had the same average characteristics as the ones in our sample. We then generated data that had the same average mean and standard deviation as our hypothetical example, but different correlations between the variables. We computed the average revenue for that hypothetical measurement point during a 6-month time period. We used a wide range of correlations, including the median value found in the above example. Finally, we compared the revenue to a baseline of zero correlation.

We estimate that the median correlation we found would result in a revenue loss of about $1,400 for each measurement point during a 6-month time period, as shown in table 1. Each row of the table is the result of one million simulations of data with the given correlation and the mean and average standard deviation of the measurement points in our sample. However, the common royalty percentage in the leases at the measurement points we sampled from––which accounts for about 85 percent of measurement points in the RIK gas program––would make it easier to detect the under-delivering when prices were high. It follows that this may introduce a bias into our distribution of correlations. Specifically operators at those measurement points may be less likely to link gas allocations to price because they fear detection, therefore we would be less likely to find negative correlations. At measurement points with a mix of different royalty percentages––about 15 percent of measurement points in the RIK gas program––the potential for this practice may increase, and could result in more negative correlations. As table 1 shows, a more negative correlation would result in higher revenue losses for these measurement points. For example, a correlation of negative 0.5 would result in a loss of about $21,000 during a 6-month time period for that measurement point.

Appendix III: Comments from the Department of the Interior

Appendix IV: GAO Contact and Staff Acknowledgments

Staff Acknowledgments

In addition to the individual named above, key contributors to this report included Karla Springer, Assistant Director; Robert Baney; Benjamin Bolitzer; Melinda Cordero; Cindy Gilbert; Alison O’Neill; Dae Park; Justin Reed; Holly Sasso; Ben Shouse; and Barbara Timmerman.