Oil and Gas Royalties: The Federal System for Collecting Oil and Gas Revenues Needs Comprehensive Reassessment
Released: 2008-09-12T00:00:00

Letter

Background

Interior, created by the Congress in 1849, oversees and manages the nation’s publicly owned natural resources, including parks, wildlife habitats, and minerals, including crude oil and natural gas resources, on over 260 million surface acres and 700 million subsurface acres onshore and in the waters of the Outer Continental Shelf. In this capacity, Interior is authorized to lease federal oil and gas resources and to collect the royalties associated with their production, Interior’s Bureau of Land Management (BLM) is responsible for leasing federal oil and natural gas resources on land, whereas offshore—including the U.S. Gulf of Mexico— Minerals Management Service (MMS) has the leasing authority. To lease U.S. Gulf of Mexico waters for oil and gas exploration, companies generally must first pay the federal government a sum of money that is determined through a competitive auction and evaluated by Interior against departmental economic and geologic models. This money is called a bonus bid. Companies are required to submit one-fifth of any bid for a lease tract up front at time of bid, and pay the remaining four-fifths balance of their bonus payment and their first year rental payment after acquiring a lease. After the lease is awarded and production begins, the companies must also pay royalties to MMS based on a percentage of the cash value of the oil and gas produced and sold or “in kind,” as a percentage of the actual oil or gas produced. Royalty rates for onshore leases are generally 12.5 percent. Royalty rates for leases in the U.S. Gulf of Mexico, prior to 2007, ranged from 12.5 percent for water depths of 400 meters or deeper (referred to as deepwater) to 16-2/3 percent for water depths less than 400 meters (referred to as shallow). In 2007, the Secretary of Interior twice increased the royalty rate for future U.S. Gulf of Mexico leases—in January, the rate for deep water leases was raised to 16-2/3 percent and in October, the rate for all future leases, included those issued in 2008, was raised to 18-3/4 percent.

A considerable body of legislation has been enacted pertaining to the management of resources on federal and Indian trust lands and within federal waters. This legislation includes the Mining Law of 1872, Mineral Lands Leasing Act of 1920, 1947 Mineral Leasing Act for Acquired Lands, Outer Continental Shelf Lands Act of 1953, Federal Land Policy and Management Act of 1976, the Outer Continental Shelf Lands Act Amendments of 1978, Federal Oil and Gas Royalty Management Act of 1982, as well as the Federal Onshore Oil and Gas Leasing Reform Act of 1987, the Outer Continental Shelf Deep Water Royalty Relief Act of 1995, and the Energy Policy Act of 2005. The Outer Continental Shelf Lands Act, as amended (OCSLA) is, among other things, intended to ensure the public “a fair and equitable return” on the resources of the shelf. The law directs the Secretary of Interior to conduct leasing activities to assure receipt of fair market value for the lands leased and the rights conveyed by the federal government. In addition, the Federal Land Policy and Management Act indicated that, unless otherwise provided by statute, it is the policy of the United States to receive “fair market value” for the use of the public lands and their resources. In 1982, Interior’s MMS convened a task force to review its fair market value procedures. Upon completion of the task force’s work, the Secretary of Interior informed the Congress by letter in March 1983 that the Department had completed its analysis and validation of the process by which it will assure a fair return to the American people. The Secretary indicated in that letter that the process in place will assure the American people a full and fair return as it pertains to bonuses, rentals, royalties, and taxes. The 1983 Interior task force report also provided some clarity regarding a fair return, or fair market value. The report indicated that the market value of a lease is not the market value of the oil and gas eventually discovered or produced. Instead, it is the value of the right to explore and, if there is a discovery, develop and produce the energy resource.

Currently Interior has the legal authority to change most aspects of the oil and gas fiscal system. Specifically, Interior is allowed by statute to change bid terms for offshore leases including the royalty rate, the bonus bid structure, rental terms, and even the minimum 12.5 percent royalty rate, so long as there is only one variable or “flexible” term—such as a royalty rate that adjusts upwards or downwards with oil and gas prices—in the resulting system, and so long as Congress does not pass a resolution of disapproval within 30 days of Interior’s changes to the system. With regard to onshore leases, Interior is generally allowed by statute to change bid terms including the royalty rate, the bonus bid structure, rental terms, and the minimum royalty rate so long as the bid structure meets certain bid terms, but with certain additional limits on flexibility than the offshore leases. Over the past 25 years, Interior has implemented several programs that adjusted royalty rates or other system components. Such programs included the net profit share leases, which were for offshore leases that based royalties on a percentage of net profits derived from production; sliding scale royalty rates, which was an onshore royalty rate system based on changing production levels; and royalty rate reduction for stripper wells and lower-grade, more viscous crude oil, where onshore oil wells producing less than 15 barrels of oil per day were eligible for royalty rate reductions. Interior officials told us they also “experimented” with a variety of flexible royalty rate and profit sharing systems in the early 1980s, but found them difficult to administer and validate the amount of payments due to MMS, which in Interior’s estimation more than offset any enhanced flexibility associated with a variable royalty rate.

The Gulf of Mexico Has a Relatively Low U.S. Government Take and the United States Is an Attractive Place to Invest in Oil and Gas Development

Multiple studies completed as early as 1994 and as recently as June 2007 all indicate that the U.S. government take in the Gulf of Mexico is lower than most other oil and gas fiscal systems. Four recent studies by private consultants or resource owners indicate that the U.S. government take in the Gulf of Mexico is relatively low. For example, data we evaluated from a June 2007 report by Wood Mackenzie reported that the government take in the deep water U.S. Gulf of Mexico ranked as the 93rd lowest out of 104 oil and gas fiscal systems evaluated in the study. Other U.S. oil and gas regions are also listed in the Wood Mackenzie study and some but not all other studies. However, these regions are not uniquely under federal jurisdiction, so a direct comparison of the government take in these other regions cannot be used to isolate the federal oil and gas fiscal system. The results of the four studies are summarized below in table 1.

As we reported in May 2007, the results of five other studies completed between 1994 and 2006 had similar findings. The information reported by Wood Mackenzie and other such expert studies are used by resource owners and oil and gas companies alike to aid in making investment or policy decisions and these studies represent the best data on government take available. However, we recognize there are limitations with the government take studies and the relative ranking of government take alone is not sufficient to determine whether the federal government is receiving its fair share of oil and gas revenues. A number of other factors that are not part of the government take determine company decisions of where and how much to invest and how much to pay for access to oil and gas resources. These factors include the relative size of oil and gas resource bases in different regions and the relative costs of developing these resources. Thus government take is a major, but not sole factor in determining the attractiveness of a fiscal system for oil and gas development.

When other factors are taken into consideration, the U.S. Gulf of Mexico is an attractive target for investment because it has large remaining oil and gas reserves and the United States is generally a good place to do business compared to many other countries with comparable oil and gas resources. For example, once reserves that are entirely owned by governments are removed from the analysis, of the 104 remaining fiscal regimes ranked by Wood Mackenzie that allow some participation by international oil companies and that have remaining oil and gas reserves, the deep water U.S. Gulf of Mexico ranked 18th highest in terms of remaining oil and gas reserves. Three other U.S. regions were ranked in the top 18 in terms of reserves. These were the U.S. Rocky Mountains (8th), Alaska (14th), and U.S. Gulf Coast (15th), but these regions are not uniquely covered by the federal fiscal regimes, as state and private resource owners may also exist.

Wood Mackenzie also ranked oil and gas fiscal regimes in terms of their attractiveness for investment. Wood Mackenzie’s measure of oil and gas fiscal attractiveness took into account both reward associated with factors such as resource size; and risk, including the extent to which government take includes bonuses. With respect to reward, Wood Mackenzie compared the levels of government take with the size of oil and gas fields governed by the various oil and gas fiscal systems. The risk ranking reflected whether or not the system included bonus payments, which increase the risk to investors because they must be paid whether or not economic volumes of oil and gas are eventually found on an oil and gas tract. Risk also included a measure of the extent to which and the way in which the resource owner held an equity share in the resources being developed. The impact of the fiscal terms on the rewards and risks associated with a wide range of hypothetical new investments were assessed under the terms of each of the 103 oil and gas fiscal systems included in this section of the study. Based on these assessments, Wood Mackenzie ranked the deep water U.S. Gulf of Mexico fiscal system as more attractive for investment than 60 (about 58 percent) of the 103 fiscal systems ranked.

More broadly, other measures indicate that the United States is an attractive place to invest in oil and gas production. For example, since 2002 as oil prices have risen and gas prices have remained high by historical standards, the number of oil and gas drilling rigs operating in the United States has increased much faster than in the rest of the world, which indicates companies in recent years have continued to find the United States a conducive place to invest in oil and gas production. Specifically, according to data on crude oil rig counts from Baker Hughes, the number of rigs in use globally excluding the United States increased by about 18 percent from an annual average in 2002 of 998 to 1,180 through the first 4 months of 2008, while the number of rigs operating in the United States increased about 113 percent, from 831 rigs in 2002 to 1,768 rigs in 2007 and 1,829 rigs in April 2008. These increases coincided with the increase in oil and gas prices over the same period and indicate that the United States has remained an attractive place to invest in oil and gas as prices have risen.

While rig counts can reasonably be associated with the attractiveness of a region for development and production, they do not tell the whole story. For example, according to Baker Hughes, the Gulf of Mexico rig count fluctuated over the longer term and has decreased in recent years. Specifically, from 1973 to 1981, rig counts in the Gulf of Mexico increased, from 80 to 231, before generally decreasing to 45 in 1992. They then generally rose again until 2001. From 2001 to April 2008, the annual rig count in the Gulf of Mexico decreased from 148 to 58. This decline has occurred despite the Gulf of Mexico being generally considered an attractive target for investment, both from the perspective of the government take and because of the potential for significant oil and gas resources.

Other analyses report the oil and gas industry appears to have performed favorably in recent years compared with other industries.

The Energy Information Administration reported in December 2007 that from 2000 through 2006, the return on equity, which compares a company’s profit with the value of the shares held by the company’s owners, for the major energy producers, referred to as Financial Reporting System (FRS) companies, averaged 7 percentage points higher than that of the U.S. Census Bureau’s “All Manufacturing Companies.” According to the report, this reversed a trend where the return on equity for the major energy producers averaged 2 percentage points lower than All Manufacturing Companies from 1985 to 1999.

The American Petroleum Institute, in a 2007 study, showed that from 2000 to 2005, the average return on investment for oil and gas production was about 61 percent higher than for the Standard & Poor’s (S&P) industries. However, the average return on investment for the industry has matched or exceeded the returns for the S&P industrials only in recent years; over the 25-year period from 1980 to 2005, the average return on investment for oil and gas production was about 18 percent lower than for the S&P industries.

A GAO analysis found that the “upstream,” or exploration and production segments, of the domestic oil and gas production companies also received higher rates of return than companies operating in other U.S. manufacturing industries from 2002 through 2006. We analyzed financial data from S&P’s Compustat and EIA’s FRS. From 2002 through 2006, the upstream segments of the domestic oil and gas production companies have averaged a 17.4 percent return on investment, compared with 15.2 percent for all other manufacturing companies. When both upstream and “downstream” the refining and marketing segments are included in the analysis, the oil and gas industry return on investment averaged over 20 percent during this period. This short term picture, however, contrasts with a longer-term analysis, which shows the oil and gas industry receiving a return on investment that is comparable, or slightly lower, than that received by other manufacturing industries over the past 30 years. Our analysis found that during this period, upstream oil and gas production has averaged 11.2 percent return on investment with the entire oil and gas industry receiving an average 13.7 percent return on investment. All other manufacturing companies have averaged 12.3 percent return on investment during this period. This recent improvement in financial performance from 2000 through 2006 coincided with rising oil and gas prices. Further, since 2006, oil and gas prices have risen even higher, while EIA’s most recent projections to 2030 are for oil and gas prices to remain much higher than they were for most of the period 1985 through 1999. In addition, the United States is also generally ranked favorably as a place to conduct business by the World Bank and by business media sources, including The Economist, and AM Best. For example, the World Bank ranked the United States as the third most favorable place to conduct business of 178 countries analyzed in a 2007 study. The Economist in October 2007 ranked the United States as the ninth highest of 82 countries analyzed for projected favorability of business environment from 2008 to 2012. Finally, as of February 2008, the United States remained in the top tier—of five possible tiers—on AM Best’s countries for business risk index, meaning the United States generally posed the least risk for investors of the five possible levels assigned.

The Inflexibility of Royalty Rates to Changing Oil and Gas Prices Has Cost the Federal Government Billions of Dollars in Foregone Revenues

The lack of price flexibility in royalty rates and the inability to change fiscal terms for existing leases have put pressure on Interior and the Congress to change royalty rates in the past on future leases on an ad hoc basis. For example, in 1980, a time when oil prices were comparable in inflation-adjusted terms to today’s prices, Congress passed a windfall profit tax, which amounted to an excise tax per barrel of oil produced in the United States. Congress repealed that tax in 1988 at time when oil prices had fallen significantly from their 1980 level. The tax attempted to recoup for the federal government much of the revenue that would have otherwise gone to the oil industry as a result of the decontrol of oil prices.

Further, in 1995—a period with relatively low oil and gas prices—the federal government enacted the Outer Continental Shelf Deep Water Royalty Relief Act (DWRRA). In implementing the DWRRA for leases sold in 1996, 1997, and 2000, MMS specified that royalty relief would be applicable only if oil and gas prices were below certain levels, known as “price thresholds,” with the intention of protecting the government’s royalty interests if oil and gas prices increased significantly. MMS did not include these same price thresholds for leases it issued in 1998 and 1999. In addition, the Kerr-McGee Corporation— which was active in the Gulf of Mexico and is now owned by Anadarko Petroleum Corporation—filed suit challenging Interior’s authority to include price thresholds in DWRRA leases issued from 1996 through 2000. Recently, the U.S. District Court for the Western District of Louisiana granted summary judgment in favor of Kerr-McGee concerning the application of price thresholds to those leases and this ruling is currently under appeal. In our June 2008 report on the potential foregone revenues at stake in the Kerr- McGee litigation, we found that the value of future forgone royalties is highly dependent upon oil and gas prices, and on production levels. Assuming that the District Court’s ruling is upheld, future foregone royalties from all the DWRRA leases issued from 1996 through 2000 could range widely—from a low of about $21 billion to a high of $53 billion, depending on the outcome of ongoing litigation concerning the authority of Interior to place price thresholds that would remove the royalty relief offered on certain leases. The $21 billion figure assumes relatively low production levels and oil and gas prices that average $70 per barrel and $6.50 per thousand cubic feet over the lives of the leases. The $53 billion figure assumes relatively high production levels and oil and gas prices that average $100 per barrel and $8 per thousand cubic feet over the lives of the leases. A royalty relief provision was also included in the Energy Policy Act of 2005 on leases issued during the 5-year period beginning on August 8, 2005.

In 2007, the Secretary of the Interior twice increased the royalty rate for future Gulf of Mexico leases—in January, the rate for deep water leases was raised to 16-2/3 percent and in October, the rate for all future leases in the Gulf, including those issued in 2008, was raised to 18-3/4 percent. Interior estimated these actions will increase federal oil and gas revenues by $8.8 billion over the next 30 years. The January 2007 increase applied only to deep water Gulf of Mexico leases; the October 2007 increase applied to all water depths in the Gulf of Mexico. These royalty rate increases appear to be a response by Interior to the high prices of oil and gas that have led to record industry profits and raised questions about whether the existing federal oil and gas fiscal system gives the public an appropriate share of revenues from oil and gas produced on federal lands and waters. However, the royalty rate increases do not address these record industry profits from existing leases at all and high profits will likely remain as long as the existing leases produce oil and gas or until oil and gas prices fall. In addition, in choosing to increase royalty rates, Interior did not evaluate the entire oil and gas fiscal system to determine whether or not these increases were sufficient to balance investment attractiveness and appropriate returns to the federal government for oil and gas resources. On the other hand, according to Interior, it did consider factors such as industry costs for outer continental shelf exploration and development, tax rates, rental rates, and expected bonus bids. Further, because the new royalty rates are not flexible with respect to oil and gas prices, Interior and the Congress may again be under pressure from industry or the public to further change the royalty rates if and when oil and gas prices either fall or continue rising. Finally, these royalty changes only affect Gulf of Mexico leases and do not address onshore leases at all, which should also be considered in light of the increases in oil and gas prices.

In addition, Wood Mackenzie reports that the deep water U.S. Gulf of Mexico ranked in the bottom half of countries in terms of oil and gas fiscal system stability based on repeated changes to fiscal terms for future leases and on the relative lack of built-in flexibility that would allow the fiscal terms to adjust to market conditions. Specifically, the Wood Mackenzie study ranked the deep water U.S. Gulf of Mexico fiscal terms as lower than 71 (about 72 percent) of the 103 oil and gas fiscal systems. In contrast, among the key trends among governments in recent years has been to make fiscal terms more responsive to market conditions. By adding such progressive features to oil and gas fiscal systems including royalty rates that increase with oil and gas prices, these other entities are making their systems more stable over time by reducing incentives for industry or the public to push for ad hoc changes in fiscal terms as future prices change. Wood Mackenzie’s measure of fiscal stability combines two criteria: recent history of changes to fiscal terms and built-in flexibility. As discussed previously in this report, changes to royalty rates occurred in the Gulf of Mexico three times since 1995, with the royalty relief in the mid 1990s and the two increases in royalty rates in 2007. However, as noted above, the study was conducted before the second 2007 increase in royalty rates, so the government take would likely have increased but the U.S. stability rating could have fallen in the intervening period. Built-in flexibility reflects the relative degree to which a fiscal system is regressive or progressive, with more progressive systems being more flexible. A flexible system does not mean changing the fiscal terms of existing contracts but having a system in place that automatically adjusts to changing economic and market conditions.

Oil and gas companies we communicated with stated a clear preference for stable fiscal terms, other things being equal. Overall, oil and gas companies may be more willing to invest in flexible systems, given that they tend to be inherently more stable and therefore are less likely to be arbitrarily changed on a recurring basis. Oil and gas companies and industry trade associations we contacted provided us a range of views on the advantages and disadvantages of various oil and gas fiscal systems, and generally indicated that one of the most important features of any system is its stability and predictability. Stability of fiscal terms is important because oil and gas companies are making very long-term investments and uncertainty about whether or not the resource owner will change the fiscal terms during the lifetime of the investment adds to the investment risk. The respondents also said that the terms of the oil and gas fiscal system should consider industry exploration and development costs, the likelihood of discovery, and political and economic risks. While companies surely prefer lower government take, all else constant, to the extent that stability is also preferred, a more stable system may be able to remain competitive for investment while resulting in a higher government take than a less stable system. In particular, companies may be willing to pay a larger average share of oil and gas revenues if they believe that oil and gas fiscal systems will not change when market conditions change, such as the windfall profits charges that a number of countries have recently imposed. Such willingness to accept lower expected profits in exchange for lower risk is a common feature of investment markets.

In addition to the potential trade-off between oil and gas fiscal system stability and government take, companies may be willing to pay higher average shares of revenues if governments bear some of the risk that companies take on when they purchase the rights to explore for oil and gas. For example, in the United States as well as for a number of other governments, leases are awarded through a bidding process that requires companies to pay bonus bids for the rights to explore and develop leases. With regard to bonus bids, there are advantages to requiring such bids. First, when companies have to compete with one another to win a lease, the lease is more likely to be awarded to a company with the expertise and resources to properly explore and develop the resources on the lease than if leases are awarded using some other rationing mechanism that does not take into account how much companies are willing to pay for the lease. In addition, it guarantees the public some revenue early on in the exploration and development process, which can take a number of years to complete. However, the use of bonus bids pushes a great deal of risk onto oil and gas companies and requires them to estimate many uncertain factors, including the amounts of oil and gas that will ultimately be produced on the lease, the costs of that production, and the prices of gas and oil over the entire working life of the lease. In general, by increasing the risk that companies bear, these companies will have to expect to receive a higher rate of return to be willing to take on the project. In fiscal systems requiring bonus bids or other up-front payments, the companies bear the risk that leases will not generate economically significant oil and gas production. In fact, in the United States, a large proportion of leases that companies have paid for do not generate economic levels of production and the companies, after purchasing the lease, and paying rent for the duration of the initial term of the lease and whatever resources they spent on exploring for oil and gas, simply let the lease revert back to the government when the initial term expires.

Some oil and gas fiscal systems mitigate the risk associated with up-front company expenditures by allowing the companies to recover exploration and development costs prior to starting higher royalty payments. For example, Alberta, Canada, has used such fiscal terms. Other fiscal systems share risk with companies by more strongly linking government take to company profits. In such oil and gas fiscal systems, government take is low in early years of a lease, when exploration and early development are being undertaken, but increases if production increases or if oil and gas prices increase once production begins. The state of Alaska has recently changed its fiscal terms to increase its government take and to increase the linkage between government take and company profits. Both Alberta and the state of Alaska have higher government takes than the U.S. Gulf of Mexico according to the Wood Mackenzie study.

Interior Does Not Have a System in Place to Evaluate Whether the Federal Fiscal System Is in Need of Reassessment

Interior does not routinely evaluate the federal oil and gas fiscal system as a whole, monitor what other resource owners worldwide are receiving for their energy resources, or evaluate and compare the attractiveness of the United States for oil and gas investment with that of other oil and gas regions. As a result, Interior cannot assess whether or not there is a proper balance between the attractiveness of federal lands and waters for oil and gas investment and a reasonable assurance that the public is getting an appropriate share of revenues from this investment. This is true of the U.S. Gulf of Mexico as well as other federal oil and gas producing regions. Interior does not have procedures in place for routinely evaluating the ranking of (1) the federal oil and gas fiscal system against other resource owners or (2) industry rates of return on federal leases compared to other U.S. industries which could factor into any decisions about whether or how to alter the fiscal systems in response to changing market conditions. Interior officials told us that they have a “bid adequacy review process” for offshore leases that determines whether the bonus bid meets criteria designed to ensure fair market value of the leased tract but that onshore leases do not have a similar bid adequacy provision. Moreover, Interior maintains it has been responsive to changes in market conditions through revisions to lease terms, including changes in minimum bonus bid levels, fluctuating royalty rates, and price thresholds. However, as we have discussed previously in this report, bonus bids have both positive and negative sides with respect to their likely impact on overall government take. Further, frequent adjustments to fiscal terms are not looked on favorably by industry, especially when they involve increases in royalty rates or other charges. Interior indicated, in commenting on the report draft, that it is in the process of evaluating other fiscal approaches such as sliding scale royalties for some oil and gas leases.

We did not evaluate the effectiveness of the bid adequacy review process in terms of its intended goal of ensuring bonus bids on offshore federal leases are competitive. However, even assuming that these bids are competitive, we do not think that this is sufficient to ensure that the other elements of the system are appropriately balancing the interests of taxpayers and oil and gas companies. In light of the complexity of oil and gas fiscal systems, the great deal of uncertainty surrounding the volumes and future prices of oil and gas, and the costs of producing it, oil and gas companies cannot be expected to accurately forecast all the factors that will ultimately determine the value of a lease at the time that lease is sold. As a result, oil and gas company profits have tended to rise and fall over time with oil and gas prices, putting pressure on Interior to alter fiscal terms in a reactive rather than a strategic way. Further, the fact that Interior does not apply the same or a similar bid adequacy process for onshore leases raises questions about how Interior, overall, is providing reasonable assurance that even the bonus bids it receives are competitively determined in all publicly owned oil and gas producing regions.

While Interior has made many specific changes to components of the federal oil and gas fiscal system over the years to adjust to changing market conditions, these changes were generally not done as part of a comprehensive review of the fiscal system that took into account the relative ranking of the U.S. government take or other comparisons with other countries or regions. The last time Interior conducted a comprehensive evaluation of the oil and gas fiscal system was over 25 years ago. The lack of a recent comprehensive re-evaluation of the U.S. federal fiscal system stands in contrast to the actions of many other governments that have recently reevaluated or are currently re-evaluating their fiscal systems in light of rising oil and gas prices and higher industry profits and rates of return. For example, as previously discussed in this report, a number of countries have recently imposed windfall profits taxes or other mechanisms to increase the resource owners’ shares of oil and gas revenues from existing projects. Wood Mackenzie estimates that these changes will ultimately result in these countries’ collecting additional oil and gas revenues of between $118 billion and $400 billion, depending on future oil and gas prices.

In evaluating an oil and gas fiscal system, all components of the system, including bonus bids, land rental rates, royalties, and oil and gas company taxes, must be considered. However, while Interior has a great deal of expertise and data from years of administering and collecting revenues from oil and gas leases on federal lands and waters that would be essential for any review of the federal oil and gas fiscal system, they do not have the authority to change taxes and, therefore, cannot fully revise the system without legislative action by the Congress. Further, it is essential to keep federal leases competitive with other potential investments governed by different fiscal systems. Therefore, in addition to input from Interior, oil and gas industry experts must also be consulted in any comprehensive review of the federal oil and gas fiscal system. For example, when Alberta recently reviewed its oil and gas fiscal system, it convened a panel that included experts from academia, energy research and consulting firms, and the energy industry and also hired a consultant to evaluate the system and make specific recommendations. Following this review, Alberta increased some elements of the oil and gas fiscal system. However, prior to this review, Canadian government corporate taxes were reduced, which made Alberta more attractive for investors. In any comprehensive review of the U.S. oil and gas fiscal system, taxes may need to be part of the discussion. Therefore, congressional action may be needed to change the federal oil and gas fiscal system, if changes are ultimately determined to be appropriate.

Conclusions

Oil prices have increased in recent years to levels not seen since the late 1970s and early 1980s when adjusted for inflation. Natural gas prices have also been high by historical standards in recent years. These high prices have coincided with rising oil company profits. Moreover, the EIA’s long- term outlook projects these prices to remain much higher than what they had been for much of the past 25 years. Our work indicates that federal oil and gas leases in the deep water U.S. Gulf of Mexico and other U.S. regions are attractive investments and that the government take in the U.S. Gulf of Mexico ranks among the lowest across a large number of other oil and gas fiscal systems. Our work further indicates that other measures, including fiscal attractiveness and rates of return, indicate the U.S. Gulf of Mexico and other U.S. oil and gas producing regions are attractive places to invest. However, the regressive nature of the U.S. federal fiscal systems and other factors have caused these fiscal systems to be unstable over time and this adds risk to oil and gas investments and may reduce the amount oil and gas companies are willing to pay in total for the rights to explore and develop federal leases. Because of these facts and because Interior has not re-evaluated its oil and gas fiscal system in over 25 years, a comprehensive re-evaluation is called for. While Interior could collect data and commission studies to re-evaluate the federal fiscal system, the agency does not currently have the information to fully compare the federal fiscal system with those of other governments, including states or foreign countries. In addition, Interior does not have the authority to make changes to all elements of federal fiscal system if such changes were found to be desirable. Finally, because of the complexity of evaluating oil and gas fiscal systems and the importance of striking a balance between remaining an attractive place for investment and providing revenue to the federal government, it is important that independent experts also be consulted as well as representatives from the oil and gas industry.

Matter for Congressional Consideration

In the draft report we sent to Interior for comment, we made recommendations to address these issues. In its response, Interior stated that it did not fully concur with our recommendations because it had already contracted for a study that will address many of the issues we raise. However, because Interior’s ongoing study is limited in scope and is limited to a specific region in the Gulf of Mexico, rather than a review of the entire federal oil and gas fiscal system as we recommended, we do not find the agency’s stated rationale for not agreeing fully with our recommendations to be convincing. Therefore, we believe that Congress may wish to consider directing the Secretary of the Interior to convene an independent panel to perform a comprehensive review of the federal oil and gas fiscal system.

Further, in order to keep abreast of potentially changing market conditions going forward, the Congress may wish to consider directing the Secretary of the Interior to direct the Minerals Management Service and other relevant agencies within Interior to establish procedures for periodically collecting data and information and conducting analyses to determine how the federal government take and the attractiveness for oil and gas investors in each federal oil and gas region compare to those of other resource owners and report this information to the Congress.

Agency Comments and Our Evaluation

The Department of the Interior provided us comments on a draft of the report. Overall, the department agreed that it is important to reassess the federal oil and gas fiscal system but did not fully concur with either of our two recommendations to (1) perform a comprehensive review of the system using an independent panel and (2) adopt policies and procedures to keep abreast of important changes in the oil and gas market and in other countries’ efforts to adjust their oil and gas management practices in light of these changes. We disagree with Interior’s rationale for its lack of full concurrence with our recommendations and have, therefore, elected to reframe the recommendations into Matters for Congressional Consideration in the final report.

In response to our first recommendation, Interior indicated that it would be premature and duplicative for the department to undertake such a review because it had recently contracted with an outside party to conduct a 2-year study of the policies affecting the pace of area-wide leasing and revenues in the Central and Western Gulf of Mexico. We disagree that our recommended review is either premature or duplicative with this Interior study effort. First, a comprehensive review is overdue, given that Interior has not performed a comprehensive evaluation of the oil and gas fiscal system in over 25 years and in light of the dramatic increases in oil and gas prices and industry profits in recent years. Further, as documented in this report, many other oil and gas owners have been re-evaluating and changing their oil and gas fiscal systems in response to these recent market conditions. The Congress and the public are justifiably concerned about whether the federal government is getting a fair return for its energy resources as oil and gas company profits have reached record levels. In addition, our recommended review would not be duplicative with Interior’s ongoing study, which is geographically limited to only two sections of the Gulf of Mexico. In contrast, we recommended that Interior review all its oil and gas fiscal systems, both onshore and offshore. Nor does Interior’s ongoing study cover the full scope of review that we recommended, including looking at how other resource owners are managing their oil and gas fiscal systems. Further, Interior’s ongoing study does not explicitly look at the stability of the system as we recommended and this appears to be a critical factor influencing changes to oil and gas fiscal systems globally. Finally, Interior’s ongoing effort does not utilize an independent panel. We believe it is essential to empanel an independent body, representative of major stakeholders, including those representing the interests of industry and the public, in order to develop recommendations that strike an appropriate balance between remaining and attractive place for investment and providing revenue to the federal government.

In response to our second recommendation, Interior implied that such an effort was unnecessary because Interior agencies that lease federal minerals already keep abreast of current literature on fiscal systems of other resource owners. During our work, we identified only one Interior study done over the past 25 years that provided information on the U.S. government take compared to other fiscal systems. While that one Interior study issued in 2006 showed, similar to our work, that the U.S. government take was low compared to other fiscal systems, it is also worth noting that the study itself relied on dated 1994 government-take information. Therefore, we do not believe that Interior has adequately kept abreast of important trends in oil and gas management, especially as it relates to how other resource owners are managing these resources. In addition, our recommendation went further than simply keeping abreast of current literature. In particular, our recommendation sought to have Interior monitor and report on how the federal government’s fiscal terms for oil and gas development compare with the terms of other resource owners worldwide.

Interior’s full letter commenting on the draft report is printed as appendix III, and our detailed response follows. In addition, Interior made technical comments that we have addressed as appropriate.

As agreed with your offices, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days from the date of this report. At that time, we will send copies to appropriate congressional committees, the Secretary of the Interior, the Director of MMS, the Director of the Office of Management and Budget, and other interested parties. We will also make copies available to others upon request. In addition, the report will be available at no charge on GAO’s Web site at http://www.gao.gov.

If you or your staff have any questions about this report, please contact me at (202) 512-3841 on ruscof@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made major contributions to this report are listed in appendix IV.

Appendix I: Scope and Methodology

We performed our work at the Department of Interior’s (Interior), Bureau of Land Management’s (BLM), and Minerals Management Service’s (MMS) offices and in Washington, D.C. from May 2007 to September 2008 in accordance with generally accepted government auditing standards. We focused our analysis of government take and industry rates of return on the U.S. Gulf of Mexico because it represents approximately 79 percent of oil and 50 percent of gas production on federal leases, and because there are complicating factors for onshore oil and gas leases, such as state and local taxes or fees that may differ by locality, which the available studies do not fully address. We did evaluate information that applied more broadly to the United States, specifically with respect to overall measures of the attractiveness of the United States for oil and gas investment. However, we cannot infer from our review of the Gulf of Mexico federal oil and gas leases how the data on federal government take or industry returns to investment are applicable to federal onshore leases. In general, the results of this review can compare the federal system associated with the U.S. Gulf of Mexico to that of other oil and gas fiscal systems but cannot provide specific prescriptive recommendations for how to change the federal fiscal system to achieve a fair return for the public from sale of oil and gas on public lands and waters. We also compared the federal oil and gas fiscal system to all types of fiscal systems around the world to encompass the range of choices that oil and gas companies are faced with when deciding where to invest.

To determine the degree to which the federal government is receiving a fair return, our work included reviewing various pieces of energy resource management legislation enacted over the last several decades. This included, among others, the Outer Continental Shelf Lands Act of 1953 (OCSLA) and its amendments and the Federal Land Policy and Management Act of 1976 (FLPMA) and its amendments. We also collected and analyzed various pieces of Interior energy resource policy and management information. To evaluate how the U.S. government take compares to those in other countries, we reviewed the results of a study procured from Wood Mackenzie, a leading industry consultant, and recent studies conducted by other private consultants or resource owners. We also collected and analyzed various studies generated by MMS, the agency responsible for collecting oil and gas royalties from federal lands and waters and interviewed private consulting firm officials. In evaluating the study results, we conducted interviews with study authors and an industry expert to discuss the study methodologies and the appropriate interpretation of the results. Based on these interviews and our review of study results, we believe the general approach that these study authors took was reasonable and that the results of the studies are credible. However, we did not fully evaluate each study’s methodology or the underlying data used to make the government take estimates. Overall, because all the studies came to similar conclusions with regard to the relative ranking of the U.S. federal government, and because such studies are used by oil and gas industry companies and governments alike for the purposes of evaluating the relative competitiveness of specific oil and gas fiscal systems, we are confident that the broad conclusions of the studies are valid. To assess the extent to which the United States’ oil and gas fiscal system is able to remain stable as market conditions change, we relied heavily on the study and data we obtained from Wood Mackenzie. We interviewed industry experts and gathered information regarding the types of fiscal systems and the relative stability offered with each. We interviewed company officials and industry experts to obtain information on their preferences regarding fiscal system characteristics.

We also purchased data from Compustat and analyzed that data and data published by the Energy Information Administration. The financial data we procured are widely used by private companies and governments for purposes of comparing company and industry rate of return over time, because Interior in the past used rate of return as a credible measure to evaluate the profitability of the Gulf of Mexico for firms conducting oil and gas exploration there versus the relative profitability of other manufacturing firms operating in the United States. We also evaluated data reported by the American Petroleum Institute and other sources. Further, we reviewed various reports prepared over the last 2 years by private sources on the profitability of oil and gas companies operating in the U.S. versus operating elsewhere in the world. We also spoke to industry officials regarding aspects of the various fiscal systems in which they operate. Finally, we discussed the issue of a “fair return” with various Interior, BLM, and MMS officials, as well as members of the oil and gas industry. To determine what steps Interior takes to get reasonable assurance that the federal government take provides a fair return to the public, we reviewed Interior studies and procedures, and interviewed officials from MMS.

We conducted this performance audit from May 2007 to September 2008, in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Appendix II: Companies Receiving Royalty Relief in the U.S. Gulf of Mexico

According to Interior, companies operating in the U.S. Gulf of Mexico had received more than $1.3 billion in royalty relief through September 30, 2007. Table 2 lists the companies that have received royalty relief under DWWRA and the amounts of that relief. Six companies had signed agreements with Interior, allowing thresholds to be placed for royalties to be paid in the future. Those companies are BP Exploration and Production; ConocoPhillips & Burlington Resources Offshore, Inc.; Marathon; Shell; Walter Hydrocarbons; and Walter Oil and Gas. According to Interior information dated February 4, 2008, ConocoPhillips & Burlington Resources Offshore, Inc., had not received royalty relief.

Appendix III: Comments from Department of the Interior

The following are GAO’s comments on the Department of the Interior’s letter dated August 8, 2008.

GAO Comments

1. Regarding Interior’s statements that (1) the draft report relies heavily on measures of government take but does not clarify the link between government take and investment attractiveness, and (2) the draft report does not relate the significance of the OCSLA and FLPMA laws, we disagree. The report on page 1 states that several factors need to be considered, including the size of availability of the oil and gas resources in place; the cost of finding and developing these resources, and the stability of other the oil and gas fiscal systems and the country in general. Also on page 2, we note that a fair government take would strike a balance between encouraging private companies to invest in the development of oil and as resources on federal lands and waters while maintaining the public’s interest in collecting the appropriate level of revenues from the sale of the public’s resources. Further, we devote a significant portion of our discussion of objective one to how the attractiveness of the U.S. oil and gas fiscal system compares with those of other resource owners, and concludes that U.S Gulf of Mexico and other U.S. places are attractive places to invest. With regard to the significance of the OCSLA and FLPMA laws, on page 3 of the report we discuss the provisions of the OCSLA and FLPMA laws and how they relate to the management of the federal oil and gas fiscal system. 2. Interior commented that the report’s conclusion that inflexibility in the federal oil and gas fiscal system is responsible for significant reductions in the federal fiscal take is not supported. We maintain that the inherent inflexibility of the federal fiscal system means that government receipts from the production of oil and gas on federal lands and waters have not tracked with the prices of oil and gas. This lack of flexibility explains, in part, why the Congress enacted the Deep Water Royalty Relief Act in 1995, a time when oil and gas prices were much lower than they are today. The lack of flexibility of the royalty rates for some of the leases issued under this Act, as implemented by Interior, will end up costing the public billions of dollars in foregone revenues. Further, the recent increases to royalty rates that Interior references in its comments do nothing to address the bulk of leases already held and for which industry profits have increased as high as they have precisely because neither the royalty rates, nor other components of the oil and gas fiscal system were sufficiently flexible to allow federal revenues to increase automatically when oil and gas prices and industry profits increased. Overall, Interior should strive to achieve fair market value over time, not simply evaluate market conditions at the time leases are issued. 3. With regard to Interior’s comments that although it has not conducted a comprehensive evaluation of the federal oil and gas fiscal system, it has evaluated expected resources and conditions on the Outer Continental Shelf (offshore) tracts, we agree that Interior takes some steps to evaluate offshore leases but the objective addresses a broader evaluation of how Interior monitors the performance and appropriateness of the entire federal oil and gas fiscal system, including offshore and onshore, and also including assessing performance over time rather than at the time a lease is sold. Interior officials told us they evaluate offshore tracts before the issuance of a lease for prospectivity of the lease and use such measures to determine an adequate minimum bid for the lease. However, as Interior makes note in its own comments, Interior officials have not systematically reviewed the bid outcomes of offshore tracts. 4. We agree that onshore and offshore leases can be very different and for the reasons stated in Interior’s comments. That is why we recommended a comprehensive review of the entire federal oil and gas fiscal system, including onshore and offshore. We also recommended that the results of this comprehensive review be presented to the Congress so that it can act appropriately in the event any existing laws or regulations that govern the leasing and collection of revenues from federal oil and gas leases could be improved in light of the recommendations of the independent panel. 5. Interior states that the report implies that Interior maximizes government receipts from oil and gas leases. We disagree that the report implies this and can find no place in the report where we believe a reader would make such an inference. 6. We disagree with Interior’s statement that it “analyzes fiscal terms before each lease sale and reviews the results of each sale.” Interior’s analysis of prospective leases is for offshore leases only and, according to Interior officials, is an analysis of the prospectivity of the offshore tract, designed to set minimum adequate bids. It is not a review of “fiscal terms,” as Interior states in its comments. With regard to the two recent royalty rate increases for future oil and gas leases in the Gulf of Mexico, these increases do not resolve fair market value for past leases issued with inflexible fiscal terms and are themselves inflexible. Therefore, if future oil and gas prices turn out to be different than what Interior expected when they made the changes, the resulting outcome will again not reflect a fair return and could be too high or too low, depending on what happens in the oil and gas markets. 7. With regard to Interior’s comment that it recently contracted with a panel of academic oil and gas industry experts to conduct a study of fiscal arrangements including fixed and sliding royalty terms, please see our general response to Interior’s comments on page 24. 8. We agree with the statements Interior makes in this paragraph, and note that these concepts are also well represented in our report. For example, we note that investment choices are affected by many variables, including the fiscal system of rents, royalties, and bonus bids, as well as the cost of capital, risk, and the attractiveness of investments; indeed, we designed the job to discuss the first range of issues in our first objective, and the second range of issues in the second objective. We conclude, and Interior agrees, that any increases in federal revenues through higher fiscal terms must be carefully weighed; however, Interior has not done this “careful weighing” in making its royalty rate increases. That is why we recommended a comprehensive review of the federal oil and gas fiscal system. 9. With regard to Interior’s comment that it operates under a management and leasing policy defined by the Congress in the OCSLA and FLPMA, we agree and this is reflected on page 3 of the draft report. However, Interior cannot effectively conduct the mineral leasing programs without evaluating federal mineral leasing systems and assessing industry rates of return and other factors discussed in this report. Interior must keep abreast of these issues and developments in fiscal regimes elsewhere, and advise Congress on developments in the competitiveness of the federal oil and gas fiscal system versus those employed by other resource owners. Further, our audit work shows that Interior has responded to oil and gas market changes in a reactive, rather than strategic and forward-looking manner, and we believe the Congress needs to be kept abreast of changes affecting federal oil and gas leasing and revenue generation. 10. Interior comments that the draft report does not mention the royalty relief mandated by the Congress in the Energy Policy Act of 2005, and its decision to seek repeal of this provision, and that the impact of the law should have been taken into consideration. We agree that the draft report did not discuss the 2005 law explicitly but note that the results we report do implicitly take this law into consideration. Our results on the government take and attractiveness of investment in the deep water Gulf of Mexico derive largely from a 2007 study done by Wood Mackenzie that took into account the impact of the existing laws at the time of the study. We have added language to make explicit acknowledgement of the Energy Policy Act of 2005 11. See our general response to Interior’s comments on page 24-25 of this report. 12. See our general response to Interior’s comments on page 24-25 of this report. 13. See our general response to Interior’s comments on page 24-25 of this report.

Appendix IV: GAO Contact and Staff Acknowledgments

Staff Acknowledgments

In additional to the individual named above, Jon Ludwigson (Assistant Director), Robert Baney, Ron Belak, Nancy Crothers, Glenn Fischer, Michael Kendix, Carol Kolarik, Michelle Munn, Daniel Novillo, Ellery Scott, Rebecca Shea, Dawn Shorey, Barbara Timmerman, and Maria Vargas made key contributions to this report.