oversight

Federal Oil Valuation: Efforts to Revise Regulations and an Analysis of Royalties in Kind

Published by the Government Accountability Office on 1999-05-19.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                    United States General Accounting Office

GAO                 Testimony
                    Before the Subcommittee on Government Management,
                    Information, and Technology, Committee on Government
                    Reform, House of Representatives


For Release
on Delivery
Expected at
                    FEDERAL OIL VALUATION
2 p.m. EDT
Wednesday
May 19, 1999
                    Efforts to Revise
                    Regulations and an Analysis
                    of Royalties in Kind
                    Statement of Susan D. Kladiva,
                    Associate Director, Energy,
                    Resources, and Science Issues,
                    Resources, Community, and Economic
                    Development Division




GAO/T-RCED-99-152
Mr. Chairman and Members of the Subcommittee:

We are here today to testify on the valuation of federal oil. In fiscal year
1998, the Department of Interior’s Minerals Management Service (MMS)
collected $3.6 billion in royalties from oil and gas leases on federal lands.
States in which federal leases are located received a share of the royalties
collected. The value of these royalties depended upon the price of oil. As
an alternative to accepting cash royalty payments, the federal government
could have taken a percentage of the actual oil and gas produced and then
arranged for its sale, taking what are known as royalties in kind.

Historically, the value of much of the oil from federal leases has been
based on posted prices which are offers by purchasers to buy oil from a
specific area. However, recent evidence indicates that oil is now often sold
for more than the posted prices, suggesting that the value of the oil from
federal leases and the amount of federal royalties should both be higher.
On the basis of this evidence, in 1995 MMS began revising its oil valuation
regulations so that they rely less on posted prices and more on other, and
oftentimes, higher prices. These revised regulations are still pending.

Most of my statement will summarize the results of a report that we issued
in August 1998 on the Department of Interior’s attempts to revise the
federal oil valuation regulations and the feasibility of the government’s
taking its oil and gas royalties in kind.1 Specifically, I will discuss three
issues: (1) the information MMS used to justify the need for revising its
regulations; (2) how MMS addressed concerns expressed by the oil industry
and the states in developing these regulations; and (3) the feasibility of the
government’s taking its oil and gas royalties in kind, instead of in cash.

In summary, Mr. Chairman, MMS relied heavily on the findings of an
interagency task force to revise its oil valuation regulations. This task
force concluded that the major oil companies’ use of posted prices in
California to calculate federal royalties was inappropriate and
recommended that the federal oil valuation regulations be revised. MMS
also relied on contracted studies of oil markets and on valuation disputes
between the states and oil companies that the oil companies agreed to
settle for more than $1 billion. To address concerns of the oil industry and
the states, MMS solicited public comments on the proposed regulations in
seven Federal Register notices, held 17 public meetings, and revised its
regulations five times. Proposed changes to the regulations are still

1
 Federal Oil Valuation: Efforts to Revise Regulations and an Analysis of Royalties in Kind
(GAO/RCED-98-242, Aug. 19, 1998).



Page 1                                                                           GAO/T-RCED-99-152
             pending. Concerning the government’s taking of its royalties in kind, we
             concluded that this would not be feasible except under certain conditions.
             These conditions include having easy access to pipelines, leases that
             produce large volumes of oil and gas, competitive arrangements for
             processing gas, and expertise in marketing oil and gas. However, these
             conditions are currently lacking for the federal government and for most
             federal leases.


             In fiscal year 1998, MMS collected about $2.4 billion in royalties for gas sold
Background   from leases on federal lands and about $1.2 billion in royalties for oil sold
             from leases on federal lands. Oil and gas royalties are calculated as a
             percentage (usually 12-1/2 percent for onshore federal leases and
             16-2/3 percent for offshore federal leases) of the value of production less
             certain allowable adjustments (such as the cost of transporting oil to
             markets). The value of production is determined by multiplying the
             volume produced (which is measured in barrels of oil and in cubic feet of
             gas) by the sales price.

             MMS promulgated the oil valuation regulations that are currently in effect in
             1988. These regulations differentiate between oil sold “at arm’s length”
             and oil that is not sold at arm’s length. “At arm’s length” refers to oil that is
             bought and sold by parties with competing economic interests, and the
             price paid establishes a market value for the oil. However, roughly
             two-thirds of the oil from federal leases is not sold at arm’s length; it is
             exchanged between parties that do not have competing economic interests
             under terms that do not establish a price or market value. For example, oil
             companies that both produce and refine oil may transport the oil they
             produce to their own refineries. These oil companies may also exchange
             similar quantities of oil with other oil companies to physically place oil
             closer to their refineries and thereby reduce their costs of transporting it.

             The 1988 regulations define the price of oil sold in arm’s-length
             transactions, for the purpose of determining federal royalties, as all
             financial compensation accruing to the seller. This compensation, known
             as gross proceeds, includes the quoted sales price and any premiums the
             buyer receives. For other transactions (i.e., those not at arm’s length), the
             price of the oil is defined as the higher of either the gross proceeds or the
             amount arrived at by the first applicable valuation method from the
             following list of five alternatives: (1) the lessee’s posted or contract prices,
             (2) others’ posted prices, (3) others’ arm’s-length contract prices,




             Page 2                                                        GAO/T-RCED-99-152
(4) arm’s-length spot sales2 or other relevant matters, and (5) a netback3 or
any other reasonable method. The first two alternatives, and to a lesser
extent the third, can rely on posted prices in establishing value.

Under the revised oil valuation regulations that are currently proposed,
MMS would continue to require, for federal royalty purposes, that gross
proceeds be used to establish the price of oil sold in arm’s-length
transactions, except in certain circumstances involving multiple
exchanges or sales. For transactions that are not at arm’s length, however,
the proposed regulations substantially change the means for determining
the price of the oil, no longer relying on the use of posted prices and
instead relying on spot prices.

To determine federal royalties, the proposed regulations define the price
of oil not sold in arm’s-length transactions differently in each of three
domestic oil markets: (1) Alaska and California (including leases off the
shore of California); (2) the six Rocky Mountain states of Colorado,
Montana, North Dakota, South Dakota, Utah, and Wyoming; and (3) the
rest of the country, including the Gulf of Mexico.

In Alaska and California, the price of oil not sold in arm’s-length
transactions is defined in the proposed regulations as the Alaska North
Slope spot price, adjusted for the location of the lease and the quality of
the oil. In the six Rocky Mountain states, this price is proposed to be the
first applicable valuation method from the following list of four
alternatives: (1) the highest bid in an MMS-approved tendering program
(akin to an auction) conducted by the lessee; (2) the weighted average of
the lessee’s arm’s-length purchases and sales from the same oil field, when
they exceed 50 percent of the lessee’s purchases and sales in that specific
oil field; (3) the spot price for West Texas Intermediate crude oil at
Cushing, Oklahoma, (where several major oil pipelines intersect and
storage facilities exist) adjusted for the location of the lease and the
quality of the oil; or (4) a method established by the MMS Director. For the
rest of the country, the price of oil is defined by local spot prices, adjusted
for the location of the lease and the quality of the oil.

While oil and gas royalties are most often paid in cash, they may instead be
paid with a portion of the actual oil and gas that is produced—referred to


2
Under spot sales, the buyer and seller agree to the delivery of a specific quantity of oil in the following
month.
3
 A “netback” involves adjusting a price that is established for a sale occurring away from the lease site
to approximate a sales price that would have been paid at the lease, by taking deductions reflecting the
transportation costs and the quality of the oil sold.


Page 3                                                                             GAO/T-RCED-99-152
                      as paying royalties in kind. Paying royalties in kind rather than in cash
                      eliminates the need to determine the sales price of the production because
                      royalties in kind are calculated only on the basis of the volume of oil or gas
                      that is produced.


                      MMS’  decision to revise the oil valuation regulations relied on the findings
Information Used by   of an interagency task force that examined whether the use of posted
MMS to Justify        prices for the purpose of determining federal royalties in California was
Revised Regulations   appropriate. By 1991, the City of Long Beach, California, reached
                      agreement with six of seven major oil companies to accept $345 million to
                      settle a lawsuit it had filed years earlier. Although the lawsuit and
                      settlement included issues other than the valuation of oil, one of the major
                      issues was whether the companies’ use of posted prices represented the
                      market value of oil produced from leases owned by the city and the state.
                      After conducting a preliminary assessment of the implication of the
                      settlement for federal oil leases in California and consulting with state
                      officials, in June 1994 Interior assembled an interagency task force with
                      representatives from MMS, Interior’s Office of the Solicitor, the
                      departments of Commerce and Energy, and the Department of Justice’s
                      Antitrust Division. The purpose of the task force was to examine whether
                      the use of posted prices was appropriate for the purpose of determining
                      federal royalties in California. MMS also initiated audits of two of the seven
                      major oil companies that produced oil from federal leases in California.

                      The task force examined documents submitted by the companies in the
                      lawsuit, reviewed the results of MMS’ audits, and employed consultants to
                      analyze the market for oil in California. The market studies noted that the
                      seven major oil companies dominated the oil market in California by
                      controlling most of the facilities that produce, refine, and transport oil in
                      the state—that is, most of these transactions were not at arm’s
                      length—and that this domination in turn suppressed posted prices.
                      According to one of the studies, transactions involving Alaska North Slope
                      crude, an oil that is transported into the state by a company that does not
                      own any California refineries and that is actively traded at arm’s length,
                      commanded substantial premiums over California oil that was comparable
                      in quality. The task force concluded that the major oil companies in
                      California inappropriately calculated federal royalties on the basis of
                      posted prices, rather than include the premiums over posted prices that
                      they paid or received. The task force estimated that the companies should
                      have paid between $31 million and $856 million in additional royalties (the
                      wide range reflects the use of different methodologies and different



                      Page 4                                                       GAO/T-RCED-99-152
    treatments of accrued interest) to the federal government for the period
    1978 through 1993. In its final report issued in 1996, the task force
    recommended that MMS revise its oil valuation regulations to reduce
    reliance on the use of posted prices for valuing oil for royalty purposes.

    MMS also relied on additional studies, for which it had contracted, that
    examined oil pricing in other areas of the country. These studies provided
    MMS with information on how oil is exchanged, marketed, and sold, as well
    as information on the relevance of posted prices, spot markets, and NYMEX
    (New York Mercantile Exchange)4 futures prices in oil markets. The
    studies concluded that posted prices do not represent the market value of
    oil, citing situations in which oil is bought and sold at premiums above
    posted prices throughout the country. The studies cited the common
    practice of oil traders’ and purchasers’ quoting a posted price plus a
    premium, in what is known as the P-plus market, as additional evidence
    that posted prices are less than market value.

    In addition, various states supplied MMS with information on legal
    settlements they had reached with major oil companies concerning the
    undervaluation of oil from leases on state lands. In general, the states
    disputed the oil companies’ use of posted prices as the basis for
    determining royalties paid to the states. For example:

•   Alaska reported settling a lawsuit filed against three major oil companies
    for about $1 billion. These companies produced oil and transported it
    directly to their refineries, paying state royalties based on prices the
    companies had themselves calculated. The state contended that these
    transactions from 1977 through 1990 were not at arm’s length and that the
    calculated prices were less than the market value of the oil.
•   A major oil company agreed to pay Texas $17.5 million to settle allegations
    that from 1986 through 1995 it had paid royalties on prices for oil from
    state leases that were less than market value.
•   Louisiana reported it settled 10 disputes involving oil companies that
    owned their own refineries and paid state royalties on posted prices from
    1987 through 1998. These companies agreed to collectively pay about
    $6 million to settle these claims and to make future royalty payments
    based on average spot prices in the Louisiana oil market.
•   New Mexico reported two settlements with a major oil company that used
    its own posted prices as a basis for state royalties from 1985 through 1995.
    The company paid the state about $2 million.

    4
     Each NYMEX futures contract establishes a price for the future delivery of 1,000 barrels of sweet
    crude oil (similar in quality to West Texas Intermediate) at Cushing, Oklahoma.



    Page 5                                                                          GAO/T-RCED-99-152
                       From December 1995 through April 1999, MMS solicited public comments
How MMS Has            on its proposal to change the way oil from federal leases is valued for
Addressed Industry’s   royalty purposes in seven Federal Register notices and in 17 public
and States’ Concerns   meetings throughout the country, and it has revised the proposed
                       regulations five times in response to the comments received. Comments
                       submitted by states were often at odds with comments provided by the oil
                       industry. States generally support the proposed regulations because MMS
                       anticipates that royalty revenues—which are shared with the states—will
                       increase. MMS estimates that its proposed regulations will increase federal
                       royalties by $66 million annually. The oil industry generally opposes the
                       proposed regulations because they would increase oil companies’ royalty
                       payments and administrative burden.

                       In its first Federal Register notice, published in December 1995, MMS
                       announced that it was considering revising its oil valuation regulations
                       because it had acquired evidence indicating that posted prices no longer
                       represented market value. In response, representatives of the oil industry
                       generally commented that they opposed any changes to the current
                       regulations but that pending litigation prevented them from offering
                       specific comments on the issues identified by MMS. Several states
                       commented that they believed that posted prices no longer reflected
                       market value, provided evidence supporting their position, and
                       recommended that MMS adopt spot prices or NYMEX futures prices for
                       valuing oil from federal leases that was not sold at arm’s length.

                       MMS’ second Federal Register notice, published in January 1997, proposed
                       retaining the use of gross proceeds for valuing federal oil sold at arm’s
                       length-but reduced the number of oil companies that could use this
                       method by restricting its applicability to those companies that had not sold
                       oil in the past 2 years. It also eliminated the use of posted prices for oil not
                       sold at arm’s length. For these sales, MMS proposed that the value of oil
                       from federal leases in Alaska and California would be based on Alaska
                       North Slope spot prices and that the value of oil from other federal leases
                       would be based on NYMEX futures prices. Both the Alaska North Slope and
                       NYMEX prices would be adjusted for differences in the location of the leases
                       and the quality of the oil.

                       In its third through seventh Federal Register notices, published from July
                       1997 through March 1999, MMS responded to comments and modified its
                       regulations in response to these comments. For example, in response
                       primarily to the oil industry’s comments, MMS eliminated the use of NYMEX
                       for establishing the value of oil not sold at arm’s length, proposed a



                       Page 6                                                        GAO/T-RCED-99-152
                   separate system for valuing oil not sold at arm’s length in the Rocky
                   Mountain states, and modified the definition of “affiliate.” In response
                   primarily to the states’ comments, MMS proposed the use of spot prices in
                   valuing oil not sold at arms’ length and proposed certain price adjustments
                   for location and quality. As suggested by the oil industry and the states,
                   MMS also deleted a proposed 2-year limitation on the use of a valuation
                   methodology relying on gross proceeds. When MMS disagreed with a
                   comment received, the agency provided reasons for not revising the
                   proposed regulations as suggested. For example, MMS disagreed with and
                   dismissed the oil industry’s suggestion to initiate a royalty-in-kind program
                   as an alternative to the proposed regulations, stating that the agency
                   would seek input on this issue through other avenues.


                   Although most oil and gas lessors take their royalties in cash, several
Feasibility of a   limited programs exist in the United States and Canada under which
Royalty-In-Kind    lessors accept their royalties in kind. Oil royalty-in-kind programs are
Program            currently operated by MMS,5 the Canadian Province of Alberta, the City of
                   Long Beach, the University of Texas, and the states of Alaska, California,
                   and Texas. Gas royalty-in-kind programs are also currently operated by
                   Texas and the University of Texas. According to information from studies
                   and the programs themselves, royalty-in-kind programs are feasible if
                   certain conditions are present. In particular, the programs are workable if
                   the lessors have (1) relatively easy access to pipelines to transport the oil
                   or gas to market centers or refineries, (2) leases that produce relatively
                   large volumes of oil or gas, (3) competitive arrangements for processing
                   gas, and (4) expertise in marketing oil or gas. However, these conditions
                   do not exist for the federal government or for most federal leases.

                   Several of the entities operating royalty-in-kind programs told us that
                   having relative ease of access to pipelines is a key component of their
                   programs because it assures them that they can transport oil and gas to
                   where they need it at a relatively low cost. However, the federal
                   government does not currently have the statutory or regulatory authority
                   over pipelines that would ensure relative ease of access for transporting
                   oil and gas from federal leases. In addition, some pipelines are privately
                   owned and the owners are free to set their own transportation fees. In
                   some areas of the country, oil from federal leases can be transported on
                   just a single pipeline, and the owner of that pipeline may charge
                   substantial fees. Oil and gas marketers we contacted confirmed that the

                   5
                    The purpose of MMS’ royalty-in-kind program is to supply oil to small refineries that may otherwise
                   not be able to obtain oil at competitive prices.



                   Page 7                                                                          GAO/T-RCED-99-152
           federal government would need to transport any royalty-in-kind
           production it received to market centers or refineries in order to increase
           its revenues.

           To be cost-effective, royalty-in-kind programs must have volumes of oil
           and gas that are high enough for the revenues made from selling these
           volumes to exceed the programs’ administrative costs. The majority of oil
           and gas leases on federal lands, however, produce relatively small volumes
           and are geographically scattered—particularly federal leases located in the
           western states. For example, MMS estimates that about 65 percent of the
           wells on federal oil leases in Wyoming produce less than 6 barrels of oil
           daily, which would result in less than 1 barrel per day in oil royalties in
           kind. Most federal leases in the San Juan Basin of New Mexico also
           produce low volumes.

           Because natural gas may need to be processed before it can be sold,
           arranging for processing is a critical consideration in operating a gas
           royalty-in-kind program. Many federal leases produce small volumes of gas
           that need to be processed. In certain areas, there is only a single plant to
           process the gas from many of these leases. In these circumstances, the
           lack of competition might allow the plants to charge high fees. For
           example, MMS estimates that the federal government could lose up to
           $4.3 million annually if the agency accepted royalties in kind from federal
           leases in Wyoming for which there is access to only a single gas-processing
           plant.

           Lessors who accept royalties in kind must sell the oil or gas to realize
           revenues, and they are likely to receive higher prices if they move it away
           from the lease and closer to marketing centers or refineries. Storing,
           transporting, marketing, and selling oil or gas can be complicated
           processes. Profit margins are often thin, and there may be little room for
           error. The nonfederal royalty-in-kind programs have generally been in
           existence for years, and the entities running these programs have gained
           both experience and expertise. In contrast, the federal government has
           limited experience in marketing oil or gas royalties in kind.


           Mr. Chairman, this concludes our prepared statement. We will be pleased
           to respond to any questions that you or Members of the Subcommittee
           may have.




(141323)   Page 8                                                     GAO/T-RCED-99-152
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