Mineral Revenues: A More Systematic Evaluation of the Royalty-in-Kind Pilots Is Needed
Released: 2003-01-16T00:00:00

Letter

Background

In fiscal year 2001, the latest period for which data are available, the Minerals Management Service reported that it collected about $5.2 billion in gas royalties and about $2.3 billion in oil royalties. There are more than 20,000 producing federal leases located in the continental United States and Alaska and more than 2,000 producing federal leases in the waters off the shores of the United States. Despite the larger number of onshore leases, offshore leases (most of which are in the Gulf of Mexico) account for 81 percent of all federal oil and gas royalty payments. In general, royalty rates for onshore leases are 12-1/2 percent of the value of the oil and gas produced, whereas royalty rates for most offshore leases are 16- 2/3 percent. The government generally distributes about half of the royalty payments collected onshore back to the states in which the leases are located. The government also shares with the coastal states a smaller portion of the royalty payments collected from offshore leases located within 3 miles of the coast, known as the 8(g) zone. However, the government does not share royalties from offshore leases beyond the 8(g) zone, where the majority of offshore oil and gas is produced.

The collecting, reporting, and auditing of cash royalty payments have been challenging for MMS. MMS relies upon royalty payors to self-report the amount of oil and gas they produce, the value of this oil and gas, and the cost of transportation and processing that they deduct from royalty payments. There are concerns about the accuracy and reliability of these data. Although MMS is responsible for auditing these data, with more than 22,000 producing leases and often several companies paying royalties on each lease each month, the auditing becomes a formidable task. In addition, there has been considerable disagreement between industry and MMS over the value of the oil and gas produced and the cost of transportation and processing deductions, leading to time-consuming and costly appeals and litigation.

While most companies that lease federal lands pay their royalties in cash, the federal government can instead take a portion of the oil and gas that these companies produce—known as “taking royalties in kind.” The Congress authorized royalties in kind under the Mineral Leasing Act of 1920 and under the Outer Continental Shelf Lands Act of 1953. Standard leases for the exploration of oil and gas on federal properties reserve the right for the federal government to take its royalties in kind.

The Federal Managers’ Financial Integrity Act of 1982 directed federal agencies to develop management control for safeguarding resources and required GAO to prescribe standards for agencies to follow in establishing management control. Management control plays a significant role in helping managers achieve strategic and annual performance goals that are required under the Government Performance and Results Act of 1993. Management control consists of several components: (1) an environment that sets a positive and supportive attitude toward management control and conscientious management (control environment); (2) an assessment of the risks that an organization faces from both external and internal sources (risk assessment); (3) procedures, techniques, and mechanisms that enforce management’s directives (management control activities); (4) recording and communicating information to management and to others that need it within the organization (information and communication); and (5) monitoring the quality of performance over time (monitoring).

MMS Has Taken Increasing Amounts of Royalties in Kind Since 1995 to Meet Several Objectives

From January 1995 through September 2001, MMS took 178 million barrels of oil and 213 billion cubic feet of gas in kind primarily for three purposes: (1) to provide small refiners with a stable source of crude oil, (2) to fill the Strategic Petroleum Reserve (SPR), and (3) to study alternatives to the traditional system of cash royalty payments. MMS sold the majority of the oil that it took in kind to small refineries under the Small Refiners Program—a long-standing program designed to assist small refiners that are having difficulty obtaining an adequate supply of crude oil. MMS also transferred substantial quantities of federal royalty oil to the SPR as a safeguard against disruptions in the nation’s supply of crude oil. MMS takes lesser quantities of oil and gas in kind under a series of pilot sales in Wyoming and the Gulf of Mexico to study alternatives to the traditional system of cash royalty payments. In doing so, MMS has been testing whether it can improve the administrative efficiency of royalty collections and whether it can sell the federal royalty oil and gas for at least as much as it would have collected from traditional cash royalty payments.

MMS Takes Oil in Kind and Sells It to Small Refiners

From January 1995 through September 2001, MMS sold to small refiners about 143 million barrels of oil, or about 25 percent of the federal government’s royalty share of all oil produced on federal lands during this time period. The amounts of oil taken in kind each year for small refiners have ranged from about 10 to 40 percent of the total federal royalty oil, as shown in figure 1. These amounts were worth from $138 million to $588 million, as shown in figure 2. The majority of federal royalty oil sold to small refiners since 1995 was produced in the Gulf of Mexico. Other purposes for which MMS took oil in kind, such as for the Wyoming and Gulf pilots and the SPR, are also shown in figures 1 and 2.

Under the Mineral Leasing Act, as amended by P.L. 79-506, if the Secretary of the Interior determines that there are insufficient supplies of crude oil available on the open market to refiners that do not have their own supply, the Secretary is required to give preference to these small refiners in selling federal royalty oil. Accordingly, the Secretary provides small refiners with a stable source of crude oil at equitable prices so that these small refiners can compete in areas dominated by integrated oil companies and large refiners. Although the Secretary has long held this authority, the Secretary conducted few sales prior to 1970 because of little interest from small refiners. The Secretary delegated the responsibility to administer small refiner sales to MMS shortly after its formation in 1982. After MMS assesses small refiners’ needs for crude oil, MMS identifies federal royalty oil to meet these needs, and then conducts sales. Often, more than one small refiner wanted to purchase the same oil, so MMS in recent years conducted a lottery to determine the purchaser.

Prior to 2000, MMS relied upon the producer of the oil to report its sales value and subsequently billed the small refiner this amount plus an administrative fee to cover the costs of running the program. After billing the small refiners, however, MMS determined that the producers had understated the value of the oil, so MMS sent additional bills to the small refiners. These bills often surprised the small refiners, and in some cases, large bills threatened their financial solvency. Because small refiners were dropping out of the program owing to the uncertainty over the value of the oil, MMS changed its small refiner sales in 2000 from lottery-based sales to competitive auction-based sales. The bidders and MMS now agree to the price before receiving the oil, just as they do in sales of other federal royalty oil.

MMS Takes Oil in Kind to Fill the Strategic Petroleum Reserve

The Congress established the Strategic Petroleum Reserve to provide emergency oil in the event of a disruption in petroleum supplies. The SPR consists of a series of underground salt caverns along the coastline of the Gulf of Mexico that can store up to 700 million barrels of oil. It is managed and maintained by the Department of Energy (DOE). Largely to reduce the federal deficit, the federal government withdrew and sold oil from the SPR in fiscal years 1996 and 1997.

To replace the amounts withdrawn from the SPR, MMS assisted with the transfer of about 29 million barrels of federal royalty oil from the Gulf of Mexico to DOE in 1999 and 2000. This amount represented about 17 percent of the federal government’s royalty share of all oil produced on federal lands in each of these 2 years, as shown in figure 1. By filling the SPR, the federal government had forgone the receipt of royalty revenues that it would have otherwise collected in cash. The Office of Management and Budget in February 1999 estimated that the total cost of filling the SPR would be $370 million, but oil prices rose since then, and the total cost was probably higher. Refilling stopped in December 2000 but commenced again in April 2002 under presidential directive and is expected to continue into 2005. From April through July 2002, MMS assisted in transferring to DOE about 7.5 million barrels of oil, worth about $169 million. MMS plans to increase deliveries to DOE from 63,000 barrels per day in July 2002 to about 130,000 barrels per day in 2003.

MMS Is Studying the Increased Use of Royalties in Kind

MMS began studying the use of federal royalty oil as an alternative to cash royalty payments through a series of pilot sales in Wyoming. Through nine consecutive sales that began in October 1998, MMS and the state of Wyoming collectively sold federal and state royalty oil. In doing so, MMS acquired information on how to group properties for sale and how to establish a price basis for bidding. Although the federal portion of these volumes far exceeded the state portion, we estimate that the federal oil that MMS sold during the 3-year period from October 1998 through September 2001 accounted for about 1 percent of the federal government’s royalty share of all oil produced on federal lands. MMS expanded its study of royalty oil to the Gulf of Mexico with two competitive sales, the first of which delivered oil to purchasers starting in November 2000. Unlike the pilots in Wyoming, the amount of federal royalty oil that MMS sold in the Gulf of Mexico reached significant quantities during the second pilot sale—about 32 times the amount of oil sold in Wyoming during the same 6- month period. We estimate that the federal royalty oil that MMS sold during this second sale, which commenced in October 2001 and ended in March 2002, might have accounted for about 20 percent of the federal government’s royalty share of all oil produced on federal lands during the term of the sale.

MMS first began studying the taking of gas in kind by conducting a gas pilot in 1995. This pilot assessed the administrative efficiency and revenue impacts of taking gas in kind relative to cash royalty payments. MMS accepted about 6 percent of the federal royalty gas in the Gulf of Mexico and sold it through auctions for about $72.6 million. Although this pilot showed that MMS could execute the sale of royalty gas, MMS estimated that these sales resulted in about 6 percent less revenue than MMS would have received in cash royalty payments, or more than a $4 million loss. MMS attributed this loss primarily to unforeseen problems in securing transportation of the gas through pipelines and to industry’s volunteering the royalty gas for sale, rather than to MMS’s selecting this gas. MMS continued studying RIK and issued a report in 1997 that concluded that RIK sales could be administratively more efficient and could generate at least as much revenue as traditional cash royalty payments. MMS began testing these conclusions with a series of pilot sales in the Gulf of Mexico that began in December 1998. The gas that MMS sold during these pilot sales averaged about 10 percent of the federal government’s royalty share of all gas produced on federal lands from January 2000 through September 2001, as shown in figure 3. The annual revenues that MMS reported collecting from the sale of this federal royalty gas are illustrated in figure 4. MMS studied various methods of selling this royalty gas, including negotiating the sales price, paying gas marketers to aggregate smaller volumes of gas into larger volumes, and auctioning the gas. As a result of these pilot studies, MMS decided to sell federal royalty gas through auctions open to all buyers meeting minimum standards of credit worthiness.

MMS Has Established Some Management Control over Its RIK Program, but Additional Efforts Are Needed

Management control is a necessary safeguard to protect against the risks of fraud, waste, abuse, and mismanagement. MMS has made progress in establishing some components of management control over its RIK Program, such as (1) identifying and mitigating the risks associated with oil and gas sales and (2) developing written procedures for these sales and for collecting and reporting revenues. However, MMS has yet to develop several key management control activities and does not plan to develop them until 2004, when it will consider the RIK Program to have changed from a pilot status to a fully operational status. Specifically, MMS has not clearly defined its strategic objectives, linked performance measures to these objectives, and collected the necessary information to monitor and evaluate the RIK Program.

Management Control Is a Necessary Safeguard

The Federal Managers’ Financial Integrity Act of 1982 directs federal agencies to develop management control for safeguarding resources against the risks of fraud, waste, abuse, and mismanagement. Management control is critical to ensure that revenues and expenditures from agency operations are recorded and accounted for properly and that financial and statistical reports are reliable. The act also directs us to issue standards for management control within the federal government. These standards provide broad criteria for agencies to use, in conjunction with guidance issued by the Office of Management and Budget. Management control includes (1) developing strategic objectives, (2) linking performance measures to these objectives, (3) collecting the necessary information to monitor and evaluate performance, (4) identifying and mitigating risks, and (5) developing written procedures and documenting compliance with these procedures.

Management control also plays an important role in helping managers comply with the Government Performance and Results Act of 1993 (Results Act), which requires federal agencies to establish strategic goals, measure performance, and report on accomplishments. The Results Act shifts the focus of federal agencies away from traditional concerns, such as staffing and reporting on activities, toward achieving results. There is no more important element in results-oriented management than an agency’s strategic-planning process, and establishing formal strategic objectives can help clarify what the agency seeks to accomplish and can help unify the agency’s staff in achieving its goals.

MMS Has Begun to Establish Management Control

MMS has begun to establish management control over its RIK Program by addressing the risk that oil and gas sales will be unsuccessful, addressing inherent risks associated with the sale of oil and gas, and developing written procedures for various activities within the Royalty-in-Kind Program. These activities include conducting RIK sales, collecting revenues, and reporting on revenues. MMS also has made progress in documenting the results of its RIK sales.

MMS has addressed the risk that RIK sales will be unsuccessful by ensuring that prior to these sales, certain conditions exist for the properties from which MMS will sell royalty oil and gas. In 1998, we identified the conditions necessary for successful oil and gas sales by surveying state governments, universities, and the Province of Alberta, which, at various times, had programs that took oil and gas in kind. We identified several conditions that made these programs feasible. In particular, these programs seemed successful if these entities had (1) relatively easy access to pipelines, (2) properties that produce relatively large volumes of oil or gas, (3) favorable arrangements for processing gas, and (4) expertise in marketing oil and gas. MMS has considered these conditions in addressing risk. Specifically, MMS’s practice of negotiating the cost of transporting gas through pipelines helps to secure relatively easy access to pipelines. Similarly, MMS’s practice of grouping the properties that produce royalty oil or gas according to the pipelines to which they are connected helps ensure that properties produce relatively large volumes of oil or gas. MMS has also arranged for the processing of natural gas and has increased its knowledge of oil and gas marketing by hiring consultants and interviewing oil and gas marketers and representatives of pipeline companies in Wyoming and the Gulf Coast.

MMS has also developed procedures to manage the inherent risks, or uncertainties, in the selling of oil and gas. Such risks include fluctuating oil and gas prices, the varying amount of oil and gas that wells produce, and the credit worthiness of purchasers. To manage the risk associated with fluctuating prices, for example, MMS does not try to maximize revenues by guessing which way the market will move but, instead, accepts bids relative to the fluctuating market prices. Thus, MMS avoids substantial losses that could result from wrong guesses. MMS also manages the risk due to the inability of properties to deliver consistent quantities of gas, which could require that MMS purchase or supply more costly alternative gas in the event of a shortfall. MMS manages this risk by guaranteeing that it will deliver only a portion of the gas (base volume) at a stable price and offering the other portion (swing volume), without guarantee, at published prices that vary daily. MMS has also developed procedures to monitor the credit worthiness of oil and gas purchasers and can terminate their sales contract or demand additional credit guarantees, if necessary. These procedures led MMS to promptly cancel its contract with Enron, thereby limiting losses to 1 month’s worth of gas production from the Enron contract.

MMS has developed written procedures for conducting RIK sales activities, collecting revenues from these sales, and reporting on these revenues. Sales activities include identifying properties from which to take oil and gas in kind, announcing the oil and gas for sale, determining a minimum acceptable bid, analyzing bids, and awarding contracts. We examined documents for sales that MMS conducted from October 1998 through October 2002 and found documentation of these activities in all sales in which they were appropriate. However, we did not determine the adequacy of MMS’s procedures for collecting and reporting on revenues, nor did we assess the degree to which MMS complied with these procedures.

MMS Has Not Developed Clear Objectives and Linked Performance Measures to These Objectives

MMS developed the following seven strategic objectives for the RIK Program: Implement RIK where applicable and when it is an improvement over traditional cash royalty payments (royalty in value).

Leverage MMS’s position as an asset holder. Take advantage of potential interagency synergies. Minimize the cost of royalty administration. Reduce business cycle time (the time to collect, disburse, audit, and reconcile revenues).

Accelerate timing of revenue collections. Adopt energy industry business practices and controls wherever feasible.

Overall, none of the seven objectives address the revenue impacts of the RIK sales. The seven objectives do not address requirements in the law that MMS (1) collect at least as much revenue from the RIK pilots as it would have from traditional cash royalty payments and (2) obtain fair market value. The Congress directed MMS in the fiscal years 2001 and 2002 Appropriations Acts for Interior and Related Agencies to collect at least as much revenue from the sale of royalties in kind as MMS would have collected from traditional cash royalty payments. Moreover, the Congress had previously directed the Secretary of the Interior in the Mineral Leasing Act of 1920 and the Outer Continental Shelf Lands Act of 1953 to obtain fair market value for oil and gas taken in kind. The Congress defined “fair market value” in the Outer Continental Shelf Lands Act as the average unit price for the mineral sold either from the same lease or, if such sales did not occur, in the same geographic area.

Furthermore, the first three objectives are not expressed in either a quantitative or measurable form. The last four objectives, although being quantitative, address administrative efficiency only. Without objectives to guide agency staff in the quantitative evaluation of the revenue impacts of RIK sales, MMS will be unable to determine whether RIK sales generate more or less revenue than traditional cash royalty payments; whether MMS obtains fair market value; and hence, whether it should convert the RIK pilots to an operational status.

MMS has also not developed any performance measures that it linked to the seven strategic objectives for its RIK Program. However, MMS has developed two performance measures—(1) confirm and reconcile, within 90 days, all production royalties taken in kind and (2) accelerate the timing of revenue receipt by 5 days over traditional cash royalty payments (royalty in value)—that are linked to the broader agency-wide objective of “collecting royalties in the shortest time possible.” In addition to supporting the broad agency-wide objective, these two performance measures support RIK Program objectives that are designed to improve administrative efficiency. MMS officials told us that they intend to develop performance measures that are specific to the RIK Program in 2004, when the RIK Program changes from the pilot status to a fully operational status and they acquire and fully implement new information systems that can better measure performance.

MMS Has Not Obtained the Necessary Information to Monitor and Evaluate the RIK Program

After 5 years of conducting pilot programs and completing 24 oil and gas pilot sales, MMS’s ability to effectively and efficiently monitor and evaluate its RIK Program is limited because it has not obtained the necessary information to do so. This information includes the administrative costs of the RIK Program, the savings from avoiding potential litigation and appeals, the savings in auditing properties, and the revenue impacts of all sales. MMS lacks information largely because it has not developed an information systems infrastructure to rapidly and efficiently collect this information. Without quantitative costs, savings, and revenue information, MMS is unable to determine the program’s overall cost and effectiveness, whether RIK generates at least as much revenue as traditional cash royalty payments, and whether the RIK Program should be expanded or contracted.

MMS Has Not Quantified Anticipated Costs and Savings from Implementing the RIK Program

MMS has not quantified the costs of administering the RIK Program. Such costs, which MMS incurs when selling RIK but does not incur when collecting traditional cash royalty payments, result from identifying properties from which to sell oil and gas, calculating minimum acceptable bids, analyzing bids, awarding and monitoring contracts, billing purchasers, negotiating transportation rates, reconciling discrepancies in volume, and comparing RIK revenues with traditional cash royalty payments. MMS has not quantified these costs because its current personnel, payroll, and budgeting systems do not capture data in sufficient detail. Although MMS tracks employees’ time charges with these systems, MMS does not distinguish between time charges that support only the RIK Program and time charges that support both the RIK Program and the traditional system of collecting cash royalties. Similarly, MMS has not decided how to assign the cost of MMS’s financial system and other significant overhead costs to the RIK Program and to the traditional cash royalty system. MMS officials told us, however, that they plan to implement an activity-based cost-accounting system in fiscal year 2003 that will assist in resolving these issues.

MMS also has not quantified anticipated savings from avoiding potential appeals and litigation by selling oil and gas in kind. MMS officials explained that MMS anticipates that it can avoid substantial costs associated with appeals and litigation involving primarily the valuation of natural gas and the transportation of both oil and gas. MMS officials have not estimated the costs of appeals because of problems with implementing the information system that tracks these costs and because of their uncertainty that these costs are recorded in a consistent manner. In addition, the Office of the Solicitor within the Department of the Interior, which is responsible for litigation concerning MMS’s activities, does not have an automated system to track litigation costs.

Although MMS anticipates that the cost of auditing revenues will decrease because of taking RIK, MMS has not quantified these savings. MMS anticipates substantial savings because verifying the value of oil and gas is much easier when taking RIK because the purchaser and MMS agree to the sales price before the sale occurs. Similarly, when MMS negotiates transportation costs itself, it knows the exact transportation rate that companies can charge MMS, unlike when companies pay royalties in cash. In addition, MMS does not need to audit transportation costs when MMS sells royalty oil or gas at the location of the lease because there are no transportation costs, since the buyer assumes the responsibility for transportation. Although MMS has projected decreases in the number of staff auditors as a result of future RIK sales, MMS has not finalized these estimated savings because MMS is uncertain of how much oil and gas it will take in kind in the future. MMS officials also question the reliability of the time that auditors have charged to the RIK Program in the past— information that formed the baseline for their projections.

MMS Has Not Fully Determined the Revenue Impacts of RIK Sales

MMS also has not fully quantified the revenue impacts of all the royalty oil and gas that it sold, preventing a comprehensive comparison between RIK sales revenues and the revenues that MMS would have received under the traditional cash royalty system. MMS does analyze factors that affect the revenues of upcoming RIK sales, including current oil and gas prices; anticipated market conditions; and transportation and processing, if applicable. However, MMS does not systematically compare RIK sales revenues with what it would have received in traditional cash royalties after these gas sales are completed. Of the 15.8 million barrels of federal royalty oil sold in pilot sales from October 1998 through July 2002, MMS quantified the revenue impacts of about 9 percent. Of the approximately 241 billion cubic feet of federal royalty gas that MMS sold from December 1998 through March 2002, we estimate that MMS quantified, either in whole or in part, the revenue impacts resulting from the sale of about 44 percent of this gas. Although MMS analyzed revenue impacts from 44 percent of the federal royalty gas it sold, almost none of this analysis was done in a timely manner, thereby precluding the use of this information to improve or modify subsequent sales. For example, MMS did not complete the evaluation of the gas that it sold competitively each month over a 19- month period until after it had discontinued selling gas in this manner. Similarly, MMS did not evaluate the revenue impacts of using a gas marketer to aggregate gas volumes until 1 year after it terminated these sales. If MMS had evaluated these aggregated sales earlier, it might have discontinued this method of selling royalty gas because it would have confirmed employees’ suspicions during the initial sale that the manner in which gas was being sold was disadvantageous to MMS. Instead, MMS let another three contracts with similar terms, resulting in an overpayment of almost $3 million on transportation valued at about $13 million.

MMS’s information systems hinder the timely monitoring and evaluation of the RIK Program and the evaluation of the revenue impacts from individual sales. The RIK Program’s current system for managing RIK sales revenues consists of a series of unlinked computer spreadsheets into which personnel manually enter RIK data. Such a manual system is prone to errors, which could lead to inaccurate information. Prior to September 2002, RIK Program personnel did not compile basic monthly reports on revenues collected and royalty volumes sold, which could have been used to monitor the RIK Program on a periodic basis. Also, limitations of MMS’s agency-wide financial system—the system that generates agency-wide accounting reports and maintains and manages all royalty data—currently hamper the timely comparison of RIK sales revenues with cash royalty payments. MMS personnel were unable to use the financial system to produce summary data that were more current than 1-year old. As of October 2002, for example, MMS personnel were unable to use the financial system to determine how much total revenue MMS collected and how much oil and gas had been produced from federal lands since September 2001. MMS personnel also said that because of missing or erroneous data in the agency-wide financial system, data extracted from this system cannot be used in revenue comparisons without time- consuming checks for accuracy and reasonableness. Furthermore, it will be more difficult to use RIK gas data in this system to calculate revenue impacts because MMS personnel do not enter these data at the lease level. Lastly, RIK Program personnel said that because they have to manually acquire data to evaluate federal properties for prospective sales, the growth of the RIK Program has slowed.

MMS officials also said that they have not evaluated the revenue impacts from the sales of all royalty oil and gas largely because they have delayed the development of performance measures for the RIK Program until 2004. These performance measures will incorporate benchmarks against which to compare RIK sales revenues. MMS personnel said that MMS has generally encountered difficulty in establishing benchmarks against which to measure the revenue impacts of RIK oil and gas sales because once it takes all federal royalty oil or gas in kind in a specific area, it no longer receives any traditional cash royalty payments for comparison. However, MMS officials explained that by 2004, MMS expects to acquire and fully implement two additional information systems dedicated to the RIK Program that will automate the acquisition of necessary information for attempting revenue comparisons. MMS personnel said that they had not acquired these automated systems earlier because they believed that they first needed to process a large number of transactions and sell a large volume of oil and gas before they could justify the expense of acquiring these systems.

Conclusions

MMS has begun to establish management control over its RIK Program. It has initiated positive steps to address the risks that affect its oil and gas sales and has developed written procedures for various activities within the RIK Program. MMS has also made progress in documenting the results of its RIK sales. However, MMS has not established clear objectives for the program that are linked to statutory requirements. MMS’s current objectives for its RIK Program are not clearly linked to requirements in the law that MMS (1) collect at least as much during pilot sales as it would have collected in cash royalty payments and (2) obtain fair market value.

In addition to the lack of objectives linked to statutory requirements, MMS is not systematically collecting the necessary information to monitor and evaluate the RIK program. Such information includes the administrative costs of the RIK program, anticipated savings from reductions in audit efforts and from avoiding appeals and litigation, and the revenue impacts of all sales. Without clear objectives and the systematic collection of evaluative information, MMS cannot assess and ultimately determine whether it should expand or contract the use of royalty in kind sales.

Recommendations for Executive Action

To continue the further development of management control for the Minerals Management Service’s Royalty-in-Kind Program, we recommend that the Secretary of the Interior instruct the appropriate managers within the Minerals Management Service to do the following: Clarify the Royalty-in-Kind Program’s strategic objectives to explicitly state that goals of the Royalty-in-Kind pilots include obtaining fair market value and collecting at least as much revenue as MMS would have collected in cash royalty payments.

Prior to expanding the Royalty-in-Kind Program, identify and acquire key information needed to monitor and evaluate performance. Such information, as identified by the Minerals Management Service, should include the revenue impacts of all Royalty-in-Kind sales, administrative costs of the Royalty-in-Kind Program, estimates of savings in avoiding potential litigation, and expected savings in auditing revenues.

Agency Comments and Our Evaluation

We provided the Department of the Interior with a draft of this report for review and comment. Interior fundamentally agreed with our observations and recommendations and emphasized MMS’s future plans for improving management control over the RIK Program. Where appropriate, we have included additional references to the activities that Interior mentions in its comments. Interior’s comments and our response to these comments are reproduced in appendix I.

Scope and Methodology

In reviewing MMS’s RIK Program, we reviewed congressional directives in pertinent legislation; standards for the development of management control issued by us and the Office of Management and Budget; and prior reports and documentation on the Small Refiners Program, Strategic Petroleum Reserve, and RIK pilots. We also obtained statistical information from MMS on oil and gas volumes taken in kind and the revenue that MMS generated by selling these volumes. In addition, we reviewed documentation pertaining to management control and interviewed MMS personnel about their efforts to establish management control over the RIK Program.

We conducted our work from January to November 2002 in accordance with generally accepted government auditing standards. For a more detailed discussion of the scope and methodology of our review, see appendix II.

As agreed with your offices, unless you publicly announce its contents earlier, we plan no further distribution of this report until 7 days from the date of this letter. At that time, we will send copies of this report to the Secretary of the Interior; the Director, Office of Management and Budget; and other interested parties. We will also make copies available to others upon request. This report will be available at no charge on GAO’s Web site at http://www.gao.gov.

If you have any questions about this report, please call Mark Gaffigan or me at (202) 512-3841. Key contributors to this report are listed in appendix III.

Appendix I: Comments from the Department of the Interior

The following are GAO’s comments on the Department of the Interior’s letter dated December 13, 2002.

GAO’s Comments

1. We clarified our report to reflect these comments. 2. We acknowledge that the Mineral’s Management Service’s (MMS) difficulties in obtaining royalty data from its financial system may be due, in part, to the court-ordered shutdown of this financial system in December 2001. However, 9 months had passed since operation of the financial system was restored on March 23, 2002. Additionally, MMS personnel said that the statistical subsystem designed to generate routine summary data that we requested for October 2001 through July 2002 had not yet been deployed and was not expected to be deployed until April 2003 at the earliest. 3. We expressed Royalty-in-Kind (RIK) volumes as a percentage of total federal royalty oil and gas volumes to show the overall significance of taking royalties in kind compared with receiving cash royalty payments. Using percentages also made it easier to show that large percentages of oil were taken in kind for the Strategic Petroleum Reserve (SPR) and for the Small Refiners Program relative to the small percentages taken for pilot purposes. In expressing RIK volumes as percentages, we used actual RIK sales volumes supplied by MMS but had to estimate the total federal royalty volumes because MMS does not maintain these data. 4. In this report, we state that MMS’s strategic objectives do not address the requirements in the law because nowhere in the seven strategic objectives is there reference to the terms “fair market value” or “collecting at least as much revenue as would have been collected in cash royalty payments.” In its response, Interior states that it has intended to accomplish these legislative mandates, and Interior apparently believes that these intentions are implied by the strategic objective stating that MMS will implement RIK “when it is an improvement over traditional cash royalty payments.” In light of Interior’s agreeing with us that the objectives for the RIK Program should include achieving fair market value and collecting revenues at least equal to what MMS would have collected in cash royalty payments, we continue to recommend that MMS clarify the language in its strategic objectives to reflect these intentions. 5. We acknowledge that MMS performs substantial analysis prior to converting leases from traditional cash royalty status to RIK. For oil sales, MMS generally calculated a minimum acceptable bid that bidders had to exceed before MMS made an award. For gas sales, MMS relied upon gas indexes to assess bids. While relying on minimum acceptable bids and gas indexes prior to a sale is a first step in ensuring that RIK revenues will equal or exceed cash royalty payments, MMS cannot determine actual revenue impacts until after the sales are completed. To effectively monitor and evaluate the performance of the RIK pilot sales, MMS should calculate revenue impacts in a timely manner after sales are completed and adjust future sales on the basis of these results.

Relying on codified valuation regulations as an indicator of what MMS would have collected in cash royalty payments is not as straightforward as Interior implies, and the application of valuation regulations is often a source of dispute between MMS and industry. For example, MMS often does not know which provision of the valuation regulations will apply to future royalty collections from a given lease until after the sale. Also, MMS’s market analyses suggests that many of the provisions for valuing oil and gas sold to affiliated companies may no longer reflect the manner in which many companies buy and sell oil and gas today. To compensate for these uncertainties, MMS must use considerable judgment in estimating revenue impacts prior to RIK sales.

While MMS has evaluated the revenue impacts after some completed sales, MMS has not evaluated the revenue impacts of all sales. We point out in this report that MMS evaluated the revenue impacts, either in whole or in part, of about 9 percent of the oil sold in kind and about 44 percent of the gas sold in kind. With regards to the Wyoming oil pilots and the Texas 8(g) gas pilots that Interior mentions in commenting on this report, MMS evaluated and published the results of 3 of the 8 completed pilot sales in Wyoming and 19 of the 29 monthly Texas 8(g) sales. Furthermore, only a few of MMS’s analyses were done in a timely manner, precluding MMS from using this information to modify subsequent sales. For example, MMS did not analyze the revenue impacts of the Texas 8(g) monthly sales or its aggregated gas sales until after it had discontinued selling gas by these methods. However, we encourage MMS to analyze the revenue impacts of its Gulf of Mexico oil pilots despite these sales’ current suspension because the oil from these properties is being transferred to the SPR. The results of such a study could be useful, should MMS continue the Gulf of Mexico oil pilots in the future. 6. MMS supplied us with the estimated loss of about $3 million on the aggregation contracts. We calculated that transportation was worth about $13 million on the basis of transportation costs and volumes supplied by MMS. MMS reported that the total value of royalty payments on the aggregated gas was about $363 million. 7. Our assessment that MMS has difficulty obtaining royalty information from its financial system is based largely on MMS personnel, who have used these data to estimate the revenue impacts of RIK sales and told us that they could not use these data without first performing time- consuming checks for accuracy and reasonableness. At our request, these personnel supplied us with royalty data from nine Wyoming oil properties that we estimate accounted for about 50 percent of the oil sold during the Wyoming pilots. Although we did not find widespread systemic problems with this small data set, we confirmed that a small amount of missing, incomplete, and inaccurate data, in addition to numerous modifications of data entries by payors (adjustments), precluded using these data for calculating revenue impacts without first inspecting these data for accuracy and reasonableness. We confirmed that the manual inspection of these data was time-consuming. In addition, MMS personnel told us that RIK gas data are not entered into the system at the lease level, and we believe this will complicate comparing RIK revenues with cash royalty payments.

Appendix II: Objectives, Scope, and Methodology

In this report, we discuss (1) the extent to which the Minerals Management Service has taken federal royalties in kind since 1995 and the reasons for doing so and (2) the status of MMS’s efforts to implement management controls for its RIK program.

To determine the extent to which and the purposes for which MMS has taken RIK since 1995, we reviewed legislative directives concerning RIK in the Mineral Leasing Act of 1920, the Outer Continental Shelf Lands Act of 1953, and the Appropriations Acts for the Interior and Related Agencies for fiscal years 1995 though 2002. We also reviewed presidential directives for using federal royalty oil to fill the SPR. We reviewed prior reports and other documentation on the Small Refiners Program, the SPR, and the RIK pilots in Wyoming and the Gulf of Mexico. We then asked MMS personnel to supply data on the amount and values of federal royalty oil and gas taken in kind and of total oil and gas royalties from January 1995 through July 2002. Although MMS personnel within the RIK Program could supply data on RIK revenues and volumes taken in kind during this time period, they could not supply data on total royalty revenues and the total amount of oil and gas produced on federal lands that were more current than September 2001. We did not review the accuracy of these figures.

To review the status of MMS’s efforts to implement management control over its RIK Program, we reviewed the Federal Managers’ Financial Integrity Act of 1982, the standards for management control that we issued entitled Standards for Internal Control in the Federal Government (GAO/AIMD-00-21.3.1, November 1999), and the implementation guidance issued by the Office of Management and Budget in OMB Circular A-123. We also reviewed our tool for assessing an agency’s management controls entitled Internal Control Management and Evaluation Tool (GAO-01- 1008G, August 2001) and our guide for assessing an agency’s strategic plan entitled Agencies’ Strategic Plans Under GPRA: Key Questions to Facilitate Congressional Review (GAO/GGD-10.1.16, May 1997). Standards for Internal Control in the Federal Government establishes the criteria that agencies must meet in developing and maintaining management control, which is not one event but a series of actions and activities that occur throughout an agency’s operations on an ongoing basis. Our review focused on MMS’s efforts to address risks that could affect the RIK Program and on some management control activities that we identified as being critical to MMS’s implementation and management of the program. These management control activities are (1) developing strategic objectives, (2) linking performance measures to these objectives, (3) obtaining the necessary data for making management decisions and for monitoring and evaluating the RIK Program, and (4) developing written procedures and documenting compliance with these procedures. We assessed MMS’s efforts to establish these management control activities by reviewing relevant documentation and interviewing MMS personnel.

We reviewed MMS’s efforts to mitigate the risks associated with differences in the properties that produce federal oil and gas, fluctuating oil and gas prices, disruptions in production, and credit worthiness. In assessing strategic objectives and linked performance measures, we reviewed these objectives and measures for their results-orientation, clarity, specificity, ability to be expressed quantitatively or in a measurable form, and consistency with congressional directives. In reviewing the availability of key data for management decisions and monitoring and evaluating the RIK Program, we assessed the extent to which MMS had determined the revenue impacts of all RIK sales, the administrative cost of operating the RIK Program relative to collecting cash royalties, and the expected savings from avoiding litigation and appeals and simplifying auditing. We also examined whether MMS had compared revenue impacts from each RIK sale with expected revenues from traditional cash royalty payments or other benchmarks and assessed whether MMS had collected monthly RIK revenues and sales volumes for monitoring purposes. In reviewing MMS’s efforts to develop written procedures, we determined if written procedures existed as of January 1, 2002, for conducting sales activities, collecting revenues, and reporting on these revenues. We determined major sales activities to be the selection of properties from which to sell RIK, the announcement of the sale, the calculation of a minimum acceptable bid, the evaluation of bids, and the determination of the winning bidders. For each sale completed as of October 2002, we also reviewed whether MMS documented these major activities. However, we did not assess the adequacy of written procedures to collect and report on revenues, nor did we assess MMS’s compliance with these procedures. Because at the time of our review, MMS had not implemented an automated system to support the RIK Program, we reviewed its current manual system and its efforts to acquire automated systems.

Appendix III: GAO Contacts and Staff Acknowledgments

GAO Contacts

Acknowledgments

In addition to those named above, Letha Angelo, Ronald Belak, Robert Crystal, Cynthia Norris, Frank Rusco, Dawn Shorey, Jamelyn Smith, and Maria Vargas made key contributions to this report.