Interior lacks adequate assurance that it is receiving the full royalties it is owed because (1) neither BLM nor OMM is fully inspecting leases and meters as required by law and agency policies, and (2) MMS lacks adequate management systems and sufficient internal controls for verifying that royalty payment data are accurate and complete. With regard to inspecting oil and gas production, BLM is charged with inspecting approximately 20,000 producing onshore leases annually to ensure that oil and gas volumes are accurately measured. However, BLM’s state Inspection and Enforcement Coordinators from Colorado, Montana, New Mexico, Utah, and Wyoming told us that only 8 of the 23 field offices in the 5 states completed both their (1) required annual inspections of wells and leases that are high-producing and those that have a history of violations and (2) inspections every third year on all remaining leases. According to the BLM state Inspection and Enforcement Coordinators, the number of completed production inspections varied greatly by field office. For example, while BLM inspectors were able to complete all of the production inspections in the Kemmerer, Wyoming, field office, inspectors in the Glenwood Springs, Colorado, field office were able to complete only about one-quarter of the required inspections. Officials in 3 of the 5 field offices in which we held detailed discussions with inspection staff told us that they had not been able to complete the production inspections because of competing priorities, including their focus on completing a growing number of drilling inspections for new oil and gas wells, and high inspection staff turnover. However, BLM officials from all 5 field offices told us that when they have conducted production inspections they have identified a number of violations. For example, BLM staff in 4 of the 5 field offices identified errors in the amounts of oil and gas production volumes reported by operators to MMS by comparing production reports with third-party source documents. Additionally, BLM staff from 1 field office we visited showed us a bypass built around a gas meter, allowing gas to flow around the meter without being measured. BLM staff ordered the company to remove the bypass. Staff from another field office told us of a case in which individuals illegally tapped into a gas line and routed gas to private residences. Finally, in one of the field offices we visited, BLM officials told us of an instance in which a company maintained two sets of conflicting production data—one used by the company and another reported to MMS. Moreover, OMM, which is responsible for inspecting offshore production facilities that include oil and gas meters, did not inspect all oil and gas royalty meters, as required by its policy, in 2007. For example, OMM officials responsible for meter inspections in the Gulf of Mexico told us that they completed about half of the required 2,700 inspections, but that they met OMM’s goal for witnessing oil and gas meter calibrations. OMM officials told us that one reason they were unable to complete all the meter inspections was their focus on the remaining cleanup work from hurricanes Katrina and Rita. Meter inspections are an important aspect of the offshore production verification process because, according to officials, one of the most common violations identified during inspections is missing or broken meter seals. Meter seals are meant to prevent tampering with measurement equipment. When seals are missing or broken, it is not possible without closer inspection to determine whether the meter is correctly measuring oil or gas production. With regard to MMS’s assurance that royalty data are being accurately reported by companies, MMS’s systems and processes for collecting and verifying these data lack both capabilities and key internal controls, including those focused on data accuracy, integrity, and completeness. For example, MMS lacks an automated process to routinely and systematically reconcile all production data filed by payors (those responsible for paying the royalties) with production data filed by operators (those responsible for reporting production volumes). MMS officials told us that before they transitioned to the current financial management system in 2001, their system included an automated process that reconciled the production and royalty data on all transactions within approximately 6 months of the initial entry date. However, MMS’s new system does not have that capability. As a result, such comparisons are not performed on all properties. Comparisons are made, if at all, 3 years or more after the initial entry date by the MMS compliance group for those properties selected for a compliance review or audit. In addition, MMS lacks a process to routinely and systematically reconcile all production data included by payors on their royalty reports or by operators on their production reports with production data available from third-party sources. OMM does compare a large part of the offshore operator-reported production data with third-party data from pipeline operators through both its oil and gas verification programs, but BLM compares only a relatively small percentage of reported onshore oil and gas production data with third-party pipeline data. When BLM and OMM do make comparisons and find discrepancies, they forward the information to MMS, which then takes steps to reconcile and correct these discrepancies by talking to operators. However, even when discrepancies are corrected and the operator-reported data and pipeline data have been reconciled, these newly reconciled data are not automatically and systematically compared with the reported sales volume in the royalty report, previously entered into the financial management database, to ensure the accuracy of the royalty payment. Such comparisons occur only if a royalty payor’s property has been selected for an audit or compliance review. Furthermore, MMS’s financial management system lacks internal controls over the integrity and accuracy of production and royalty-in-value data entered by companies. Companies may legally make changes to both royalty and production data in MMS’s financial management system for up to 6 years after the reporting month, and these changes may necessitate changes in the royalty payment. However, when companies retroactively change the data they previously entered, these changes do not require prior approval by, or notification of, MMS. As a result of the companies’ ability to unilaterally make these retroactive changes, the production data and required royalty payments can change over time, further complicating efforts by agency officials to reconcile production data and ensure that the proper amount of royalties was paid. Compounding this data reliability concern, changes made to the data do not necessarily trigger a review to determine their reasonableness or whether additional royalties are due. According to agency officials, these changes are not subject to review at the time a change is made and would be evaluated only if selected for an audit or compliance review. This is also problematic because companies may change production and royalty data after an audit or compliance review has been done, making it unclear whether these audited royalty payments remain accurate after they have been reviewed. Further, MMS officials recently examined data from September 2002 through July 2007 and identified over 81,000 adjustments made to data outside the allowable 6-year time frame. MMS is working to modify the system to automatically identify adjustments that have been made to data outside of the allowable 6-year time frame, but this effort does not address the need to identify adjustments made within the allowable time that might necessitate further adjustments to production data and royalty payments due. Finally, MMS’s financial management system could not reliably detect when production data reports were missing until late 2004, and the system continues to lack the ability to automatically detect missing royalty reports. In 2004, MMS modified its financial management system to automatically detect missing production reports. As a result, MMS has identified a backlog of approximately 300,000 missing production reports that must be investigated and resolved. It is important that MMS have a complete set of accurate production reports so that BLM can prioritize production inspections, and its compliance group can easily reconcile royalty payments with production information. Importantly, MMS’s financial management system continues to lack the ability to automatically detect cases in which an expected royalty report has not been filed. While not filing a royalty report may be justifiable under certain circumstances, such as when a company sells its lease, MMS’s inability to detect missing royalty reports presents the risk that MMS will not identify instances in which it is owed royalties that are simply not being paid. Officials told us they are currently able to identify missing royalty reports in instances when they have no royalty report to match with funds deposited to Treasury. However, cases in which a company stops filing royalty reports and stops paying royalties would not be detected unless the payor or lease was selected for an audit or compliance review. MMS’s increasing use of compliance reviews, which are more limited in scope than audits, has led to an inconsistent use of third-party data to verify that self-reported royalty data are correct, thereby placing accurate royalty collections at risk. Since 2001, MMS has increasingly used compliance reviews to achieve its performance goals of completing compliance activities—either full audits or compliance reviews—on a predetermined percentage of royalty payments. According to MMS, compliance reviews can be conducted much more quickly and require fewer resources than audits, largely because they represent a quicker, more limited reasonableness check of the accuracy and completeness of a company’s self-reported data, and do not include a systematic examination of underlying source documentation. Audits, on the other hand, are more time- and resource-intensive, and they include the review of original source documents, such as sales revenue data, transportation and gas processing costs, and production volumes, to verify whether company- reported data are accurate and complete. When third-party data are readily available from OMM, MMS may use them when conducting a compliance review. For example, MMS may use available third-party data on oil and gas production volumes collected by OMM in its compliance reviews for offshore properties. In contrast, because BLM collects only a limited amount of third-party data for onshore production, and MMS does not request these data from the companies, MMS does not systematically use third-party data when conducting onshore compliance reviews. Despite conducting thousands of compliance reviews since 2001, MMS has only recently evaluated their effectiveness. For calendar year 2002, MMS compared the results of 100 of about 700 compliance reviews of offshore leases and companies with the results of audits conducted on those same leases or companies. However, while the compliance reviews covered, among other things, 12 months of production volumes on all products— oil, gas, and retrograde, a liquid product that condenses out of gas under certain conditions—the audits covered only 1 month and one product. As a result of this evaluation comparing the results of compliance reviews with those of audits, MMS now plans to improve its compliance review process by, for example, ensuring that it includes a step to check that royalties are paid on all royalty-bearing products, including retrograde. To achieve its annual performance goals, MMS began using the compliance reviews along with audits. One of MMS’s performance goals is to complete compliance activities—either audits or compliance reviews— on a specified percentage of royalty payments within 3 years of the initial royalty payment. For example, in 2006 MMS reported that it had achieved this goal by confirming reasonable compliance on 72.5 percent of all calendar year 2003 royalties. To help meet this goal, MMS continues to rely heavily on compliance reviews, yet it is unable to state the extent to which this performance goal is accomplished through audits as opposed to compliance reviews. As a result, MMS does not have information available to determine the percentage of the goal that was achieved using third- party data and the percentage that did not systematically rely on third- party data. Moreover, to help meet its performance goal, MMS has historically conducted compliance reviews or audits on leases and companies that have generated the most royalties, with the result that the same leases and companies are reviewed year after year. Accordingly, many leases and companies have gone for years without ever having been reviewed or audited. In 2006, Interior’s Inspector General (IG) reviewed MMS’s compliance process and made a number of recommendations aimed at strengthening it. The IG recommended, among other things, that MMS examine 1 month of third-party source documentation as part of each compliance review to provide greater assurance that both the production and allowance data are accurate. The IG also recommended that MMS track the percentage of the annual performance goal that was accomplished through audits versus through compliance reviews, and that MMS move toward a risk-based compliance program and away from reviewing or auditing the same leases and companies each year. To address the IG’s recommendations, MMS has recently revised its compliance review guidance to include suggested steps for reviewing third-party source production data when available for both offshore and onshore oil and gas, though the guidance falls short of making these steps a requirement. MMS has also agreed to start tracking compliance activity data in 2007 that will allow it to report the percentage of the performance goal that was achieved through audits versus through compliance reviews. Finally, MMS has initiated a risk-based compliance pilot project, whereby leases and companies are selected for compliance work according to MMS-defined risk criteria that include factors other than whether the leases or companies generate high royalty payments. According to MMS, during fiscal year 2008 it will further evaluate and refine the pilot as it moves toward fuller implementation. Finally, representatives from the states and tribes who are responsible for conducting compliance work under agreements with MMS have expressed concerns about the quality of self-reported production and royalty data they use in their reviews. As part our work, we sent questionnaires to all 11 states and seven tribes that conducted compliance work for MMS in fiscal year 2007. Of the nine state and five tribal representatives who responded, seven reported that they lack confidence in the accuracy of the royalty data. For example, several representatives reported that because of concerns with MMS’s production and royalty data, they routinely look to other sources of corroborating data, such as production data from state oil and gas agencies and tax agencies. Finally, several respondents noted that companies frequently report production volumes to the wrong leases and that they must then devote their limited resources to correcting these reporting problems before beginning their compliance reviews and audits. Because MMS’s royalty-in-kind program does not extend the same production verification processes used by its oil program to its gas program, it does not have adequate assurance that it is collecting the gas royalties it is owed. As noted, under the royalty-in-kind program, MMS collects royalties in the form of oil and gas and then sells these commodities in competitive sales. To ensure that the government obtains the fair value of these sales, MMS must make sure that it receives the volumes to which it is entitled. Because prices of these commodities fluctuate over time, it is also important that MMS receive the oil and gas at the time it is entitled to them. As part of its royalty-in-kind oversight effort, MMS identifies imbalances between the volume operators owe the federal government in royalties and the volume delivered and resolves these imbalances by adjusting future delivery requirements or cash payments. The methods that MMS uses to identify these imbalances differ for oil and gas. For oil, MMS obtains pipeline meter data from OMM’s liquid verification system, which records oil volumes flowing through numerous metering points in the Gulf of Mexico region. MMS calculates its royalty share of oil by multiplying the total production volumes provided in these pipeline statements by the royalty rates for a given lease. MMS compares this calculation with the volume of royalty oil that the operators delivered as reported by pipeline operators. When the value of an imbalance cumulatively reaches $100,000, MMS conducts further research to resolve the discrepancy. Using pipeline statements to verify production volumes is a good check against companies’ self-reporting of royalties due the federal government because companies have an incentive to not underreport their share of oil going into the pipeline because that is the amount they will have to sell at the other end of the pipeline. For gas, MMS relies on information contained in two operator-provided documents—monthly imbalance statements and production reports. Imbalance statements include the operator’s total gas production for the month, the share of that production that the government is entitled to, and any differences between what the operator delivered and the government’s royalty share. Production reports contain a large number of data elements, including production volumes for each gas well. MMS compares the production volumes contained in the imbalance statements with those in the production reports to verify production levels. MMS then calculates its royalty share based on these production figures and compares its royalty share with gas volumes the operators delivered as reported by pipeline operators. When the value of an imbalance cumulatively reaches $100,000, MMS conducts further research to resolve the discrepancy. MMS’s ability to detect gas imbalances is weaker than for oil because it does not use third-party metering data to verify the operator-reported production numbers. Since 2004, OMM has collected data from gas pipeline companies through its gas verification system, which is similar to its liquid verification system in that the system records information from pipeline company-provided source documents. Our review of data from this program shows that these data could be a useful tool in verifying offshore gas production volumes. Specifically, our analysis of these pipeline data showed that for the months of January 2004, May 2005, July 2005, and June 2006, 25 percent of the pipeline metering points had an outstanding discrepancy between self-reported and pipeline data. These discrepancies are both positive and negative—that is, production volumes submitted to MMS by operators are at times either under- or overreported. Data from the gas verification system could be useful in validating production volumes and reducing discrepancies. However, to fully benefit from this opportunity, MMS needs to improve the timeliness and reliability of these data. After examining this issue, in December 2007, the Subcommittee on Royalty Management, a panel appointed by the Secretary of the Interior to examine MMS’s royalty program, reported that OMM is not adequately staffed to conduct sufficient review of data from the gas verification system. We have not yet, nor has MMS, determined the net impact of these discrepancies on royalties owed the federal government. The methods and underlying assumptions MMS uses to compare the revenues it collects in kind with what it would have collected in cash do not account for all costs and do not sufficiently deal with uncertainties, raising doubts about the claimed financial benefits of the royalty-in-kind program. Specifically, MMS’s calculation showing that MMS sold the royalty oil and gas for $74 million more than MMS would have received in cash payments did not appropriately account for uncertainty in estimates of cash payments. In addition, MMS’s calculation that early royalty-in-kind payments yielded $5 million in interest was based on assumptions about payment dates and interest rates that could misstate the estimated interest benefit. Finally, MMS’s calculation that the royalty-in-kind program cost about $8 million less to administer than an in-value program did not include significant costs that, if included, could change MMS’s conclusions. MMS sold the oil and gas it collected during the 3 fiscal years 2004 through 2006 for $8.15 billion and calculated that this amount exceeded what MMS would have received in cash royalties by about $74 million—a net benefit of approximately 0.9 percent. MMS has recognized that its estimates of what it would have received in cash payments are subject to some degree of error but has not appropriately evaluated or reported how sensitive the net benefit calculations are to this error. This is important because even a 1 percent error in the estimates of cash payments would change the estimated benefit of the royalty-in-kind program from $74 million to anywhere from a loss of $6 million to a benefit of $155 million. Moreover, MMS’s annual reports to the Congress present oil sales data in aggregate and therefore do not reflect the fact that, in many individual sales, MMS sold the oil it collected in kind for less than it estimates it would have collected in cash. Specifically, MMS estimates that, in fiscal year 2006, it sold 28 million barrels of oil, or 64 percent of all the oil it collected in kind, for less than it would have collected in cash. The government would have received an additional $6 million in revenue if it had taken these royalties in cash instead. These sales indicate that MMS has not always been able to achieve one of its central goals: to select, based on systematic economic analysis, which royalties to take in cash and which to take in kind in a way that maximizes revenues to the government. According to a senior MMS official, the federal government has several advantages when selling gas that it does not have when selling oil, a fact that helps to explain why MMS’s gas sales have performed better than its oil sales. For example, MMS can bundle the natural gas production in the Gulf of Mexico from many different leases into large volumes that MMS can use to negotiate discounts for transporting gas from production sites to market centers. Because purchasers receive these discounts when they buy gas from MMS, they may be willing to pay more for gas from MMS than from the original owners. Opportunities for bundling are less prevalent in the oil market. Because MMS generally does not have this, or other, advantages when selling oil, purchasers often pay MMS about what they would pay other producers for oil, and sometimes less. Indeed, MMS’s policies allow it to sell oil for up to 7.7 cents less per barrel than MMS estimates it would collect if it took the royalties in cash. MMS told us that the other financial benefits of the royalty-in-kind program, including interest payments and reduced administrative costs, justify selling oil for less than the estimated cash payments because once these additional revenues are factored in, the net benefit to the government is still positive. However, as discussed below, we have found that there are significant questions and uncertainties about the other financial benefits as well. Revenues from the sale of royalty-in-kind oil are due 10 days earlier than cash payments, and revenues from the sale of in-kind gas are due 5 days earlier. MMS calculates that the government earned about $5 million in interest from fiscal years 2004 through 2006 from these early payments that it would not have received had it taken royalties in cash. We found two weaknesses in the way MMS calculates this interest. First, the payment dates used to calculate the interest revenue have the potential to over- or underestimate its value. MMS calculates the interest on the basis of the time between the actual date that Treasury received a royalty-in- kind payment and the theoretical latest date that Treasury would have received a cash payment under the royalty-in-value program. However, MMS officials told us that cash payments can, and sometimes do, arrive before their due date. As a result, MMS might be overstating the value of the early royalty-in-kind payments. Second, the interest rate used to calculate the interest revenue may either over- or understate its value because the rate is not linked to any market rate. From fiscal year 2004 through 2007, MMS used a 3 percent interest rate to calculate the time value of these early payments. However, during this time, actual market interest rates at which the federal government borrowed fluctuated. For example, 4-week Treasury bill rates ranged from a low of 0.72 percent to a high of 5.18 percent during this same period. Therefore, during some fiscal years, MMS likely overstated or understated the value of these early payments. MMS has developed procedures to capture the administrative costs of the royalty-in-kind and cash royalty programs and includes in its administrative cost comparison primarily the variable costs for the federal offshore oil and gas activities—that is, costs that fluctuate based on the volume of oil or gas received by MMS, such as labor costs. Although MMS also includes some department-level fixed costs, it excludes some fixed costs that it does not incur on a predictable basis (largely information technology costs). According to MMS, if it included these IT and other such costs, there would be a high potential of skewing the unit price used to determine the administrative cost savings. However, by excluding such fixed costs from the administrative cost comparison, MMS is not including all the necessary cost information to evaluate the efficacy of the royalty-in- kind program. MMS’s administrative cost analysis compares a bundle of royalty-in-kind program administrative costs divided by the number of barrels of oil equivalent realized by the royalty-in-kind program during a year, with a bundle of cash royalty program administrative costs divided by the number of barrels of oil equivalent realized by that program. The difference between these amounts represents the difference in cost to administer a barrel of oil equivalent under each program. MMS then multiplies the difference in cost to administer a barrel of oil equivalent under the two programs by the number of barrels of oil equivalent realized by the royalty-in-kind program to determine the administrative cost savings. However, MMS’s calculations excluded some fixed costs that are not incurred on a regular or predictable basis from the analysis. For example, in fiscal year 2006, royalty-in-kind IT costs of $3.4 million were excluded from the comparison. Moreover, additional IT costs of approximately $29.4 million—some of which may have been incurred for either the royalty-in-kind or the cash royalty program—were also excluded. Including and assigning these IT costs to the programs supported by those costs would provide a more complete accounting of the respective costs of the royalty-in-kind and royalty-in-value programs, and would likely impact the results of MMS’s administrative cost analysis. Ultimately the system used by Interior to ensure taxpayers receive appropriate value for oil and gas produced from federal lands and waters is more of an honor system than we are comfortable with. Despite the heavy scrutiny that Interior has faced in its oversight of royalty management, we and others continue to identify persistent weaknesses in royalty collections. Given both the long-term fiscal challenges the government faces and the increased demand for the nation’s oil and gas resources, it is imperative that we have a royalty collection system going forward that can assure the American public that the government is receiving proper royalty payments. Our work on this issue is continuing along several avenues, including comparing the royalties taken in kind with the value of royalties taken in cash, assessing the rate of oil and gas development on federal lands, comparing the amount of money the U.S. government receives with what foreign countries receive for allowing companies to develop and produce oil and gas, and examining further the accuracy of MMS’s production and royalty data. We plan to make recommendations to address the weaknesses we identified in our final reports on these issues. We look forward to further work and to helping this subcommittee and the Congress as a whole to exercise oversight on this important issue. Mr. Chairman, this concludes our prepared statement. We would be pleased to respond to any questions that you or other members of the subcommittee may have at this time. For further information about this testimony, please contact either Frank Rusco, at 202-512-3841, or ruscof@gao.gov, or Jeanette Franzel, at 202-512- 9406, or franzelj@gao.gov. Contact points for our Congressional Relations and Public Affairs may be found on the last page of this statement. Contributors to this testimony include Ron Belak, Ben Bolitzer, Lisa Brownson, Melinda Cordero, Nancy Crothers, Glenn C. Fischer, Cindy Gilbert, Tom Hackney, Chase Huntley, Heather Hill, Barbara Kelly, Sandra Kerr, Paul Kinney, Jennifer Leone, Jon Ludwigson, Tim Minelli, Michelle Munn, G. Greg Peterson, Barbara Timmerman, and Mary Welch. This is a work of the U.S. government and is not subject to copyright protection in the United States. The published product may be reproduced and distributed in its entirety without further permission from GAO. 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Summary: Companies that develop and produce federal oil and gas resources do so under leases administered by the Department of the Interior (Interior). Interior's Bureau of Land Management (BLM) and Offshore Minerals Management (OMM) are responsible for overseeing oil and gas operations on federal leases. Companies are required to self- report their production volumes and other data to Interior's Minerals Management Service (MMS) and to pay royalties either "in value" (payments made in cash), or "in kind" (payments made in oil or gas). GAO's testimony will focus on whether (1) Interior has adequate assurance that it is receiving full compensation for oil and gas produced from federal lands and waters, (2) MMS's compliance efforts provide a check on industry's self-reported data, (3) MMS has reasonable assurance that it is collecting the right amounts of royalty-in-kind oil and gas, and (4) the benefits of the royalty-in-kind program that MMS has reported are reliable. This testimony is based on ongoing work. When this work is complete, we expect to make recommendations to address these and other findings. To address these issues GAO analyzed MMS data, reviewed MMS, and other agency policies and procedures, and interviewed officials at Interior. In commenting on a draft of this testimony, Interior provided GAO technical comments which were incorporated where appropriate. Interior lacks adequate assurance that it is receiving full compensation for oil and gas produced from federal lands and waters because Interior's Bureau of Land Management (BLM) and Offshore Minerals Management (OMM) are not fully conducting production inspections as required by law and agency policies and because MMS's financial management systems are inadequate and lack key internal controls. Officials at BLM told us that only 8 of the 23 field offices in five key states we sampled completed their required production inspections in fiscal year 2007. Similarly, officials at OMM told us that they completed about half of the required production inspections in calendar year 2007 in the Gulf of Mexico. In addition, MMS's financial management system lacks an automated process for routinely and systematically reconciling production data with royalty payments. MMS's compliance efforts do not consistently examine third-party source documents to verify whether self-reported industry royalty-in-value payment data are complete and accurate, putting full collection of royalties at risk. In 2001, to help meet its annual performance goals, MMS moved from conducting audits, which compare self-reported data against source documents, toward compliance reviews, which provide a more limited check of a company's self-reported data and do not include systematic comparison to source documentation. MMS could not tell us what percentage of its annual performance goal was achieved through audits as opposed to compliance reviews. Because the production verification processes MMS uses for royalty-in-kind gas are not as rigorous as those applied to royalty-in-kind oil, MMS cannot be certain it is collecting the gas royalties it is due. MMS compares companies' self-reported oil production data with pipeline meter data from OMM's oil verification system, which records oil volumes flowing through metering points. While analogous data are available from OMM's gas verification system, MMS has not chosen to use these third-party data to verify the company-reported production numbers. The financial benefits of the royalty-in-kind program are uncertain due to questions and uncertainties surrounding the underlying assumptions and methods MMS used to compare the revenues it collected in kind with what it would have collected in cash. Specifically, questions and uncertainties exist regarding MMS's methods to calculate the net revenues from in-kind oil and gas sales, interest payments, and administrative cost savings.